Saturday, December 21, 2013

Surveys showing massive ignorance and inexpertise, why no reply from the freshwater and others?

During the recent brouhahas over microfoundations I've been citing in comments surveys on finance expertise, numeracy, and government showing extreme ignorance and inexpertise, and yet these comments are ignored by Stephen Williamson, and even non-freshwater economists. Of course, you could say it's ignored because it's me, but I have been lucky enough to engage in a lot of conversation with bloggers like Williamson, Noah, Nick Rowe, and Simon Wren Lewis. So I suspect it may be more than this.

First, what are some of the surveys I've been citing:

Consider these microfoundations from Chicago economist Richard Thayler:
• Suppose you had $100 in a savings account and the interest rate was 2 percent a year. After five years, how much do you think you would have if you left the money to grow? More than $102, exactly $102 or less than $102? 
• Imagine that the interest rate on your savings account was 1 percent a year and that inflation was 2 percent. After one year, would you be able to buy more than, the same as or less than you could today with the money? 
• Do you think this statement is true or false: “Buying a single company stock usually provides a safer return than a stock mutual fund”? 
Anyone with even a basic understanding of compound interest, inflation and diversification should know that the answers to these questions are “more than,” “less than” and “false.” Yet in a survey of Americans over age 50 conducted by the economists Annamaria Lusardi of George Washington University and Olivia S. Mitchell of the Wharton School of the University of Pennsylvania, only a third could answer all three questions correctly.
And these:
From a Center for Economic and Financial Literacy survey: 
"1 in 3 people didn't know how much money a person would be spending on gifts if they spent 1% of their $50,000/year salary." 
"65% of people answered incorrectly when asked how many reindeer would remain if Santa had to lay off 25% of his eight reindeer."
– Personal Finance for Dummies, 7th edition, 2012, page 9
Now, if your models assume that people (the micro units) have perfect public information, and prefect expertise to utilize that information to always find the perfectly optimal strategy (with zero time and effort cost), then I don't think it's unreasonable or stupid to ask how might the real world macroeconomic results differ given the enormous evidence of widespread high levels of ignorance and inexpertise among the people. Why do you think that nonetheless the qualitative results will be the same – or even just about exactly the same?

Yet when I ask about this I'm always ignored, and not just by freshwater economists like Williamson, but by any economists, like it's beneath them to consider something as unfancy as straightforward surveys and tests, where there's no plausible reason for people to lie and make themselves look stupider [1].

Honestly, I think to a significant extent economists are scared to cite simple surveys and tests showing massive ignorance and inexpertise as reasons for why the results of freshwater models are very different from reality. This information is just not fancy enough. They're already going out on a limb questioning the awesome looking math that controls the journals and macro departments. To now cite something so pedestrian as straightforward surveys and test, that's just too scary. If you're going to question those claiming that mantle of high science, with so much power to punish and reward, you want to at least use something fancy sounding, like some Harvard evolutionary theory, or some lab experiments done by a Nobel Prize winner.

But from what I've seen, just pure massive and widespread ignorance and inexpertise seems like a stronger factor in explaining the macroeconomy. I can admit it because I'm on the outside; I'm a businessman and adjunct professor of personal finance, but if I were on the inside in academic economics, where you can be severely punished or rewarded based on how "scientific" you sound, I'd be scared too, even though the best definition of science is logical; logic fully linked from your assumptions to your conclusions – including conclusions from the model to reality, not just conclusions within the model and then we can throw logic out the window when making conclusions from the model to reality. And in making conclusions from the model to reality you will need more assumptions to attach your logic to, but hopefully those assumptions will be relatively mild. Some will, of course, be necessary; what we see actually exists,..., but hopefully nothing too bold.

As I always say, a model is only as good as its interpretation. The interpretation to reality is the most important part of the model to get right, and the right interpretation is usually substantially different from literal. 

The logic for this evidence of massive ignorance and inexpertise mattering, given what I know, is very strong. It should definitely be asked about – and answered. 

[1] I must note that in reality it's not at all stupid to have little expertise and knowledge about finance, economics and government. People are terribly busy today with work hours so high, both spouses working, no stay at home spouse to manage the home and children full time, and much greater demands from child rearing today. Of course with their tiny free time they're not going to want to study finance, economics, and government. 

You can be as smart as Einstein, but if you don't have the time to learn, you won't. Einstein actually said, "The hardest thing in the world to understand is the income tax." He had the intelligence, obviously, but he was a little busy with his physics job.

Thursday, October 17, 2013

Cutting Medical Costs Substitutes for a Tax Increase in Negotiations

An important point, inspired by an Ezra post today, is that there's another big way to cut deficits besides spending cuts and tax increases. That other way, and an enormous, profound one, is cutting medical costs, like with patent reform and greater Medicare bargaining. Republicans will never agree to any deal to end sequestration, or anything else, with a tax increase (unless maybe it's on the poor), but they may agree to a deal with measures to cut medical costs, a third way to slash deficits.

Thus, what Obama can bargain for with sequestration is things like patent reform, bargaining on prescription drugs, and letting Medicare bargain in general, and have much more power to say no based on effectiveness evidence. This can slash budget deficits just as much as a big tax increase, even a lot more over the long run. And, as part of a compromise, we can throw in medical tort reform, which has been important to Republicans. It's not a major factor, but it certainly can be improved.

And it frees up money to ask for more for basic scientific and medical research, education, smart infrastructure, and other high social return investments, that increase growth and decrease deficits over the long run.

And, in general, whenever there are efforts and plans to cut the debt, there are two ways, spending cuts and tax increases. But it might really be powerful to instead change the thinking to there are three ways, and that third way, perhaps the most powerful over the very long run, is measures to cut medical costs and inflation, and not just for the government, but in general, society-wide. So part of the bargain, part of the compromise, part of the deficit reduction, is things like greater Medicare bargaining, patent reform, and tort reform. I know currently to get anything passed with the Republicans of today is, shall we say, a challenge, but longer run, with the Republicans and their control of 5 years from now, 10 years, 20,...

Now, you might say that deficits aren't that big of a problem right now anyway, especially in the middle of a historic economic slump. But the Democrats have to have some concern about the direction of deficits, because otherwise Republicans can use them as a club (even moreso than otherwise) in coming elections. Anything that can help Republicans in elections, merited or otherwise, is a source of grave concern. Could you imagine what it would be like right now if Romney had won, or if the Republicans win in 2016 and Obamacare is repealed, they lock in the Supreme Court for 30 years,…

Saturday, October 12, 2013

If We Let One Sub-Branch Govern by Extortion, Others Can Follow

There's no saving face when you threaten to take a baseball bat to your own country if you don't get what you want.

But it's more than this.

Some might say, let's let the House govern by extortion. Let's give them the power to get laws rescinded, or enacted, or programs cut, without approval from the President and Senate just by threatening to do grievous harm to their own country if they don't get what they want. The House should have more power, like a parliament.

Well, first, this would be a parliament so undemocratically gerrymandered by the Republicans that they could control it with just 43% of Americans' votes.

But more importantly, if the House starts governing by extortion, the other branches of government could follow. The President could decide, if the House and Senate don't give me what I want, I won't sign any budget and will shut the government down for as long as necessary until the damage to the country is so great that you give me what I want. He could threaten to cripple agencies with executive orders as extortion to get what he wants, and worse. The Senate could also shut down the government if they don't get what they want, and wreak havoc in other ways. And the Supreme Court also has ways take a hatchet to the country to extort.

Sound far fetched? Imagine a Republican President, like Tea Party favorite (at least before immigration reform) Marco Rubio, unable to get a law rescinded, or passed, or spending cuts he wants, so he threatens not to sign any budget from the Democratic House and Senate, thus shutting down the government for as long as it takes until he gets what he wants. Or imagine if the Republicans lose the Presidency and the House, but control the Senate, and they do the same, with the Senate shutting down the government until their demands are met.

Is this the kind of country we want, where each branch or sub-branch threatens to do it grievous harm until it's demands are met? Or is this a historically shameful atrocity that has to stop here and now.

Tuesday, October 8, 2013

Summing it up...

The Republicans: Give me $1,000 or I'll burn our own house down. Why won't you negotiate?! Why won't you offer $500?!

The traditional media: Both sides are equally at fault (always, the facts are irrelevant); the Democrats should "negotiate".

Sunday, October 6, 2013

Personal finance education can be good, but is typically poor

Eminent Chicago behavioural economist Richard Thaler wrote Saturday on the poor effectiveness of typical personal finance education, "It would be premature to conclude that all efforts at improving financial literacy are futile. But it is a fair conclusion that simply doing more of the training commonly used now will not produce significant results. So what else might we try?"

I have long written that the vast majority of personal finance education is very poor, and I've been teaching it at the University of Arizona continuously since 2005. The great Harvard financial distress expert Elizabeth Warren has written the same thing. Below is a quote from her seminal personal finance book, "All Your Worth". I believe "All Your Worth" gave birth to good modern American personal finance, and I've assigned it cover-to-cover since it first came out in 2005. But, sadly, I'm one of the only personal finance instructors in the country to use that book, or even the core Balanced Money Plan in it. Here's the quote:
The Two Income Trap did more than raise some public policy issues; it touched a raw nerve. We would be going about our business, and then, out of the blue, someone – a neighbor, a caller to a radio program, a mom dropping off her son at preschool – would pause and say quietly, “You’re not just talking about money, you know. You’re describing my entire life.” And then the voice would drop to an urgent whisper, “No one knows how much I worry about money. What should I do?”

Of course, we gave the best answer we could. But how much could we really say in the grocery store checkout line or in the 90 seconds allowed to a radio caller? Over time, those conversations began to haunt us. Whenever we had a quiet moment, we would think about the people who had asked us for help. Sure, America needs policy changes, and in time maybe we’ll get some laws that make more sense. But in the meantime, what should people do?

At first we thought the answer would be really easy – just find a couple of good books we could recommend. So we started looking for a great book that would help ordinary people get control of their money.

And we looked.

And looked.

Everywhere we went we found pretty much the same thing. Plenty of books on the difference between bull and bear markets, and lots of tips on how to find a great deal in potato futures. In other words, we found oodles of advice for people who are financially secure and just want to make a little more money. But what about people who aren’t so secure? What about the people who stopped us in the grocery store, the mothers at the preschool, and the guys at Home Depot? Where was the advice for them?

It didn’t exist, so we developed All Your Worth. (pages 6-7)
In 2009, I was asked to do a chapter review for the Springer book, "Consumer Knowledge and Financial Decisions" (2012). In it, I wrote about the terrible state of personal finance education, and what would constitute good effective personal finance education. I agree with all the suggestions Professor Thaler offered in his op-ed, and long incorporated them into my courses, as did Professor Warren in her book. To show you that I've thought this for a long time, I'm going to print an excerpt from that chapter review verbatim, as it was in 2009, with no modification, even though for a post like this, rather than a specific reply to a chapter, I'd like to modify and improve it, and I'd like to add what I've learned in the last four years. But, I'll have more posts on this. For now, as I wrote it in 2009:
4) Personal Finance is taught very poorly today – Now we get to the biggest issue: For the vast majority of personal finance textbooks, popular books, courses, and materials I have seen (and that's a lot), even if you learned it 100%, it would improve your personal financial success very little, and it would decrease your odds of personal financial distress, or ruin, very little.
It's just full of trivia, vagueness, things of little value to personal financial success, and avoiding personal financial distress or ruin, and vague, poor, or even dangerous advice. I think this is partly due to the fact that good personal finance has changed greatly over the last generation or two but what is taught has changed little.

America is far riskier and more dangerous financially than in the past: 
-- Regulation a generation ago prevented very dangerous tricks and traps. 
--Excessive prestige/positional arms races were prevented by bank regulation leading to strict lending limits for homes, cars, etc.  
--The social safety net was stronger, and employment was much more secure.  
--There was usually a second earner in reserve in case the husband lost his job. A stay at home wife could also care for the ill, with no family income loss.  
--Medical insurance was far cheaper, and far more secure. In addition, the co-pays and deductibles were far lower.  
--Most people had guaranteed pensions, not voluntary, you invest, 401Ks, or nothing.
 and more 
As a result, advice like, just clip coupons and eat less steak, worked in the past because it was not possible to grossly overspend on large fixed expenses, and financial life was much more secure. You could teach trivia and little things then, and it didn't matter nearly as much as it does today.

This is also, by and large, the opinion of Harvard bankruptcy and personal finance expert Elizabeth Warren. Professor Warren writes in her 2005 book "All Your Worth" (which I think is by far the best personal finance book available today, and which I assign to my students cover-to-cover):
The Two Income Trap did more than raise some public policy issues; it touched a raw nerve. We would be going about our business, and then, out of the blue, someone – a neighbor, a caller to a radio program, a mom dropping off her son at preschool – would pause and say quietly, “You’re not just talking about money, you know. You’re describing my entire life.” And then the voice would drop to an urgent whisper, “No one knows how much I worry about money. What should I do?”

Of course, we gave the best answer we could. But how much could we really say in the grocery store checkout line or in the 90 seconds allowed to a radio caller? Over time, those conversations began to haunt us. Whenever we had a quiet moment, we would think about the people who had asked us for help. Sure, America needs policy changes, and in time maybe we’ll get some laws that make more sense. But in the meantime, what should people do?

At first we thought the answer would be really easy – just find a couple of good books we could recommend. So we started looking for a great book that would help ordinary people get control of their money.

And we looked.

And looked.

Everywhere we went we found pretty much the same thing. Plenty of books on the difference between bull and bear markets, and lots of tips on how to find a great deal in potato futures. In other words, we found oodles of advice for people who are financially secure and just want to make a little more money. But what about people who aren’t so secure? What about the people who stopped us in the grocery store, the mothers at the preschool, and the guys at Home Depot? Where was the advice for them?

It didn’t exist, so we developed All Your Worth. (pages 6-7)
To illustrate why I think personal finance education is so poor today, I'm going to list what I think are the most important things that should be taught in personal finance. Then, I will show how poorly the widely used Jump Start survey/exam tests for those things.
Most Important
i. Budgeting – Fixed costs less than 50% of after tax pay, savings at least 20% (Harvard professor Elizabeth Warren's Balanced Money Plan in her book, "All Your Worth")

ii. Counting the dollars is far more important than counting the pennies – For the vast majority of people clipping coupons and cutting back on the lattes won't come close to making up for overspending on home and vehicles. The big expenses have got to be taken care of first and foremost. This is the largest problem in personal finance today. Family fixed expenses have gone from an average of 54% of after tax income in 1972 (with a potential second earner housewife typically in reserve) to 75% even with two earners (Warren, 2007). This leaves only 25% that can be cut back quickly to weather a job loss or other crisis without resorting to destroying savings and then possible a debt spiral (my play on the accounting term death spiral). With fixed expenses (including basic food, all fixed expenses) instead at 50% or less, a family could probably just cut back on discretionary expenses and get by on the other spouses income and unemployment without touching savings. The destruction of savings and a debt spiral is unlikely.

iii. Understanding and Handling Well Positional/Context/Prestige externalities

iv. Investing – Well diversified stock portfolio like Wilshire 5000 for money you won't need for at least 10 years, and won't need a lot for at least 20, TIPS, dangers of non-government backed bonds, inflation danger of long term bonds even if they are government backed, paying off mortgage faster a great safe investment, no home equity loans, making sure you have enough safe liquid money.

v. Real Estate – How much to spend on a home, thinking of it as an expense, not an investment, avoiding bubbles, avoiding mortgage and other traps, when to buy, when to rent, the breakeven period for home buying and selling costs, when to wait longer and keep renting for a larger down payment, better credit, and therefore a much lower mortgage rate, all of the costs of a home, not just the mortgage payment, a small apartment will allow more wealth creation than a large house if the savings from rent being less than the mortgage payment, from not having a downpayment, from not paying for maintenance, etc. is put into savings like a Wilshire 5000 type fund and TIPS, the average home price appreciation is less than inflation when including maintenance, insurance, etc., and so on.

vi. The exponential growth of compound return, and the power of saving – The curve is ski sloped shaped, not a straight line, so great wealth can be amassed over the long run with just steady moderate saving. How this power can work against you when taking out debt.

vii. The biggest and most dangerous tricks and traps: Private student loans, home equity loans, extreme sub-prime mortgages, the most exorbitant and dangerous for profit schools, fringe economy businesses/services/scams, etc.

viii. Diversification – Not just in stocks, also as a general concept, diversifying with a paid for home, with not having most or all savings in a small business 401K, which unfortunately have little government protection, with having no debt, with flexibility and good relationships with family and friends, etc.

ix. Education and careers – The value of a college degree, the value of training, that it's not just about money, with good personal financial practice you can be financially secure and much happier in a lower paying career that you enjoy more, than you would be in a higher paying career that you enjoy less, or in a career whose hours allowed little of a family or personal life, the volatility of career pay today so be careful about raising your expenses automatically in proportion to pay increases, researching the careers you're interested in.

x. Bankruptcy – It's something that's important to know and consider in today's far less secure world. It can prevent a lifetime of constant financial distress and oppression, and having poverty and suffering linger unnecessarily for many years or decades, the purpose of bankruptcy, why the founding fathers made sure to put it right in the constitution.

xi. Handling crises well and understanding that in today's far less secure America, they are not that unlikely to occur in your lifetime – Knowing how to handle crises well can prevent destroying all savings, and after that a debt spiral. Don't wait until you exhaust your savings and have resorted to debt if you're unemployed, etc., instead act very early and proactively in the crisis, slash expenses, move in with your parents, etc., very quickly, do not cash out home equity and retirement accounts if it looks like medical bills, or any crisis, will lead to bankruptcy anyway, instead declare bankruptcy before cashing out those things as you can keep most or all of them in bankruptcy.

xii. Insurance – Health, term life, liability, disability if reasonable (which is often), the concept of insurance; it's a negative average return, so only for catastrophic, or very difficult, losses.

xiii. The fact that good personal finance has changed greatly over the last generation or two so be careful of the older advice – America is far riskier and more dangerous financially than in the past when regulation prevented very dangerous tricks and traps, excessive prestige/positional arms races were prevented by bank regulation leading to strict lending limits for homes, cars, etc., the social safety net was much stronger, employment was much more secure, and there was usually a second earner in reserve in case the husband lost his job, a stay at home wife could also care for the ill with no family income loss, medical insurance was far cheaper and far more secure, in addition the co-pays and deductibles were far lower, most people had guaranteed pensions, not voluntary, you invest, 401Ks, or nothing, and so on. As a result, advice like, just clip coupons and eat less steak, worked in the past because it was not possible to grossly overspend on large fixed expenses, and financial life was much more secure.

Next Most Important
i. The importance of good relationships and handling money issues with loved ones well – Good cooperation and coordination is valuable for the personal financial success of couples. Divorce can be devastating to one's personal finances (of course sometimes people are just not compatible, or a spouse is abusive). It's far more expensive for two people to live separately than together. In addition, diversification is decreased greatly when we live singly, and when we don't have close friends and loved ones who can help us weather crises; being able to move back in with parents, and have it be mutually enjoyable, can be extremely valuable for weathering unemployment and other crisis without destroying all savings and/or beginning a debt spiral.

ii. The importance of good nutrition, fitness, and other health and safety practices to personal financial success – Illness, which includes accidents, is the number one cause of bankruptcy. Better health means better and more secure employment. Smoking can cost as much, or more, than transportation in cigarette purchase costs alone. Poor driving can lead to thousands of dollars per year in ticket and excess insurance costs, and it can lead to an accident whose medical bills and lost work can easily bankrupt you even with health insurance; it can cause you to miss so much work that you lose your job, and it can leave you with a permanent disability.

iii. The how much to work after childbirth decision – Do you, or do you not, really make much or any more money working after childbirth when considering everything, daycare costs, extra transportation, eating out more, taxes, etc. At the same time, there is a danger for a woman staying out of the workforce for many years; her earning power stagnates, or declines, when it might have increased greatly over five, ten, or more years. If a divorce occurs, she may be in trouble financially with little earning power.

iv. Great enjoyment of life with little or no money – Sports, bridge, chess, and other games, many hobbies, nature, reading, music, learning an instrument/creating music, with a $300 electronic keyboard you can play almost any instrument, and the keyboard will have a built-in recording studio; it should also last for decades, social connectedness and romance, family memberships at tennis/recreation clubs can be inexpensive, and more.

v. How to be a smart shopper in general, especially for the big items – The importance of smart comparison shopping; it's especially worth your time for the large items, home, mortgage, vehicles, childcare, insurance, the great saving power of buying used, especially with cars (and how to buy and maintain used cars well), and furniture, but also many other things, especially in the eBay, craigslist era.
Please stay tuned for more posts on this, but let me just note for now, how I, and Elizabeth Warren, advocate for simple rules of thumb, like Thaler suggests, and understanding just basic intuitions, nothing complex, long, or hard to understand and maintain in you memory, things like Professor Warren's foundational, no more than 50% of income spent on "Must-Haves" (basically fixed and necessary costs) and the short memorable intuition why (good intuition, itself, tends to be very memorable, much more so than rote), and the memorable intuition why diversification makes sense in stocks, and in general.

Saturday, September 21, 2013

Positional Externalities, Culture, and Regulation vs. Taxes

The normal thinking is that pollution taxes are much more efficient than regulations. So, if you want to lower carbon – because you don't think the probability of frying your grandkids' planet has to be 100% before you take preventative action – then you put in a gas tax, rather than increase mileage standards a lot.

This way, if someone really wants to drive a ginormous truck, they can still do it, just pay a lot more to cover the cost of their increased polluting, endangering other drivers, sending money to terrorist supporting regimes, wearing the roads, using parking space, blocking other people's view,…

But as usual, this kind of analysis doesn't take into account the pink elephant of economics, positional externalities. If you just raise the gas tax, a lot of people will still buy these ginormous trucks. Then others will feel bad about buying regular size and compact trucks; they will feel a lot of pressure to just spend the money, borrow more, buy the cheap health insurance, etc., so they can buy a bigger truck, and not be the one with the tiny one (yes, we're still talking about trucks, but it's the same idea).

On the other hand, if you have a regulation that says no truck can get less than 30 mpg, unless there's a valid work reason, then no one can get a ginormous pollution machine; there's not this pressure. And also it can change public attitudes and culture when no one is driving around in these monsters. I'm old enough to remember in around 1980, when mileage standards suddenly skyrocketed and cars and engines suddenly became way smaller. It really changed the car culture. Prestige now came much more from luxury amenities and crushed velvet.

Of course, you could increase the gas tax enough to pay for not only the pollution externalities you incur on others, but also the positional externalites, the collision danger externalities, the sending money to terrorist sponsoring regimes externalities, etc. But you still don't change the culture as strongly as with a blanket regulation.

Look at World War II, where the war effort really helped give birth to the great middle class, until the recent generation of far right dominance killed it. You had a lot of rationing on things like meat, rather than just a tax. So everyone was contributing in this way. It was a community effort. Not the middle class and poor were able to eat very little meat, but the rich went right on eating steak just like they used to, war or no war, and just easily paid the tax.

And look at regulations against racism. Sure, you could have a tax on business to somehow cover the cost of racism they incur on others and society, but it would be hard to decide on what such a tax should be. And, it wouldn't do nearly as much to change the culture of racism.

I should add, though, that it's probably best to have a combination of taxes and regulation. Sometimes the polluting, or other externalities, are so varied and/or fungible, that it's most efficient to just get at the root with a root tax, and perhaps some regulation in addition, to get the best of both approaches.

Friday, September 6, 2013

The Intuition for Wallace Neutrality, Part II: Why it doesn't Work in the Real World

My first post explaining the elusive intuition behind Wallace Neutrality was well received. In particular, I was happy to see it discussed in a post on the blog of the think tank Bruegel. Bruegel is a very large and impressive organization. It was the #1 think tank in Western Europe, and the #1 international economic policy think tank in the World according to a 2012 University of Pennsylvania report. It's a project of 17 EU countries, chaired, until recently, by Mario Monti, and now by Jean-Claude Trichet.

I mention their excellent post now, in part, because reading it a second time after being away from this material for a while finally really crystalized in my mind a key intuition for why Wallace neutrality won't work in the real world – and why quantitative easing can.

The Bruegel authors wrote at the time, "Richard Serlin will have a detailed post in the next few days detailing the problems when thinking Wallace neutrality actually occurs with QE in the real world. Stay tuned." Embarrassingly, a few days became a year! But I just could never really crystalize it, and nail it down the way I wanted to. Then, after putting it down for a year and picking it up again, it all came together. So, without further ado...

Why Wallace neutrality doesn't work in the real world, and thus quantitative easing can

The intuition came when I was reading, and reflecting on, Bruegel's paraphrasing of something I had written:
Richard Serlin (HT Mark Thoma) gives the bottom line intuition of Wallace neutrality. Consider that 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.
I had gone down various roads in thinking about why the neutrality that worked in Wallace's model would not work in the real world, and I just wasn't able to really nail down any of them the way I wanted to, at least not the ones I wanted to. But thinking about this again, the idea came to me. The intuition is this:

Suppose the Fed does buy up 100 million ounces of gold in a quantitative easing. And the people who are savvy, well informed, expert, and rational know that in some years the economy will turn around, and the Fed will just sell back all of those 100 million ounces. So, in 10 years, the supply of gold will be the same as it would have been if the quantitative easing had never occurred. The ownership papers will shift from private parties to the federal government in the interim, but will be back again to private parties like they never left in 10 years. So, no fundamental change to the asset's value in 10 years.

And if no fundamental change to the asset's value in 10 years, then no fundamental change to the asset's value today, as the value today, for a financial asset with no dividends, coupons, etc., is just the discounted present value of the asset's value 10 years from now.

Now, as should be obvious – especially with gold – not all investors are savvy, well informed, expert, and rational – let alone sane! So, when the price of gold starts to go up, some of them will not sell at that higher price, even though fundamentally the price should not go higher; nothing has changed about the long run, or 10 year, price of gold.

In the Wallace model, and commonly in financial economics models, no problem, arbitrage opportunity! Suppose there are investors who are less than perfectly expert, knowledgeable, and rational – or way less – and they don't sell when the government buys up the price a little. Who cares. It just takes one expert knowledgeable investor to recognize that there's an arbitrage opportunity when the price of gold goes up merely because the government is buying it in a QE, and he'll milk it ceaselessly until the price is all the way back down again and the arbitrage disappears.

What's the arbitrage? Well, we're pretending we live in the world of Wallace's model (and many models like it). Markets are 100% complete and frictionless. If the price of gold goes up by even one cent, when there's no change in its fundamental value, that is when there's no change in its payoffs in the various states ten years from now, then an investor can, first, synthetically construct and buy from the primitive and/or other assets in the market a combination that has the same exact payoff as gold in any possible state of the world ten years from now.

At the same time as the investor purchases this synthetic gold, he sells, or sells short, the natural gold.

Because we're assuming that the markets at the start of this QE are efficient, an ounce of the synthetic gold portfolio sells for the same as an ounce of the natural gold. But once the natural gold goes up by even one cent, arbitrage! That single expert informed investor sells (or sells short) the natural gold and buys the synthetic gold. And he does this for as many ounces, without limit, as it takes to bring back down the price of gold to where it was, undoing the government's QE 100%, no matter how large it was, no matter how many trillions the government spent.

Now, for this to work as advertised, first you need 100% complete markets, so you must have a primitive asset (or be able to synthetically construct one) for every possible state at every possible time in the world.

[using Chandler Bing voice] Have you seeeen our world? The number of states just one minute from now is basically infinite. Even the number of significant finitized states over the next day, let alone a path of years, is so large, it's for all intents and purposes infinite. Thus, try to construct a synthetic asset that pays off the same as gold, now and over time, and you're not going to come very close. And if you try buying it to sell gold, or vice versa, to get an "arbitrage", you're going to expose yourself to a lot of risk.

And this is a key. I think a lot of misunderstanding comes from loose use of the word "arbitrage". The textbook definition of arbitrage is a set of transactions that has zero risk, zero. It's 100% risk free. It's not low risk, as often things that are called arbitrage are. It's not 99% risk-free. It's riskless, zero. That's what makes it so powerful in models, at least one of the things.

Another one of the things that makes it so powerful in models is that it requires none of your own money. If there's an expert and informed enough investor anywhere, even just a single one, who sees it, it doesn't matter if he doesn't have two nickels to rub together, he can do it. He can borrow the money to buy the assets necessary, and at the market interest rate. Or, he can just sign the necessary contracts, for whatever amounts, no matter how big. His credit and credibility are always considered good enough.

So, if markets are incomplete, and your synthetic gold, or gold substitute, is significantly different from gold in its future payoffs, then your "arbitrage" is not an arbitrage. It's not risk free, and you – even with perfect expertise, perfect public information, perfect forsight, and perfect rationality – are going to, at most, put limited money into it. You certainly won't limitlessly put money into it for as long as it still exists, without a second thought, like you would with a real arbitrage.

Second, of course, people do have serious liquidity and credit constraints that prevent them from limitlessly jumping on an "arbitrage".

Third, in the Wallace model world, it's frictionless. There are no transactions and time costs and problems that could eat up a complicated, or ultra-complicated, arbitrage.

So, in the real world, unlike Wallace's, what you have when the government does a QE and starts pushing up the price of gold is not an arbitrage, but a good deal. You have an opportunity for an above average risk-adjusted return, an abnormal profit, if you will. And that's if you're one of the people expert and knowledgeable enough to see it, and to the extent that you have the money or credit to take advantage of it.

Well, let me say something that's fundamental here, but so often grossly not understood or appreciated:

A good deal is not an arbitrage.

It typically has nowhere near the power to move prices to their fundamental values.

Now, what you will often hear is that the market is efficient, or highly efficient. Suppose that the price of gold, or of IBM stock, is fundamentally worth some amount, and its price strays from there. It goes up by a few dollars due to the government doing a large, or vast, QE and buying it up. Well, so what if it's not a true arbitrage opportunity, it's still a good deal (to sell it, or sell it short); it's still an above average risk-adjusted return. It may be true that most investors have little finance expertise, little finance public knowledge, and little time and willingness to study and analyze individual financial assets even if they did have the expertise. But there are still a lot of big money investors and institutions that do have the expertise and knowledge, and the willingness to spend the time to use it to analyze. And those savvy investors will jump in and sell (or sell short) and sell until the price goes back down again, and it's no longer a good deal, just an average risk-adjusted deal.

Well, what are the problems with that? The usual one you hear is that savvy investors are only a small minority of all investors, and this is especially true of highly expert investors who are highly informed about a given individual asset, or even asset class. And they only have so much money. Eventually, if the government keeps buying in a QE it could exhaust their funds, their ability to counter, by, for example, selling gold they own, or selling gold they don't own short.

Even rich people and institutions only have so much money and liquidity, or credit. You can't outlast the Fed, if the Fed is truly determined. Your pockets may be very deep, but the Fed's pockets are infinite.

So, you usually hear that.

But there's another reason why the savvy marginal investor is limited in his ability and willingness to push prices back to their fundamentals that I never hear. It's a powerful and important reason: The more a savvy investor jumps on a mispriced individual asset, the more his portfolio gets undiversified, and that can quickly become dangerous and not worth it.

Gold may sell for $1,700/ounce and you think its fundamental price is $1,650, but it gets very risky, very fast, to put 10%, 20%, 30% of your wealth in gold, and the price is still only up to $1,651. What do you say then? It's still only $1,651, and it's fundamental value is $1,700, I'll put more in? What if you put 80% of your money into gold, and the price is still only up to $1,652? Put in 100%? What if the price is even then still only up to $1,653? What do you do next? Say, hey, it's still only $1,653, and it's fundamental value is $1,700, so I'll start borrowing money to buy gold?

Obviously not. Gold is a good price at $1,650, an above average risk-adjusted return, when put in a portfolio in the appropriate diversified proportion, which in the CAPM would be the market weight. But as you add more than that weight, your portfolio becomes unbalanced, and any additional gold becomes worth less to you, and very quickly.

Let me be very clear on this powerful idea. It got me a letter published in The Economists' Voice, an outstanding economics and policy journal, whose chief editor is Joseph Stiglitz. The key quote from that letter is here:
...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.
So, taking the gold example, suppose the government goes in and starts buying up gold big time and pushing its price up. As you can imagine, lots of gold owners are of the Fox News, and, shall we say, not so expert, variety, and aren't even going to think of selling their precious gold if it goes up by 10, 20, 30%. In fact, that will probably make them want to buy more! But, a lot of savvy expert investors will sell what they have, and even sell some short, but they will start taking on a lot of unbalanced risk as they start doing this in earnest, and the government can outlast them and keep the price up.

And likewise with any asset, or asset class, that the Fed decides to attack in earnest with a QE.

The bottom line is that unlike in Wallace's model, an arbitrage will not be created, only a good deal, something very different. And while the government can't overwhelm even a single savvy investor, without even two nickels to rub together, with an arbitrage, the government can overwhelm all of the savvy marginal investors when there's just a good deal created.

I don't think this (multipart) reason is the only reason why Wallace neutrality won't hold, and QE can work, in the real world, but it's a big whopping one. So I think at some point, at least, QE would have a large effect, albeit the QE might have to be much larger than anything ever attempted.

One last note: Individual assets that the fed may buy in a QE may sometimes have pretty close substitutes, but with the unlimited buying power of the Fed, they can buy up large percentages of not just the individual assets, but of the close substitutes to the individual assets too! So, in another words, they can buy up and move the demand curve for whole classes of assets, close substitutes and all.

Monday, August 26, 2013

The Intuition Behind Simsek's, "Speculation and Risk Sharing with New Financial Assets"

Mark Thoma guides us to an article about a very interesting new finance paper by MIT economist Alp Simsek, “Speculation and Risk Sharing with New Financial Assets” .

If I might take a stab at the intuition:

Suppose you have a world with just two underlying assets, A and B, which are highly negatively correlated.

And there's only one security people can buy. It's 1/2 A and 1/2 B. So everyone has just this security in their portfolios.

Now suppose the financial system becomes more sophisticated, so people can now choose from three securities: Just A, Just B, and 1/2 A and 1/2 B.

If there are sharp disagreements in beliefs about the assets A and B, everyone might go from a portfolio of just 1/2 A and 1/2 B, to a portfolio of either only A, or of only B. So, the average risk of people's portfolios would go up greatly; total risk in the economy would go up greatly; diversification would go down greatly.

Essentially, the more you give people options and ease to gamble based on strong and differing beliefs, the more they will drop some of their diversification and go in and gamble against the people with sharply differing beliefs, like in a winner-take-all-tournament. As Simsek says in the article, “as you increase assets [what I call securities above], this speculative part [of risk] always goes up.”

Friday, August 23, 2013

In Praise of the 15-Year Fixed Mortgage -- as Opposed to the 30

Recently there's been talk in praise of the 30-year fixed mortgage.

I teach one of the largest personal finance courses in the country at the University of Arizona and am president and founder of National Personal Finance Education, one the largest licensed providers of a personal finance course required for people in bankruptcy.

I've thought about this a lot.

My opinion on this is that usually 30 years is too long, at least for most college graduates with a decent income. And if it's a Wal-Mart worker couple, they should be very careful about buying any home they can just barely afford with a 30 year mortgage. The focus should really be about trying to upgrade their skills and education, and especially the education of their children, so as not to be a Wal-Mart couple.

Anyone who's followed my blog knows I have a lot of sympathy for the working poor. I'm a strong advocate of not only free universal high quality pre-school, but also free universal high quality bachelor's degree, or worthwhile vocational training. I favor free universal healthcare, like Medicare for all, and a stronger safety net. But a Wal-Mart couple doesn't help themselves by creating severe financial stress to just barely be able to afford a home with a 30-year mortgage. It doesn't take anything that rare or unlikely going wrong to lead to a traumatic foreclosure. Living even in a modest house can be much more expensive than living in an apartment in a comparable neighborhood; consider the mortgage, the downpayment, maintenance, property taxes, insurance, increased furniture and utilities costs, an attitude that you should spend more with a house, and more. It would be better for the kids to live in a more affordable but decent apartment complex, and have some financial security, accumulate a cushion of thousands of dollars in the bank, and to help yourselves and your kids you focus on education, education, education.

So while I think for the working poor a 30-year mortgage may be necessary -- if it is prudent and affordable to buy the home -- usually the 15-year fixed is best for the solidly middle class and college educated (and even then it's often best to make additional payments to end it even sooner). The interest rate is lower, usually by a lot; the payments aren't that much higher (due to the lower interest rate and the surprising exponential nature of compound interest over long periods of time – Try comparing the monthly payments and see.), and it's so valuable with the country so financially insecure for families to get to no mortgage as quickly as possible. Elizabeth Warren in her seminal personal finance book, "All Your Worth", rightly stresses the great importance of getting your "Must-Haves" (basically fixed expenses) low in today's dangerous America, and having no mortgage is a great way to lower your Must-Haves. Get some solar panels (in the right area with the right tax spiffs), and now you have little or no utility bill too.

Life, especially today, gets a lot riskier as you get older. At 25 you might have super health and resilience and no dependents, and be able to live happily and healthily on nothing, eating macaroni and cheese, sleeping on a futon, and driving a beater. That becomes way harder when you're 45, with kids. And if you lose your job at 45, it will be a lot harder to find one close to as good, or good enough, with age discrimination, declining health and energy, and perhaps antiquated, or rapidly antiquating, skills. 45 is a really good time to have no mortgage payment, as opposed to not until 60.

In addition, as usual, positional/context/prestige externalities are profound and huge. When a family thinks 15-year mortgage, they are likely to buy a smaller home, not get so much wood, granite, and stainless steel, buy less large and expensive vehicles, etc. But because they get used to that level -- and don't start getting used to a higher level of position, prestige, etc., the decreased utility is not that much, and the increased security of having no mortgage right when the kids are setting off for college can be huge. And how important it is for kids to be able to go to college without having to flip burgers 20-40+ hours per week, a great advantage for graduating, GPA, and learning. And in any case, the buying a smaller home, cars, etc., can mean that total payments aren't even higher.

Interestingly, given the ginormous importance of positional externalities, if the government nudged forward 15 year mortgages, you might see people commonly owning their own homes twice as quickly with little loss of utility, as you wouldn't lose position, prestige, or context of quality if everyone else was also doing 15-year mortgages and so they also had commensurately less to buy a home with.

Of course, we'd also have to control home equity predators from undoing this.

Sunday, August 4, 2013

Is maximal profit at any cost really what shareholders want?

Rajiv Sethi has a great post on the recent reprehensible behavior of Goldman Sachs.

What I'll add is this: There's the horrible argument that Goldman Sachs should do these horrible things because they should do whatever maximizes the profits of their shareholders – Sell crack, poison the streams children drink from, whatever, it must be good because invisible hand! But, of course, any trained and decent economist knows about all of the ways the pure free market and invisible hand can go horribly wrong, especially if you care about optimizing total societal utils, which I consider ridiculously more important than Pareto optimality. These ways include externalities, asymmetric, and just poor, information, monopoly power, relatively high transactions/negotiations costs, giant economies of scale, zero marginal cost idea/information goods,...

But here's something you rarely hear: Are you really optimizing shareholder utility, or doing what shareholders really want, if you do anything that maximizes profits? And the answer is often, of course not. Would the average shareholder of Goldman Sachs vote for these (and many more and far worse) horrible actions in exchange for what's sometimes just a relatively small increase in return (to their portfolio as a whole), if they had to spend the time to vote and were completely informed of what was going on, and the implications?

Many shareholders hold extremely diversified portfolios. So they can vote that none of the companies in Goldman Sach's industry do these horrible things, and thus the decrease in profits is much less than if Goldman Sachs is the only one acting ethically. And, even if it would hurt Goldman Sach's industry, it might (and very likely would) help other industries in a well diversified investor's portfolio.

And on top of that, any decrease in return would apply to everyone, and this is huge due to ginormous positional externalities. You basically don't lose prestige, position, context, due to falling behind others in wealth and consumption. Everyone's return is lowered the same amount.

Of course, the vast majority of shareholders hold only a micron of each company, and so it's not worth their time to vote, and if you own through a mutual fund, the mutual fund votes for you anyway. I've owned a piece of pretty much every company on every major exchange for years, at least through mutual funds and ETFs, but I've never voted. So, who controls tends to be rich individual major shareholders (often very greedy), pension funds, mutual funds, and other institutions and companies, and/or the managers themselves.

With regard to institutions, like pension funds and mutual funds, their managers basically consider it their fiduciary duty to vote however maximizes the dollar returns of shareholders, regardless of ethical/social issues. I was in an MBA program in the 90's and a finance Ph.D. program in the 2000's; the constant message was, a mangers duty is to do whatever maximizes shareholder wealth, or return. And I've seen a lot more evidence of this through the years in experience and study. It's a very, invisible hand, greed is good, message. The culture is very important and different from a generation or two ago. Because the policeman can't be everywhere, and the law can't cover every kind of situation and gaming that can come up, culture and norms are very important.

So, with regard to the shareholder voting of mutual funds, this quote from a 2006 Wall Street Journal article is consistent with my experience and study:
On proposals related to social issues, fund companies commonly vote against them or abstain, basing their decision on whether the measures would financially benefit shareholders.
Now, interestingly, you have the word, "commonly", as if sometimes the mutual funds do vote for social proposals. And you can see in that article that there are significant percentages of times when they do. And also here, with regard to global warming proposals. But I suspect that most of the voting for social proposals is for profit reasons, to protect the name of the corporation and its brands, something Apple may be making a mistake in not worrying about more (but remember, the managers may be long gone, with their huge bonuses, before the long term price is really paid). Of course, the argument that corporations will always be forced to act ethically to protect their reputation is very wrong. Amongst other problems, often the vast majority of the public won't know what's going on, and often the profits will outweigh the bad publicity, such as it gets known.

But the bottom line is that, the shareholders only care about money at any cost, greed is good, invisible hand, message is wrong, and the change in our corporate culture towards this has been extremely harmful. Maximal profit at any cost is not always what the average shareholder wants, even weighted by shares owned. The average shareholder, even weighted by shares owned, is often very willing to have a slightly lower return on his total portfolio to have his companies not doing horrible things.

Tuesday, July 30, 2013

Politicians vs. Bloggers

After reading Jonathan Chait's posts on Howard Dean I was thinking an interesting post would be how the kinds of things that tend to make someone a successful politician differ from the kinds of things that tend to make someone a successful blogger, like Chait -- and the very different kinds of people that tend to go into each.

One really common way to increase your odds of success as a politician is to be kind of a weasel, or a huge weasel. There are exceptions; you can be very successful through great charisma and competence (Elizabeth Warren), but few people have that kind of charisma and competence.

Note, however, what true weaselness is: Sometimes looking like a weasel is actually doing what you think is best for the country – You support, or go along with, something bad in exchange for helping some greater good get done. Any good politician should do this sometimes, and to some extent. It's unavoidable if you want to optimize the good of 300 million Americans and 7 billion human beings. But the weasels will do this not for the greater good, but for more personal power, prestige, and/or money.

And politicians tend to be people who will go to incredible lengths, often unethical, often that they know really hurt the country and the world, for power and prestige (although there's an argument that women politicians are much less like this [1]). John McCain is a prime example; it's all about him and what he wants, and his personal vendettas, rather than 300 million Americans and 7 billion human beings.

As a blogger, however, there's very rarely big bucks and prestige among the general public. You do it largely because you care, rather than a super drive to win and have power. And you better be smart and do your homework, because your derp, or mistakes, are often immediately attacked by people who largely determine how respected and influential you are. And your audience is way more informed than the average, so you just can't get away with politicians tricks nearly as well.

Of course, I'm not speaking of conservative bloggers, who primarily speak to a bizarro tribal world, and say what their super-rich patrons want them to say.

[1] From the New York Times, 6/11/11:
Research points to a substantial gender gap in the way women and men approach running for office. Women have different reasons for running, are more reluctant to do so and, because there are so few of them in politics, are acutely aware of the scrutiny they draw — all of which seems to lead to differences in the way they handle their jobs once elected.

“The shorthand of it is that women run for office to do something, and men run for office to be somebody,” said Debbie Walsh, director of the Center for American Women and Politics at Rutgers University. “Women run because there is some public issue that they care about, some change they want to make, some issue that is a priority for them, and men tend to run for office because they see this as a career path.”

Thursday, July 25, 2013

What about Expenditure Cascades?

Paul Krugman has an interesting post on the question of the causes of the explosion in household debt that was an important factor in our financial and economic crisis:
The president came down pretty much for what we might call a Stiglitzian view (although it’s widely held): debt was driven by rising inequality. The rich were taking an ever-larger share of the pie, but not spending to match, while working Americans took on ever more debt to make ends meet.

What’s the alternative? Minsky: debt exploded because the Great Depression was receding into the mists of forgetfulness, and both lenders and borrowers — enabled and encouraged by financial deregulation — forgot the dangers of leverage.
I'd add to this, importantly, expenditure cascades, from Cornell economist Robert H. Frank.

In an expenditure cascade, the tip-top pulls away in income, and thus spending, so level two notches up their spending to not lose their position and feel bad and embarrassed, and this involves more borrowing/less saving. When level two notches it up, this induces level three to do the same, and so on.

How much pressure do middle class people now feel to put granite, wood, and stainless steel in their perfectly functioning kitchens so they don't feel and look crappy and poor?

The 1/10th of 1% used to drive $120,000 Mercedes, and the 1% used to drive $70,000 Mercedes. Now the 1/10th of 1% are buying $400,000 Rolls Royces, making the 1% feel like their $70,000 Mercedes are crappy and embarrassing, so they save less/borrow more and buy $200,000 Bentleys. Now that the 1% went from $70,000 Mercedes to $200,000 Bentleys, the 5% feel like their $45,000 Mercedes are crappy and embarrassing, so they save less/borrow more and buy $80,000 Mercedes, and so on down the line.

I think expenditure cascades are important to add, especially since positional externalities are the pink elephant of economics.

Wednesday, July 17, 2013

How about a model just as a simulator/tester, free of the constraints from having to solve for the global optimum?

Please bear with me and read this long quote from a paper in the lifecycle portfolio strategy literature:
The original literature on dynamic portfolio choice, pioneered by Merton (1969,1971) and Samuelson (1969) in continuous time and by Fama (1970) in discrete time, produced many important insights into the properties of optimal portfolio policies. Unfortunately, closed-form solutions are available only for a few special parameterizations of the investor's preferences and return dynamics, as exemplified by Kim and Omberg (1996), Liu (1999a), and Wachter (2002).

The recent literature therefore uses a variety of numerical and approximate solution methods to incorporate realistic features into the dynamic portfolio problem. For example, Brennan, Schwartz, and Lagnado (1997) solve numerically the PDE characterizing the solution to the dynamic optimization. Campbell and Viceira (1999) log-linearize the frst-order conditions and budget constraint to obtain approximate closed-form solutions. Das and Sundaram (2000) and Kogan and Uppal (2001) perform different expansions of the value function for which the problem can be solved analytically. By far the most popular approach involves discretizing the state space, which is done by Balduzzi and Lynch (1999), Brandt (1999), Barberis (2000), and Dammon, Spatt, and Zhang (2001), among many others. Once the state space is discretized, the value function can be evaluated by a choice of quadrature integration (Balduzzi and Lynch), simulations (Barberis), binomial discretizations (Dammon, Spatt, and Zhang), or nonparametric regressions (Brandt), and then the dynamic optimization can be solved by backward recursion.

These numerical and approximate solution methods share some important limitations. Except for the nonparametric approach of Brandt (1999), they assume unrealistically simple return distributions. All of the methods rely on CRRA preferences, or its extension by Epstein and Zin (1989), to eliminate the dependence of the portfolio policies on wealth and thereby make the problem path-independent. Most importantly, the methods cannot handle the large number of state variables with complicated dynamics which arise in many realistic portfolio choice problems. A partial exception is Campbell, Chan, and Viceira (2003), who use log-linearization to solve a problem with many state variables but linear dynamics…
From: Brandt, Michael W., Amit Goyal, Pedro Santa-Clara, and Jonathan R. Stroud, 2005, A simulation approach to dynamic portfolio choice with an application to learning about return predictability, Review of Financial Studies 18, 831–873.

The authors go on to present their new numerical solution method which overcomes a lot of the limitations of old solution methods, and allows more realistic modeling – IF you feel like you can only create a model if you are able to find the global optimal solution to it.

But this is my point. In all of those papers cited on lifetime portfolio choice strategy, the authors put in severe unrealism for one reason, so that they would be able to solve for the perfect globally optimal behavior of the people in the model.

What if, at least for just one paper, let alone a branch of the literature, they said, I’m not going to be severely constrained by the need to calculate the exact utility optimizing behavior. I’m going to create a really really realistic model, say of lifetime portfolio strategy, and use it as a simulator tester. I’ll try various popular and/or intuitive strategies, plug them into the model on my computer and see what expected utility score comes out.

Wouldn’t this be a great way to prove and see which strategies are better than others, with a really realistic model, that could have really complicated realistic utility and other functions – functions which wouldn’t even have to be analytical; they could be highly complicated and realistic empirical functions; functions written with multiple lines of computer code, instead of being limited to one neat compact simple equation.

Sure, such a model might be so complicated and irregular that you’ll never solve for the global optimum with a high degree of confidence, even with numerical methods and supercomputers, but you could test really well how one important and/or popular strategy compares to others in expected utils. You could use your intuition and new understandings in the field to come up with ever better strategies that test higher and higher in utils in the super realistic simulator. You could quickly test hunches in the simulator. Heck, you could even put out a prize for the first person to come out with a strategy that exceeds X expected utils in the simulator.

Why does no one do this in economics or finance? It seems in the physical sciences that they always use simulators to test things, making them as realistic as possible, instead of making them way less realistic in very important ways in order to be able to exactly calculate the perfect global optimum.

Tuesday, May 14, 2013

Are stocks especially safe for the long run as a hedge against robot/computer unemployment?

Wonkblog has a great interview with Kevin Drum on the dangers of long term, or permanent, unemployment in the future with great advancement of computers and robots. As an adjunct professor of personal finance at the University of Arizona and President of National Personal Finance Education this is a subject I've been studying and thinking about a long time, along with, of course, how to protect yourself and your children. It's very important, and I hope to say a lot about it in the future.

But for right now, there's a big thing I've been conjecturing for a while, and I think I'm ready to at least state it publicly for discussion:

Stocks are widely acknowledged among experts and academics to have a great risk-adjusted average, or "expected", return over the long run, decades, and for some conventional reasons. And I have a hypothesis for the "Equity Premium Puzzle" too, that I haven't heard in the literature or elsewhere, basically that a firm can simply create more value and be more productive when they finance with stock because it gives the ability to think long term and be flexible, without the short term constraints and requirements that come with debt. There is more too it, though, like the particular way it affects the aggregate supply curve of firms. For details, see here.

Now, one big thing that lowers the risk of stocks over the long run, that you often hear, is that, unlike fixed income assets, they move very well with inflation, being claims on real assets and income (See the great book, "Stocks for the Long Run", by Wharton financial economist Jeremy Siegel.)

But there's potentially another big thing; if robots and computers really take off, creating a huge risk of being long term unemployed, then stocks may be a fantastic hedge against this risk. As the better the robots do – the more wealth they create, the more they produce – the more the value of your stocks may explode, because your stocks are robots; they're claims of ownership of corporations' robots and computers. It’s like you own your own robots to create wealth for you personally, and you may not have to own many when each one can produce the equivalent of a well skilled man for a lifetime.

So one of the best ways to protect the future of your children may be to every year put money into your 401k and IRA in a well-diversified stock index fund, not just for your retirement, but for even longer term, for your children when they're 30, 40, 50, and have a family, and it may be very hard for them to find any job that robots can't do for 50 cents per hour, or much less. Then they'll own many of these fantastic robots themselves to year after year make a good income for them.

And, of course, it would be great if you could skip the McMansion and new cars every three or five years, and instead put more into stocks for your children than just the 401k and IRA limits, like starting trusts. Believe me, the kids are a lot better off driving around in older used cars and not having a great room or granite countertops, but having their future insured against devastating long-term unemployment and poverty.