Thursday, November 15, 2012

What else do you consider gifts, Romney and Republicans?

So Mitt Romney considers things like health care, which may keep you or your children alive, and relief from often crushing and inescapable college loan debt, gifts.

Is there anything that the government does that they don't consider gifts for moochers?

The government provides free schooling for all children from the ages of five to eighteen. Is this a gift for moochers that Mitt and his fellow Republicans would like to see eliminated – you want your child to be educated, you pay for it? We've already dropped behind most advanced countries in the education of our population; why not just go straight to the bottom. You gotta eliminate those gifts to the takers. Hey, it's not like the long term wealth, health, and strength of a country depend on how educated it's population is.

What about aid to make a high quality college education affordable for the majority? Is that a gift for the takers we should completely eliminate? We've already dropped to 16th in college educated citizens after a generation of Republican dominance. How stupid do Mitt and the Republicans want us to be?

What about free public roads and infrastructure and vaccinations and fire protection? Gifts for the takers that should be eliminated? We should have only toll roads and private roads? Put out the fire yourself; it won't spread to the gated compounds of the rich, and neither will your diseases?

How much should we Hondurusize the country, Republicans, to eliminate all of the gifts?

Wednesday, November 7, 2012

No Law of One Price in the Presidential Betting Markets?

Uber-Efficent market types love to proclaim how the market is the most efficient and wise at setting the odds for anything, including the Presidential elections. But if that market is so efficient and wise, why does the Law of One Price not even hold?

From Ezra Klein, October 30th:
... BetFair markets give him a 67.8 percent chance, the InTrade markets give him a 61.7 percent chance...
Why wasn't this arbitraged away? You could put $61.70 on Obama winning at InTrade, with a $100 payoff with a win, and $32.20 on Romney winning at BetFair with a $100 payoff. And for a total of $93.90 you could get a guaranteed $100 a week later.

Why didn't people jump on this until it was bid away? According to Daily Kos:
The gamblers know about the existence of Intrade. They talk about how it isn't worth it to them to try to take advantage of the market inefficiency. They detail the process involved with trying to get a deposit on...

The gamblers also know about the existence of 538. Most knew Nate's work from baseball prior to politics. His work was very helpful for gamblers. Those people who tailed him profited. He has done some good work in other sports like soccer as well. He had models for entertainment betting as well (film awards and such). His work on politics made a lot of people money too. Senate races and presidential race in specific states were mispriced. (This was partially a loss-leader for the big websites, a known mispricing without that much exposure. Offer Senate races priced at 95% when they were really closer to 100%, but only at low limits. Max win from any race was $50. You'd have to tie up a grand to get that $50. Many sportsbettors had thousands tied up as they took all the huge favorites available.) Even by blindly following his numbers, you made money.
Update: Ravij Sethi informed me of a great post at overcommingbias on why arbitrage is difficult, and limited, to enforce the Law of One Price. Quoting:
Some noteworthy aspects of the situation are:

    – Americans can’t deposit money into Intrade using credit and debit cards – they have to use bank transfers.
    – Bank transfers take at least two days to arrive and cost over $20.
    – Everyone else can choose between cards and bank transfers.
    – Cards are instantaneous and free (if denominated in US dollars anyway) but have a $2,000 deposit limit in the first month, and $5,000 thereafter.
    – It takes at least a day, probably two, to open a new Intrade account and have it approved.
    – There are other significant barriers to entry – knowing about the issue, learning about the fees, opening an account with another betting agency and finally having the time and confidence to correctly place the hedge.
    – Intrade seems very widely covered by the US media.

Sunday, September 9, 2012

Want to Understand the Intuition for Wallace Neutrality (QE Can't Work), and Why it's Wrong in the Real World?

This refers to Neil Wallace’s 1981 AER paper, “A Modigliani-Miller theorem for open-market operations”. The paper has been influential today, as it has been used as a reason why quantitative easing can’t work. Here are some example quotes:
"No, in a liquidity trap, if the Fed purchases gold, it does not change the price of gold, just as it will not change the prices of Treasury bonds if it purchases them." – Stephen Williamson

"The Fed can buy all the government debt it wants right now, and that will be irrelevant, for inflation or anything else." – Stephen Williamson

"If it were up to me, I would have given Wallace the [Nobel] prize a long time ago, and I think Sargent would say the same. However, not everyone in the profession is aware of Wallace's contributions, and people who are aware don't necessarily get as excited about them as I do." – Stephen Williamson

"...the influence of Wallace neutrality thinking on the Fed is clear from the emphasis the Fed has put on telling the world what it is going to do with interest rates in the future...I have a series of other posts also discussing Wallace neutrality. In fact, essentially all of my posts listed under Monetary Policy in the June 2012 Table of Contents are about Wallace neutrality." – Miles Kimball
In Wallace’s model, when the Fed prints money and buys up an asset with it, this affects no asset’s price, and doesn’t even change inflation! Amazing claims, but they’re mathematically proven to be true – in Wallace’s model, and with the accompanying assumptions. So the big question is, even in a model, how can claims like this make sense? What could be the intuition for that?

For the vast majority of well-educated laypeople, the paper is impenetrable, foreboding math, and I’d say this is, to a large extent, true of economists not specialized in this area. I have a very mathematical economics background (see, for example here), and it took a lot of time and effort for me to really penetrate and understand this paper. It’s extremely terse, with very little explanation and derivation for non-specialists.

I had hoped to find someone who could explain the intuition on the internet, especially in the economics blogosphere. But after a lot of looking, and a lot of asking, I couldn’t find anything that really did it for me (The closest by far was this post from Brad DeLong.) So, I made the decision a couple of months ago to spend whatever time I could come by reading, studying, understanding, decoding, deciphering, this paper. Here are my current conclusions:

In the paper's model, the government's particular printing of more dollars and buying an asset has no effect on the price of any asset, and no effect on inflation either, but let's look at the particulars:

The government prints dollars and buys the single consumption good, which I like to call c's. It holds the consumption good for one period, storing it (investing it, or putting it into production) at the return x, the same return the private sector, or anyone else, gets for storing (investing in production) c's.

Then, at the end of that period, it takes all of those stored (invested) c's, plus whatever return it got for them at x, and uses it all to buy back dollars at the then prevailing rate of dollars for c's.

Now, note that Wallace does not say this explicitly, but if you study the equations and think about what they imply, you can see, and prove, that this is what must be happening. I spent a lot of time doing this (It would have been nice if he wasn't so amazingly terse and had explained/derived this – and a lot more).

Now, in this economy it's very simple. You either consume c's, or you store (invest) them. You can buy (or sell) state-contingent contracts to get a c in a particular state next period (People, who are clones with perfect information, foresight, and rationality, only live two periods, a young period and an old period.), but those contracts are backed-up just by one thing, storage of c's (or next periods economy-wide endowment, which is analogous to GDP not counting savings and their return).

So, in this model it's simply a case that when government prints money, it's just storing c's for one period. People are going to want to store a certain amount of c's anyway, because that's utility maximizing to help smooth consumption. What the government essentially does in this model is say, hey, store your c's with us instead of at the private storage facility. Give us a c, and we'll give you some dollars, which are like a receipt, or bond. We'll then store the c's – we won't consume them, we won't use them for anything (these are crucial assumptions of Wallace, required to get his stunning results) – We will just hold them in storage (implied in the equations, not stated explicitly).

Next period, you give us back those dollars, and we give you back your c's, plus some return (from the dollar per c price changing over that period). In equilibrium, the return from storing c's via the dollar route must be equal to the return from storing c's via the private storage facility route. Or at least the return must be worth the same amount at the equilibrium state prices; so either way you go you can arrange at the same cost in today c's, the same exact next period payoff in any state that can occur.

Note that dollars in this model are just zero-coupon bonds. Wallace assumes no value of dollars in lowering transactions costs, in convenience, or in liquidity. Transactions, liquidity, and convenience costs are zero in his model. People will hold no dollars (buy no dollars with their c's) unless their value appreciation will be equal (at the equilibrium state-prices) to if they stored their c's privately.

So essentially in the Wallace model the "open market operation", the QE, the printing of dollars, is just the government offering storage of c's that's exactly equivalent to what the private sector is offering, at no better a price (or maybe an epsilon better to get people to switch).

So what happens? Private storing (investing or utilizing in production) of c's goes down, and government storing (investing or utilizing in production) of c's goes up by an equivalent amount (and both the private sector and government get the same return from storing: x). No prices change, and people's consumption in youth and old age doesn't change.

It is analogous to Miller-Modigliani, in that if a corporation increases its debt holding, then shareholders will just decrease their personal debt holding by an equivalent amount, so that their total debt stays exactly where it was, which was the amount they had previously calculated to be utility maximizing for them (And there's a lot of very unrealistic and material assumptions that go with this that have been long acknowledged as such in academic and practitioner finance; when you learn Miller-Modigliani, at the bachelors, masters, and PhD levels – which I have –  they always start by teaching the model and its strong assumptions, and then go into the various reasons why it far from holds in reality. This is long accepted in academic finance; pick up any text that covers MM.)

There is one more powerful intuition that I'd like to note that's buried implicitly in this model:

Suppose dollars are printed and used to buy 10 year T-bonds. Or gold, like in the Stephen Williamson quote at the beginning of this post. And everybody knows (making a Wallace-like assumption) that in five years the T-bonds or gold will be sold back for dollars. We're making all of the perfect assumptions here: For all investors, perfect information, perfect foresight, perfect analysis, perfect rationality, perfect liquidity,...

Now, what is the price of gold? How is it calculated in this world of perfects?

Well, as a financial asset it's worth only what it's future cash flows are. Suppose you are going to hold onto the gold and sell it in one year. Then, what it's worth is its price in one year (which you know at least in every state – perfect foresight) discounted back to the present at the appropriate discount rate.

But suppose this: During that year that you will be holding the gold in your vault, you are told the government will borrow your gold for five minutes, take it out of your vault, and replace it with green slips of paper with dead presidents, then five minutes later they will take back the green slips and replace back your gold in the vault. Do you really care? This doesn't affect how much you will get for the gold when you sell it in a year, and as a financial asset that's all you care about when you decide how much gold is worth today.

If you're going to hold the gold for ten years, and sell it then, then you only care about what the price of gold will be in ten years. And the price of gold in ten years only depends on what the supply and demand for gold is in ten years. If the government takes 100 million ounces of gold out of private vaults, and put it in its vaults, then puts it back in the private vaults three years later, this has no effect on the supply of gold in ten years. So in ten years the price of gold is the same. And if gold will be the same price in ten years, then it will be worth the same price today for someone who's not going to sell for ten years anyway.

But what if you're going to hold the gold for less than ten years, for only one year, say? Here, I could see how you could do like an overlapping generations model kind of thing and say it still doesn't make a difference.

But I think the bottom line intuition is – with these very strong assumptions – if the price of gold, or zero coupon T-bonds, is the discounted value of what their price will be in ten years. And their price in ten years is based on their supply and demand in ten years. Then, if the government just holds it in its vault for a few of those intermediate years and then releases it, there will be the same supply of it in ten years, and thus it will have the same price in ten years. And if it will have the same price in ten years, then it will have the same price today (ceterus paribus, and with the typical assumptions of perfect frictionlessness, rationality, foresight, etc.). 

Here's a concise, and perhaps clearer version of this:

The government buys 100 million ounces of gold in a QE. The assumption is, of perfect foresight, perfect everything investors, that over the next several years, unemployment will go down and the Fed will reverse course, and then sell all of those 100 million ounces back again. Thus, the supply of gold in 10 years will be exactly the same as if the QE had never occurred. The gold just temporarily sits in government vaults (or with government ownership papers), rather than private ones, then goes back to the private vaults – no difference at all in 10 years. So, in 10 years the supply of gold is exactly the same, so the price of gold in 10 years will be exactly the same. If the price of gold in 10 years will be exactly the same, then its price today will be exactly the same, since with prefect foresight, perfect analysis, etc. investors, the today price is just the discounted 10 years from now price.

Next post, part II, I'll get to the problems when thinking if this actually occurs with QE in the real world:

Saturday, August 18, 2012

Try-and-See is the Key

Via Mark Thoma, Columbia economist Jeffrey Sachs writes:
Only a big political realignment, perhaps spurred by a third party bold enough to campaign on free social media rather than expensive television advertising, is likely to break the status quo.
The billionaire powered right has done immense, profound harm over the last generation, but what to do?

If Obama wins, Obamacare will survive for try-and-see, which will decimate the disinformation and ignorance, and we'll have universal healthcare that the Republicans won't dare ever take away.

But what next? Try-and-see is the absolute key to decimate ignorance and billionaire powered disinformation. The best thing we can do to make try-and-see far easier is end the filibuster -- very doable; the Democrats can do this with just a simple majority in the Senate.

Then, everything can change -- public option, even Medicare for all, can pass, and once try-and-see'ed the Republicans will never dare take it away (and will be devastated at the ballot box if they do, and it will then be reinstated quickly). Universal free pre-school and bachelor's degree, same thing.

And public appreciation for these things, like after the New Deal, can really increase the power of liberals. This can allow the passage of a huge public campaign finance bill, big enough to severely dilute the power of billionaire and corporate money, and it can also mean enough Democratic Supreme Court Justices to reverse Citizens United, and a virtuous circle can begin. So try-and-see is the key, and can start a virtuous circle.

A liberal third party, on the other hand, with our system, just makes things worse, giving it to the Republicans -- and we can thank a liberal third party for 8 years of W. But ending the filibuster, making try-and-see much easier, now that can strike a monumental blow against ignorance and billionaire powered disinformation. That can really change things for the better. For more on this, see here.

Wednesday, August 8, 2012

Wallace 1981 AER Puzzle

I'm currently putting whatever spare time I can find into Neil Wallace's 1981 AER. I'm trying to understand every equation, term, and sentence, separately and in combination, completely, and with the important intuitions to the real world. Not an easy project, especially since this is not one of my areas, but I really wanted to see if there was anything to the amazing claims you hear justified with this paper [1]. So far it's gone surprisingly well. I've by and large decoded it – and this paper is amazingly terse, with little or no derivation or explanation.

What I'd like to look into, when I'm finished going through the paper, is expanding on it by adding an error term, Eh, to the true state return vector, and/or state probability vector, to model heterogeneity of investor beliefs. That's something that obviously exists in large measure in the real world. I think if I did this I could prove that the irrelevance proposition no longer holds, and may be able to get some interesting results as to how and why. Currently in the model all investors are identical clones; same exact beliefs, utility functions, age, and perfect information, perfect foresight, perfect optimization analysis.

But first, my puzzle, which I find really curious:

For the example in section IIe, the economy has no ability to produce, in expectation, other than its annual endowment of Y. The gross return vector has a geometric average of 1. So why is the expected lifetime consumption in his purported equilibrium greater than the endowment – and for all t? Each individual h, and this is true of every generation, only gets a lifetime endowment of y, yet his expected lifetime consumption in Wallace's claimed equilibrium is y/2 + .5(3y/8) + .5(3y/4) = 8.5/8y?! And there's no way for individual h, or his fellow identical clones, or the government, or anyone else, to invest or produce with a positive expected return? How can you have an equilibrium where every individual forever has an expected consumption of 8.5/8y, but expected production and endowment of only y?

[1] "No, in a liquidity trap, if the Fed purchases gold, it does not change the price of gold, just as it will not change the prices of Treasury bonds if it purchases them." – Stephen Williamson

"The Fed can buy all the government debt it wants right now, and that will be irrelevant, for inflation or anything else." – Stephen Williamson

"If it were up to me, I would have given Wallace the [Nobel] prize a long time ago, and I think Sargent would say the same. However, not everyone in the profession is aware of Wallace's contributions, and people who are aware don't necessarily get as excited about them as I do." – Stephen Williamson

"...the influence of Wallace [1981 AER] neutrality thinking on the Fed is clear from the emphasis the Fed has put on telling the world what it is going to do with interest rates in the future...I have a series of other posts also discussing Wallace neutrality. In fact, essentially all of my posts listed under Monetary Policy in the June+ 2012 Table of Contents are about Wallace neutrality." – Miles Kimball

Monday, July 30, 2012

If Cowen’s really concerned about habit formation…

Paul Krugman writes about Tyler Cowen’s new defense of decreased societal mobility; it’s a good thing in that habit formation would make it especially bad for the rich to become middle class, or less rich.

Habit formation is an important issue, especially for someone with a career in personal finance like myself, but:

1) If Cowen is so concerned with habit formation and its effect on utility, he should support highly progressive taxation, which really blunts the effects of a drop in income (by lowering your tax rate substantially to compensate), and keeps lifetime income a lot more steady, especially if it's used to better fund the safety net and public, non-positional goods. I've long said that progressive taxation is a great partial insurance against income variability, and takes a lot of the risk out of financial life – and life is incredibly financially risky today after a generation of dominance from the right. Yes, there will be a one time adjustment for the current rich to greater progressivity, but from then on, income will be a lot more steady for everyone, every generation. Will Cowen now support highly progressive taxation? Yeah, right.

2) He should also support a strong social safety net, and government supported education and re-training, as that greatly decreases the risk of income variability over people’s lives. Don't hold your breath.

3) A solution to greater income mobility's risk of going downward doesn’t have to be locking in the classes. Good personal finance is an excellent solution, or part of the solution. If your income is high now, you carefully consider how risky that income is. Are you a medical doctor with a high income, but one that's also relatively secure (but keep an eye on Watson and other developments), or are you the owner of a business with a lot of risk? If it's the latter, then during good times your savings should be far higher, and your "Must-Haves" − a term from Elizabeth Warren's personal finance book, "All Your Worth" (the best today) − should be very low as a percentage of your income. Must-Haves are long term fixed expenses, the foundation of your lifestyle, like your home and cars. You should have your consumption be a relatively low percentage of your income in good times if that income is risky. Evaluating the riskiness of your income and setting your Must-Have and saving percentages accordingly is a very important part of good personal finance today.

4) As Cowen is now suddenly concerned with total societal utils, aren't there other factors in that besides habit formation? Hmmm…, maybe gigantically decreasing marginal utility of dollars making severe inequality disastrous for maximizing total societal utils? When the marginal utility of an extra dollar is vastly greater for a member of the middle class or poor, than a member of the 0.1%, that should make Cowen support much more progressive taxation, universal healthcare, a stronger safety net,...., and don’t tell me the rich will work a lot less hard Tyler; you know better. Yeah, when the Lions win the Super Bowl.

5) As Cowen is now enthused about habit formation, how about its sibling, positional externalities. Strong and ubiquitous positional externalites, combined with Cowen’s newfound concern for maximizing total societal utils, would mean support for steeply progressive taxation to fund much greater non-positional goods like universal healthcare, universal government funded preschool and bachelor’s degree, basic scientific and medical research, public health, recreation, and safety,… Yeah right, when Paul Krugman shaves his beard.

Tuesday, May 8, 2012

Perhaps the Biggest Libertarian Bias in Economics

Oxford Macroeconomist Simon Wren-Lewis has an excellent recent post on libertarian bias in economics:
In RBC models, all changes in unemployment are voluntary. If unemployment is rising, it is because more workers are choosing leisure rather than work. As a result, high unemployment in a recession is not a problem at all. It just so happens that (because of a temporary absence of new discoveries) real wages are relatively low, so workers choose to work less and enjoy more free time...

If anyone is reading this who is not familiar with macroeconomics, you might guess that this rather counterintuitive theory is some very marginal and long forgotten macroeconomic idea. You would be very wrong. RBC models were dominant in the 1980s, and many macroeconomists still model business cycles this way. I have even seen textbooks where the only account of the business cycle is a basic RBC model...

Yet what seems like a rather important fact about business cycles, which is that changes in unemployment are involuntary, is largely ignored...

What could account for this particular selective use of evidence? One explanation is ideological. The commonsense view of the business cycle, and the need to in some sense smooth this cycle, is that it involves a market failure that requires the intervention of a state institution in some form. If your ideological view is to deny market failure where possible, and therefore minimise a role for the state, then it is natural enough (although hardly scientific) to ignore inconvenient facts. For the record I think those on the left are as capable of ignoring inconvenient facts: however there is not a left wing equivalent of RBC theory which plays a central role in mainstream macroeconomics.
Wren-Lewis focuses on RBC models, and the central role they play in macroeconomics. I'd like to add another libertarian bias. This one is throughout economics, not just macro. It's fundamental, integral -- and, I believe, tragic. It's how in economics the concern, the goal, is almost always Pareto optimality rather than total societal utils optimality.

A common reason given is that it’s hard to measure total societal utils. Well, it’s hard to measure lots of things, so is it then optimal to completely ignore them, and just go 100% with random luck for our strategy of optimizing them? Even for things that are of great fundamental importance to us, our strategy should be just ignore them, spend zero time thinking about them and trying to optimize them, and hope that by random luck you end up doing a good job of optimizing them?

We can’t improve on that? When you choose a city and a home, do you say, hey, it’s hard to estimate the expected utils I'll get from a home, so I’ll just throw a dart at a map of the world and decide that way? I’ll put no thought into it whatsoever, and completely ignore the great deal of important information that I do have and can get because it's hard to estimate the utility I'll get from a given home? Of course not.

Plus, you think it's hard to estimate the utils people get from goods, but it's not hard to rank, for any and all bundles, which will give higher utility? You're not ok with a function that estimates numerical utils, but you are ok with one that ranks any and all bundles of goods by the utility they will provide a person, or all persons? You're ok with saying a function like lnX does this, THAT'S Ok, that’s a close enough to reality estimate. We're ok with all of the assumptions behind that, but not a util function?

And in any case, the field already commonly assumes a representative agent and a continuous utility function for dollars. So you're assuming all agents (people) have the same exact function that describes the utility they get out of any amount of dollars. Already we have enough then to talk about optimizing total utils for all members of society added together (although in the model for this to really be useful in total utility analysis, you need to be explicit that there's not one agent, but many with homogeneous utility functions).

Yet somehow this is "controversial", or "outside the bounds of economics"; we can only talk about the extreme libertarian concept of change only with unanimous consent (i.e. Pareto optimality), and never change in order to increase total societal utils (total societal utils optimality).

Clearly it’s hard to get a more pro-libertarian and anti-utilitarian bias than saying I’ll almost always make Pareto optimality (changes are only made if there is unanimous consent) a central focus, and almost always completely ignore total societal utils (changes can be made if it's for the greater good). You're virtually coming right out and saying I'll almost always be a libertarian in my analyses and almost never a utilitarian, or anything in between. I won't even say what the utilitarian optimum is in a positive way. I will always rule it out by not even considering it, so that only two things may be considered, and everything else I will instantly rule out in a very normative and libertarian biased way. All other alternatives I immediately rule out as impermissible, and only allow to be consider, analyzed, the two libertarian alternatives, Pareto or nothing.

This fundamentally underlies, and profoundly influences, economics towards libertarianism. For example, it allows the profession to by and large ignore the fact that severe diminishing returns of utiltiy from dollars means that substantial progressive taxation can skyrocket total societal utils.

We do have this general notion of inequality as, for many economists, being bad in of itself, but because we can pretty much only talk about Pareto optimality, and never optimizing total societal utils, we can never really talk about how the extreme concavity of utiltiy makes it so that progressive taxation can skyrocket total societal utils. And that's not even counting positional/context/prestige externalities, and the fact that there can be enormous social returns from investing progressive taxes in the poor and middle class through, for example, education and in other high externality public goods.

Think of how different economics would be (and the effect on policy over the long run) if it were acceptable and common to calculate and optimize total societal utils in models even in just a purely positive way -- this is what the utilitarian optimum is and this is what the Pareto (libertarian) optimum is.

Thank goodness we now have the emerging happiness research, which is saying we DO care about total societal happiness (utils, at least largely). But predictably, who do we see attacking this research?.

Sunday, March 25, 2012

Home Solar Panels: A New Safety Net and More

I'd like to expand on my last post about home solar panels (which I think has important points I don't hear being made). There's something very different and important about home solar panels compared to the typical advancement that increases GDP.

Long ago I came to the realization that not all $10 trillions in GDP are the same. You could have two countries (or separate worlds): One has $10 trillion in GDP, but $7 trillion in yachts, mansions, super-luxury resorts and restaurants, etc., vast income inequality, and $0.5 trillion in high return investments like basic science, education, and smart infrastructure. The other has the same $10 trillion in GDP, but is far less unequal, and has ten times the high return investment, $5 trillion.

That second country (or planet, to preclude the issue of free riding on technological advance), even though it has the same $10 trillion in GDP, could have much higher total societal utils today, and at the same time, in 50 years will be far wealthier – ridiculously wealthier a century later. After all, $5,000 meals and 50,000 square foot homes don't do much to advance science and productivity. And even the most extreme libertarian economists haven't yet had the gall to claim that marginal utility doesn't diminish greatly with increased consumption. And don't even get me started on positional externalities.

Remember, economists love to talk about Pareto optimality, but when you draw your Edgeworth Box in micro, with your curvy line containing all of the Pareto Optimal allocations, some of them have vastly more total societal utils than others. And it really shows the right wing bias in economics that the focus is almost exclusively on Pareto efficiency as opposed to maximizing total societal utils efficiency.

So not all $10 trillions in GDP are the same, and not all $X increases in GDP are the same. Take home solar panels, suppose that in 20 years 100 million American homes will have solar panels (not to mention solar walls and windows) that generate an average of $5,000/year in power. That's $500 billion more in GDP (Let's assume the panels are already installed, and they last 50+ years with little maintenance; see my last post for details and cites). But as we've painfully seen, an increase in GDP of a half-trillion can go almost all to the rich, or super rich, and do very little to add to total societal utils.

But there's more than that; In finance were always talking about states of the world, state-dependent utility, and how investments that pay off in bad states are much more valuable than those that pay off in good ones, even if they have identical expected payoffs. So even an extra half-trillion that went to the middle class and poor would still be a lot less increasing of expected utils if it was: in good times you get a nice windfall on top, and in bad times you get little or nothing.

Instead, what would really increase expected utility for the middle class and poor is an expected half trillion that paid off just as well in bad times, when you really need it (or really really need it), as in good times. In other words, a safety net. And that's just what solar panels are, a new and important safety net for the middle class and poor. If you lose your job, and have to support a family on very meager unemployment, it really helps if you have solar panels (and maybe walls and windows too) that make it so you have no utilities bill, and with potential increases in efficiency over the next 20-30 years -- both in the panels and the things they power -- no fuel bill (the panels power your electric cars), and no property taxes and insurance (with those potentially paid for by selling solar power back to the grid).

If Obamacare survives for try-and-see to decimate the disinformation (and outright lies), this gives people the opportunity, with a paid off home (an important focus in good personal finance), to always have a home, health care, utilities, and fuel, even in the worst of times. So that they can get by on just unemployment (and maybe food stamps and other aid), without financial ruin for their families, and maybe foreclosure, or worse -- shamefully, homeless families aren't that rare today. This would be a fantastic safety net to have commonly available with how profoundly risky our country has become over the last generation (see Yale political scientist Jacob Hacker's 2007 book The Great Risk Shift for details).

So far I've talked about how home solar panels represent a potentially large increase in GDP that (1) is for the 99%, not just the 1%, or 0.1% (or 0.01%), and (2) is a safety net that's there when you need it most, in, as finance academics would say, bad states. Next I'd like to add, (3) solar panels are (more or less) a non-positional good.

Suppose $5,000 per year was added to the GDP for every household, but it was in car spending. So every five years families spent $25,000 extra on their cars. So you go from a Honda to an Acura. Well, I think the vast majority of readers will see (or admit) that you get a lot less utility out of an Acura if everyone has an Acura, and it's just a normal car now. And in fact, if everyone is getting Acuras, or otherwise spending $25,000 extra on their cars, and you aren't, then you're going to be the poor guy with the cheap-ass car. And unless you’re a freshwater economist with a strong libertarian agenda, you'll probably admit, at least to yourself, that this will cause you substantial disutility (at least to your love life -- but that's positional too).

So positional externalities are very real and very large (for the formal evidence see here). They're an important reason why countries much poorer than the US have as high, or higher, happiness in surveys and studies. When everyone buys a fancier car a lot of the utiltiy goes up in the smoke of positional externalities, as the car is no longer fancy. Same for clothes, homes, and so much else that we buy. But solar panels, and the electricity and fuel they generate, aren't very positional, especially once the novelty wares off. So the utiltiy you get from them doesn't go down by much when you go from being one of the only guys in the neighborhood with them, to everyone has them. Bottom line: $5,000 added to everyone in a non-positional good will add much more total societal utils than $5,000 added to everyone in positional goods. 

And I'll add a (4) here. Home solar panels create profound positive externalites in that they help insure against catastrophic global warming and starve funds from some of the worst authoritarian and terrorist sponsoring regimes in the world. And without petro-money, these regimes are in serious trouble, and face great pressure to change for the better, or starve and be overthrown. In fact, there's a strong correlation between reform (and backsliding) in these countries and the price of oil.

So home solar panels really are different and rare in how they add to GDP: (1) They’re for the 99%, not just the 1% (or a lot less), (2) They're an important new safety net, (3) They're non-positional, and (4) They have profound positive externalites.

Sunday, March 18, 2012

The Unique Personal Finance/Investment Benefits of Home Solar Panels

An interesting and important aspect of home solar panels is their unique investment and personal finance properties. In some ways they're a rare very low risk investment.

A cornerstone of finance is the risk-expected return tradeoff. The lower the risk of an investment, the lower an expected return it makes sense to settle for. And if the asset is negative risk (it lowers your current total risk), like insurance, then it can even make sense to accept a negative expected return. And people do that all the time when they buy fire insurance. A great example, too, though too few even economists seem to realize it, is global warming insurance.

With solar, you have an investment that can really lower a family's risk. And today's America is amazingly risky for most families (see Yale political scientist Jacob Hacker's book, The Great Risk Shift). A job loss can all too quickly and easily lead to ruin for a family, as unemployment insurance pays very little. A great defense is to have your house paid in full, and I usually advise a 15 year mortgage (when it does makes sense to buy), and even then, paying it off faster. But you still have utilities, property taxes, insurance, etc.

If you solar up your house, especially in a state like mine, Arizona, this means little or no utility bill, and eventually the panels may generate enough electricity to also mean no fuel bill (with electric cars). And even no property tax bill! Why? It's already common in Arizona to have backwards running meters to sell back excess power from solar panels (and it was offered in 43 other states in 2010), so the money you make from your home power plant can cover your property taxes. This, of course, depends on how many panels you have on your roof (and the rest of your property, solar gazebos!), what state you live in (not everyone lives in solar ground zero, Arizona), things like how southern facing your panels are, and the ever increasing efficiency of the panels.

Few people, even in Arizona, may generate the kind of power that covers your utilities, fuel, and property taxes today. But in 20 years, the power capturing ability of panels may double or quadruple (see, for example, here, here, and here). We can also expect big advancements in energy efficiency in our homes, appliances, and electric vehicles, also contributing to solar panels providing much more. And if solar starts providing these kinds of financial benefits, believe me, you're going to see a whole lot more people moving from cold states to Arizona, Nevada, etc. (more on this below). And panels are going to be put in a lot more places than just the southern facing part of the roof, along with perhaps other solar power capturing devices like special windows and walls.

Elizabeth Warren has what I think is the best personal finance book available today, "All Your Worth". In it she really stresses -- above all else -- the importance of keeping your "Must-Haves" (fixed expenses) low to withstand today's risky world. Solar is a very nice addition in this respect. The panels are typically guaranteed for 25 years, and may last much longer. And there are potential advancements that can extend lifespan, maybe greatly (see, for example, here and here).

Of course, you could just take the money you were going to put into solar and put it into some other very safe asset, like TIPS, but:

(1) The TIPS market can be funny and maybe illiquid, with TIPS real returns recently going negative.

(2) If you have the money in solar panels instead, it may not be touchable in bankruptcy, or by creditors or litigants in general. Many states protect your home, including additions, (homestead exemption), up to a large, or unlimited, amount. It definitely adds to your family's badly needed security knowing that no matter how bad things get, you can never lose your home, or your free electricity, fuel, and maybe regular supplemental income from your panels. Creditors and litigants can take your TIPS, but in many states they can't take your home, or your panels.

(3) When applying for college financial aid, often your home equity, including solar panels, is not considered. But I can guarantee you a hunk of money in TIPS is (unless perhaps it's in an IRA or 401k, but the panels should be on top of maxing your IRA and 401k contribution limits). The same is true of some government assistance and other need-based programs.

(4) The solar return can be really good, way better than TIPS. From what I've heard, a 7 year payback, or less, is not that rare already in Arizona. (yes, I know very well after years in finance, that NPV is the ultimate, but payback period can help you estimate NPV, because all other things equal, a shorter payback period means a less risky, less uncertain, project. So knowing the payback period helps you make a better decision on the discount rate to use.) The payback period depends a lot on the tax spiffs, and those can vary a lot by state. So interestingly, this study, found a shorter payback period in Massachusetts than Arizona.

(5) Solar Panels protect you against inflation too, and maybe a lot better than TIPS do. With TIPS, you get compensated for changes in the price of the CPI basket, but your purchases may be very different from the CPI basket. And if your family is in a financial crisis, you're not going to be purchasing much of the discretionary or luxury items that are in the basket, but electricity and fuel will be very important. A spike in their prices could really hurt you during a family financial crisis. It's very risk-decreasing knowing those things will always be free, or small, if you have to ride out a crisis.

In 20 years, if Obamacare survives for try-and-see to decimate the disinformation, it could be common for people to always have health insurance, power, and fuel for their cars that they can never lose, and maybe substantial supplemental income from selling solar power on top. This would certainly be a welcome huge step forward in families' security.

On a related note, I think in 20 years Arizona could really be hot -- in more ways than one. Advanced, powerful, and inexpensive panels (and other solar collecting devices like special windows and walls) could really make it relatively cheap to live there, with free utilities and fuel, and with selling the excess back to the grid free property taxes, homeowners insurance, and maybe more, the way the generation of these panels keeps increasing. I always tell my wife I want to turn our backyard into a solar plant! Gazebos with panels on top! She's not thrilled with the idea.

Next: Part II:  Home Solar Panels: A New Safety Net and More

Tuesday, March 6, 2012

Microfoundations Models: Square Peg, Round Hole

I think part of the problem with microfoundations modeling (at least how many of them are done) is trying to force a very square peg into a very round hole.

Here's Simon Wren-Lewis:
It is hard [microfoundations modeling] because these models need to be internally consistent. If we think that, say, consumption in the real world shows more inertia than in the baseline intertemporal model, we cannot just add some lags into the aggregate consumption function. Instead we need to think about what microeconomic phenomena might generate that inertia. We need to rework all relevant optimisation problems adding in this new ingredient. Many other aggregate relationships besides the consumption function could change as a result. When we do this, we might find that although our new idea does the trick for consumption, it leads to implausible behaviour elsewhere, and so we need to go back to the drawing board. This internal consistency criteria is partly what gives these models their strength.
It is hard then, in part, because you are trying to fit a square peg into a round hole. You're trying to fit perfect optimizing behavior of individuals ("internal consistency") to the behavior of aggregates that did NOT, in fact, result from perfect optimizing behavior of individuals. They resulted from very imperfect optimization of very imperfect individuals, with very limited expertise, information, time for analysis, and self-discipline, to name a few (and I can tell you first hand, as a businessman and family man, that with how busy and distracted people are, it can take them a while to analyze and react, even with their imperfect public knowledge, analysis, and reaction).

Here's Simon again:
It took many years for macroeconomists to develop theories of price rigidity in which all agents maximised and expectations were rational…
Again, square peg, round hole. It's very hard to find a model where every single person has perfect maximization and perfect rational expectations, and you still get, at least qualitatively, the type of aggregate behavior we see in the real world, because that aggregate behavior we see in the real world is not generated from individuals who all have perfect maximization and perfect rational expectations, not even close for many things.

If, on the other hand, you're just modeling the behavior of the aggregate based on how we have actually seen it behave, not some ideal, this gives you an advantage in creating a more realistic model that can better predict, and be used to study the effects of policy. It's not without problems though, even though it has important advantages:

-- There's the Lucas critique, although sometimes this effect may be very weak and/or slow.

-- We sometimes don't have a great deal of relevant historical data to model the aggregates on.

-- There can be substantial regime change, so that past history of the aggregate(s) is not very representative, or relevant, to the present (Of course, you should look for enduring features of the aggregate(s) that survive regime shifts.)

So, like in the physical sciences (Noah gives the example of meteorology), it's best to study and model both the micro units and the aggregates as a whole.

And, it would be nice if our microfoundations models could make more realistic assumptions about the knowledge, expertise, education, self-discipline, and other behavioral factors of the micro units, i.e. people. I know this can make it very hard, or intractable, to solve the model in closed form, but why not just have it be a computer simulation, to test things with a very complicated, and mathematically and global-optimizationally intractable, but much more realistic model? That could be extremely useful.

Short of more realistic microfoundations models, let's please keep in mind, a model is only as good as its interpretation, and the smartest interpretation is usually far from literal.

Sunday, March 4, 2012

Haugen's Critique of Microfoundations in Finance

In the recent round of criticisms of microfoundations modeling (see, for example, here, here, and here), there's an important criticsim that I haven't seen really hit directly: If you're going to start out micro and aggregate up to a very complicated reality, then it's very hard (at least) to do without making extremely strong, simplifying, and unrealistic assumptions, and that's where the microfondations models can be very unrealistic, and bad for understanding, predicting, and policy.

This issue is in finance too. One of the biggest, and certainly loudest, critics of microfounded finance models is Robert Haugen. Haugen now runs an investment services firm, but he was previously a finance professor at University of California, Irvine, and is #17 on a publications' prestige weighted list of finance's most prolific authors, 1959 -- 2008.

Haugen's criticism is that the aggregate of very complicated, highly interacted, micro behavior can be better understood if you just observe the behavior of that aggregate, rather than trying to understand it, predict it, and make good policy from modeling micro unit behavior and then aggregating up.

In finance, then, you can understand and model the behavior of financial asset markets just by looking at how those markets behave over time, and creating a model to fit that observed behavior. This will get you a much more accurate, realistic, and useful model, than if you make very simplifying assumptions about individual behavior and interaction so that it's tractable to aggregate up to the market as a whole.

So in other words, a model of aggregates can be much more realistic and accurate in describing the behavior of those aggregates because you aren't forced to make extremely unrealistic simplifying assumptions about micro units in order to make aggregating them tractable.

In Haugen's own words:
Chaos aficionados sometimes use the example of smoke from a cigarette rising from an ashtray. The smoke rises in an orderly and predictable fashion in the first few inches. Then the individual particles, each unique, begin to interact. The interactions become important. Order turns to complexity. Complexity turns to chaotic turbulence... ("The New Finance", 2004, 3rd Edition, page 122)

How then to understand and predict the behavior of an interactive system of traders and their agents?

Not by taking a micro approach, where you focus on the behaviors of individual agents, assume uniformity in their behaviors, and mathematically calculate the collective outcome of these behaviors.

Aggregation will take you nowhere.

Instead take a macro approach. Observe the outcomes of the interaction – market-pricing behaviors. Search for tendencies after the dynamics of the interactions play themselves out.

View, understand, and then predict the behavior of the macro environment, rather than attempting to go from assumptions about micro to predictions about macro... (page 123)
For more on this see here.

Now you may reply, Lucas critique! But, as is a theme of this post, let's be realistic. The Lucas critique in many cases relies on people having a ridiculous amount of knowledge, expertise, free time (or little value for the time they must spend analyzing economic, political, and governmental policy, something that few people get much enjoyment from), and self-discipline to have much effect. Sometimes the Lucas effect may be very weak (or slow).

Take a look at surveys of people's knowledge of the governments' budgets and then tell me that it's common for people to accurately, precisely, and regularly adjust their consumption to expected changes in government spending.

In the words of Paul Krugman:
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. No, the point is that the effort isn't worth it. If a family has arrived at a sensible rule of thumb for deciding how much to spend, trying to improve on that rule by making sophisticated predictions about the future implications of government spending will improve the families decisions so little that it isn't worth the investment of time and attention.
– "Peddling Prosperity", 1994, page 208.

Saturday, February 18, 2012

To: John Cochrane, Re: Positional Externalites


Years ago, when your excellent book, Asset Pricing, first came out, I was a finance PhD student. I found some errors and sent you an email with them, and some feedback and suggestions I had. You replied, and were very gracious. So I'm hoping you might reply to this.

In your current blog post, you write:
Frank's article is hilarious in another way. Higher taxes are fine, he says, because more money won't make you feel better when everyone around you is wealthier too. Too much low-hanging fruit there, just go read it and have a laugh. Or shake your head in amazement. No, he's not joking.
With regard to Frank's contention that position/rank/prestige/context is a substantial part of how much utility the average person gets from goods, please give us the evidence why this is wrong. Please don't just say, ha ha, it's hilarious, it's too obvious. Because Frank's contention was published in one of economics' top journals, the American Economic Review, "Positional Externalities Cause Large and Preventable Welfare Losses." (2005).

And other authors have based top journal papers on the same contention. For example:

"Neighbors as Negatives: Relative Earnings and Well Being", by Erzo Luttmer, Quarterly Journal of Economics, August 2005.

"Diamonds Are a Government's Best Friend: Burden-Free Taxes on Goods Valued for Their Values", by Yew-Kwang Ng, American Economic Review, March 1987

Now, surely the wrongness of this idea can't be so laughably obvious if the editors of some of economics' top journals repeatedly published articles based on it. And, not to beat a dead horse, Nobel Prize winning economist Gary Becker wrote a paper based on this idea:

"Evolutionary Efficiency and Happiness", Journal of Political Economy, April, 2007 (with Louis Rayo)

Quoting Becker and Rayo:
For a long time, utility was assumed to depend only on the absolute level of an individual’s economic conditions. However, a large body of research now shows that the relative level of these conditions also plays a central role: an individual’s utility, whether defined in terms of decision making or hedonic experience, tends to be sharply influenced by his personal history and social environment. Examples include Markowitz (1952), Stigler and Becker (1977), Frank (1985), Constantinides (1990), Easterlin (1995), Clark and Oswald (1996), and Frederick and Loewenstein (1999).
-- pages 302-3.

So please John, don't treat Frank's general idea as laughably, obviously wrong. Becker's not an idiot. None of the very successful economists noted above are idiots. The editors of the AER, the QJE, and the JPE aren't idiots. So if positional/context/prestige externalites are insignificant factors in peoples' utility we're going to need your evidence for that.

For me personally, I'd be stunned if position/rank/context/prestige were insignificant or insubstantial factors in how much utility people get from clothes, cars, homes, etc., if the utility a person gets from a given house or car is not substantially different if it's in the 90th percentile or the 10th. I would be at a complete loss to explain all that I've seen, read, and experienced, day by day, in 48 years in this world. It would be hard for me to think of any alternative hypothesis that would fit it. But I'm very open to your evidence, and very curious to hear it.


Richard Serlin

Thursday, January 5, 2012

Who does more "bossing around"?

From Jonathan Chait today:
Consider Will’s column from the past weekend. It centered primarily on climate change, a favorite Will topic – he is a climate-science skeptic. Occasionally, Will ventures forth to cast doubt on the science directly, but he usually takes the total falseness of the climate-science field for granted and proceeds from that basis. In his recent column, Will argues that liberals made up the global warming scare in order to justify their desire to ration energy:
Because progressivism exists to justify a few people bossing around most people...
Now, aside from the conservative anti-science, I love this line, "Because progressivism exists to justify a few people bossing around most people..."

Even at the height of government power in the 1960s, when were people ever anywhere near as bossed around by government as by the free market, as by, say, THEIR BOSS!

The more income inequality we have, the more plutocracy we have, the more people get bossed around. It's very often government that PREVENTS large numbers of people from being bossed around. Try being an indentured servant to a private student loan holder, after being conned into a culinary institute and now working at Taco Bell. See how bossed around you are.

Yeah, before the progressive movement in the early 1900s, people were never bossed around.