tag:blogger.com,1999:blog-1228600871357307162024-03-16T00:08:19.484-07:00Richard H. SerlinEconomics, Finance, Personal Finance, Politics, and Other Subjects with a Focus on Intuition, Clarity, and Non-MisleadingRichard H. Serlinhttp://www.blogger.com/profile/09824966626830758801noreply@blogger.comBlogger165110tag:blogger.com,1999:blog-122860087135730716.post-79331394282042490652016-09-18T19:51:00.002-07:002016-12-15T19:43:11.646-08:00AI and Krugman's Hot Dogs<div class="MsoNormalCxSpMiddle">
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Yes, I know, I missed a great clickbait headline
opportunity… But as Wayne Campbell would say, I'm not worthy!</div>
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<o:p></o:p></div>
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Anyway, I've been studying the issue of potential
revolution in artificial intelligence and robotics extensively for the last few
years. I've read thousands of pages, including most of the recent <a href="http://www.oxfordmartin.ox.ac.uk/downloads/academic/The_Future_of_Employment.pdf">major</a>
<a href="http://www.oecd-ilibrary.org/social-issues-migration-health/the-risk-of-automation-for-jobs-in-oecd-countries_5jlz9h56dvq7-en">economics</a>
<a href="http://jeffsachs.org/2016/06/the-best-of-times-the-worst-of-times-macroeconomics-of-robots/">papers</a>,
and <a href="https://www.amazon.com/Second-Machine-Age-Prosperity-Technologies/dp/0393350649/ref=sr_1_1?s=books&ie=UTF8&qid=1473489785&sr=1-1">general</a>
<a href="https://www.amazon.com/Rise-Robots-Technology-Threat-Jobless/dp/0465097537/ref=pd_sim_14_1?ie=UTF8&psc=1&refRID=829Q7Z1BG6FA3XZQSVCY">public</a>
<a href="https://www.amazon.com/Industries-Future-Alec-Ross/dp/1476753652/ref=pd_sim_14_6?ie=UTF8&psc=1&refRID=829Q7Z1BG6FA3XZQSVCY">books</a>
(<a href="https://www.amazon.com/Future-Professions-Technology-Transform-Experts/dp/0198713398/ref=pd_sim_14_8?ie=UTF8&psc=1&refRID=829Q7Z1BG6FA3XZQSVCY">this
one just ordered</a>). And I'm actually doing a good deal of learning about
artificial intelligence, itself, as in <a href="https://www.amazon.com/gp/product/1107057132/ref=oh_aui_detailpage_o03_s00?ie=UTF8&psc=1">studying</a>
<a href="https://www.amazon.com/Machine-Learning-Optimization-Perspective-Developers/dp/0128015225/ref=sr_1_1?s=books&ie=UTF8&qid=1473487761&sr=1-1&keywords=machine+learning+bayesian">textbooks</a>.<o:p></o:p></div>
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Note to economists: You'll actually be very
comfortable with much, or all, of AI. One of the five major types of machine
learning (which basically is AI) is statistical modeling, especially Bayesian
Monte Carlo. And all five, which can be powerfully combined, involve very
advanced mathematics. And the goal of the ML is always maximizing a utility
function! (or equivalently, minimizing a loss function) <o:p></o:p></div>
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So ML will be, in fundamental ways, very familiar
and comfortable to an economist. But there are some important differences. It's
not perfect optimization or bust (or no pub). You recognize that's usually not
realistic. You just try to get the highest utility score you can, even if, as
is usual, you don't know if that's the global optimum. And you don't just assume a
local optimum is the global optimum.<o:p></o:p></div>
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I think there's a lot economists can learn from ML
scientists, but there's also, I think, a lot ML scientists can learn from
economists. For example, with evolutionary algorithms (one of the five ML
methods), algorithms compete to be the highest scoring on the utility function,
and they mutate to evolve, and can even reproduce sexually! where the features
of two algorithms are spliced and combined. In the explanations of this I've
seen, and it's benefits and costs, I have not seen something that occurred to
me quickly from financial economics. <o:p></o:p></div>
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With options, you place much greater value on
assets that have a high variance, all other things equal. As the upside
benefits you far more than the downside costs you. Likewise, consider sexual reproduction. Suppose one species has good members, but not great ones; there's
little variation, but they always reproduce for a good, but not great, average.
Now, suppose another species is poor on average, and has some members which <i>overall</i> are not very good, <i>but</i> they do have <i>some</i> great feature, or features. That second species will evolve to take over the
first with sexual reproduction, because eventually it will produce offspring
which have the best of the greatest members all spliced together in some
offspring. Those offspring, even if initially rare, will then eventually take over because
they will be so super-fit, and become the bulk of the future populations. So,
the lesson is that sexual reproduction of algorithms will be more likely to
have benefits that outweigh the computational costs, the greater the variability (and it might be very beneficial to look for ways to juice up the variability.)<br />
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Note, in the natural world at least, there are complications, as genes proliferate in future populations, or not, in a tribe, so the success of a whole tribe is an important factor. And a tribe's success depends on some specialization and variety of members. Also, note that in the natural world, especially, sexual reproduction is extremely costly, yet it has nonetheless evolved to be in every organism beyond the most simple, so the logic for it is very powerful.<br />
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This whole thing does give you an idea of the interdisciplinary nature of artificial intelligence, and how the field could benefit from learning from, and collaboration with, other fields -- and vice versa.</div>
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The AI field is fascinating, and I have gained many
insights already. I will eventually have a long blog post/article on all of
this, but given the size of this issue, it's best not to wait, and get down
some insights and ideas along the way. This is both to help my thinking and
understanding, and hopefully to provide some. <o:p></o:p></div>
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So, without further ado, let's get to today's
topics. <o:p></o:p></div>
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<b><u>Krugman's
Hot Dogs<o:p></o:p></u></b></div>
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The blog of The Bank of England, Britain's central
bank, recently had a sanguine <a href="https://bankunderground.co.uk/2016/09/06/robot-macroeconomics-what-can-theory-and-several-centuries-of-economic-history-teach-us/">post</a>
on the whole robots/AI's issue. The author, B of E economist John Lewis, uses Nobel
Prize winning economist Paul Krugman's <a href="http://web.mit.edu/krugman/www/hotdog.html">hot dog mini-model</a> as a
justification for his optimism:</div>
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Technology can lead to workers being
displaced in one particular industry, but this doesn’t hold for the economy as
a whole. In Krugman’s celebrated
example, imagine there are two goods, sausages and bread rolls, which are then
combined one for one to make hot dogs.
120 million workers are divided equally between the two industries: 60 million producing sausages, the other 60
million producing rolls, and both taking two days to produce one unit of
output. Now suppose technology doubles
productivity in bakeries. Fewer workers
are required to make rolls, but this increased productivity will mean that
consumers get 33% more hot dogs.
Eventually the economy has 40 million workers making rolls, and 80
million making sausages.</blockquote>
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The problem, however, is this: Substitute roll
makers and sausage makers with low-skilled workers and high-skilled workers.
Suppose the economy starts at 4 billion low-skilled workers and 400 million
high-skilled workers, and produces $80 trillion/year in goods and services. <o:p></o:p></div>
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Now suppose that advances in AI and robotics
result in there being, for the purposes of producing pecuniary goods and
services, 12 billion low-skilled workers, but only 500 million high-skilled
workers. With the old production processes, you had a ratio of 1 high-skilled
worker to 10 low-skilled workers. Keeping these processes, you would need just
5 billion low-skilled workers, not the 12 billion you now have, with the influx
from Robotia and the AI Republic. So what happens to the other 7 billion low-skilled
workers, machine and human?<o:p></o:p></div>
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Well, you could go to other production processes
that use less high-skilled workers to low-skilled workers, again, where
low-skilled workers now include the machine kind. But the problem may be, and I
think is, in the real world, that production processes that have a low
proportion of high-skilled workers produce a lot less per worker. And if they
produce a lot less per worker then it does not make sense in the market to do
them, <i>unless</i> they cost a lot less per worker. Thus,
real cost per worker must drop. <o:p></o:p></div>
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Now, the high-skilled workers can be utilized for
the old high-skilled production process, so the market must pay them at least
that old wage. But now to get businesses in the free market to employ a very
heavy low-skilled production process, they will only do it if the wage of the
low-skilled workers drops, and maybe very dramatically, perhaps to poverty
level – or below. And a human subsistence wage need not be a floor, as the
subsistence wage for a machine may be well below that, with the cheap solar
power of the future. And, with how smart and advanced these machines may become,
they may have very low maintenance costs. They may mostly maintain themselves,
and each other. <o:p></o:p></div>
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Essentially, the problem is, what if the roll
makers don't have the skills to make the sausages. Then, you can't just shift
to this new higher production economy with more hot dogs produced, but with a
lower proportion of roll workers and a higher proportion of sausage workers. So
what do you do? You train roll makers to now make sausages? What if sausage
making requires far more education and skill? This may be very costly, and the
benefit may be mostly hard to recoup for the payer of this education and
training. Meanwhile, governments may be unwilling or unable to pay, especially
with the horrifying power of the billionaire funded right, and its government
always bad, always a waste, propaganda machine. <o:p></o:p></div>
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And aside from that, many workers may be too old
to practically learn advanced new skills. And if even a fifth of the population
do not have the cognitive and other abilities necessary to learn high-skilled
sausage making, then do you have a fifth of the population permanently
unemployed if the new robots can do any and all of the roll making at
less than a human subsistence wage? <o:p></o:p></div>
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So, what then? If you can't just shift enough
workers into the high-skilled sausage making, what do you do? <o:p></o:p></div>
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You use a different production process? This may
be a lot less productive. You end up with three rolls per sausage. It generates
a lot less GDP per worker. It won't be done unless the roll workers' wages go down.<br />
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But the sausage workers' wages won't go down; if they did, they would be hired
away into old style 1-1 facilities, but even moreso, with rolls very cheap now,
sausages will command relatively more money (the price of their complement, some would say necessary complement, has gone down). And, if sausages command more money, then so also will the relatively
rare sausage makers, all other things equal.<br />
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So, the sausage makers' wages go up, but the roll workers' wages will have to go down – and as far
as it takes, to employ even the least productive of the roll workers, if they aren't to
be unemployed. And this is just the strong trend <a href="http://richardhserlin.blogspot.com/2015/11/robotai-revolution-decimating.html">we've
seen over the last two generations</a> for low-skilled workers.<o:p></o:p></div>
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Now, the B of E blog post author Lewis does
concede, "In the interim, the transition might lead to unemployment,
particularly if skills are very specific to the baking industry. But in the
long run, a change in relative productivity reallocates rather than destroys
employment"<o:p></o:p></div>
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But think about what that could mean here if
robots become able to do almost anything that a low-skilled human could do,
only at a cost below human subsistence. You would have to "in the long
run" give almost every low-skilled human a college education, and not a
Potemkin college education, but the academic and cognitive skills of the
typical graduate of a well-respected major university, like my employer, the
University of Arizona. <o:p></o:p></div>
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This may be a very, very long run, with massive, or
catastrophic, poverty, unemployment, and homelessness in the interim. And the
public will have to dramatically change their attitude about the size and value
of government, because the private sector won't come close to funding this,
given the severe free market problems with education. There's good reason government
funds the vast majority of education in every first world country.<o:p></o:p></div>
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The key intuition here is if you just add a ton of
low-skilled workers, including low-skilled workers from the countries of Robotia and the AI Republic, without high-skilled workers, or with proportionally way
less high-skilled workers, then you're going to lower the marginal product and average product of low-skilled workers greatly, and thus their market wage. <o:p></o:p></div>
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You could say, like Clouseau, problem sol-ved,
just have low-skilled workers become high-skilled workers, like the roll makers
in Krugman's model just becoming sausage makers. But that is one incredible
endeavor to suddenly massively increase the world's, or any country's,
education level. I would love to do so, and would certainly vote to
invest in it, but as I said in a <a href="http://richardhserlin.blogspot.com/2015/11/robotai-revolution-decimating.html">recent
post</a>:</div>
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How are we supposed to get the vast majority of
men, and women, up to this level of skill and education?</div>
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To do so would take a regime shift in our
politics, and in public understanding of economics. By and large, one of our
two major parties not only does not believe in global warming, or evolution for
that matter, they don't believe in externalities, asymmetric information,
natural monopoly, contracting limitations and costs, and basically anything
that says the pure free market is imperfect (except in cases where it benefits
the rich). But providing a massive increase in the education, skills, and
general capabilities for most of the population is something that free market
companies could only extract a small fraction of the benefits from in profits.
And therefore they alone would grossly underprovide this. </div>
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The externalities, contracting and enforcement
problems and costs, adverse selection and other asymmetric information, and so
on, are profound and enormous. This is why general education has historically
been predominantly publicly funded. To say that now, so that most of the
population won't go the way of horses, we have to enormously increase our
investment in Heckman-style early human development, education, public
nutrition, healthcare, and more, from prenatal until at least well into a
person's 20's, is to say that we should have an unprecedented increase in
governments' size and roles. </div>
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Right now, this is impossible, as the Republican
party is dogmatically against any government, except for a small number of
areas; mainly military, police, courts, prisons, and perhaps minimal public
infrastructure and education.</div>
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A <a href="http://www.oecd-ilibrary.org/docserver/download/5jlz9h56dvq7.pdf?expires=1474190611&id=id&accname=guest&checksum=0A558E9CFBF5A738CC0411534A3F5A86">recent
OECD paper</a> put it dryly, but seriously, "If the tasks that complement
machines become increasingly complex and demanding, the employment prospects
for workers lacking certain skills may deteriorate." (page 23)<o:p></o:p></div>
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<b><u>Are robots and AI like shipping containerization?</u></b></div>
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Lewis gives the example of the revolution in shipping
containerization, which plummeted the workers needed per ton to transport goods, yet workers were redeployed, and the amount of shipping increased dramatically to counter:<br />
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Take the humble <a href="http://www.nytimes.com/2006/03/23/business/23scene.html?_r=0">shipping container</a>. Transporting goods in pre-packed locked
containers, which can be lifted straight onto a lorry or train, yielded
enormous savings relative to having cargo transported in crates which needed
loading and packing individually at each port.
<a href="https://en.wikipedia.org/wiki/Malcom_McLean">Their inventor estimated</a> that the combined savings on labour costs, time
at the dockside and insurance for breakage and theft reduced the price of a
tonne of cargo 39-fold. <a href="http://www.sciencedirect.com/science/article/pii/S0022199615001403">Bernhofen et al</a>
calculate this led to an eight fold increase in bilateral trade between
countries with container ports. Whilst employment fell, productivity of labour
increased nearly 20 fold. For the shipping industry this wasn’t a massively
disruptive technology- though <a href="https://wweb.uta.edu/insyopma/prater/Eurofood%20Case%20Info%20and%20Articles/Ocean%20Container%20Shipping.pdf">trade patterns changed, the industry became moreconcentrated and ironically less profitable.</a> </blockquote>
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But by reducing the cost of trading,
containerisation opened up the possibility of new supply chains and trading arrangements
that were previously too expensive to undertake. And, inso doing, the resultant
trade flows led to a substantial spatial reallocation of economic activity.</blockquote>
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A point I'd like to make here is that with the kinds of robots, machines,
and AI's we may see in the future, it won't be just a clever idea that
eliminates many specific jobs in a specific business, so demand increases in
other businesses and workers move there, or to different jobs in the same
business. It will instead be whole classes of work eliminated. A whole class
of work, or a whole class of skill or ability, say dexterous movement and
sorting with good visual recognition, will be eliminated from pretty much <i>every</i> business, <i>every</i> industry, in the
entire economy – permanently – as happened to horses.</div>
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It's <i>whole
skills</i> that will be eliminated from employment by these new robots and
AI's, across every business, not some specific jobs that will be eliminated in
a specific business, so I'll take my skillset elsewhere. Your skillset may no
longer be needed anywhere. It may be replaced everywhere, or replaced in 90% of
businesses.<o:p></o:p></div>
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And again, there are problems with, well, then
production will just increase 10-fold to sop up all those low-skilled workers.
There are serious bottlenecks in high-skilled workers and raw materials,
and there are inelasticities of demand, at least for certain types of products.</div>
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<b><u>Is
increasing GDP share of capital the only distributional concern, or even the biggest? <o:p></o:p></u></b></div>
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This is the issue you always hear, and the one
Lewis discusses (and downplays). But you rarely hear a similar issue that's
perhaps more important, and I think is probably far more important in the short
and medium run: It’s not just that robots and other AI's may increase the share
of the pie going to capital owners. It's that they could cause massive
increases in inequality in how the labor share is distributed among laborers. <o:p></o:p></div>
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These technologies can send <a href="http://www.nytimes.com/2014/02/23/business/winners-take-all-but-cant-we-still-dream.html">the superstar, or winner-take-all, phenomena</a> to the moon. Moreover, an increasing share of
workers, due to revolutionary advance in these technologies, may find that the
wage the market will pay for their education, skills and other characteristics
drops below minimum wage. Or well below, for those who think cutting the
minimum wage is the answer.<o:p></o:p></div>
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What happens if these robots and AI's make it so
that 10% of the population is basically unemployable at a wage above minimum?
then 20%, 30%,… Suppose at a grocery store cameras watch everything shoppers
put in their carts, and know what it is; the cart is mechanized and follows
you, the cameras also recognize your face and have your payment info on file,
so no need for any workers at checkout other than a security guard. Dexterous
robots can do the vast majority of stocking and unloading,… We are not far from
this now, and going the rest of the way looks not that hard in the next 30
years, from what I've learned of this technology. <o:p></o:p></div>
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Then, about 90% of the grocery store jobs are
gone. Where are those 90% going to be redeployed? They're low-skilled laborers,
where they can be redeployed are similar places where robots can also do those
kinds of manual jobs; fast food, manufacturing, waiting tables,… And, as we've
seen, no, people are not willing to pay much more, in money and time, for the
human touch, to be able to chat with the checker, or teller, or waiter. They'd
rather have more badly needed time and money to spend with their own families
and friends.<o:p></o:p></div>
</div>
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<br /></div>
</div>
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<div style="text-align: justify;">
You could say, ok, the economy would expand to
have just 10 times the production then, but you hit the bottleneck of lack of
high-skilled laborers to do this that I talked about earlier. In addition, you
hit a lot of inelasticities of demand; people aren't going to just buy 10 times as many groceries, so we need 10 times as many grocery stores. Those who do still have jobs and money
can only eat so much (the wealthy with money, I would think, would tend to buy high prestige items that require a high proportion of highly skilled labor to produce). And costly raw materials can also become bottlenecks.<br />
<o:p></o:p></div>
</div>
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<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle">
<div style="text-align: justify;">
So, this is not so easy to dismiss with, in the
past,… We actually did have to increase educational levels and skills to
prevent mass unemployment with past technological advance. But, (1) Government
rose to the challenge. We didn't have such a dominant and billionaire powered,
government always bad, pure free market always good, right wing. And, (2) The
societal level of education and skill necessary with the kinds of robots and
AI's we're probably going to see will be very high indeed. It will take an
incredible increase in human capital investment, from prenatal to college and
beyond. <o:p></o:p></div>
</div>
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<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle">
<div style="text-align: justify;">
<b><u>A simple
test of the veracity, or completeness, of normal-employment robot/AI arguments<o:p></o:p></u></b></div>
</div>
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<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle">
<div style="text-align: justify;">
Finally, I'd like to note a key problem with
Lewis's post. His argument applies to <i>any</i>
technology. There's no discussion of the specific technology here, AI and
robotics, at least as far as what it's capable of. What the technology is, and how capable it
is, or may become, is irrelevant to his arguments. These arguments are supposed to work for <i>any</i> technology, so no need to consider
how good this technology might realistically get, what it might be capable of
doing. That doesn't matter; his arguments will always apply. It wouldn't matter how good engine and motor technology got, we would always find alternative uses for horses, product prices would drop, production would expand,... Except these arguments didn't work for horses.<o:p></o:p></div>
</div>
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<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle">
<div style="text-align: justify;">
And with humans, and specifically low-skilled humans, you have the same technology irrelevance in Lewis's arguments. Even if robots and AI become capable, over
the next generation, of doing <i>any</i>
pecuniary work at all that a low-skilled human can do, at less than a human subsistence
wage, this will still not be a problem for low-skilled humans "over the long
run", where presumably "the long run" will not be long enough to
ruin, or end, their lives.<br />
<br />
At least explicitly and clearly, Lewis does not discuss how the long run could be generations, and it may be extremely hard to reach this long run. <o:p></o:p>Nobel Prize winning economist Jan Tinbergen talked about <a href="http://economics.mit.edu/files/7490">"a race between education and technology"</a> to prevent massive unemployment and/or income inequality. It is possible, depending on the technological advance, and
the resources put into education, that technology can run far ahead for a very
long time, even that education could never catch up for a potential
super-technology like AI. I discuss this in a <a href="http://carolabinder.blogspot.com/2014/03/guess-post-second-machine-age-book.html">guest
post</a> at the blog of Haverford College economist and Roosevelt Institute fellow Carola Binder.<br />
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</div>
</div>
<div class="MsoNormalCxSpMiddle">
<div style="text-align: justify;">
So, I'd like
to offer a rule. Any time someone offers an argument that robots and AI cannot
cause a massive unemployment/poverty problem, if those arguments do not
consider how good the technology may, with significant probability, get, then those arguments have a fatal
flaw, or are at least significantly incomplete.<o:p></o:p></div>
</div>
Richard H. Serlinhttp://www.blogger.com/profile/09824966626830758801noreply@blogger.com3tag:blogger.com,1999:blog-122860087135730716.post-30231173538225247302016-04-03T17:05:00.000-07:002016-04-21T19:26:04.818-07:00AI Veracity Programs, and My Dream for the 2020's and 2030's Trumps<div class="MsoNormalCxSpMiddle">
<b><br /></b>
<b>The Trump
of the 2020's in a CNN interview (adapted from <a href="http://www.motherjones.com/kevin-drum/2016/03/no-america-not-poor-country">interviews</a>
of the current Trump. All facts noted are <a href="https://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal)_per_capita">for</a>
<a href="https://en.wikipedia.org/wiki/List_of_countries_by_financial_assets_per_capita">today</a>):</b></div>
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<br /></div>
</div>
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<br /></div>
</div>
</div>
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<div style="text-align: left;">
<b>Trump:</b> NATO
was set up at a different time. NATO was set up when we were a richer country.
We’re not a rich country. We’re borrowing, we’re borrowing all of this money.<o:p></o:p></div>
</div>
</div>
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<br /></div>
</div>
</div>
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<div style="text-align: left;">
<b>Interviewer:</b>
[Picks up cell phone/supercomputer] Siri, how does the US's wealth per capita
rank? <b>Siri:</b> The United States ranks
number two in the world in per capita net financial assets. Number one is
Switzerland, but this is a country with less than 10 million in population.
Source: The OECD. <b>Interviewer:</b> Mr.
Trump, how can you say then that the US is no longer a rich country?</div>
</div>
</div>
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<div style="text-align: justify;">
<div style="text-align: left;">
…</div>
</div>
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<br /></div>
</div>
</div>
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<div style="text-align: left;">
<b>Trump:</b> That’s
[South Korea] a wealthy country. They make the ships, they make the
televisions, they make the air conditioning. They make tremendous amounts of
products.... I think that we are not in the position that we used to be. I
think we were a very powerful, very wealthy country. And we’re a poor country
now. We’re a debtor nation.<o:p></o:p></div>
</div>
</div>
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<div style="text-align: left;">
<br /></div>
</div>
</div>
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<div style="text-align: left;">
<b>Interviewer:</b>
[turns to his cell phone] Siri, how does the US compare to South Korea in
wealth and GDP per capita? <b>Siri:</b> The
United States has 5.74 times the per capita net financial assets of South
Korea. It has 2.03 times the GDP per capita. Sources: The OECD and The World Bank. <b>Interviewer:</b> How can you say, then, Mr.
Trump, that the US is a poor country and South Korea is a wealthy one?<o:p></o:p></div>
</div>
</div>
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<div style="text-align: justify;">
<div style="text-align: left;">
…</div>
</div>
</div>
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<o:p></o:p></div>
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<div style="text-align: left;">
<br /></div>
</div>
</div>
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<div style="text-align: justify;">
<div style="text-align: left;">
<a href="http://www.motherjones.com/kevin-drum/2016/03/yes-press-bears-some-blame-donald-trump">I've
said before</a> journalists should work in pairs in interviews, debates, etc., with
an interviewer and a data person with a computer. The interviewer asks
questions, and the data person, hopefully someone very expert, checks any
facts and information in real time, and if there's a discrepancy he immediately
brings this up in the interview. The reply can be, this is expensive and cumbersome,
(although ridiculously worth it to society). But as Siri and Watson advance,
this will be no excuse at all. How much do journalists, and the organizations
they work for, really care about doing their jobs?<o:p></o:p></div>
</div>
</div>
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<br /></div>
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<br /></div>
</div>
</div>
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<b>The 2030's
Trump<o:p></o:p></b></div>
</div>
</div>
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<div style="text-align: left;">
<br /></div>
</div>
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<div style="text-align: left;">
In the 2030's, AI may advance to the point where
people will commonly have very good, as I will call them, veracity apps, installed on their
computing devices. So, when the 2030's Trump is interviewed, or in a debate,
and he says something like, "South Korea is a rich country. We're a poor
country now.", you will see red bars on your screen indicating the level
of untruth, and scrolling across the bottom of the screen will be a comparison
of the net worth's and GDP's per capita of both countries, and the sources of
those figures.</div>
</div>
<div style="text-align: justify;">
<div style="text-align: left;">
<br /></div>
</div>
<div style="text-align: justify;">
<div style="text-align: left;">
Moreover, with a stream, as opposed to an old fashioned airwaves TV presentation, you can pause it anytime. So you can click to read, or hear, or view, the explanation for why the veracity AI just gave the politician four red bars. And then you can click, or say, continue, when you're done, and keep going with the interview. At the end, if you'd like, you can read, hear, view, a fact and source filled report from the veracity AI on all of its claimed untruths in that event.</div>
</div>
<div style="text-align: justify;">
<div style="text-align: left;">
<br /></div>
</div>
<div style="text-align: justify;">
<div style="text-align: left;">
And the journalist doing the questioning may be wearing glasses, or contact lenses, with a projected, or "heads up", view of information coming from the veracity app, so he can follow-up question on any untruths or misleading right away, in real time, and get a response.</div>
</div>
</div>
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<div style="text-align: left;">
<br /></div>
</div>
</div>
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<div style="text-align: left;">
If you follow my blog, you'll see that I have been
studying AI extensively, reading a great number of books and articles, some very
technical, from a wide variety of sources. I would say from this study that in
the 2030's there is a very substantial chance that veracity AI's will be quite
good, and quite common. Just look at how good Watson and Siri are already, and
how fast they're improving. <o:p></o:p></div>
</div>
</div>
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<div style="text-align: left;">
<br /></div>
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<div style="text-align: justify;">
<div style="text-align: left;">
When in real time people see the lies, <i>or misleading</i>, of politicians in questioning, interviews, debates, their TV commercials, anywhere, with exact contradicting
facts and figures from standard respected sources, this will revolutionize
politics. The kinds and amounts of propaganda we see today will be considered from a past
dark age. It will be an amazing leap forward. <o:p></o:p></div>
</div>
</div>
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<div style="text-align: left;">
<br /></div>
</div>
</div>
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<div style="text-align: justify;">
<div style="text-align: left;">
And there will be, surely, a variety of these
veracity AI programs from a number of respected sources, like the google of the
day, the Apple of the day, etc., with reputations worth many billions of dollars to
protect, for accuracy, objectivity, competence, and trustworthiness. And there
will also be open source versions. And meta versions, where the meta veracity AI
checks a number of respected veracity AI's and gives a composite of them, and
notes if any of those veracity AI's give a very different answer, as a check
for one of the veracity AI's becoming biased or compromised.<o:p></o:p></div>
</div>
</div>
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<div style="text-align: left;">
<br /></div>
</div>
</div>
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<div style="text-align: justify;">
<div style="text-align: left;">
And these veracity AI's will not be just for
politics. Many, if not the great majority of people, won't choose a dentist, or
doctor, or mechanic, or plumber unless his equipment is compatible with their
veracity AI, sending all of the information from the equipment's readings; the
dental x-rays, the blood test results, the video images from the plumber's
endoscope, and so on, to your veracity AI service in the cloud. <o:p></o:p></div>
</div>
</div>
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<div style="text-align: left;">
<br /></div>
</div>
</div>
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<div style="text-align: left;">
If the dentist says you need major dental work
that it looks like you clearly don't, the red bars will go up. If he says you
need all of your silver fillings replaced because of a mercury risk, <a href="http://www.vox.com/2014/8/12/5951321/dentistry-fraud-treatments-products">the
red bars will go up</a>, and your veracity AI will show you top scientific
sources explaining how this is unscientific and well proven to be untrue, and
how this is often used as a way for dentists to profit from extensive unnecessary
work. And so on. And when the dentist gives the price estimate for his work,
the veracity AI can tell you how this compares to the average price for such
work in your area, and give a whole distribution, or histogram, if you'd like.<o:p></o:p></div>
</div>
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<br /></div>
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<div style="text-align: left;">
This could make scams in general far more
difficult, perhaps only very possible with the most tribal, and otherwise
non-analytical.<o:p></o:p></div>
</div>
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<br /></div>
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<div style="text-align: left;">
Veracity AIs can absolutely revolutionize markets
and society, and make the worlds markets far more efficient, and its societies much
smarter, richer, and better. But there's no reason to wait. Journalism easily can, and absolutely should, do so much more today.<o:p></o:p></div>
</div>
</div>
Richard H. Serlinhttp://www.blogger.com/profile/09824966626830758801noreply@blogger.com7tag:blogger.com,1999:blog-122860087135730716.post-5746795695177610122015-11-08T17:53:00.002-08:002016-08-02T04:01:16.271-07:00Robot/AI revolution decimating employment and wages, not just could it happen, has it largely happened already? Surprising data<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<i><br /></i>
<i>"My big
issue with the horse argument is that horses cannot innovate on their own
behalf, nor are they capable of imitating new innovations. People can do
both."</i><br />
<br />
– Dietz Vollrath, University of Houston growth economist, <a href="https://growthecon.wordpress.com/2015/01/26/techno-neutrality/comment-page-1/#comment-1150">January
27<sup>th</sup>, 2015</a></div>
<div class="MsoNormalCxSpMiddle">
<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br />
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
I've been studying this issue extensively for
several years now, and have carefully read/watched many or most of the biggest <a href="http://www.amazon.com/Second-Machine-Age-Prosperity-Technologies/dp/0393239357/ref=sr_1_1?s=books&ie=UTF8&qid=1443424486&sr=1-1">books</a>,
<a href="http://www.oxfordmartin.ox.ac.uk/downloads/academic/The_Future_of_Employment.pdf">papers</a>,
<a href="http://singularityhub.com/2015/07/07/its-no-myth-robots-and-artificial-intelligence-will-erase-jobs-in-nearly-every-industry/">articles</a>,
<a href="http://equitablegrowth.org/featured/technological-progress-anxiety-thinking-about-peak-horse-and-the-possibility-of-peak-human/">posts</a>,
and <a href="http://economistsview.typepad.com/economistsview/2015/04/video-technology-and-jobs-should-workers-worry.html">videos</a>.
I'm interested in it for many reasons; concerned and hopeful citizen and
father, businessman, entrepreneur, investor, economist, and science and
technology enthusiast. But also because my main career is in personal finance.
And there is a significant possibility that this technological advance will
decimate personal financial security for most Americans, at least without
strong and smart policy responses. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
The impetus for this particular post is Berkeley
economist Brad DeLong's <a href="http://www.bradford-delong.com/2015/09/highlighted-the-history-of-technological-anxiety-and-the-future-of-economic-growth-is-this-time-different.html">"Peak
Horse" post</a> last September. I agree with what Brad says. But I'd like
to add the following:<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
A big issue is not just will machines – robots,
artificial intelligence or advanced computers – replace humans, substitute for
them, but will they be able to inexpensively do so much of what low and medium
skilled and educated humans can do, that they have a great effect on the supply
and demand, and thus the market wage. And will that market wage drop below
minimum for more and more of the population – those with less skill than
average, or no college degree; or next, not even no college degree, but not one
from a major nationally-recognized university; less health and endurance, less
youth, good looks, attractive personality, clean record, etc. Will the market
wage drop below minimum for more and more of these people? For 10% of the
population, then for 20%, then 30%, 40%, 50%, 60%,… What then? <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
And, has it largely happened already? <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Yes, has it happened already, at least to a large
extent? Not just in some theoretical debated future. Please stay with me for
the evidence, which may really surprise you.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
You go into a grocery store. In 10 or 20 years
will 90+% of those jobs be gone. Will there be very advanced cameras throughout
the store, connected to a computer with amazing machine learning and other
artificial intelligence (AI). And that computer is connected to the cloud where
it learns from similar computers at grocery stores around the world,
constantly, from their experiences, and their learning, with constant updates. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
And what is it learning? How to correctly identify
everything you put in your shopping cart with its machine eyes (as well as how
to detect stealing). <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
You go to check out. No cashiers. The computer recognizes
you, and everything in your cart, and says, “That will be $127.49 Mr. Delong. Would
you like to pay with your Amazon Visa like last time?”<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
The (mechanized, computer driven) cart docks at a
conveyer, and robots with amazing dexterity and speed bag up your groceries and
call up your computer-driven car. Then, your mechanized cart (which you didn't
have to push or steer. It stayed with you.) goes to your car, and robots load
the bags in. The shelves <a href="https://www.youtube.com/watch?v=M7nLQpWiy1o">are
stocked by robots</a>, and most janitorial and other functions are done by them
too. And if you read <a href="http://www.amazon.com/Second-Machine-Age-Prosperity-Technologies/dp/0393239357/ref=sr_1_1?s=books&ie=UTF8&qid=1443681477&sr=1-1">The
Second Machine Age</a>, <a href="http://www.amazon.com/Rise-Robots-Technology-Threat-Jobless/dp/0465059996/ref=sr_1_1?s=books&ie=UTF8&qid=1443681516&sr=1-1">Rise
of the Robots</a>, or just out, <a href="http://www.amazon.com/gp/product/0465065708?psc=1&redirect=true&ref_=oh_aui_detailpage_o03_s00">The
Master Algorithm</a>, you’ll see that robots aren’t that far from a lot of this
even now. And solar, at least in the sunbelt (reporting from Tucson), powers
all these machines relatively inexpensively. The roof of the supermarket is
covered with solar panels, and the parking lot is shaded completely with solar
paneled canopies – This kind of thing is not that rare <a href="http://hereandnow.wbur.org/2014/06/12/solar-arizona-schools">even today
in Tucson</a>, and <a href="https://www.washingtonpost.com/news/innovations/wp/2015/05/01/teslas-powerwall-is-the-latest-step-toward-our-clean-energy-future/">Moore’s
law in solar</a> is <a href="http://e360.yale.edu/feature/will_new_technologies_give_critical_boost_to_solar_power/2832/">only
accelerating</a> after more than a generation. The sun food for the machines
is, and especially will be, a whole lot cheaper than the farmed food for the
humans.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
All those low skilled supermarket jobs reduced to
just a human manager, and maybe a few humans, if that, to fill in the gaps. And
the same for restaurants, factories, janitorial and maid service,… I find it
very hard to think of what jobs those low-skilled people will get instead, in
anywhere close to equal numbers to those lost, where those who still have jobs
and wealth will want to pay at least minimum wage for their services. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
How many people are going to want to pay a maid to
sweep, vacuum, and mop their floors, when for a tiny fraction of the annual
price they can buy a robotic machine that can plug itself in and manage its
cord, so that it’s no anemic baby-battery Roomba, but a full powered plugged-in
machine, exactly like the one a maid would push and guide. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
How many people today want to pay <a href="https://growthecon.wordpress.com/2015/01/26/techno-neutrality/comment-page-1/#comment-1147">the
“minimum”, or subsistence, wage for a horse</a>, rather than buy a car, or a
tractor, or take the subway, train, or a plane? Not enough to employ even a tenth of one percent of the horses we had a hundred years ago.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Now, is this all just a theoretical debated
future? <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
No, not at all, because if you look at the data,
it's happened already, to a large extent. We're already well along. The
statistics I'm about to give you are from MIT economist Michael Greenstone and
Brookings senior fellow Adam Looney in <a href="http://www.hamiltonproject.org/files/downloads_and_links/07_milken_greenstone_looney.pdf">a
2011 Milken Institute Review article</a>:<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
1) "Between 1960 and 2009, the share of men [age
25 – 64] without any formal labor-market earnings for an entire calendar year rose from 6 percent to 18
percent." (page 11)<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
2) "The percentage of men working full time [age
25 – 64] has decreased from 83 percent to 66 percent over the same period."
(page 12)<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
3) "Nonemployment for an entire calendar year among men without high
school diplomas [age 25 – 64] increased by 23 percentage points (from 11 to 34
percent) and among those with only a high school degree by 18 percentage points
(from 4 to 22 percent)". (page 12)<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
4) "One way to untangle the two phenomena is
to examine the median earnings among all working-age men – this time including
those who earn nothing at all. What appeared as stagnant earnings for workers
is really an outright decline in wages for the median men of working age. The
median wage of the American male has declined by almost $13,000 after
accounting for inflation in the four decades since 1969. (Using a different
measure of inflation suggests a smaller, but still substantial, drop in
earnings.) Indeed, earnings haven’t been this low since Ike was president and
Marshal Dillon was keeping the peace in Dodge City." (page 12)<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
5) "Consider just men between the ages of 30
and 50, a group for whom retirement is rare. The median earnings of all men in
this group declined by 27 percent between 1969 and 2009, which is nearly
identical to the 28 percent decline for those who are 25 to 64 years old."
(page 12)<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
6) "Surely, the most astonishing statistic to
be gleaned from the trend data is the deterioration in the market outcomes for
men with less than a high school education. The median earnings of all men in
this category have declined by 66 percent [not a misprint] [from 1969 to 2009].
At the same time, this group has experienced a 23 percentage point decline in
the probability of having any labor-market earnings. Roughly 10 percentage
points of the 23 percentage points is attributable to the fact that more men
are reporting disabilities, even though work in physically demanding jobs has
been declining for many decades. Men with just a high school diploma did only
marginally better. Their wages declined by 47 percent and their participation
in the labor force fell by 18 percentage points." (page 13)<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Now, it's true that all of these statistics are
just for men. The total number of jobs has increased, due to women entering the
labor force en masse, and the population increasing. Still:<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
1) The total labor force participation rate, which
considers all of this, has declined in the last 15 years from about 67%, where
it was throughout the 1990's, to about 64% (from <a href="http://data.bls.gov/timeseries/LNS11300000">the Current Population Survey</a>).<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
2) You bring up horses to some economists, and
other smart people, and sometimes the reply is, humans are different; humans
are just so much more flexible and adaptable and creative than horses, as in
the Dietz Vollrath quote at the start of this post. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
The machines eventually got horses. They shifted
the demand curve inward so much that the supply had to decrease by over 99% to
keep the market wage for those horses that remained above the subsistence level.
And you could have made the same argument for horses that you hear all the time
for humans – It never happens. Hundreds of years technology has advanced, and
we've always found jobs for as big, or bigger, a population of horses. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Well, you know what, after hundreds of years of
technological advance, it finally did happen. Machines reached the point where
they were so good at almost everything you could employ a horse at that there
was no way for 99+% of the horses to do anything else that would pay even a
subsistence market wage.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
So, relatively low-skilled, low-educated males are
not the entire group of humans. But, they are a class of humans, and a big one.
And what these data show is that it's not just a theoretical debatable thing about
the future. It's already very largely happened. They've already very largely
gone the way of the horse in the face of advancing machines (and I'll discuss alternative explanations).<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Now, you could say, well, they could become more
skilled humans, and not go the way of the horse. But, the bar keeps rising, and
pretty fast, as these machines get smarter and smarter. Already that bar is
pretty high, practically speaking, for a substantial percentage of our
population to clear, and it keeps going up. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
And, we have to then invest more and more in educating
our population, and crucially, <a href="http://heckmanequation.org/about-professor-heckman">Heckman-style early
human development</a> (all of which will, very importantly, also greatly
increase the total size of the pie, of GDP long run). But the more we vote Republican, the less
we do this, as this money is instead shoveled into more yachts and mansions for
the rich. And, no, raising taxes on the rich will not have a substantial effect on the hours they work; this is <span id="goog_983735719"></span><a href="http://www.epi.org/publication/raising-income-taxes/">well<span id="goog_983735720"></span></a> <span id="goog_983735728"></span><a href="http://www.princeton.edu/~mwatson/papers/DemRep_BlinderWatson_July2015.pdf">shown<span id="goog_983735729"></span></a> empirically, and there is the long established in economics <span id="goog_1057213549"></span><span id="goog_1057213543"></span><span id="goog_1057213538"></span><a href="http://www.economicshelp.org/blog/glossary/backward-bending-supply/">income and substitution effects and backward bending labor supply curve</a> taught at every major university.<br />
<br />
Cutting someone's after-tax wage from $10,000/hour to $5,000/hour still leaves plenty of incentive, and at these levels it's pretty much about attaining the prestige and feel of how your income and position and belongings and consumption <i>rank</i>, which is unchanged if your fellow rich pay the same higher tax rate. Your 10,000 square-foot house becomes just as prestigious and rare and awesome feeling and satisfying as a 20,000 square-foot one used to be before the tax increase.</div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
But the main point I want to make here is that
robot/AI revolution causing unemployment to soar and wages to plummet, for a
large and growing percentage of the population, is not just some debate about
the future; the evidence is it's already well on its way. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Now, of course, what are other explanations for
the shocking collapse of employment and wages for lower-skilled males over the
last half century. There are two big ones as far as I know, globalization, and
the collapse of unions/bargaining power. Could these two be the predominant, or
overwhelming, cause of this plunge in wages and employment? and, males without a
college degree (from a well-respected university) could just shrug off the
effects of technology over the last 50 years – <i>and</i> over the next 50 years – and adapt with their superior, highly
flexible, human brains? <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
So all we’d have to do is legally well-protect
unions, and put up strong barriers to globalization, and employment and wages
and job security would be at least restored to the level of a generation or two
ago for lower-skilled males? And for everyone else. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Advancing robotics, AI computers, and other
machines wouldn’t have been, and won’t be, a major, or catastrophic, problem for
males without a college degree.<br />
<br />
Is that it?<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Well, let’s examine these explanations. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Unions provide much greater bargaining power for
lower-skilled workers, and so certainly raise wages greatly for those who have
jobs at companies with strong unions. This has been extraordinarily true in the
past, when many unionized workers without even a high-school diploma had
better wages and benefits than many high-skilled workers. Wages and benefits
that would stun the typical fast-food worker of today, or low-skilled member of
<a href="http://www.motherjones.com/kevin-drum/2015/09/shiny-new-sharing-economy-sure-starting-seem-awfully-old-fashioned">the
sharing economy</a> (or is it the sharecropping economy?)<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
But that would be an explanation for the plunge in
compensation. It wouldn’t explain the plunge in employment, in the labor force
participation of lower-skilled males. If unions had remained just as strong,
and had kept on negotiating the same dream-like compensation for low-skilled
workers (dream-like to a Walmart worker today), if anything, this would have resulted
in even less employment.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Now, you might think that with strong unions,
employment for low-skilled males would be greater, as the unions would just
force it. They would strike and negotiate against automation. But this admits
that advancing machines are the cause. It just says that unions could stop, or
slow, this cause.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Next, what about globalization. So the idea here
is that trade barriers fell substantially, and the costs of transportation and
communication <a href="http://www.economist.com/blogs/economist-explains/2013/05/economist-explains-14">absolutely</a>
<a href="http://fortune.com/2015/02/02/biggest-container-shipping/">plummeted</a>,
and this led to low-skilled workers in the U.S. having to compete far more with
the vast numbers of low-skilled workers in the developing world. So essentially,
the supply of available low-skilled workers increased dramatically. And this
increase did not come with anything close to a proportionate increase in the
supply of available high-skilled workers to need the additional low-skilled
workers.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Certainly, this would depress wages and employment
opportunities paying at least minimum wage for low-skilled American males. MIT
Economist David Autor put it succinctly in a <a href="http://news.mit.edu/2012/manufacturing-overseas-competition-0224">2012
MIT News article</a> on a paper of his on U.S. manufacturing job losses, “Trade
may raise GDP, but it does make some people worse off.” Still, University of
Oregon economist, and purveyor of the central economics blog, <a href="http://economistsview.typepad.com/economistsview/">Economist’s View</a>,
Mark Thoma, <a href="http://www.cbsnews.com/news/is-donald-trump-right-to-call-nafta-a-disaster/">recently
wrote</a>, “The evidence suggests that immigration and offshoring aren't the
biggest source of the problems workers face. Technological change, particularly
digital technology, appears to be a much bigger factor.”<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
I agree with Professor Thoma on this, based on the
research and information I’ve studied. But even <i>if</i> globalization <i>were</i> the
bulk of the reason for the collapse in wages and employment for low-skilled
males over the last fifty years, this would <i>still</i>
mean that advanced robots, computers, and other machines would likely devastate
low-skilled male wages and employment in the not too far future anyway. It
would still, <i>nonetheless</i>, happen, even
if all of the globalization were ended tomorrow. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Why? <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Here's the logic:<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
First, even though I don’t think globalization is
the biggest factor, I have no doubt that the effect of it is very substantial
on wages and employment of low-skilled males. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
But what are the products and jobs in question? <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
For this phenomena, it’s predominantly manufactured
and processed goods that can be transported in the ubiquitous uniform metal
containers; on ships, trains, and trucks. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
So, the foreign workers that are putting supply
pressure on low-skilled American males are workers in production and processing
facilities and environments, because that's where the bulk of goods that can be
shipped in uniform containers are made, and that's where the bulk of the labor
hours to make them comes from. </div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
And workers in such factories and facilities are one
of the kinds of workers that advanced robots and machines are best suited to
emulate. The work is relatively simple and repetitive, and
in a relatively standardized predictable environment. </div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br />
So, the key point is that if foreign workers in
these kinds of relatively standardized, simple, and predictable environments,
with these kinds of also relatively standardized, simple, and predictable
tasks, are able to so devastate employment and wages for lower-skilled American
males over the last half-century, then machines would have done it anyway. Because
advanced machines largely can do the same things <i>already</i>, and it looks like there’s a substantial probability they
will be able to do the vast majority of this kind of work within the next
generation or two.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
So, in other words, if this is your explanation,
then it would have happened anyway, or likely will happen anyway, from the
advanced robots and machines doing the same thing as the low-skilled foreign workers. <br />
<br />
If low-wage workers in China and India can so devastate wages and employment for low-skilled American males, then so can low-wage workers in Robotia and Machinia and The AI Republic.<br />
<br />
So again we see that advanced robots and machines can devastate low-skilled male
workers. But what is the evidence that machines will have
this kind of capability to predominantly do what foreign low-skilled
manual workers do?</div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Again, it’s largely in the books The Second
Machine Age, Rise of the Robots, and The Master Algorithm; and, <a href="http://www.oxfordmartin.ox.ac.uk/downloads/academic/The_Future_of_Employment.pdf">the large 2013 study by Oxford’s Benedict and Frey</a>, which is based on the opinions and
predictions of Oxford scientists and engineers. The authors conclude (page 45):<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="margin: 0in 0.3in 8pt; text-align: justify;">
<blockquote class="tr_bq">
Our model predicts a
truncation in the current trend towards labour market polarisation, with
computerisation [instead] being principally confined to low-skill and low-wage
occupations. Our findings thus imply that as technology races ahead, low-skill
workers will [hopefully] reallocate to tasks that are non-susceptible to
computerisation – i.e., tasks requiring creative and social intelligence. For
workers to win the race, however, they will <b>have to</b> acquire creative and social skills. [emphasis mine]</blockquote>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
And here is MIT economist Erik Brynjolfsson and
MIT computer scientist Andrew McAfee in The Second Machine Age:</div>
<div class="MsoNormalCxSpMiddle" style="margin: 0in 0.3in 8pt; text-align: justify;">
<blockquote class="tr_bq">
After visiting Rethink
and seeing Baxter [a prototype, highly flexible, intelligent, and inexpensive
robot] in action, we understood why Texas Instruments Vice President Remi
El-Quazzane said in early 2012, “We have a firm belief that the robotics market
is on the cusp of exploding.” There’s a lot of evidence to support his view.
The volume and variety of robots in use at companies is expanding rapidly, and
innovators and entrepreneurs have recently made deep inroads against <a href="https://en.wikipedia.org/wiki/Moravec%27s_paradox">Moravec’s paradox</a>.
(page 31)</blockquote>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
And powerfully:</div>
<div class="MsoNormalCxSpMiddle" style="margin: 0in 0.3in 8pt; text-align: justify;">
<blockquote class="tr_bq">
All these examples
illustrate the first element of our three-part explanation of why we're now in
the second machine age: steady exponential improvement has brought us into the
second half of the chess board<span style="font-family: "times new roman" , serif;"><span style="line-height: 17.12px;"> [1]</span></span> –
into a time when what's come before is no longer a particularly reliable guide
to what will happen next. The accumulated doubling of Moore's Law<span style="font-family: "times new roman" , serif;"><span style="line-height: 17.12px;"> [2]</span></span>,
and the ample doubling still to come, gives us a world where supercomputer
power becomes available to toys in just a few years, where ever cheaper sensors
enable inexpensive solutions to previously intractable problems… </blockquote>
<blockquote class="tr_bq">
Sometimes a difference
in degree (in other words, more of the same) becomes a difference in kind (in
other words different than anything else). The story of the second half of the
chess board alerts us that we should be aware that enough exponential progress
can take us astonishing places. Multiple recent examples convince us that we're
already there. (pages 55-6, endnotes mine)</blockquote>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Other explanations for the collapse of wages and
employment for lower-skilled American males, like an increased desire or ability to claim
disability, or take on the role of homemaker, with a working wife, appear not
to be large factors, as discussed in <a href="http://www.hamiltonproject.org/files/downloads_and_links/07_milken_greenstone_looney.pdf">Greenstone
and Looney’s article</a>.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
People today typically debate <i>the future</i> with regard to robot/AI revolution, <i>will</i> it be much harder to get and hold a job that can support a
family decently, or even pay minimum wage. <i>Will</i>
it take much more education to achieve this? <i>Will</i> this happen in some hypothetical advanced robot and AI computer
future? <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Well, for male humans, it’s not a <i>will</i>. It’s a <i>has</i>. It <i>has</i>, to a very
large extent. The evidence I’ve presented I think is very strong on this. And
it hasn’t happened to just mere horses this time. Lower-skilled male humans are
humans, and they’re vastly beyond horses. And already the robots, AI computers,
and machines have brought them a long way toward the fate of the horses. And
these brilliant machines are just getting started. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
You want to ask some <i>will’s</i>, then how about these:<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<i>Will</i> it
take a bachelor's degree to have at least a 50% chance of having a reasonably <i>secure</i> career that can pay wages high
enough to support a family decently? And I emphasize secure, because I mean not
just can you <i>usually</i> hold a decent job, but will you be marketable enough that
you can avoid constant serious risk of long term unemployment before you find another
decent job. Because this risk is incredibly costly. Even one or two episodes of
3 – 12+ months of unemployment can devastate a family. Or can lead to homelessness,
<a href="http://www.theguardian.com/society/2011/dec/21/homeless-people-life-expectancy-47">which
is so harmful and dangerous</a>, there's a very good chance it's game over from
there.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<i>Will </i>it
take not just a bachelor's degree, but a bachelor's degree from a
well-respected nationally-recognized research university, like my employer, the
University of Arizona? and those kinds of skills? <i>Or even moreso</i>, the literacy, numeracy, and technical skills of
only <i>the</i> <i>top half of graduates</i> from respected national universities today?<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Because if you say: Oh, ok, it's just horses and
men who don't make the effort to become skilled and educated enough, so no
problem, they just get skilled and educated enough, and then the robots and
AI's are no risk. Then, what if skilled and educated enough so all this is no
problem goes from high school diploma to bachelor's at a nationally known
respected research university, and with the commensurate skills? Or even the
commensurate skills of just the top half of such graduates today, so we can't
just grade hyper-inflate our way out of this, and throw up a bunch of Potemkin
colleges.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
How are we supposed to get the vast majority of
men, and women, up to this level of skill and education?<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
To do so would take a regime shift in our politics,
and in public understanding of economics. By and large, one of our two major
parties not only does not believe in global warming, or evolution for that
matter, they don't believe in externalities, asymmetric information, natural
monopoly, contracting limitations and costs, and basically anything that says
the pure free market is imperfect (except in cases where it benefits the rich).
But providing a massive increase in the education, skills, and general
capabilities for most of the population is something that free market companies
could only extract a small fraction of the benefits from in profits. And
therefore they alone would grossly underprovide this. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
The externalities, contracting and enforcement
problems and costs, adverse selection and other asymmetric information, and so
on, are profound and enormous. This is why general education has historically
been predominantly publicly funded. To say that now, so that most of the
population won't go the way of horses, we have to enormously increase our investment
in Heckman-style early human development, education, public nutrition,
healthcare, and more, from prenatal until at least well into a person's 20's, is to say that we should have an unprecedented increase in governments' size
and roles.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Right now, this is impossible, as the Republican
party is dogmatically against any government, except for a small number of
areas; mainly military, police, courts, prisons, and perhaps minimal public
infrastructure and education. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Of course, to win elections they have to favor
Social Security and Medicare for seniors. But, from my study of politics, I
think that most of those who control the party would like, if they could get
away with it without losing political capital, to end Social Security and
Medicare. And, in fact, they fought Social Security and Medicare <a href="http://talkingpointsmemo.com/dc/gop-social-security-medicare-freedom">tooth</a>
<a href="http://krugman.blogs.nytimes.com/2008/10/03/raising-the-white-flag-of-surrender-to-medicare/">and
nail</a> when they were first enacted. And I also think that many of those in
control of the Republican party would like, if they could get away with it at
no cost in political capital, to eliminate most, if not all, <i>publicly financed</i> education, infrastructure, and research.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
This is my conjecture, but certainly it's obvious,
and not controversial among experts, to say they would oppose any significant
increase in investment in education and human development, let alone an
increase to an unprecedented level. Just read their platform, and the positions
of their major candidates; it's pretty obvious that the direction they'd like
to go in is the opposite one.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
So, if it's going to require a massive increase in
human development, education, skills, and general capability for most men not
to go the way of the horse, then that edification is not going to happen
anytime soon. And things could get very bad. And for a large segment of the
population, the statistics show it already has. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Republican control of the House (with gerrymandering,
disproportionate weighting of rural votes, etc.), and the Supreme Court, could easily
last another decade. And if the Republicans take the Presidency too, things could
go viciously in the wrong direction. They would likely be able to enact extreme
legislation and executive orders. Moreover, the Supreme Court, which could
strike down any major program, in spite of what's in the Constitution, could be
cemented in Republican control for another generation with a Republican
President to appoint more Republican Justices.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
So, I don't think we can take that much solace in
the reply, all the low-skilled men have to do is become high-skilled to avoid
going the way of the horse.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Nonetheless, longer run at least, I do think that
this is a critical part of the solution (see, for example, my 2014 <a href="http://carolabinder.blogspot.com/2014/03/guess-post-second-machine-age-book.html">guest
post</a> at Carola Binder's.) I do think that if we had a massive increase in
public investment in human development, especially <a href="http://heckmanequation.org/about-professor-heckman">Heckman-style early human development</a> (Nobel Prize winning economist James Heckman's research has shown a high social return to public investment in <i>high quality</i> prenatal and postnatal care, training, and assistance, <i>high quality</i> developmental daycare and preschool, and other early assistance and intervention) that we would greatly decrease the percentage of our population without secure
employment. And we would greatly increase the size of the economic pie long-run.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Moreover, an unprecedented increase in human development investment would, in of itself, create an enormous number of jobs. <o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
But the benefits would extend way beyond jobs. A
much smarter, healthier, stronger, less criminal, more knowledgeable and expert
population would make for a much stronger and better country, and a much
healthier democracy.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
Eventually, there is a good chance that AI will
reach the point where few if any humans will be smart and skilled enough to do
anything pecuniary that a machine can't. At that point, substantial redistribution
will be unavoidable. Most people have little wealth outside of their labor endowment. If that becomes worthless, they quickly starve without
redistribution<span style="font-family: "times new roman" , serif;"><span style="line-height: 17.12px;"> [3]</span></span>. If we can maintain a
democracy, in spite of the efforts of many plutocrats, then large-scale
redistribution will probably be inevitable.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
But, of course, there will be an aversion to just
giving people money without it being earned. But there, a solution I see is
allowing people to earn it by working to become better people, and citizens.
The redistribution can be money paid for the job of being a student; getting a
college degree, a graduate degree, passing expertise exams,... Or, money paid for
hours spent on a physical fitness program, or studying chess and improving
your intellect and game, or Tai Chi, Yoga, psychological study, or therapy...,
at least until you have reached a certain number of hours worked, or age, and
are allowed to retire with a pension if you wish<span style="font-family: "times new roman" , serif;"><span style="line-height: 17.12px;"> [4]</span></span>.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="text-align: justify;">
So, in this way, there may be one job that we can
never lose. In the end, our final job may be ourselves.</div>
<div>
<div style="text-align: justify;">
<div style="text-align: left;">
<br /></div>
<hr size="1" style="text-align: left;" width="33%" />
<div id="edn1">
<div class="MsoEndnoteText" style="text-align: justify;">
<br /></div>
</div>
</div>
<div id="edn1">
<div class="MsoEndnoteText" style="text-align: justify;">
<span class="MsoEndnoteReference"><!--[if !supportFootnotes]--><span class="MsoEndnoteReference"><span style="font-family: "times new roman" , serif; font-size: 10.0pt; line-height: 107%;">[1]</span></span><!--[endif]--></span>
This refers to an old story that the inventor of chess presented his game to
the emperor of India, who was so impressed, he asked the man what he'd like as
a gift in return. The man replied, simply some rice for my family, one grain on
the first square of the chess board, then two on the second, four on the third,
and so on, doubling until the end of the board. The emperor agreed, thinking it
a modest request. But due to the power of exponential growth, the last square
would require 2<sup>63 </sup>grains, more than 18 quintillion; more rice than
has been produced in the history of the world!<o:p></o:p></div>
<div class="MsoEndnoteText" style="text-align: justify;">
<br /></div>
<div class="MsoEndnoteText" style="text-align: justify;">
In the first half of the chess board, the number of
grains grows relatively, or very, slowly. For a while the growth looks linear,
and with a modest slope. By the end of the first half of the chessboard, the
current square is about 4 billion grains, still just one large field. But now
we're in the famed "second half of the chess board". Each doubling,
or square, now causes not a small improvement, not a relatively modest, or
ordinary, improvement, but a qualitative leap. <o:p></o:p></div>
<div class="MsoEndnoteText" style="text-align: justify;">
<br /></div>
<div class="MsoEndnoteText" style="text-align: justify;">
And the idea with computer advance, and Moore's law, is
that we are at, or near, the second half of the chess board, where every routine
doubling of Moore's Law, or similar doubling in computer-power-per-dollar-of-cost, due
to software advance, 3-D circuits, parallel processing, etc., causes a startling
increase in capability. An increase equal to every increase that came before it for the last 80 years. For supercomputers this means that a new square on the
chess board, which happens every few years, <i>now</i>
means <a href="https://en.wikipedia.org/wiki/Tianhe-2">an additional
thirty-four thousand million operations performed <i>every</i> <i>second</i>!</a> Very
different than early doublings, which only <a href="https://en.wikipedia.org/wiki/ENIAC">added <i>hundreds</i></a> of calculations per second to the capability!<o:p></o:p></div>
<div class="MsoEndnoteText" style="text-align: justify;">
<br /></div>
</div>
<div id="edn2">
<div class="MsoEndnoteText" style="text-align: justify;">
<span class="MsoEndnoteReference"><!--[if !supportFootnotes]--><span class="MsoEndnoteReference"><span style="font-family: "times new roman" , serif; font-size: 10.0pt; line-height: 107%;">[2]</span></span><!--[endif]--></span>
Many experts expect Moore's Law to continue for decades or more, at least in
spirit. Originally, Moore’s Law, or “Law”, as it’s an observed and predicted, approximate relationship, not an immutable physical law, was basically that the
number of transistors per square inch would increase exponentially for a long
period. But the term, “Moore’s Law”, is often used now to say, basically, that
computing power, or capability, per dollar of cost will increase exponentially over a
long period. And I think this is a much more useful definition. The number of transistors per square inch cannot double
that many more times before a transistor becomes as small as an atom. So
we're approaching the physical limit of matter's smallest units, and many
experts say the practical limit will be hit in a decade or less. But there are
many ways that the computing power, or ability, per dollar might keep doubling
every few years for decades or more.<br />
<br />
These include: (1) <a href="http://www.livescience.com/52207-faster-3d-computer-chip.html">3-D chips</a>
– micro-layers of chips on top of each other; (2) <a href="http://ime.uchicago.edu/features/the_promise_of_dsa_technology_for_nanoscale_manufacturing/">Directed
self-assembly (DSA)</a>; fascinatingly, this is like the way DNA constructs our
bodies. Certain molecules attract or repel others, and you use this to form the
transistors, the connections between them, and other components and
architecture in a chip. This can both plummet the cost of production, and create revolutionary
increases in capability; (3) Improvements in architecture in general; (4) <a href="http://semiengineering.com/3-ways-to-reload-moores-law/">Massively Parallel Processing</a>, like the human brain. This can lead to an astounding
increase in capability, but it also can plummet power usage and heat. The human brain,
which is incredibly massively parallel, has in many ways the capability of
today's supercomputers, and more, but with about one one-billionth the energy
usage; (5) <a href="http://www.wired.com/2015/09/googles-quantum-computer-just-got-a-big-upgrade-1000-qubits/">Quantum Computers</a>; (6) Advanced new materials like <a href="http://www.computerworld.com/article/2485289/emerging-technology/replacing-silicon-with-nanotubes-could-revolutionize-tech.html">carbon</a>
<a href="http://www.nytimes.com/2015/10/02/science/ibm-scientists-find-new-way-to-shrink-transistors.html">nanotubes</a>,
potentially inexpensive <a href="http://www.ibtimes.co.uk/max-planck-institute-reports-superconductor-breakthrough-common-materials-1508622">room-temperature</a> <a href="http://news.mit.edu/2014/cheaper-superconducting-computer-chips-1017">superconductors</a>, and other <a href="http://www.technologyreview.com/news/534606/atom-thick-silicon-makes-crazy-fast-transistors/">new nanomaterials</a> with amazing properties and applications; (7) Much faster and denser memory, such as <a href="http://www.technologyreview.com/news/529386/super-dense-computer-memory/">RRAM (Restrictive Random Access Memory)</a>;(8) And there is more; this is not an
exhaustive list.</div>
<div class="MsoEndnoteText" style="text-align: justify;">
<o:p></o:p></div>
<div class="MsoEndnoteText" style="text-align: justify;">
<br /></div>
<div class="MsoEndnoteText" style="text-align: justify;">
And one thing I'd like to especially focus on is
software advance. We always hear about hardware speed and capability doubling,
but often as important, or even more, is the exponential advance of software.
There are many examples you can give – <a href="http://www.pcworld.com/article/2996620/google-reports-strong-profit-says-its-rethinking-everything-around-machine-learning.html">Machine
learning</a>, which is revolutionary, is the reason for computers driving
cars in dense city traffic, recognizing faces better than humans, and beating
the best at Jeopardy. It is a new kind of software (at least in this form, and at
this level). Certainly, it is made more powerful with hardware advance, but
that hardware would never have been capable of coming close to what it does
without this software advance.<br />
<br />
MIT's Brynjolffsen and McAfee wrote in their
first book on robot/AI revolution, <a href="http://www.amazon.com/Race-Against-Machine-Accelerating-Productivity/dp/0984725113/ref=sr_1_1?s=books&ie=UTF8&qid=1445644104&sr=1-1"><i>Race Against the Machine</i></a> (2011),
"It also seems that software progresses at least as fast as hardware does,
at least in some domains. Computer scientist Martin Grotschel analyzed the
speed with which a standard optimization problem could be solved by computers
over the period 1988-2003. He documented a 43 millionfold
improvement...Processor speeds improved by a factor of 1,000, but these gains
were dwarfed by the algorithms, which got 43,000 times better..." (page
18).<o:p></o:p></div>
<div class="MsoEndnoteText" style="text-align: justify;">
<br /></div>
<div class="MsoEndnoteText" style="text-align: justify;">
So, as a result of all of this, we see many different promising
avenues by which "Moore's Law", at least a Moore's Law for doubling
of capability per real dollar of cost, can continue for possibly decades, or
more. And these doublings are now in the second half of the chessboard (see
endnote 1 above), where each one is a gigantic, and possibly profound, advance.<o:p></o:p></div>
<div class="MsoEndnoteText" style="text-align: justify;">
<br /></div>
</div>
<div id="edn3">
<div class="MsoEndnoteText" style="text-align: justify;">
<span class="MsoEndnoteReference"><!--[if !supportFootnotes]--><span class="MsoEndnoteReference"><span style="font-family: "times new roman" , serif; font-size: 10.0pt; line-height: 107%;">[3]</span></span><!--[endif]--></span>
One might argue that with the technology explosion things would get so cheap
that even a small amount of savings, maybe even $1,000 or less, would be enough
to live ok for a lifetime. However, interestingly, I think this would be unlikely
to work. The <i><u>real</u></i> price of at least many goods <i>will</i> plummet, but remember, the Fed, and all first-world central
banks, hate even moderate deflation. For this to work, for your $1,000 to blow
up in real value, they would have to allow hyperdeflation. Extremely unlikely.
They are going to print as much as it takes to prevent more than at most modest
deflation. <o:p></o:p></div>
<div class="MsoEndnoteText" style="text-align: justify;">
<br /></div>
<div class="MsoEndnoteText" style="text-align: justify;">
For you to have your wealth explode in value will
require having it in real assets, like stocks, or ownership of raw materials that will be necessary, and relatively rare, in the robot-revolution future,
not cash or fixed-interest bonds. This looks to me like the way to hedge
against robot/AI unemployment, other than things like improving your and your
children's education and skills. <o:p></o:p></div>
<div class="MsoEndnoteText" style="text-align: justify;">
<br /></div>
<div class="MsoEndnoteText" style="text-align: justify;">
I'll eventually do a post on this, but for now, if
you'd like to find out more, please see my comments <a href="http://economistsview.typepad.com/economistsview/2015/11/links-for-11-04-15.html#comment-6a00d83451b33869e201b7c7e7bc58970b">here</a>, and this <a href="http://richardhserlin.blogspot.com/2015/08/my-response-to-shiller-on-stock-prices.html">recent post</a>.<o:p></o:p></div>
</div>
<div id="edn4">
<div class="MsoEndnoteText" style="text-align: justify;">
<br /></div>
<div class="MsoEndnoteText" style="text-align: justify;">
<span class="MsoEndnoteReference"><!--[if !supportFootnotes]--><span class="MsoEndnoteReference"><span style="font-family: "times new roman" , serif; font-size: 10.0pt; line-height: 107%;">[4]</span></span><!--[endif]--></span>
Of course, there would be a lot of specifics to work out here.<o:p></o:p><br />
<br /></div>
</div>
</div>
Richard H. Serlinhttp://www.blogger.com/profile/09824966626830758801noreply@blogger.com7tag:blogger.com,1999:blog-122860087135730716.post-37527542487042803172015-08-31T01:17:00.002-07:002017-05-03T02:49:33.616-07:00My Response to Shiller on Stock Prices and Historical P-E's<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">What is the better alternative to<a href="http://www.nytimes.com/2015/08/30/upshot/rising-anxiety-that-stocks-are-overpriced.html?rref=upshot"> the "high" P-E's</a>?</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Bonds with near-zero real interest?</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Real estate?</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Let's consider real estate. A very serious bad future state [1], with a very substantial probability for most people, is artificial intelligence/robot revolution decimating jobs and wages [2]. What will happen to real estate in that state? The 80%+ have had their employment, and employment security, decimated, and wages have plummeted. How is that going to affect their ability to bid on homes and apartments?</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">And simultaneously, these robots will be able to build new homes and apartments at a fraction of the cost it takes today – Heard of massive 3-D printers on rails printing an entire track of homes' frames [3]? You will. When in the not too far future new homes, apartments, and offices can be built for half the cost, or a quarter of the cost, today, and be much higher quality, with incredible energy efficiency, solar built right into the structure, the walls even, and incredible computer control of the home or office built in seamlessly and beautifully, with amazing new materials for soundproofing, durability, and beauty, how is that going to affect the price of the real estate you're buying today?</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">So, real estate will plummet in this AI/robot revolution state, while in this same state the tech explosion may be very good for the owners of the robots – the owners of stocks. An asset that plummets in a majorly important bad state? Very risky. One which does well in that state, important insurance. The discount rate for the former is very high, all other things equal (and the former's expected return is also, I think, far lower than almost everybody thinks, because almost no one is considering this AI/robot revolution scenario with regard to real estate investing). The discount rate for the latter is very low, all other things equal.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Yes, there's also the possibility of the winner-take-all explosion getting the bulk of the tech revolution's bounty, but still, the 80% won't be winner-take-all's (WTA's), so at least they can own still needed robots, and raw materials, and patents, and have some negotiating power with the WTA's through the corporations they own, so they get some substantial percentage of the bounty; the WTA's don't get it all.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Because of the great future technological danger to the 80%+, stocks are becoming more and more insurance-like long run, and so meriting a lower and lower discount rate (even though very few people will think about this). And at the same time, bonds are currently paying nothing, and real estate is looking very risky long run.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">So, what is better than stocks for long run savings? I ask seriously.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">And, especially since Shiller wants to use historical comparisons for P-E ratio, we should also consider historical comparisons for other things too. Shiller writes, "… and within a year or two restore CAPE ratios to historical averages. This would put the S&P closer to 1,300 from around 1,900 on Wednesday."</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Ok, so if we're invested in the S&P 500 now (a broader market index is better, like the Vanguard Total Stock Market Index Fund, or one of the many similar offerings available elsewhere) at 1,900, and it drops to 1,300 in 1.5 years, how long until it's back up to 1,900 (adjusting for inflation too, so in today dollars)?</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Well, we're going with historical averages, like Shiller, right? So what's the historical average real return on the stock market? Wharton's Jeremey Siegel has possibly the best long run data base. In his seminal book Stocks for the Long Run, 5th edition, he finds that from 1802 until 2012, <a href="https://sites.google.com/site/richardhserlin/the-geometric-average">the geometric average</a> return was 6.6% real, inflation adjusted. And it was about the same for three major sub-periods in this 210 year span (see chapter 5).</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">So, at 6.6%, how long until the 1,300 gets back to 1,900? Taking out my trusty Hewlett Packard 10bII, 5.93 years. So, in about 7.5 years we're back where we started, inflation adjusted. And that's better than government bonds, which have a somewhat negative real expected return, and about equal to high grade corporates which are at about the expected inflation rate.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">But what about after 20 years pass? We keep up with that historical 6.6% average, and after 20 years, 12.5 years will pass since break-even. Those 12.5 years take us to 4,361. So, investing today, with these historical averages, 1,900 goes to 4,224 in 20 years. That gives us a 4.08% real return.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">What's going to beat that today? And with a risk level that provides insurance against future inflation (stocks are ownership of real assets which go up with inflation) [4], and crucially, robot/AI revolution causing devastation to employment income and security for the 80%+.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Even if Shiller's right with his historical averages, what's going to beat stocks for long run investment? And yes, if you knew stocks would drop to 1,300 first, then you'd leave until it happened, and then go back. But that's risky to try. It's far from certain they will drop to 1,300. What if things start going really well in the economy? What if the robot/AI revolution starts to really take off within just the next few years? P-E's could start dropping fast not because prices drop fast, but because earnings rise fast.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">I still can't see a better vehicle for long run savings than a well-diversified stock portfolio. If you know of one please let me know.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">A final point: It is possible that investors are a lot more savvy than in the past, and so less unduly afraid of the risk of stocks. Therefore, they discount their future expected earnings less, resulting in a new era of higher P-E ratios.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">So this would argue for stocks not being overpriced at their current CAPE's. INSEAD economist Antonio Fatas <a href="http://fatasmihov.blogspot.com/2015/08/a-third-scenario-for-stock-markets.html">just made this point</a>:</span></div>
</div>
<div>
<blockquote class="tr_bq">
<div style="text-align: justify;">
<span style="font-family: inherit;">The other justification for high CAPE ratios is that the risk aversion of investors has gone down relative to previous decades. While talking about low risk perception this week might not sound right, the reality is that the years while the stock market had CAPE ratios of around 17 where also the years where academics wondered about why risk aversion was so high among investors (what we called the equity risk premium).</span></div>
</blockquote>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">So, here we get to the famous equity premium puzzle in financial economics. I've talked about this a lot in previous posts because for years I've had an explanation that I haven't seen in the literature, and I've studied this literature very thoroughly as a finance PhD student, you can't help but. So, please bear with me, and let's talk about this; I really think there are important points to think about.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">The equity premium puzzle is that going back a century or two in the US (and this has also been observed <a href="http://www.amazon.com/Triumph-Optimists-Global-Investment-Returns/dp/0691091943/ref=sr_1_1?s=books&ie=UTF8&qid=1441011475&sr=1-1&pebp=1441011482632&perid=0A5F6R08RP3C4HS8M6PK">in almost every developed market</a>) stocks appear to have had a very high real return relative to their risk. So the question, or "puzzle", is how can this have persisted for as long as two centuries. With people being oh so efficient, oh so smart, expert, and savvy; or, with the expert minority being willing and able to buy as much of assets as it takes to push them to efficient pricing, <a href="http://works.bepress.com/richard_serlin/1/">or so they say</a>, why wasn't the return on stocks bidded down?</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Or at least, why have most people put so relatively little of their savings into stocks when the expected return relative to the risk seems so good?</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">And the explanations that have gotten published in the top journals basically come down to maybe for some reason stocks are riskier than they appear to be, and the general public understands this better than finance professors with massive statistical, mathematical, theoretical, and empirical knowledge. Or, people are a lot more risk averse than they appear to be.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">So there's this thought that if people discovered what a good deal stocks are, they would start investing in them a lot more, and that increased demand would push up the price of stocks, and thus down their expected return from that point on.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">So, it's always a thought about demand. Once people wake up and see that stocks aren't that dangerous for getting so much higher a return on average, then they will start bidding down the expected returns permanently, until they are no longer such an abnormally good deal.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">But, what I ask is if this were any other good, would we think that once consumers change their attitudes and greatly increase their demand, the price of the good must go up, not just over the short run, but over the long run too?</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">And the answer, from long established and well proven economics, is not necessarily at all.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">It comes down to the production technology, the supply side. Is it constant returns to scale, the old CRTS, or increasing returns to scale, IRTS, or decreasing returns to scale DRTS, or is the supply fixed, perhaps like gold (although, while the supply of gold on the planet is fixed, the supply available to the market is much less fixed; it depends on surveying and mining technology).</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">And whether production is CRTS or IRTS or DRTS can depend on the quantity and time horizon. For a large range of quantities production may be IRTS, then it may go to CRTS after that, and finally if you keep producing more it will eventually go to DRTS.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Well, with stocks, what are you purchasing? Ultimately, the money put into stocks goes into corporate investment projects. And those investment projects ultimately produce goods. Now, what I argue in my explanation of the equity premium puzzle is that investment projects financed with equity, rather than debt, are intrinsically more productive. It's like a technology that produces more output. If you produce with technology X, for every $100 you invest in that kind of production you will permanently get $3/year of goods out. But if you invested that $100 instead with the more efficient technology Y, then you would produce more, $7/year.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">And why might equity-financed investments be more efficient and higher productivity than debt-financed? Because equity financing gives managers the option much more to take much longer term projects whose exact fruition and cash flow is harder to predict with certainty, but have nonetheless a very high risk-adjusted expected return. If the financing is in debt, often these projects will be forgone, because the debt provides an often very substantial risk to managers from taking on these projects. If the cash flows don't come in in time, the company can be put under severe financial distress, really costing the manager who took on that project in his career, in just keeping his job. Equity is flexible, there are no fixed interest payments which must be made on precise schedule to avoid very bad consequences. So, basically we can expect, given this, that equity-financing will persistently provide a higher risk-adjusted return than debt. </span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">Now, what if suddenly people recognize this much more, and start investing much more in equity to take advantage of this, say twice as much. Will they bid down the risk-adjusted expected returns on equity? Well, not if there exist twice as many good equity projects. So, in other words, if the good equity type projects are CRTS over this range, then the increase in demand won't move the price. The long run supply curve is flat over this range, and so an increase in demand does not change the price. In fact, if the potential equity based projects are IRTS an increase in their demand would even push up the risk-adjusted expected return, allowing for excellent large scale projects that otherwise wouldn't have been possible.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">So, this is my supply side explanation for the equity premium puzzle. For more, I have a brief write up <a href="http://works.bepress.com/richard_serlin/18/">here</a>. And so when Fatas writes, "But I wished that he [Shiller] would have considered as well the third possible scenario where current CAPE levels are fine and investors should get used to lower-than-historical returns but returns that are consistent with what is going on in other asset classes.", he's saying that maybe now investors are more savvy, and so are willing to invest a lot more in stocks and so will push down the risk-adjusted expected return, but be fine with that. What I'd reply is that even if what he hypothesizes about the demand side is true, it will not necessarily mean lower future risk-adjusted expected returns for stocks due to my supply side explanation, where higher demand will just mean more of these high risk-adjusted expected return equity-type projects get financed. And less will be financed through less efficient debt. Which may be a very good thing.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;"><br /></span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">[1] The state of nature framework is standard in academic financial economics. You say in the future there are a number of possible states, where various things happen, or various levels of good or bad economic factors occur. And each state has a certain probability of occurring.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">[2] To learn about this I recommend, The Second Machine Age (2014), by MIT Economist Erik Brynjolfsson and MIT information technology expert Andrew McAfee, and Rise of the Robots (2015), by software expert and entrepreneur Martin Ford. Ford's not an economist, and the economics is often off, or quite wrong, but the technological information is amazing, and often surprising.</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">[3] See Rise of the Robots above in endnote 2</span></div>
</div>
<div>
<div style="text-align: justify;">
<span style="font-family: inherit;">[4] I'm not talking about Zimbabwe inflation, but over the next decade or two it is possible we'll start intelligently considering the dangers of lowflation, the ZLB, and lost decades, and raise the target to 3 or 4 percent, even 5, or at least make the current 2% a target, not a ceiling.</span></div>
</div>
Richard H. Serlinhttp://www.blogger.com/profile/09824966626830758801noreply@blogger.com19tag:blogger.com,1999:blog-122860087135730716.post-57718279484849298202015-07-19T16:32:00.000-07:002016-01-14T19:46:21.090-08:00The Intuition behind Wallace Neutrality<div style="text-align: justify;">
[PDF version available <a href="http://works.bepress.com/richard_serlin/22/">here</a>.]<br />
<br />
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Why not "Attempt
4"? After all, I had <a href="http://richardhserlin.blogspot.com/2012/09/want-to-understand-intuition-for.html">my
original</a> in 2012, <a href="http://richardhserlin.blogspot.com/2013/09/the-intuition-for-wallace-neutrality.html">part
2 </a> in 2013, <a href="http://richardhserlin.blogspot.com/2014/08/the-intuition-behind-wallace-neutrality.html">and
part 3</a> last August. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
It's because <i>here</i> I think I've really nailed it,
really gotten at the heart of it, in a way that's <i>relatively</i> quickly accessible to professional economists (and maybe
to well-educated laypeople too, but probably only with a great deal of side
googling and reading). So, I think this one really stands out from the others,
and is the one that I'd like to make my, "the explanation", or at
least my relatively concise and accessible explanation. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
It's not that I
think my earlier attempts were wrong (by and large). It's just that there are
many valuable intuitions you can get from Wallace '81, but what I'm about to
present to you, I think, really gets at the heart of it, and thoroughly, from
the start of the process through to the finish.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Now, as you can
quickly see, this is very long for a blog post. But I think it's well worth the
time to be one of the very rare people to really understand (and not
misunderstand) this crucial model in the quantitative easing, and just whole monetary
policy, debate. However, I will next, in a future post, try to condense this a
lot, and perhaps make it more accessible for well-educated laypeople. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
But really, for
economists and other professionals, this is not that long at all to be one of
the few people in the world to really understand this intuitively. And the
depth it contains is really worthwhile for professionals. It may sound egotistical
for me to say that, but I honestly think it’s true, and important to make clear.
It's still short for an academic work (with some blogging humor, informality,
and commentary), and I think it's well worth the relatively short time. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
O.k., so let's
get to it: <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Suppose the
government decides to do a quantitative easing (QE) where it creates, and sells,
one more dollar ("unit of money"). In the Wallace model, it sells
dollars for the single composite consumption good, which I have nicknamed C's. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
C's are the
real deal, real goods, what everyone ultimately wants, and the one and only
argument in their utility functions. And, C's are what people sell their
financial assets for, when they eventually sell them.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So, that dollar
is sold to, let's just say in this first scenario, one person, even though
everything is infinitely divisible in this model. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
What's the cost,
the price in C's, of that dollar? <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Well, first,
we're trying to see if this QE can be done without changing the price of any
asset in the economy at all, whether financial or real. And that includes
money, so with no inflation. And this is what Wallace claims in his Irrelevance
Proposition.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Thus, we're
going to assume that all prices remain unchanged; they are as before. And then
we will see if equilibrium still holds after the QE if we still have those
original prices.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
The previous
regime we call the "_" regime. So, the previous state prices at time
t were s_(t). The previous money supply in circulation was M_(t), and so on.
And the previous price of a unit of money in C's was p_(t), all consistent with
Wallace's notation.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So, if p_(t) is
4, then it takes 4 C's to buy one dollar. If all you have is 1 C, then you can
only buy a quarter.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Now, we started
in equilibrium in the "_" regime. This means, by the rules of this
model, and almost all modern macroeconomic models, that all people were
perfectly optimizing at the current, and forecasted, prices. All people had,
with their perfect, super-human, foresight, knowledge, expertise, and calculating
ability, figured out the 100% maximum utility consumption plan for now and the
rest of their lives. And they we're going to follow it perfectly, with their
perfect self-discipline; saving and investing exactly as necessary to
accomplish it. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
And also,
markets are assumed to be complete (which is actually crucial), and
frictionless, in Wallace’s model. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So, any given
person h, of generation t, had a consumption path over his two period life, ch(t),
that perfectly optimized his utility, given his budget constraint, and given
the ability to buy and sell anything perfectly and frictionlessly in the complete
markets with state prices s_(t) .<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So, as I
started to say, before I was so rudely interrupted, by myself, suppose the
government decides to do a QE where it creates and sells one more dollar.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Some person,
we'll call him person z, decides to buy that dollar for p_(t) C's. And, the
government decides to, in turn, promise to buy it back from him next period for
the perfectly foreseen, at least given the state, market price of p_(t+1). <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
I'll later get
to why we assume the government will promise to do this, and will honor its
promise with 100% certainty.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Remember, in
standard macroeconomic models today, including Wallace '81, everyone has
perfect foresight about, basically everything, including the state-dependent
future path of all prices. They don't know what state will occur, but they do
know what any price will be perfectly given a state, or path of states, occurring.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
And, the government
promises more: <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
When they sell that
dollar they will store/invest the C's they get for it, earning a
state-dependent return of x(t+1). The state-dependent return vector for storing
C’s at time t is specified in the Wallace model. It’s considered exogenous, and
very interestingly, and consequentially I think, it does not depend on
quantity. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
The demand to
put your C’s into this x investment, no matter how big it gets, never pushes
down the return. It is essentially like continuous-returns-to-scale technology.
You never run out of x type investments or projects. Their supply curve is
perfectly flat, at least for quantities as high as could ever occur in the
world of the model.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
The important
results of the model depend on this. And I really found it interesting because
for years I’ve had an explanation of the equity premium puzzle that was based
on this kind of supply. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So, please bear
with my digression here: <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Basically, my
idea is that equity gives managers a lot more flexibility in how they invest
funds, especially long-term, compared to much more constrained and difficult
debt. As a result, the firm can invest the funds more efficiently and productively
over the long run with this increased flexibility. Therefore, they can put the
funds in higher, even risk-adjusted, return projects than they can with
debt-raised funds – There’s no worry about potential disaster from having to make
short run interest payments so you decide to pass up better much higher expected
return, but longer run and somewhat more risky projects, that, again, to be
very clear, are higher expected return <i>even</i>
when adjusting for their increased risk.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
If the supply
curve of these good, equity-based, flexible long-term projects in the world is
very long and flat, at about the historical high average equity return
(approximately 7% real), then even if the demand for equity did get really
high, because it’s such a good deal, with such a long flat supply curve of
projects at a rate of 7%, the equilibrium rate still won’t get pushed down
below 7%.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Essentially,
with this explanation there’s always going to be a really big equity premium,
not because of something puzzling about people’s utility functions, or
behavioral factors, or there's some hidden source of risk we're not seeing, but
just because you will <i>always</i> be able
to find equity projects that have a much higher return than the average debt
project – as many as you need. Equity just increases the efficiency and
productivity greatly by not having all of the hassles and constraints that come
with debt, and the result is projects that produce a lot more, especially over
the long run, even when considering any increased real risk (although the
question still remains, why don't investors jump on this more; why is there not
more stock in their portfolios).<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
You hear a
concern with the equity premium puzzle that once people realize that the
risk-adjusted return on equity is so high, the demand for equity will shoot up,
and its expected return will come down. But this will not be the case if
equity-based projects just have a very real and very substantial flexibility
and efficiency advantage. And the number of such possible projects is easily
high enough to meet even a great increase in demand.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
I have a brief
write up of this <a href="http://works.bepress.com/richard_serlin/18/">here</a>.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Of course, this
is an explanation for why the risk-adjusted equity premium is so seemingly
high. There's still the "puzzle" of why people then don't jump on
this much more. Why then do they invest so relatively little in stocks,
because, after all, we know the market is sooooooo efficient, and people are
soooooo rational, and knowledgeable, and expert – <a href="http://www.nbcdfw.com/news/health/Consumer-Reports-Overuse-of-CT-Scans-289977021.html">in
everything</a>, in an ultra-complicated world that's <a href="http://richardhserlin.blogspot.com/2010/09/optimal-level-of-governemnt-investment.html">light-years
from 1810</a>. Otherwise, libertarianism might look a lot worse, and a government
role a lot better. Horrors! <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
But might I
just offer a crazy idea. Perhaps the "puzzle" of why people seem to
underinvest in stocks when they appear to carry such an abnormally high
risk-adjusted return is not because they know some hidden sophisticated kind of
risk that finance professors don't and are missing. Perhaps, just perhaps,
instead, it's because 65% of people <a href="http://richardhserlin.blogspot.com/2013/12/surveys-showing-massive-ignorance-and.html">answered
incorrectly</a> when asked how many reindeer would remain if Santa had to lay
off 25% of his eight reindeer.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Anyway, I’ve
never seen my supply-side explanation of the equity premium puzzle in the
literature, and I’ve studied this a lot. As a finance PhD student, you can’t
help but. And I don’t know why. It seems to make a lot of sense. But assuming
there’s not something wrong with it that I don’t see, it’s likely going to take
someone with a name, and/or at a name, writing it very formally, full of math,
and completely, to get it considered.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Anywho,<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Ok, end of
digression, back to Wallace's model.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Recapping where
we left off in our QE:<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
1) The
government prints one more dollar. It sells it to a person for the price of
p_(t) C's. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
And p_(t) is
part of the previous regime of prices, the "_" regime, which had us
in equilibrium before the QE.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
2) The
government takes the p_(t) C's it gets and stores/invests them for the
state-dependent return it will get next period, x(t+1).<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
3) Next period
– time t+1 – the government will buy back that extra dollar that it printed in
its QE.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So, that's
where we left off. Now let's continue. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
The government
sold a dollar for p_(t) C's. It stored/invested those C's for a return of
x(t+1) to get p_(t)x(t+1) C's at time t+1. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Then, also at
time t+1, the government will buy back that dollar it printed in the QE for
p_(t+1) (That will be the price, if the price path that we started with before
the QE stays the same afterwards. And we will see if equilibrium can still hold
if it does.) <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
All of this is
implied by the equations in the model, primarily requirement (b) of the Irrelevance
Proposition. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Therefore, the
government will make a profit/loss from the QE, at time t+1, of:<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
p_(t)x(t+1) –
p_(t+1) <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
What does the
government do with this profit or loss? <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Equation (b)
requires that the government foist it on the people. The government gives it to
one or more members of the citizenry by adding it to their taxes net of
transfers. If it's a profit, hey, tax cut! and/or increase in transfer
payments! If it's a loss, tax increase, and/or decrease in transfer payments. But
due to the perfect foresight and public information that Wallace's model
assumes, the people know exactly how the government is going to do it
beforehand, and to which specific citizens. And they act accordingly in an
optimal way.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Now, WLOG
(without loss of generality; this will still be true in general, even though
now we will restrict our attention to a specific case.), for simple clarity,
let's, for now, assume the case where the government announces its plan to
foist this profit/loss <i>on just one person</i>,
our intrepid person z. They're not going to split it 50-50 between persons z
and w, or 71-29, or split it evenly among every person in the country. They
could, again WLOG, as I'll go into later, but here the whole profit loss that
will occur at time t+1 will go just to person z.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
How will person
z, an optimizing mother–shut your mouth! (<a href="http://www.imdb.com/title/tt0067741/">Shaft</a> reference for you young'ns),
react to this?<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Well, person z
was optimizing before the QE. The amount of saving he chose, and how he chose
to invest that saving, was optimal given the prices (and state dependent price
paths) at the time, the "_" ones. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
If those prices
don't change, as we posit, but now person z finds out he will be getting, p_(t)x(t+1)
– p_(t+1), at time t+1, how will his optimal strategy change? <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Will he save
more in his two period life? Will he invest his savings differently? Buy a
different set of state-price contracts, store/invest more for the return
x(t+1)? What?<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Well, the first
thing to notice in answering this question is that the profit/loss, p_(t)x(t+1)
– p_(t+1), at the existing "_" state prices, is, at time t, worth,…<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Zero<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
You're giving
person z, at time t, something that's worth zero at time t. Its net present
value at the current ("_") state prices is zero. It's not a cost, and
it's not a benefit. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Why?<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
We started in equilibrium,
so there were no arbitrages, and Wallace explicitly requires this with
equations (3) and (4). <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
If p_(t)x(t+1)
is worth more than p_(t+1) at the time t state-prices, then there would be an
arbitrage. You would just: <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
1) Sell short a
dollar to someone, and get p_(t) C's. You now owe them a dollar at time t+1,
which will cost you p_(t+1) C's at time t+1.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
2) You take
your p_(t) C's and store/invest them at x(t+1) which will give you p_(t)x(t+1)
C's at time t+1. You use those C's to pay off the person you owe from the short
sale a dollar, which costs you p(t+1) C's to buy. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So, this
strategy cost you nothing at time t, and at time t+1 you get:<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
p_(t)x(t+1) –
p_(t+1)<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
If this
expression is not zero, then an arbitrage would exist. So, given you assume
that the economy starts in equilibrium, you assume that this expression is
equal to zero. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
I'm not going
to show the details of every arbitrage in this post to keep it from really
getting long, but if you'd like to see them, just email me. And, I'll
eventually do an article version of this which will at least be at my academic
site, which will go through all claimed arbitrages in end notes or appendices.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So, the
profit/loss that the government foists upon person z (or some combination of
citizens in the economy) is worth zero at time t. So person z can completely
rid himself of it for free. He can sell it in the markets for nothing. And, in
fact, that's just what he will do! <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
How can I be so
sure of that? Well, whatever his utility function was, he was optimizing perfectly
before the QE at the market prices (and their state-dependent paths) that
existed before the QE. If those same state prices still exist after the QE (as
we're assuming, and then seeing what happens), then he will choose the same
consumption and investment path as before. He won't change anything. Give him
some new investment, worth zero, that changes his state-dependent consumption
and investment paths, and he will sell it.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
A good way to
look at it is this: There are perfect complete frictionless markets, and perfect
people; a person has a lifetime path of income and transfers net of taxes. And
in optimizing it, what he essentially does is say, what's the net present value
of all of that at birth. People are supermen right out of the womb! Or time t.
Then, with that net present value lump of wealth, he plans out completely the
consumption and investments he's going to buy over the course of his life, to
perfectly optimize his expected utility function.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
As long as the
net present value lump he's born with is worth the same amount, and as long as
the state dependent price paths are the same, he's going to have the same
possibility set to choose from. And he will thus will chose the same optimum
(Wallace restricts the possible utility functions hardly at all, but he does say
they're well behaved so that the optimum is unique.)<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Foisting on a
citizen a profit/loss from a QE that has a net present value of zero at the
prices in a frictionless and complete market doesn’t change the possibility set
at all for that citizen. So he will optimally chose the same exact
consumption/investment path as before. And to get to that path he just sells
this QE profit/loss for zero. In other words, he will engage in transactions to
100% undo it.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Now, next
question: How exactly does he undo it, and who takes the other side of those
transactions if market prices stay the same as before the QE.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
The answer is,
he does the opposite of what the government does in its QE transactions, and so
the government is taking the other side of the transactions. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Specifically:<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
When the
government sells that extra dollar in its QE, person z buys it from his private
storage of C's. Thus, his saving in stored C's goes down by p_(t) C's, and his
saving in stored dollars goes up by one dollar. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
And, at time
t+1, when the government offers to buy back that dollar at the same price path
as before the QE, he buys it back. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
What does all
of this get person z? How does this alter his wealth at time t+1?<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
The forgone
p_(t) stored C's used to buy the dollar at time t, means that he won't get a
return of x(t+1) on those C's now. So the loss is: –p_(t)x(t+1).<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
But, he will
now be able to sell a dollar for p(t+1) at time t+1. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So, at time
t+1, his wealth will go up/down by:<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
–p_(t)x(t+1) +
p_(t+1)<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
And the government
will be foisting the QE profit/loss on him of:<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
p_(t)x(t+1) –
p_(t+1)<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle">
So, the two perfectly cancel each other out, and
he's left with the same exact consumption/investment path possibility set as
before, and so he will do exactly the same thing as before. And because he will
voluntarily take the other side of the government's QE transactions at the old
market prices, the old market prices will have no pressure to move. They'll
stay the same.<o:p></o:p></div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So, boys and
girls, if you start in equilibrium with a certain set of market prices and
optimizing behavior of your citizens, you will stay in equilibrium after this
QE, and with no change in prices, of any asset, including money, and no change
in consumption and investment decisions of any person! Viola!<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
But! A lot of
things to note. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<b><u>So, it works in the model. But,
important notes:<o:p></o:p></u></b></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Wallace's
requirements for a QE are really strong and unrealistic. This is really
sensitive to and dependent on perfectly complete and frictionless markets,
which we are far from. Let alone perfect expertise, perfect public information,
perfect self-discipline, perfect liquidity, superhumans.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
But still, even
given these things, you might ask in the just completed example, what if our
intrepid person z, who the QE profit is to be foisted on, doesn't have any
saved/stored C's with which to buy the government's newly printed QE dollar? <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Well, complete
and frictionless markets! Person z borrows p_(t) C's from someone, and uses them
to buy the QE dollar. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
At time t+1 person
z owes that person what that person would have gotten had he stored/invested those
C's as originally planned: p_(t)x(t+1). <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
But, person z
will get at time t+1, p_(t+1), from selling the dollar. So, the net at time t+1
is: <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
–p_(t)x(t+1) +
p_(t+1) <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Just as before.
Which will neutralize completely the QE profit the government will foist upon
person z at time t+1.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
O.k., so what
else could go wrong? <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
What if, in
foisting the government's QE profit/loss on the citizens, they decide they will
give it to person z <i>only</i> if it's a
profit, and person w only if it's a loss. That would certainly cause a change
in those two people's consumption and investment plans, which would then put
pressure on prices to change. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Well, uh-uh.
Wallace has that covered. He just doesn't allow it. Any QE, or other
monetary/fiscal operations, are required to not change the net present value of
any person's lifetime wealth. So, every person's consumption/investment path possibility
set must remain 100% unchanged by the QE. This is what requirement (a) of the
Irrelevance Proposition means.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Note, of
course, that in the real world any profit/loss the government has from a QE
will not be distributed so that there are no winners and losers. If the QE ends
up taking money away from the government, some people will lose, and others
won't be affected, or won't be affected as much. If the QE gives money to the
government, some people will get tax cuts/transfers; others won't, or will get
smaller tax cuts/transfers.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So really,
honestly, in this model it works because Wallace rigged the game, with his
extremely unrealistic requirements for the QE, and assumptions about the people
and markets. This is not to say that the model is still not good and useful,
that it still cannot give us intuition, but it does show the folly of interpreting
it literally to reality.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<b><u>The Natural State in the World of
Wallace – Hold on to your seat!<o:p></o:p></u></b></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Now, important
and interesting note: People voluntarily hold money in this model even though
no liquidity/convenience benefit is included. They do so for the financial
return. It's an interesting (or funny) thing about this model, and it makes it
so that deflation – and the zero lower bound – <i>are the natural state!</i><o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Why? We're
assuming we start in equilibrium, so all assets are held unless they are
worthless. But a monetary model where money is always worthless is not very
useful, so Wallace mathematically requires that this cannot happen with
equation (4), which makes it so money is worth something: p(t) > 0, all t.
But the only way it can be worth something in this model is its financial
return, since the model gives it no convenience for making transactions benefit,
or ease of wealth storage benefit. The model gives it no benefits at all other
than its return, no different from any other financial asset.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
And if you were
to calibrate this model to typical historical conditions in an advanced
economy, the expected return on all financial assets would be positive (other
than those which act as insurance). Thus, typically, money appreciates, i.e.
deflation! And people voluntarily hold money without getting interest, just for
the appreciation. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
And in this
model there's not a reason to pay interest when borrowing money. First, if
someone borrows a dollar, there is no default risk. The model does not specify
one, and it includes no frictions. And dollars, unlike C's, are not productive.
They don't produce anything over time. It's C's, the real goods, that produce
something, and give you that return the model specifies of x(t). Papers with
dead presidents just sit in a vault, or as electrons on bank computers. You
only get a positive return from them if their price in real goods, C's,
appreciates, which it does under normal circumstances.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So people are
going to hold these papers with dead presidents collecting dust and doing
nothing anyway. It's no cost to them to loan them to someone during the time
they were going to just sit there anyway. And the markets are frictionless, so
there's no extra fee for selling short any asset, including dollars. You might
say the perfect competition in the model, no monopoly power, pushes the short
selling fee to the actual costs of the short-seller, which are zero. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
But finally, in
the model, equation (4) makes it so the price appreciation alone makes the
return on dollars fair at the current state prices. If there were interest on
top, there would be an arbitrage. You would just construct a synthetic dollar,
like with state price contracts, sell it short, buy an actual dollar, and
collect the interest for free. So the arbitrage pressure will push the interest
rate on dollars to zero.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
There is,
though, the question of why in the real world then money normally has a
positive interest rate. I would say the answer is that the interest rate is
really on the borrowing of real productive goods. The money just facilitates
the borrowing of real goods transactions.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
But in any
case, you can see clearly by arbitrage that in Wallace's model money pays no
interest. All you get is appreciation.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Thus, the
interest rate on money is zero, i.e., zero lower bound!<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So in Wallace
ZLB and deflation are not some weird exception; they're the rule!<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<b><u>Wallace Neutrality in the Real World?<o:p></o:p></u></b></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Ok, now, we
see, hopefully, the intuition for why irrelevance works <i>in the model</i>, why a QE would have no effect, but what about in the
real world?<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
First, of
course, the vast majority of people in the real world are very far from having
perfect expertise in finance – and every other subject there is – as the
Wallace model, and the typical modern macro model, assumes. They're also far
from possessing in their brains all of the public information there is, and
being able to access it, and analyze it, instantly, perfectly, and costlessly,
to find the perfect optimization path for their consumption, and how to invest their
savings.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So, of course
we don't interpret this kind of modern macro model literally to the real world.
We think very carefully about how the big, or <a href="http://richardhserlin.blogspot.com/2013/12/surveys-showing-massive-ignorance-and.html">comically
big</a>, deviations of the real world from the model's assumptions will affect
the results, how policy will work, and what the optimal policy is for what you
want, and for your values, for what your optimization function is for society,
for what your loss function is, etc. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
This last one
is not a normative statement where I note one's values, loss functions, etc. I
am saying – to give an example – <i><u>if</u></i>
you want to maximize total societal utils, <i><u>then</u></i>
this is the best policy. I'm not saying you should choose the policy that
optimizes total societal utils, just like if I give the policy that's Pareto
optimal, I'm not saying that you should choose that option. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
And no, you
don't do the Pareto option automatically. Just because it's better than the
status quo, does not mean it's the option society will prefer the most of any
available option. <a href="http://richardhserlin.blogspot.com/2014/05/always-rule-out-all-options-but-two.html">There
are other choices besides Pareto and the status quo.</a> One of the biggest
ones of interest to most people would be the one which maximizes total societal
utils, and since often that one will provide gargantuanly more total societal
utils than the Pareto one, or make 99+% of the people better off than the
Pareto one, well, call me funny, but that might be something people might want
to know about, other than being kept blind to any option but two, Pareto and
status quo.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
In any case,
whatever our values, and if the analysis is being completely positive, and just
exploring and giving information on options of interest to the public, with no
endorsement, it is not intelligent, or realistic, to not consider carefully how
the real world differs, and behaves differently, from the model. And this is especially
true with a model as extremely unrealistic in very material ways as Wallace's. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So, let's
consider this here.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Wallace works
because people see what the government is going to do in every possible state
of nature perfectly, and respond with their plans perfectly to the QE. Again, I
have to dwell on this, because it's frighteningly, and maddeningly, absurd to
see economists at top universities taking this literally, or highly literally –
And yes, many of them are not that stupid or detached from reality. For many they
say this to make their hard won specialization more valued, or to make their
right-wing ideology sound more attractive to the public, to the policy makers
and the voters. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
But it should
be obvious, if you've lived beyond childhood not detached from the world, that
almost no human is anywhere close to like this. And the vast majority are very
far. Just one example, which should come as little surprise: People were <a href="http://www.washingtonpost.com/blogs/wonkblog/wp/2013/11/07/the-budget-myth-that-just-wont-die-americans-still-think-28-percent-of-the-budget-goes-to-foreign-aid/">recently
surveyed</a> on what percentage of the federal government budget is foreign
aid. Now, these are the people who supposedly know government spending so well
that they always respond perfectly in their consumption and investment plans to
any change; or expected change. On average, they overestimated it by 28-fold!
And it's not 28 times a trivial amount. Actual foreign aid spending is just
under 1%, and the average estimate is 28%, of government spending! <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
And it's not
just some outliers skewing the average. Only 4% of those surveyed answered in
the correct range, 0-1%. Only 29% gave an answer that was off by less than
10-fold.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle">
Paul Krugman wrote in his<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;"> 1994 book, Peddling Prosperity:<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="margin-bottom: 8.0pt; margin-left: .3in; margin-right: .3in; margin-top: 0in; mso-add-space: auto;">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">Does this argument sound
convincing? It did (and still does) to many economists. Akerloff pointed out,
however, that it depends critically on the assumption that people do something
that they are unlikely to do in real life: take account of the implications of
current government spending for their future tax liabilities. That is, the
claim that deficits don't matter implicitly assumes that ordinary families sit
around the dinner table and say, "I read in the paper that President
Clinton plans to spend $150 billion on infrastructure over the next five years;
he's going to have to raise taxes to pay for that, even though he says he
won't, so we're going to have to reduce our monthly budget by $12.36...the
truth is that even families of brilliant economists don't have conversations
like this. (page 208)<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">So the vast majority, to the extent they're aware at all of a QE, are not
going to explicitly change their consumption and investment plans – to the
extent they even have them – to counter the government's QE. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">But what about sophisticated investors? What about actively managed funds,
which have some of the savings of the unsophisticated?<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">It is often counter argued that you don't need every investor to be
rational. As long as you have some marginal investors who are rational, then
they will be enough to push prices all the way to efficiency, all the way to
what the model says. My reply to this argument is as follows, with the first
points being more general, followed by those more specific to the Wallace model:<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<b><u><span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">Why a minority of savvy
investors at the margin is not enough to push prices to efficiency<o:p></o:p></span></u></b></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">1) Enormous, Profound, and Widespread Inexpertise and Ignorance – We
always hear the issue as being rational vs. irrational. Well, I could be 100%
rational and logical, but if you ask me my opinion on the construction of a
nuclear power plant, I will give you some extremely sub-optimal advice. Why?
Duh, because it's far more than rationality; it's usually far more expertise
and information. No matter how rational I am, I'm incredibly inexpert on making
decisions on nuclear power plant design, and have comically little of the information
important to making those decisions. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">Again, should be ridiculously obvious, yet the discussion in academic
economics and finance is always about rationality. Is there some Harvard evolutionary
theory that shows how people can be tricked to think and act irrationally in
some way, sometimes. Well, this may be fancy and intellectual sounding enough
that you can get it published in a top journal, and avoid grievous career
punishment and get big career rewards, but it's usually nothing compared to the
typical person's massive and profound inexpertise, ignorance, and
misinformation. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">But that's not fancy enough sounding or otherwise acceptable to give as
an answer, or put in a paper, if you don't want the massive sticks or to lose
the massive carrots those with power in economics and finance academia wield.
So we ignore the pink elephant in the room.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">2) Undiversification – A savvy investor is limited in how much he will
push the price of an asset to efficiency by how undiversified his portfolio
becomes as he buys more and more of that asset. This is a point that honestly I
have never heard explicitly stated in six years of intensive finance PhD study,
and much academic study after that. I got it published in a </span><a href="http://works.bepress.com/richard_serlin/1/"><span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">letter in The Economist's Voice</span></a><span style="line-height: 107%; mso-bidi-font-size: 12.0pt;"> (a journal written to be
accessible to policy makers, but edited by Joseph Stigletz and Brad DeLong).
Quoting myself:<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle" style="margin-bottom: 8.0pt; margin-left: .3in; margin-right: .3in; margin-top: 0in; mso-add-space: auto;">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">...One reason which was missing,
at least explicitly, and which I have not seen yet in the literature, at least
explicitly, is that a smart rational investor is limited in how much of a
mispriced stock he will purchase or sell by how undiversified his portfolio
will become. For example, suppose IBM is currently selling for $100, but its
efficient, or rational informed, price is $110. It must be remembered that the
rational informed price is what the stock is worth to the investor when added
in the appropriate proportion to his properly diversified portfolio of other
assets. Such a savvy investor will purchase more IBM as it only costs $100, but
as soon as he purchases more IBM, IBM becomes worth less to him per share,
because it becomes increasingly risky to put so much of his money in the IBM
basket. By the time this investor has purchased enough IBM that it constitutes
20 percent of his portfolio, the stock may have become so risky that it’s worth
less than $100 to him for an additional share. At that point he may have only
purchased enough IBM stock to push the price to $100.02, far short of its
efficient market price of $110. Thus, if the rational and informed investors do
not hold or control enough—a large enough proportion of the wealth invested in
the market—they may not be able to come close to pushing prices to the
efficient level.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">3) The Limits of Arbitrage – This refers to the seminal paper, </span><a href="http://www.nber.org/papers/w5167"><span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">The Limits of Arbitrage</span></a><span style="line-height: 107%; mso-bidi-font-size: 12.0pt;"> by Andrei Shleifer and Robert W. Vishny. It really
involves "arbitrage" (vs. arbitrage, with no quotation marks). True
textbook arbitrage, by contrast, involves zero risk and zero upfront money, yet
you get money from the transactions involved, either now or sometime in the
future. The far more popularly referred to "arbitrage" is something
that makes an abnormally good risk-adjusted expected return, or is an
abnormally good risk-adjusted gamble, but does involve some risk (sometimes a
lot!), and possibly upfront money too. The use of arbitrage for "arbitrage",
as you might guess, is something that irritates me, and I think causes a lot of
confusion and misunderstanding. We really need a separate term for
"arbitrage". I actually like "arbitrage", as the quotation
marks give it the needed pejorative connotation for those who use it like it's
arbitrage.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">In any case, the paper's main point is that if prices move away from
their efficient level, then there exists an "arbitrage" (and maybe,
but only very rarely, an arbitrage). However, the benefits of this "arbitrage"
may take a long time to appear. And, an "arbitrage" involves risk, so
even though ex-ante it's the smart move, there's usually a significant risk,
maybe even a large risk, that it will go badly or very badly ex-post. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">Next, the paper notes that often wealth is managed by an agent, not the
principle. It may be a fund manager, an advisor, or a corporate officer, to
name a few. And this is usually because the principle has relatively little
understanding of, or information on, investments.<a href="file:///C:/Users/RHS/Dropbox/Richard/Research/Wallace%2081%20AER/The%20Intuition%20Behind%20Wallace%20Neutrality,%203.1.docx#_edn1" name="_ednref1" title=""><span class="MsoEndnoteReference"><!--[if !supportFootnotes]--><span class="MsoEndnoteReference"><span style="font-family: "times new roman" , serif; font-size: 12.0pt; line-height: 107%; mso-ansi-language: EN-US; mso-bidi-language: AR-SA; mso-fareast-font-family: Calibri; mso-fareast-language: EN-US; mso-fareast-theme-font: minor-latin;">[1]</span></span><!--[endif]--></span></a> So, if a principle's agent
takes on an "arbitrage", this arbitrage may take a long time to do
well. In the short or medium run, it's not that rare for it to do badly, even
horribly. The agent can tell the principle, this is a long-term investment. In
the long run it will do well. But the principle will not know if he's lying,
given the principle's inexpertise and ignorance, so he may fire the agent and
sell the investment for a loss. Moreover, even if the principle is trusting and
patient, the investment may still ex-post do badly, or even disastrously. It
was only a good deal ex-ante.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">The agent knows that he certainly faces these risks to his job, and
career, so he may play it safe and forgo the "arbitrage" for an investment
that he knows has a worse risk-adjusted expected return, but is well respected
among laypeople, and thus relatively safe for his job and career. Asymmetric
information may not exist in the typical freshwater model, but that won't stop
it from killing an investment manager's career – or for that matter, making
Americans pay horrifying costs for their healthcare compared to countries that
admit this reality (as well as rampant monopoly power, profound externalities,…)<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">The result is that lots of wealth will not be put into "arbitrage"s
by agents, limiting the forces pushing prices towards efficiency. Agents will,
of course, still take every bit of arbitrages they can get, as they don't even
need the principle for this. They can do it for themselves. Remember arbitrages,
as opposed to "arbitrages", require absolutely no upfront money, and
are absolutely zero risk. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">Now, in the Wallace model, how would this affect the results?<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">Well, first, Wallace works because every individual is a superhuman
perfect expertise, perfect information, perfect foresight optimizer. So, no one
would pay to have someone else decide how to invest their money to start with!
And, on top of the fact that an agent would be unnecessary, he would also not
know your utility function perfectly. You could do it yourself better, in less
than a nanosecond, and perfectly, and at zero cost in effort, time, or money. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">That is what the Wallace model, and the typical modern macro model,
assumes.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">But, people do commonly hire agents, and have them manage a substantial
portion of their savings. Let's consider a fund, for example. The fund has many
participants. When the government announces the QE, the fund manager can't
perfectly counter the QE to maintain the same consumption path for all of its participants
in any states, because the transactions that perfectly counter the QE for
person i will be different than those that counter it for person j. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">But, you may say: Well, each person can just go into the perfectly
complete markets and counteract the fund manager, by buying and selling the
appropriate combination of state-price contracts. Except, of course, we have
nothing close to these kinds of assets in actual financial markets. And the markets
are far from frictionless – from transactions costs to taxes. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">I'll talk more about this agent-principle problem from "The Limits
of Arbitrage" later, with regard to other questions and issues.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">4) Incomplete and frictioned markets, especially the inability to short
sell short at low cost, or at all – In Wallace, like in the typical modern
macro model, markets are perfectly complete and frictionless. And, you start in
equilibrium, with perfect efficiency. Suppose then, the government decides to
do a QE. They start buying a financial asset, and if they push the price up,
then it now has an abnormally low risk-adjusted expected return. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">So, the savvy investors will have an incentive to sell their holdings
until the price goes back down again, so it's no longer a bad deal. But what if
the selling of the savvy investors, even completely exhausting all of their
holdings, is not equal to the government's buying at an elevated price? So the
price is not pushed all the way back to efficiency. Then, the next step the
savvy investors might want to take is to sell short. But if they can't, because
the asset is not sold short, then the savvy investors can act no further. The
price of the asset will remain above efficiency.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">And in the real world it is common for assets to not have a short sale
market, or for the transactions costs of a short sale to be high. And, savvy
investors are still limited by their resources and credit worthiness, even when
a moderately-frictioned short-sale market exists. They have to be able to meet
the margin calls, for example.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">5) Required equations (a) and (b) won't hold in the real world – Equation
(a) says that any monetary/fiscal operation, like a QE, must leave every single
citizen no better or worse off financially. That is, the net present value, at
the initial state prices, of their lifetime income and wealth must not change
as a result of the monetary/fiscal operation for Irrelevance to hold. In
addition, (b) says that any profit or loss from the monetary operation must be
100% foisted on the public, on the tax payers, by adding to or subtracting from
their transfers net of taxes. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">But, of course, in the real world the government might not fully return
all profits to the citizens in reduced transfers minus taxes, and in such a way
that everyone has the same total net-present-value of wealth as before. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">The government might take the profits from the QE and give them to
certain groups of people, but not others. Or, it may "consume" the
profits, to use Wallace's term, by spending them on infrastructure, or basic
scientific and medical research. Likewise, any loss from the QE might be
recouped by raising taxes predominantly on only some groups of people, like the
wealthy through income and estate taxes, or the poor and middle class through
payroll and sales taxes.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">The main idea is that even if every person in the country is a perfect foresight,
perfect optimizing, super-cyborg savvy investor, the QE might not conform to
Wallace's requirements (a) and (b), and so their income paths and lifetime
net-present-value of wealth will change. Thus, as perfect optimizers, they will
then change their consumption and investment plans to accommodate. And this
will affect the demand for financial assets, and their supply, thus affecting
prices. So, this is another mechanism making Irrelevance not hold.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">Of course, in the real world when the Fed does a QE, or any monetary
operation, the fiscal branches of government don't say to the public we guarantee
that any profit or loss from this QE will be returned to the citizens in
increased/decreased transfers net of taxes, and in such a way that no one is
any wealthier or poorer. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">Clearly, this is far from what happens, and basically no one watches the
ultra-complicated government and political system very closely, or accurately,
and acts accordingly with their financial plans anyway. The average person </span><a href="http://www.washingtonpost.com/blogs/wonkblog/wp/2013/11/07/the-budget-myth-that-just-wont-die-americans-still-think-28-percent-of-the-budget-goes-to-foreign-aid/"><span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">thinks</span></a><span style="line-height: 107%; mso-bidi-font-size: 12.0pt;"> the federal government
spends 28% of its budget on foreign aid. The actual amount is only about 1%. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">And even the extremely savvy minority of investors won't have this
information and ability in their heads. But even if they did, equations (a) and
(b) won't hold, so they won't keep their consumption/investment plans
unchanged, and so invest perfectly against the QE buying of the government. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">And the profits from a QE can be substantial. Since the financial crisis
of 2008, the federal government has received </span><a href="http://www.federalreserve.gov/newsevents/press/other/20150109a.htm"><span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">over half a trillion dollars
in profits remitted by the Fed</span></a><span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">, and it looks like it could exceed one trillion before it's
over. Depending on how this money is used, it could certainly have a
substantial impact on demand, and the economy.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">6) Investors cannot be sure if and when the QE will be fully reversed –
In the Wallace model, our cyborg investors know, with certainty, that all of
the dollars that the government is selling for C's, or financial assets, will
be purchased back again at a specific time in the future.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">The plan is that these dollars will be sold by the government, then you
will buy some, and then the government will buy them back from you in the
future. And, if the price changes so you get a loss from this (which will be
the government's gain), then the government will fully compensate you for this
loss with increased transfers minus taxes. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">And if the price changes in your favor, so you get a gain, compared to
your consumption/investment plan before the QE, then the government will fully
take that from you by decreasing your transfers net of taxes. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">So, the public will want to buy what the government sells, so as to keep
their optimal consumption/investment path unchanged. They know the government
will buy it back, and will be compensating them personally for whatever profit
or loss this involves.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">But of course, if they don't know that, then it's a very different story.
If they think that the government might not buy back their dollars, or all of
them; if they think that the government might permanently increase the money
supply, then they might not buy all of the dollars that the government is
selling at the current market price.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">And in the real world, unlike in the world of Wallace, the public is not
certain that the government will be buying back all of these dollars from a QE
at some future time. So they will not act accordingly, as in the Wallace model.
<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<b><u><span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">But can Wallace neutrality
kind of work, to some substantial extent? Can it be a substantial factor?<o:p></o:p></span></u></b></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">The biggest real world factor I can see in the Wallace model is the
thinking, at least by some expert investors, or expert agents of investors,
that the Fed is likely to reverse the QE at some time in the not too far future.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">If the Fed goes out and buys one billion ounces of gold, and expert
investors know that tomorrow the Fed will sell all of them back, then if the
price of gold rises by a substantial amount, you're going to see these expert investors
selling all of the gold they hold. If it rises more, they'll start really
short-selling it.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">But with a QE, even expert investors can't be so sure when, or even if,
the QE will be fully reversed. So they certainly expose themselves to risk by
selling, and/or short-selling, into the QE. And the more they do it, the higher
the risk, as their portfolios become more and more weighted by their
short-positions, and thus, more and more undiversified, more and more exposed
to the little-diversified-away idiosyncratic risks in an increasingly
undiversified portfolio. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">And the idiosyncratic risks can be very substantial, depending on the
assets. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">Now, compare this one billion ounces of gold example to another example;
one where the Fed's QE is a lot more spread out over many financial assets, and
so they're only buying just 1% of the world's gold. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">And suppose expert investors think that it will probably be at least 10
years before the government sells any of it back again. Furthermore, they think
there's a good chance that the government will never sell any of it back, or
will sell back only a small fraction of it. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">Now, what if expert investors see the price of gold inch up from the government's
QE? <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">Are they going to say, hey, I'll keep short-selling with every resource I
have until the price of gold goes 100% back down again because gold is
over-priced? <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">Of course not. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">Over a 10 year period having a portfolio composed entirely, or
predominantly, of gold-shorts would expose the expert investor to ridiculous idiosyncratic
risk! This would totally outweigh any benefit from gold having a somewhat
above-average expected return for its beta. And this isn't even mentioning the
principle-agent problem of "The Limits of Arbitrage".<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">So no, if the government does a large and a very unconventional QE, even
the expert savvy investors or agents are not going to sell into it nearly hard
enough to negate its effects on asset prices and inflation. And this isn't even
to mention the vast majority of investors who are not expert, and are just
basically oblivious to the QE, or grossly misinterpreting it. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">And look at the current QE, or unusual monetary maneuvers. Already it's
been over seven years since the Fed began its large and unconventional
stimulus, and </span><a href="http://www.federalreserve.gov/monetarypolicy/bst_recenttrends.htm"><span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">the balance sheet has only
grown</span></a><span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">, from
around $900 billion in 2008 to $4.5 trillion today. And no one thinks it will
wind all the way back to "normal" anytime soon.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">So I would think that if the QE is very large and unconventional, it will
have a substantial effect. And it appears that's what the empirical research
shows. </span><a href="http://homepage.ntu.edu.tw/~yitingli/file/Money%20and%20Banking/williamson_2014.pdf"><span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">Ben Bernanke said in 2014</span></a><span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">, “Well, the problem with QE
is it works in practice, but it doesn’t work in theory”. </span><a href="http://rogerfarmerblog.blogspot.com/2014/08/why-death-matters-for-central-bank.html"><span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">Roger Farmer also wrote</span></a><span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">, "A wealth of evidence
shows not just that quantitative easing matters, but also that qualitative
easing matters. (see for example Krishnamurthy and Vissing-Jorgensen, Hamilton
and Wu, Gagnon et al). In other words, QE works in practice but not in theory.
Perhaps it's time to jettison the theory."<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">And this is with QE's that aren't inordinately big relative to the
economy. To those who say QE's cannot have an effect due to theory, that aren't
convinced by the empirical studies, I would ask do you still think a QE would
have no effect if we made it larger and larger. Would a QE of $10 trillion have
no effect? $50 trillion? 100? <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">How confident are you that this freshwater theory mirrors reality? And
how confident would you really be if you had to pay a big price for being wrong,
like the 99% who don't have jobs they can never lose, like tenured professors.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">So, all other things equal, the longer expert investors think the QE will
last before it's substantially unwound, the less they will sell into it. And so
the more the effect from the QE. There's just more time to be exposed to idiosyncratic
risk from taking on a large short-position.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">And, again ceterus paribus of course, the more unconventional the QE, the
less investors will sell into it. Because more unconventional assets usually
have higher idiosyncratic risk. <o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">And the less sure expert investors are that the Fed will fully unwind the
QE, ever; that it won't, to some extent, be a permanent increase in the path of
money supply, the less they will sell into the QE.<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;">And finally, with the Fed potentially handing over trillions in profits
to the fiscal side of government, it is possible for a QE to result in a large,
or much larger, fiscal stimulus. And to expert investors this fiscal stimulus
certainly could justify higher asset prices. Thus, the larger the forecast
profits to the federal government from a QE, the less expert investors will
sell into it<o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle">
<br /></div>
<div class="MsoNormalCxSpMiddle">
Next, we examine the important issue of reasons
why Wallace neutrality works in the model, as opposed to reasons <i>people might incorrectly think </i>are why
it works in the model, but in fact are not necessary.<span style="line-height: 107%; mso-bidi-font-size: 12.0pt;"><o:p></o:p></span></div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<b><u>Reasons why Wallace neutrality works in
the model, and <i>not</i> reasons why it
works in the model<o:p></o:p></u></b></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<u>Reasons why
Wallace neutrality works in the model<o:p></o:p></u></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Each of these
are necessary, but not sufficient:<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
1) Perfectly complete
and frictionless markets – In the model, the government gives the citizens all
the incentive they need to buy what the government sells in a QE. The government
says any profits/losses from this QE will be 100% foisted upon you in
increased/decreased taxes-minus-transfers. We will be buying back all of these
dollars next period, and when we do, any profit or loss from this will come out
of your transfers-net-of-taxes.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Now, I've
talked about this extensively previously in this post/paper. The government
could give the whole profit/loss to just one citizen, or it could spread it
around however it wants amongst the population. It won't matter for Irrelevance
(Wallace neutrality) to hold. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
But, to make
some points clear, let's suppose this special case: The government will be
printing 1 trillion dollars and using it to buy 2 trillion C's. We'll assume
the current market rate is $1 for 2 C's, or 50 cents per C. And suppose that
the whole profit/loss from this will be foisted on just one citizen, Mr. Jones,
who we will assume has no savings at all. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Well, for
irrelevance to work, Mr. Jones will have to be able to go short enough on C's
that he can buy every one of those one trillion dollars. And, in the end, when
the government reverses the QE, and buys back all of those dollars with its
stored C's, any resulting profit will be given to Mr. Jones. And he will use
that profit to pay off his shorting contracts. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Any loss to the
government from the QE, if one occurs, will also be foisted on Mr. Jones. And
he will pay this loss, perfectly, with his profits from his shorting contracts.
<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Thus, by doing
this, Mr. Jones guarantees that his consumption path will not change as a
result of the QE. And that's just what he wants, as a perfect-optimizing,
perfect-public-information, perfect-foresight, perfect-expertise,
instant-calculating, zero-calculation-cost-in-time-or-effort, cyborg. Which, of
course, everyone is. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
As such, Mr.
Jones had already figured out that this consumption path optimizes his expected
utility, and he doesn't want it to change. Not when the net-present-value of
what he has to work with, his consumption path possibilities set, hasn't
changed as a result of the governments plan to do a QE. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
And it hasn't. The
government is buying and selling at the market prices. It's buying a bunch of
stuff at the current market prices, and then selling it all back at the same
future market prices given the future state. So the net present value of all this
is zero, discounting at the current state prices.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
If you tell
someone I'm going to take some of the dollars I've promised you, buy an ounce
of gold with them for you, then I'll hold your ounce for one period, then sell
it, and give you what I get. Then your wealth hasn't changed, if markets are
complete and frictionless. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Why? Because if
you don't like all this stuff that was done for you at the market rates, then
you can just undo it all at those same market rates with shorts. And you end up
exactly back to where you were, with the same exact cash flow paths, the same
exact consumption/investment possibility set.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
And from there
you can change your paths and investments anyway you want at the market prices,
just the same as you could before the government did this. Your possibility set
has not changed. You can do all the same things you could before this
intervention, get all the same consumption paths over the states as before.
And, I talked about this earlier in the post in a more elaborate way.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
But, for you to
be able to do this, the markets have to be complete enough for you to reverse
what the government has foisted on you. And you have to be able to do it with
no transactions costs. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
Otherwise, your
consumption path possibilities set will change, and so you may choose a
different consumption path, and so different investments, and so you will put
pressure on the markets in a different way, and so the market prices will not be
the same, and so Irrelevance – a.k.a. Wallace neutrality – will not hold. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
2) The
profit/loss from the QE is 100% returned to the tax-payers – There's zero
change in government spending as a result. So, as noted in our example above,
Wallace basically requires that we perfectly rig the game. Government has to
credibly promise any profit from the QE to the citizens in increased transfers
net of taxes. Otherwise, they won't have the incentive to completely take the
other side of the government's trades at the current market prices. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
If the citizens
think they aren't getting those profits, that instead some of them will be
going to wasteful "government consumption" – you know, like basic
scientific and medical research, Heckman-style early human development investments,
and infrastructure – then the net-present-values of their endowments change. And
thus, their consumption path possibilities sets change. And, as a result, they
will choose different paths, with different investments, which will pressure market
prices differently, moving them from where they were.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
3) Superhumans,
and that means everyone, not just a minority of savvy marginal investors –Everyone
has to have perfect public information and be perfectly rational. But it's much
more than that. What's more important, but almost always ignored, is perfect
expertise. You can be as rational as Spock, and have all of the information in
the world, but if you have very little understanding of finance, like almost
everyone, then you will be far from optimizing your investing – Or your medical
care for that matter. And you must employ this perfect expertise and
information instantly; zero cost in effort or time, or you're going to take
short-cuts in your analysis, use rules-of-thumb, and so forth. So everyone must
be an Ultron. And just having some savvy marginal investors who are Ultrons
won't bail you out.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
As I've
discussed earlier, that an asset get mispriced means that its price is good or
bad for how it adds to a diversified portfolio. The price is good, say, for the
beta. It's a good deal only when added in the appropriate amount to your
portfolio. That makes it an "arbitrage", but it doesn't make it an
arbitrage. A minority of savvy investors won't keep buying it without limit,
because the more they buy, the more they get exposed to the assets idiosyncratic
risk; the more unbalanced their portfolios become. They're going to stop pretty
quickly. If the price of gold goes from $1,500/ounce to $1,600/ounce, with the
same fundamentals, the savvy investors of the world aren't all going to sell
all of their gold, and then if the price only drops to $1,590 short it with
every dollar they possibly can. The idiosyncratic risk is just too great. That
is not optimizing behavior for them. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
And, there is
the principle-agent problem explained in "The Limits of Arbitrage".<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So, <i>everyone</i> has to be an Ultron. Everyone
has to instantly respond to the QE saying, hey, the government's doing a QE; of
course, I know with certainty that they're going to 100% reverse the QE, and,
of course, when they do, 100% of the profit/loss will be remitted to the
citizens; and of that profit, I know exactly how much will be foisted on me,
and so I'll go out into the perfectly complete and frictionless markets and
100% counteract my chunk, taking the other side of the government's trades, so
that I keep my perfectly optimal consumption path for the current market prices.
<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
It's just so
obvious the economy works this way. I don't know why it's even a discussion!<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<i><u>Not</u></i><u> reasons why Wallace
neutrality works in the model, <i>not</i>
necessary<o:p></o:p></u></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
These reasons I
have seen put forward, or just thought of myself, as possibilities for why
Wallace neutrality might work in the model, but not in the real world. But it's
important to understand that they, in fact, are not specified in the model,
either explicitly or implicitly. And it's interesting that they aren't needed
to have Wallace neutrality in the model.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
1)
Representative Agent – Everyone can be their own person. You're free to be you
– as long as you're an Ultron. You can have a unique utility function, and the
economy includes as many unique people as you want. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
The basic
reason is that whatever utility function you have (with some completely mild
restrictions), Wallace rigs it so that it will be in your best interests to
either sit on the sidelines, or take the other side of the government's trades
at the current market prices. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
The unique
individuals in the economy want to keep their optimizing consumption/investment
paths at the current market prices. And Wallace requires the government to
hoist the profit/loss from a QE on this population of individuals. And that
gives the hoistee's, no matter what their utility functions are, an incentive
to take the other side of the government's trades, so as to make sure that
their unique utility functions, whatever they are, stay optimized at the
current market prices.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
2) Simple unrealistic
utility functions – Nope again, Wallace only requires very mild restrictions on
the utility functions: More income is better, the law of diminishing returns
sets in, and twice differentiable. Within that, it can be as complicated as you
want. The utility functions are not much of a source of consequential unrealism
in the model. That lies elsewhere.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
3) Simple
unrealistic set of financial assets – Again, no. Markets are 100% complete, so
any asset you can imagine is included, or can be produced synthetically at zero
transactions cost as markets are also frictionless.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
4) Closed
economy – Interestingly, it's not necessary. For Wallace neutrality to work the
government must credibly promise to foist whatever profits/losses result 100%
on investors in increased/decreased taxes net of transfers. This makes it
optimal for those investors to take the other side of the govenrment's QE
trades. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
But the
government doesn't have to distribute the QE profits/losses to everyone in the
world. They can foist them on even just one of the seven billion people on
planet Earth, and it works. That one person takes the other side of all the
trades, borrowing and shorting as much as necessary in the perfectly complete
and frictionless markets.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So the fact
that the markets are international, yet investors in other countries are not
affected by U.S. tax and transfer policy makes no difference. You don't need
them to get enough money to take the other side of the U.S. govenrment's QE
trades. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<b><u>Extensions – Ideas for new research
based on all of this<o:p></o:p></u></b></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
I hope I've
made it obvious at this point that there's no way Wallace neutrality will hold
in the real world. But the big question next is, how far from holding will it
be? <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
I could do a
theoretical model where we deviate from some of Wallace's assumptions and
formally prove that now equilibrium doesn't hold at the current market prices.
I could introduce a class of people who are not Ultrons, say, rule of thumb
investors; or goldbugs, people with an extreme lack of expertise and/or
information; or just normal people, who are people with an extreme lack of
financial expertise and information. And/or, I could relax the perfectly
complete and frictionless markets assumptions; I could introduce borrowing and
short selling constraints and costs. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
It wouldn't be
hard in these cases to prove formally that equilibrium no longer holds if there's Wallace neutrality. Would
this be publishable? It depends on how much I could math it up nicely, and make
the math look long and impressive enough. I easily might not be able to. It
might just be too fast and simple to prove these things formally, and my
sketches of this seem to indicate this. And since I have no name, it's not
looking like that could get published. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
But aside from that,
a big problem is that Wallace's model is really really general and vague. It's
basically just, people have utility functions – that's it! I mean, to get some
idea of how big an effect real world size deviations from the model have, you
need to introduce some kind of specificity, and hopefully calibration.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So, I think
what would be most useful would be to do a specific model with some calibration
to reality. Give people specific utility functions, say isoelastic, or
whatever's best, and calibrate the parameters to the real world. Then, look at
real world studies to see what percentage of people are rule-of-thumb savers
and investors, and put that in the model. Now, finding closed form impressive
looking mathematical solutions is going out the window, but is the goal to
impress with our math or be useful. Ok, let me rephrase that, <i><u>should</u></i> the goal be to be the most
useful to society rather than to most impress with fancy looking math? <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
If yes, then a
long time ago we should have been putting a lot of resources into constructing
elaborate and realistic economic computer simulations, where you don't get
closed form solutions, but you do get a lot more realism and precision. And I've
<a href="http://richardhserlin.blogspot.com/2013/07/how-about-model-just-as-simulator.html">said
this</a> for a long time. So, what I would want to do here is do a computer
simulation, where I give the citizens utility functions, and calibrate the
parameters to reality as best I can, and put in other specifics, and then just start
running it, trying various QE's, with various levels of non-perfection of
people and markets, and seeing how it affects things. <o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
So, very
largely a programming project.<o:p></o:p></div>
</div>
<div class="MsoNormalCxSpMiddle" style="text-align: left;">
<div style="text-align: justify;">
<br /></div>
</div>
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I have some
programming chops, and know some professionals who can help me, so maybe some
year, or decade, with my five minutes a week of free time…<o:p></o:p></div>
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As far as other
future projects. I think it was important to really explain all of this in
detail, and in as clear and easy to understand way as possible (for those with the
necessary considerable pre-requisites), so it was important to have a long
version. But, of course, few will read the long version. So next I'd like to
work on boiling it down, and then linking to the longer and better explanation.
So, on the agenda is a perhaps 1,500 word Intuition Behind Wallace Neutrality,
then 500 words, and even a two or three hundred word version. And, there's at
least a few specific related questions I'd like to discuss, like the long
awaited, and very interesting, answer to <a href="http://richardhserlin.blogspot.com/2012/08/wallace-1981-aer-puzzle.html">this</a>.
Stay tuned…</div>
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<span style="font-family: times new roman, serif;"><span style="font-size: 13.3333px; line-height: 14.2667px;">[1]</span></span> Yes, this is a case where inexpertise and ignorance are actually acknowledged,
and, in fact, pivotal, in a paper published in a top academic economics
journal. But, it's an exceedingly rare case. And its authors are famous Harvard
professors, who used clever math, and referred to a big mathematical model. If
you were much short of these things it would have been extremely hard and
unlikely to get this same exact insight published in an influential academic
journal.<o:p></o:p></div>
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Richard H. Serlinhttp://www.blogger.com/profile/09824966626830758801noreply@blogger.com2tag:blogger.com,1999:blog-122860087135730716.post-72229977151856236392015-03-01T22:01:00.002-08:002015-03-30T20:42:42.952-07:00Are the tribal really all 100% impervious to evidence, logic, science?<div style="text-align: justify;">
You hear this claim a lot. The very tribal: <a href="http://mediamatters.org/blog/2015/01/26/the-conservative-movement-is-infected-with-scam/202272">The tea partiers who get affinity fleeced</a> by get rich quick schemes (that the liberals don't want you to know because they hate America); the struggling single mothers with serious health conditions, just barely hanging on for their young children due to Obamacare subsidies, <a href="http://nymag.com/daily/intelligencer/2015/02/gop-realizes-obamacare-lawsuit-would-destroy-gop.html">voting straight-ticket Republican</a>; <a href="http://nymag.com/daily/intelligencer/2015/02/inhofes-insane-climate-denial-speech.html">James Inhofe bringing a snowball to the Senate floor</a> to prove global warming is a conspiracy of virtually 100% of climate scientists worldwide. </div>
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Wait, isn't he our chairman of the Senate's Environment and Public Works Committee? Strange days indeed. Most peculiar mama.</div>
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You can't reach them with evidence and logic. They are too tribal, too anti-science.</div>
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<br /></div>
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But is this really true, or true even of the only moderately tribal and unscientific, and to that hopeless a degree? </div>
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<br /></div>
<div style="text-align: justify;">
I'll get right to the punch line: First, most people are not that extremely tribal. That's a relatively small minority. And, there are some studies showing that at least the non-extremely tribal and unscientific can often be swayed by logic, evidence, science; at least if applied again-and-again, over the long run.</div>
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<br /></div>
<div style="text-align: justify;">
This recently came up in <a href="http://krugman.blogs.nytimes.com/2015/02/27/the-closed-minds-problem/?module=BlogPost-ReadMore&version=Blog%20Main&action=Click&contentCollection=Opinion&pgtype=Blogs&region=Body#more-38200">Paul Krugman's discussion</a> of why he's often not so "polite" or "civil".<a href="http://crookedtimber.org/2015/02/28/anti-anti-anti-science/"> John Quiggin makes</a> some very good additional points, and he notes:</div>
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<blockquote class="tr_bq">
The implicit, and false assumption in the anti-anti-anti-science position is that there is some better way of convincing the anti-science group to change their minds, for example by framing climate change in terms more congenial to political right-wingers. This is pretty clearly wrong. Long experience has shown that nothing is going to shift the right on an issue that has become a tribal shibboleth.</blockquote>
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It is true that the more tribal people get, the more the brain goes out the window in making decisions and accessing reality. It's why the extreme right is so preyed upon by members of their own tribe. But what percentage of the population is this tribal? </div>
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Far less than a majority. For example, <a href="http://www.rasmussenreports.com/public_content/politics/general_politics/january_2013/just_8_now_say_they_are_tea_party_members">a 2013 Rasmussen poll</a> has only 8% of likely voters saying they are Tea Party members, and <a href="http://www.gallup.com/poll/164648/tea-party-support-dwindles-near-record-low.aspx">a 2013 Gallup poll</a> has just 22% saying they support the Tea Party movement.</div>
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<br /></div>
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It's true that our system still has some highly undemocratic flaws (although we've obviously come a long way from the days when only white male land owners could vote); a citizen in Wyoming has over 60 times the voting power in the Senate of a citizen in California; we have extreme gerrymandering, and Supreme Court justices who stop vote counting to install their candidate for President, and allow massive money to bend political will with few and diminishing limits. </div>
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<br />
But if the vast majority are only at most moderately tribal, they may still be eventually reachable by strong logic and evidence. And, a strong majority can still usually get what they want over the long run, at least if it's something they feel strongly about.</div>
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<br /></div>
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So can just the moderately tribal, the moderately resistant, be reached? </div>
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<br /></div>
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I was a top salesman at one time, and I'm a successful entrepreneur and hold an MBA from a top business school. So I have some knowledge and experience with sales and marketing, with persuasion. My conclusion is that often logic and evidence can be powerful if applied persistently and well, again and again and again, especially over the long run, even with people who are moderately tribal, or unscientific, or go largely by feel.</div>
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<br /></div>
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But what about the academic evidence? This is something I will eventually research thoroughly. But I did recently read this in support: It's <a href="http://www.cjr.org/behind_the_news/the_backfire_effect.php?page=all">from the Columbia Journalism Review</a>:</div>
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<blockquote class="tr_bq">
So perhaps a single, credible refutation within a news article isn’t likely to convince people to change their views. But other research suggests that a constant flow of these kind of corrections could help combat misinformation. The theory is that the more frequently someone is exposed to information that goes against their incorrect beliefs, the more likely it is that they will change their views.<br />
<br />
“It’s possible there is something to be said for persistence,” Reifler said. “At some point the cost of always being wrong or always getting information that runs counter to what you believe is likely to outweigh the cost of having to change your mind about something. We need to figure out what is the magic breaking or tipping point, or what leads people to get to that tipping point. I think we’re just scratching the surface.”<br />
<br />
He pointed to a 2010 paper in Political Psychology by David P. Redlawsk and others, “The Affective Tipping Point: Do Motivated Reasoners Ever ‘Get It’?”<br />
<br />
The researchers sought to determine if a tipping point exists that could cause voters to abandon motivated reasoning and view facts in a more rational way.<br />
<br />
“We show experimental evidence that such an affective tipping point does in fact exist,” they write. “… The existence of a tipping point suggests that voters are not immune to disconfirming information after all, even when initially acting as motivated reasoners.”<br />
<br />
This tipping point is far from being identified, but it’s encouraging to think that repeated efforts to debunk misinformation, or to simply to spread the truth, may have an effect.</blockquote>
</div>
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So, it's not at all a closed case that: Of course you can't reach partisans, or the tribal, or those with a large propensity to make their decisions based on feel.<br />
<br />
At least if they're not the very hard core (and only a relatively small minority are very hard core), it's not clear that the're impervious to logic, evidence, science. We should keep that in mind.</div>
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<br /></div>
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I'd also like to highlight a great point <a href="http://crookedtimber.org/2015/02/28/anti-anti-anti-science/">Quiggin made</a>:</div>
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<blockquote class="tr_bq">
As Krugman points out, what matters is not the impact on the anti-science group themselves, but on the attitudes to that group among others. The recent measles epidemic didn’t have much of an impact on anti-vaxers, as far as I can see, but it certainly changed attitudes towards them, greatly reducing sympathy for their desire to pursue their deluded beliefs regardless of the risk to the rest of the community.</blockquote>
</div>
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I think a good example is smoking. <a href="http://edition.cnn.com/2009/POLITICS/06/19/tobacco.decline/">At one time</a>, many people resisted the idea that tobacco was very harmful, despite already overwhelming scientific evidence, and it was a tribal and political issue for many. But what happened? Eventually those who held this unscientific view were repeatedly shamed by scientific evidence, again and again and again. Over time, even if the most hard core wouldn't change their views, they did die off. And the young, who are more open, grew up hearing the scientific evidence. </div>
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<br /></div>
<div style="text-align: justify;">
Moreover, the non-extremely tribal, who are the majority, and even "Balanced" journalists, grew more and more shamed not acknowledging the overwhelming science (and see the last part of <a href="http://www.motherjones.com/kevin-drum/2015/02/climate-change-deniers-take-yet-another-hit">this</a>). So over time, it became an embarrassment to say, smoking is safe; it's all just a conspiracy. And very few would say this today. Over time, repeated hitting over the head with logic, evidence, science, worked. You just can't expect immediate results.</div>
Richard H. Serlinhttp://www.blogger.com/profile/09824966626830758801noreply@blogger.com2tag:blogger.com,1999:blog-122860087135730716.post-70248880902067413612014-10-31T12:21:00.000-07:002015-03-30T20:34:41.176-07:00Stunning Dishonesty and Chutzpah in Anti-Tucson-Democrat Mailer<div class="separator" style="clear: both; text-align: center;">
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<a href="http://3.bp.blogspot.com/-f2FiJJW4ZBo/VFPgp9MACZI/AAAAAAAAADs/kJBApYL0E9U/s1600/Anti-Ron%2BBarber%2BMail%2BPiece%2C%2BStunning%2C%2Brotated.jpg" style="margin-left: 1em; margin-right: 1em;"><img border="0" src="http://3.bp.blogspot.com/-f2FiJJW4ZBo/VFPgp9MACZI/AAAAAAAAADs/kJBApYL0E9U/s1600/Anti-Ron%2BBarber%2BMail%2BPiece%2C%2BStunning%2C%2Brotated.jpg" height="640" width="460" /></a></div>
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<br />
Late last night I found in our mailbox a campaign piece that just knocked my socks off, even in today's world of unlimited billionaire-powered propaganda. As you see above, the piece accuses Tucson Democratic House Representative Ron Barber (Gabby Gifford's old district) of voting for the Paul Ryan Budget, and how horrifying that budget is – their budget! I contacted Dylan Matthews of Ezra Klein's Vox about it, and he verified it, and now has a <a href="http://www.vox.com/xpress/2014/10/31/7137339/arizona-republican-ron-barber-paul-ryan">post</a> up.<br />
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It's like the fast food industry saying don't vote for Jack LaLane, he supports the junk food diet, with all the horrors of that diet. Instead, vote for the representative of the fast food industry that created and sells that diet! It's an astounding level of lying and Chutzpah, even by today's standards. For three years straight the Ryan budget passed the house <a href="http://www.washingtonpost.com/blogs/post-politics/wp/2013/03/21/10-house-republicans-vote-against-ryan-budget/">100% with Republican votes, not a single Democratic vote.</a> For crying out loud, Paul Ryan was the Republican Vice-Presidential candidate last election!<br />
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<b>Update:</b> I see it's now also up at <a href="http://www.motherjones.com/kevin-drum/2014/10/republicans-attack-democrats-supporting-republican-demands">Kevin Drum's Mother Jones' blog</a> and <a href="http://www.huffingtonpost.com/2014/10/31/ron-barber-congress_n_6083558.html">Huffington Post</a>. And from <a href="https://twitter.com/jonkarl/status/528267145835474944">ABC Chief Whitehouse Correspondent Jonathan Karl</a>, "About as cynical and misleading as it gets".Richard H. Serlinhttp://www.blogger.com/profile/09824966626830758801noreply@blogger.com0tag:blogger.com,1999:blog-122860087135730716.post-21218179535016204102014-09-18T13:17:00.001-07:002014-09-18T19:15:00.780-07:00Guest Post at Miles Kimball's on Wallace Neutrality in Theory and Practice<div style="text-align: justify;">
University of Michigan economist Miles Kimball was kind enough to ask me to comment on a <a href="https://storify.com/mileskimball/noah-smith-brad-delong-and-miles-kimball-on-wallac">recent Twitter discussion</a> he had with Berkeley economist <a href="http://delong.typepad.com/">Brad DeLong</a> and Stony Brooke economist <a href="http://noahpinionblog.blogspot.com/">Noah Smith</a> on Wallace neutrality. He was specifically concerned with how I would answer the question, Does Wallace neutrality result from (in theory) fiscal policy canceling out the Fed, or many private agents (the minnows) canceling out the Fed (the whale)? My answer, and more, is <a href="http://blog.supplysideliberal.com/post/97788494421/richard-serlin-in-theory-but-not-in-practice-the">here</a>.</div>
Richard H. Serlinhttp://www.blogger.com/profile/09824966626830758801noreply@blogger.com1tag:blogger.com,1999:blog-122860087135730716.post-30491355903166603542014-09-04T12:33:00.000-07:002017-05-05T19:25:02.368-07:00Am I taking crazy pills?!<div class="separator" style="clear: both; text-align: justify;">
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In 2010 I <a href="http://richardhserlin.blogspot.com/2010/01/if-our-health-care-system-really-is.html">first asked publicly</a> what I thought was a crucial question on health care, that I thought was not that unobvious, that no one was asking. Since then, I've periodically re-asked it (recently <a href="http://noahpinionblog.blogspot.com/2014/09/is-americas-health-care.html?showComment=1409626239915#c9047192909362260109">at Noah's</a>), and not only has no one answered it, no one else anywhere ever asks it! I read widely and deeply the economics and politics blogosphere and other media almost every day, thousands of pages per year, from Paul Krugman to Stephen Williamson, the Atlantic, the New Republic, Fed websites, major newspapers, Jonathan Chait, Jonathan Cohn, the links in Economist's View, the links in the Plum Line, on and on. And no one, <i>no one,</i> ever asks it! Why? Why does no one else ask this?!</div>
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Am I taking crazy pills?!</div>
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Here it is, reprinted from a January, 2010 <a href="http://richardhserlin.blogspot.com/2010/01/if-our-health-care-system-really-is.html">post</a>; maybe you can tell me if I am:</div>
<blockquote class="tr_bq">
<div style="text-align: justify;">
We spend about $100 billion per year on medical research, public and private combined (see <a href="http://www.cbsnews.com/news/spending-on-medical-research-soars/">here</a>).<br />
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We spend about $2 trillion per year on health care delivery, the doctors, hospitals, administration, etc. If we adopted a European style system, cutting our spending per person in half, as in European countries (that I think the evidence shows have about as good or better health care and results anyway; see for example <a href="http://voices.washingtonpost.com/ezra-klein/2010/01/america_spends_way_way_way_mor.html">here</a>), then we would save about $1 trillion per year.<br />
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Now, what if we spent that $1 trillion in savings on medical research? It would increase medical research spending more than 10 fold.<br />
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Even if delivery did get a little worse, even if we did get a little bit less of our brightest and best becoming doctors due to lower pay, it seems like this would be totally outweighed over the long run by tremendously more advanced medical understanding and treatments due to the 10 fold increase in medical research spending (or more, as some advanced universal healthcare countries provide comparable health care to the US at about a quarter of the cost per person) .<br />
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So it looks like if you want better medical results, better treatment, breakthroughs in rejuvenation, better odds of surviving cancer, you name it, you should support going to a European style system, and using the immense savings to increase medical research more than 10 fold.<br />
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So if our health care system really is more efficient than the Europeans, then why is it possible to make such a vastly favorable trade?<br />
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If the Republicans really care about our children and grandchildren so much why don't they do this, so in 50 years they could have medicine as advanced as it would take perhaps 150 years to achieve with our current system. I don't care how bad you imagine European health care to be, you cannot think a European medical center of today is less effective than even the Mayo Clinic of 100 years ago, when penicillin and polio vaccines hadn't even been invented.</div>
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Richard H. Serlinhttp://www.blogger.com/profile/09824966626830758801noreply@blogger.com0tag:blogger.com,1999:blog-122860087135730716.post-53035751507472289242014-08-10T15:38:00.003-07:002015-02-19T15:07:04.490-08:00The Intuition behind Wallace Neutrality, Attempt 3<div style="text-align: justify;">
Ok, if I might make another attempt to explain the elusive intuition behind <a href="http://ideas.repec.org/p/fip/fedmsr/44.html">Neil Wallace's model</a>, and why Wallace neutrality doesn't work in the real world. The issue recently <a href="http://noahpinionblog.blogspot.com/2014/08/can-fed-set-interest-rates.html">re-arose</a> in the econoblogosphere. I have two <a href="http://richardhserlin.blogspot.com/2012/09/want-to-understand-intuition-for.html">earlier</a> <a href="http://richardhserlin.blogspot.com/2013/09/the-intuition-for-wallace-neutrality.html">attempts</a> that I think are interesting and show some good intuitions. Here's try three:</div>
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Please consider this:</div>
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With Miller Modigliani (MM), if the firm borrows more, it increases the overall debt level of its shareholders. Since we're assuming at the start that everyone's a perfect optimizer, with perfect expertise, public information, etc., and since we're assuming we start at equilibrium, then everyone is already at their optimal debt level, that they want to stay at.</div>
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So, when the firm borrows more, the shareholders just borrow less, enough less so that their overall debt level remains unchanged.</div>
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In MM, it's a partial equilibrium model, in that the interest rate is taken as given, exogenous, to use the term of the biz; the people in the model can't change it. But even if it weren't, the total demand for debt in the debt market doesn't change, because it all comes down to the fundamental demanders: the people. The firm is just an intermediary for them. The firm demands more debt? Well, they just demand less by an equal amount. Total demand in the market as a whole remains the same, and thus so would the market interest rate, even if this were a global equilibrium model.</div>
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So, now we go to Wallace's 1981 AER paper, “A Modigliani-Miller theorem for open-market operations”. You look at it, and it's a wall of very terse math. I have the dreaded ABD in finance. But at least I took all the courses and passed all the written exams, plus a whole lot of study on top of that. I think I'm pretty good at decoding the intuition behind math. And I spent about 50 hours on this two years ago, a giant amount for me. Still, I would love to have two months uninterrupted to just study this paper. Ah, a man can dream… Some want to pet turtles in the Galapagos when they retire, some want to get jiggy with Wallace…</div>
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Oh, oh, ok, wake up. Anyway, I think I got, nonetheless, a substantial amount of intuition out, and I would venture this:</div>
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In Wallace's model, the government is like a big MM firm. And the citizens are shareholders of the government. When the government does the Wallace version of a QE, it basically is like it borrows more money (really lends, but let's look at the converse for now). That would make its citizens overall debt level higher than they like, so they want to borrow less by an equal amount to stay at their optimal overall debt level. The total demand for debt in the market remains unchanged. Government demand goes up by X, and private demand goes down by X, so the interest rate remains the same.</div>
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In Wallace, all people are perfectly expert, with perfect public information, can do all analysis and information gathering and digesting instantly, at zero cost, and are perfect rational optimizers. They start the model in equilibrium with their optimal level of debt, and if the government, that they're "shareholders" in, borrows more, then they just instantly borrow less by an equal amount. So, interest rates don't change.</div>
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More specifically, in Wallace there is a single consumption good. I called it C's. People save some of their C's for period two of their two period lives. The government's "QE" is to print dollars and exchange them for C's, which it will store for one period. Then it will sell all of those C's back again out into the market for dollars – with 100% certainty. That's their plan, everyone knows it, and they're going to stick to it.</div>
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The people own the government. They're its shareholders; they get dividends in the form of government transfer payments, so when this government "firm" saves more C's, by selling newly printed dollars to get C's, and puts them into storage, then the people's overall savings goes up – up above their optimum that they had settled on in equilibrium.</div>
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So they sell C's out of their private stores in an equal quantity to compensate. The total demand overall for the market to save C's for the future does not change, and so the interest rate doesn't either. And that's the thinking; that's why it works in Wallace's model. That's why you can prove no change when you do the math in this model.</div>
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But why wouldn't this work in the real world?</div>
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Well, first off, people are far from perfectly expert (especially in the super complex modern world), with perfect public information that they can gather, digest, and analyze at zero time, effort, or money cost. This should be like, duh, but then you hear some of the things some freshwater economists imply, and you're stunned. Partly to sell their ideology, partly to make the models they're top experts in more valued, partly, perhaps, just detached from reality from selling, and smelling, their own B.S. for so long. But for whatever reasons, obviously the vast majority of people are far from this.</div>
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So, when the government "firm" starts to lend a lot more, almost no one thinks, MM style, or Wallace style, I want to start selling some of my bonds to compensate in equal measure as I see them doing that. And so total lending in the market does, in fact, go up, and market interest rates drop. People just don't react that way. And it won't be nearly enough if a savvy minority do. They won't control enough money to drive us to Wallace neutrality.<br />
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It's like in Miller and Modigliani's model if the firms start borrowing a lot more, but the shareholders are mostly not really paying attention, and/or don't know well the implications, so, for the most part, they don't want to borrow any less to compensate. In that case, aggregate demand for borrowing would not remain unchanged. The aggregate demand curve for borrowing <i>would, </i>in fact, shift out, and the interest rate would rise.</div>
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Other issues: In the real world there are a lot more different kinds of financial assets than just money, and borrowing and lending the single consumption good risk-free, like in Wallace's model. So, if the government does a QE in just some types of assets, people, even if they are perfect at optimizing, won't be able to funge their portfolios to relieve completely price pressure on those assets. Markets are not complete, and far from it, so that you could construct a synthetic for any asset. I talk about this in <a href="http://richardhserlin.blogspot.com/2013/09/the-intuition-for-wallace-neutrality.html">an earlier post</a> on Wallace neutrality when I ask what if the government did a QE where they printed up a dollars and used it to purchase 100 million ounces of gold.<br />
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Next, Miller-Modigliani irrelevance doesn't hold if investors face different borrowing costs and liquidity constraints than the firm. Likewise, Wallace irrelevance will not hold if individuals and firms face different borrowing costs and liquidity constraints than the federal government. Do they? </div>
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Finally, Wallace's model assumes that with 100% certainty the central bank will completely reverse the QE one period later, and everyone knows this. All of the C's purchased with the newly printed dollars will be sold back. In the real world, investors cannot be completely certain a QE will be 100% reversed in the future.<br />
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<a href="http://rogerfarmerblog.blogspot.com/2014/08/why-death-matters-for-central-bank.html">From UCLA economist Roger Farmer</a>:<br />
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A wealth of evidence shows not just that quantitative easing matters, but also that qualitative easing matters. (see for example Krishnamurthy and Vissing-Jorgensen, Hamilton and Wu, Gagnon et al). In other words, QE works in practice but not in theory. Perhaps its time to jettison the theory.</blockquote>
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Richard H. Serlinhttp://www.blogger.com/profile/09824966626830758801noreply@blogger.com2