Friday, March 27, 2015

Uncertainty and morality in a dynamic economics

Ignorance of the distinction between risk and uncertainty lies at the heart of many economic conundrums, particularly dynamic behaviours through time. Yet the critical importance of this distinction in predicting economic behaviour was clear to prominent economists of the 1930s, including Shackle and Knight. Knight wrote that
... that a measurable uncertainty, or 'risk' proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.
Economists have now forgotten that a world of uncertainty generates a strong incentive to delay choices. We do not make immediate choices informed by some probabilistic expectation of future outcomes. We usually can’t even know the potential scope of future outcomes. That means we delay choices to keep options alive, miss good opportunities, and sometimes commit to poor investments. Because time is irreversible, unlike in economic models. When we commit to decisions matters as well as the decisions themselves.

But the ignorance of uncertainty is evident in other social sciences as well. Approaching problems in philosophy and ethics without acknowledging uncertainty has lead to many seemingly intractable puzzles that are easily resolved in a world of uncertainty.

I hope that observing the crucial role uncertainty plays in these contexts encourages economists to take the concept more seriously and see the economy as a dynamic environment, rather than a static one.

In ethics, the Trolley Problem has occupied the minds of philosophers for decades. In its simplest form, the puzzle is as follows.

In Scenario A a trolley is barreling down the tracks towards five people who will be killed unless the trolley is stopped. Luckily, there is a fork in the tracks, and by simply pulling a lever, the trolley can be diverted onto a second set of tracks. Unfortunately, there is a single person in the path of the tolled on this track who will be killed if you pull the lever.

The dilemma is whether you should pull the lever and save five people by sacrificing one? In surveys, most people say they would.

In Scenario B you find yourself on a bridge next to a fat man with the same dilemma of a trolley hurtling down the tracks towards five people. The question here is whether it is permissible to push the person next to you onto the tracks if you knew it would stop the trolley and save the five people.

Most people in this scenario would not push the man off the bridge, even though the same welfare gains in terms of lives saved would be the same as Scenario A (so you know, 68.2% of philosophers would push the man to save the five). Some philosophers and psychologists put this down to a ‘dual-process’ theory and for some reason that two different setups invoke "the operations of at least two distinct psychological/neural systems".

Fundamentally the incompatibility of these two outcomes arises because we are presented with a dilemma in terms of risk, or knowable probabilities. In fact, we have point distributions at perfect certainty for each outcome. You push the fat man off the bridge (assuming away the logical problem that a man fat enough to stop a runaway trolley is somehow easily able to be pushed off a bridge) you have a probability of 1 that the man will die and the trolley will be stopped. If you don’t, you have 100% certainty that the five people on the tracks will be killed.

When you add risk by looking at possible probability distributions of choice outcomes you can generate a balance of risks that predicts survey responses. This is a step in the right direction. But it still overlooks the dynamic nature of true uncertainty.

Let us now look at the question in terms of uncertainty. For a start, how do we know the trolley is out of control? Is it possible to delay the decision to get more information?

A very simple resolution arises when we add a time dimension to the problem, which is what is required under uncertainty. We can think in terms of an option-tree expanding over time, with choices unable to be fully anticipated in advance.

We can see in the diagram below that in Scenario A, switching the tracks leads to a new situation that opens up the set of possible choices in the grey shaded area while eliminating others. Switching the trolley onto the side track buys time and keeps options open without killing anyone.

In Scenario B, most people choose not to push the fat man. Here, what they are doing is buying time before anyone gets killed. Even after the decision is made not to push the man, there will be time available for many other as-yet-unknowable situations to arise.

People are making choices in a way that allows them to navigate through a choice space over the irreversible dimension of time. I’ve highlighted in red a possible path for each scenario that could be envisaged by someone making choices in a world of uncertainty.  In both cases, there is an unknowable chance that a resolution to the dilemma will involve no death if the dynamic choices that arise are navigated appropriately. But choosing to push the fat man in Scenario B eliminates the option of resolving the situation without any deaths.

The whole rationale of making decisions in a world of uncertainty revolves around keeping options for desirable outcomes open, and often this involves buying time by not making a decision at all.

We know that buying time to keep an option open is a strong impulse. In experiments where participants are given the choice of which of two identical drowning swimmers to save, knowing they can only save one, many are unable to make the decision in a timely enough manner and instead spend their time searching for better information in the hope of maintaining the option of saving both. But in doing so, they let them both drown. Because the choice to commit to saving one swimmer is associated with a commitment to allow the other to drown, the logical choice is to delay to maintain the option of saving both.

In military training, overcoming this instinct to delay choices to keep options open forms an integral part of the psychological training. Soldiers are known to delay making any choice in high-stakes combat dilemmas (what amounts to ‘freezing') or in many cases they shoot to deter rather than to kill, to keep open the option of finishing a battle with fewer deaths in general.

In criminal behaviour, Becker’s expected utility framework has been called into question due to the radical difference between human behaviour in a world of uncertainty versus a world of risk. Increasing the chance of being caught and increasing punishment if caught are substitute methods for changing probability distributions of expected outcomes in a world of risk. But in a world of uncertainty, they have quite different effects on criminal decisions.

The same logic of uncertainty can be applied in social psychology to understand the bystander effect. The bystander effect is the label given to the occasionally observed inverse relationship between the number of people witnessing a victim in need, and the number of people offering help. Various reasons for this empirical phenomena have emerged, with the idea of a diffusion of responsibility dominating explanations.

But when we dig a little deeper we can see the logic of uncertainty at play. Repeated experiments on the bystander effect show that the degree of ambiguity is a crucial determinant of the willingness to assist, with reaction times being much slower in the presence of more ambiguous situations. The logic of how ambiguity, or uncertainty, results in the bystander effect is as follows:
…most emergencies are, or at least begin as, ambiguous events. As the bystanders are deciding whether an event is an emergency, each bystander looks to the others for guidance before acting. 
… Seeing others remain passive causes the bystander to interpret the ambiguous situation as non-serious.
So it is not that people do not want to help. But as each person individually chooses to delay their actions to gain new information, they also observe others doing the same thing. By observing others they gain the new information that the situation is non-serious, and hence as a group they ultimately choose a path through the choice space over time that resolves to a belief that the situation is a non-emergency.

What happens as people delay choices here is a cascade of new information that changes the decisions of each individual and the group as a whole. In sociology, there are many simulation models of these type of choice cascades, from standing ovations to riots, and other herding behaviour including musical tastes, and crucially for economists, asset market speculation.

Uncertainty is primarily a concept about choices in a dynamic environment. Here I have shown that human behaviour is adapted to our dynamic irreversible environment, and as such, uncertainty is required to understand behavioural logic, morality, and sociability. Moral puzzles resolve easily in an environment of uncertainty, and many psychological phenomena, from soldiers freezing in battle, to the bystander effect, to our taste in music, can be seen to arise from a result of human tendencies to delay decisions in order to cope with uncertainty.

It is not just economists who have acknowledged that uncertainty is tremendously important, but then later ignored the concept in their analysis. Given the high stakes arising from political choices based on economic analysis, putting uncertainty front and centre in a new dynamic economics is critical.

Wednesday, March 25, 2015

Economics: Blah blah blah

Economic comedian Yoram Bauman translates Mankiw's 10 Principles of Economics in this video. The three macro concepts were immediately translated to blah, blah, blah.

Here I want to improve of his efforts and translate some of the many concepts that seem to mystify all who encounter them. Some readers might not agree. Others might have better suggestions. Let me know in the comments. 

Economic Term
Actual Meaning
Accounting unit
Medium of exchange
Medium of exchange
Accounting unit
Accounting unit
Credits and debits (‘promise unit’)
Production function 
Just kidding, economists don't care about time 
Magic attractive force
Current state of the world
Unexplained residual
New recipe
Free Markets
Very specific set of government institutions 
Stylised fact
Deadweight loss
Difference between a real pudding, and the magic pudding
Structural reform
Non-specific legal change to give rich people more power in the name of efficiency
Why aren’t we in equilibrium?
Low wages
Bigger numbers devoid of meaning
Degenerative scientific research programme
Why don’t people agree with me?
Laden with hidden value judgments
State of the world
Opportunity cost
What you could be doing instead
Some other prices
Rent seeking
Buying political favours
Market failure
Real life
Outside the club. Go home.
Pipe dream
Mystical element allowing decisions to be made
Monetary incentives
Short run
Arbitrary time period that makes the model work
Long run
The end of time itself
Perfectly known distribution of possible outcomes
Comparative advantage
Started producing it first
Comparative advantage
Was on/under the land when we conquered
How rich your parents are
Representative agent
One person
Uniform distribution of agents
One person
Property rights
Unspecified institutional setting
Covertly transferring money to people you know
Someone else covertly transferring money to someone they know
Vitally important, but I can’t explain it
AggregationFallacy of composition

Tuesday, March 3, 2015

Coaches’ Calls: Should debt be on the scoreboard?

Guest post by Michael Harris, first published at Medium.
TL;DR version, because it’s long!
  1. There is no reason to think we are nationally living beyond our means at the moment.
  2. There is no “debt and deficit disaster.”
  3. Debt does not mean we (the current generation) are ripping off “our children and grandchildren” (future generations).
  4. It’s the real things that finally matter.
Also: why government budgets are not like household budgets (fallacy of composition; infinity; and printing presses).
1. The scoreboard

On a recent episode of the ABC’s panel show Q&A, radio announcer and former rugby coach Alan Jones declared that “there is a golden rule in sport. You look at the scoreboard. The Labor Party haven’t produced a surplus since 1989,” which certainly sounds like a damning indictment.

But why would that be the thing on the scoreboard? Imagine a football coach looking at the results and details of a match his or her team had convincingly won on the weekend. “OK, so we dominated in terms of share of possession. If we look at ground gained each time we gained possession, we dominated. And, of course, we ended up with twice as many points as the opposition. But look at how many times we dropped the ball! We dropped it twice as many times as the opposition did! This is terrible! You’re all losers!”

This would obviously, and rightly, be seen as the weirdest way possible to judge who won and who lost in that sporting contest. Obviously, the team with the most points wins, regardless of how messy the victory was. A good coach would focus on improving aspects of play that need improvement, but they wouldn’t confuse what’s on the scoreboard with other aspects of performance that contribute to — but aren’t the same thing as — the final score. The team may have dominated the game but still played with fumble-fingers, which would make ball-handling something to work on in training. But it’s not the criterion by which the outcome of the game is finally judged.

Neither is the budget, whether a deficit or surplus is achieved. Unlike a football game, there is no one single final score on which to adjudicate performance, but for a macroeconomy, the trifecta of economic growth, unemployment, and inflation are key indicators that should be up on any “economic performance” scoreboard. The average trend rate of unemployment during the Rudd and Gillard years was 5.1% (a period including the Global Financial Crisis); the average during the period since the Abbott government took office is just above 6%. Inflation is low, with the most recent annualised rate of CPI growth being under 2%, the bottom of the Reserve Bank’s target rate. Too-low inflation, like high unemployment, is symptomatic of a weak economy, a fact reflected in the most recent RBA decision to lower interest rates to a record low. Any sensible score -boarding of the macroeconomy would show that things have definitely not been improving since the 2013 election.

No reasonable analyst would contend that this is entirely the fault of the Abbott government. International conditions are challenging, with Chinese growth slowing, and Europe remaining subdued. The Reserve Bank sets interest rates without government influence, meaning options to manage the economy are few. Any government in power now would find circumstances difficult.

But this is exactly the problem; to manage an economy in difficult conditions requires an accurate understanding of the issues you face, and a willingness to seek — and an ability to listen to — expert advice from professionals on the government payroll whose job it is to provide such advice.

The first — and in current conditions, the worst — mistake to make is to confuse what should be prominently displayed on the scoreboard. As mentioned above, changes in GDP, unemployment and inflation are key magnitudes to monitor. Underpinning those are trends in employment and productivity growth, and international conditions as reflected in our terms of trade. What doesn’t belong in bright lights as a headline indicator is the budget “bottom line”. As a number, the budget outcome is best regarded as an outcome of events in the economy; as a process, the budget is a tool to assist with managing economic performance given all the circumstances it faces. The bottom-line number in any year cannot be finely controlled, and it’s foolish to claim that it can be.

Yet in Australia we repeatedly hear about budget emergencies and debt and deficit disasters. We’re told that we’re living beyond our means, and engaging in intergenerational theft by loading our children up with our debt. So why has political discourse turned so heavily towards treating the annual budget figure as a, if not the, key indicator of economic management? Why has “austerity economics” — with its inevitable focus on short-run budgetary outcomes over everything else — dominated the discussion when budget outcomes are not nearly the most important issues in people’s actual lives?

2. Bad reasons

A worst-case conspiratorial view would have it that “austerity economics” is really code for reducing public expenditure in order to shrink the size — and role — of the state. In this “starve the beast” view, the state is ever-growing as a share of the economy, and this growth must be arrested. Cuts in both tax rates and government expenditure are the intention, but this rather extreme philosophy puts the tax cuts first, in the belief that cutting taxes will reduce revenue and (hence) lead to spending cuts based on the realisation that there is simply less money available for government to spend. Since this contravenes the argument of supply side economics that cutting taxes will increase revenue, it is sometimes posited that starve-the-beast is the post-facto argument to use when it turns out that taxes cut based on supply side arguments have not in fact resulted in the expected revenue increases.

Slightly less conspiratorially, there have been seemingly respectable arguments for austerity economics coming from the economics profession, such as the claim by two leading economists that their evidence showed economic growth was hampered by a country’s high external debt levels, with particular problems emerging when debt levels reached 90% of GDP. Obviously, the principle that correlation does not equal causation applies given that causality could run either way (an economy slowing for other reasons would expect to see its debt-to-GDP ratio rise), and the authors carefully talked of correlations. However, this did not stop their work influencing conservative politicians in both the US and the UK in favour of austerity policies.

(This was not the only academic work used to support austerity economics. “Expansionary austerity” arguments, involving claims that fiscal consolidation improves business and consumer confidence sufficiently to bolster growth, have been proposed by serious academics. But this argument, too, has come under fire.)

Whether legitimate or dodgy, the academic work seems to serve more as a rationalisation than a pure justification for austerity economics narratives. Once you decide to engage in austerity policies, reference to scholarly work that seems to support your approach is convenient to refer to, but not essential to motivating your choice or action in the first place. What makes austerity so compelling in the first place, so that it can be sold to the media and the public as representing plausible and serious policy?

A focus on budget outcomes obviously engages with our intuition about managing our own budget and living within our means. It seems so intuitively simple that it’s obvious; a balanced budget means we are living exactly within our means, and an unbalanced budget means that we are not. In particular, a deficit budget is putting us into debt (successive deficit budgets driving us deeper into debt each year), while a surplus budget is required if there’s existing debt to be paid down (requiring lower spending/higher taxes in future). And if there’s a debt that’s being maintained, clearly it is something that our descendants will be left with to pay back, so we must be impoverishing them, right? Right?

It seems so obvious as to be self-evident. How are we to be convinced that, in fact, this intuition is almost entirely incorrect?

There are at least three reasons that a government budget is not like a household or business budget; so much unlike a household budget that it’s seriously misleading to compare them. They are, in turn, (i) the fallacy of composition problem aka “owing the debt to ourselves”, (ii) the effects of infinity, and (iii) the printing press. Working through these will not only make clear how much a government budget is not like a household budget, but that being in debt does not automatically represent “intergenerational theft” — far from it. But running deficits and accruing debt does have immediate distributional consequences that are worth paying attention to.

3. Government budgets are not like household budgets. Seriously. (Part 1. Fallacy of composition)

Let’s look at the first argument, sometimes referred to as “owing the debt to ourselves”. It’s a basic fallacy-of-composition argument; incorrectly asserting that what’s true of a part is therefore true of the whole. We think of a family/household budget as something run within a household, based on money coming in and going out of that household, just as though it was a single person’s budget, balancing incomings and outgoings. Instead, let’s look at a household budget as if all the debt occurred within the household, with multiple members borrowing from each other.

Think of it this way. There’s a head of the household who manages the “household budget” on a day to day basis. All members of the household earn their own individual incomes, and the head of the household collects a small amount from each of them to help fund collective household expenditures. Other than that, each individual family member manages their own personal budget personally. From time to time, the head of household borrows extra money for urgent household items or investments from other members of the household, writing IOUs that the lending household member can keep in their desk drawers for later repayment. The household head ensures agreed interest payments are made, and is responsible for eventual repayment of the debt. If a surplus fund is not available when any of the debt falls due, the household head simply borrows from another member to repay the one whose repayment is due.

Is the household as a whole impoverished as a result of what are in fact a series of internal transfers? Are future members of the household collectively on the hook for borrowing decisions being made today? The household head may need to increase the amount collected from household members, simply to repay what is owed to some of them, but this is obviously a redistribution of household resources rather than a net loss of household income. Intergenerationally, it is hard to see how all the future children of household members are being impoverished by all the current members.

Two things are worth considering in terms of impacts over time and whether “intergenerational theft” is occurring; first, who is owed repayment (compared to who will be contributing to the household fund in order to build up the surplus needed to make the repayments), and second, what the borrowed funds are used for and whether they have enriching impacts on the household over time. If borrowed funds are used to purchase furniture for common areas in the house, or upgrade the house physically or technologically, those actions will yield benefits to future occupants of the house, in which case it’s hard to see them as having been collectively “stolen from” as the result of the earlier reliance on IOUs.

(It is not for us to wonder why IOUs were used instead of the head of household simply “taxing” the household members more at the time. A deeper analysis could focus on this choice. For now, all we need to look at is the impact on one generation from the choice of a previous generation. It’s clear that the generational impact depends on spending choices made earlier — improving the house in long-lasting ways versus holding more parties, in effect. The pattern of cost-sharing can change based on the use of IOUs versus pure taxation, and that may affect consumption and savings choices of individual household members that flow on to their individual offspring. But the total impact across generations of using debt does not in any way imply future impoverishment.)

Convinced yet? We could look at this a different way, by going back to the Q&A episode we began with. Imagine the 5 guests + host are the entire population of a (tiny) country, with Tony Jones as the head of the country, responsible for its overall finances. Then imagine that Alan Jones and Heather Ridout represent the “rich” members of this society, while Chris Bowen, Jamie Briggs and Corinne Grant are the “less rich” members. Tony Jones runs a balanced budget, until one day he decides to do the following: (1) maintain expenditure as it stands, (2) reduce taxes on the rich folk (Alan and Heather) by cutting the top marginal rate, and (3) issue bonds (IOUs) to cover the difference — the deficit — which Alan and Heather buy up with their extra cash.

The most obvious thing about this is that there is an immediate distributional impact, as opposed to an intergenerational one: Alan and Heather have their tax liability reduced, and end up holding some financial assets they otherwise would not have had. A different tax change — say, an increase in the tax-free threshold — would have different distributional consequences, but these impacts would be felt far more between “rich” and “less rich” than they would between “older generation” and “younger generation.”

Governments do of course borrow “outside the family”, in other words from foreigners. Hence not all of our debt at any time is “owed to ourselves”. But to discuss this at length would require making the point that our domestic savings pool is insufficient for our desired investment, requiring imports of foreign capital, some of which would come in as public borrowing.

4. Government budgets are not like household budgets. Seriously. (Part 2. Infinity)

The above discussion is about the fallacy of composition that is involved in mistakenly treating the government budget as if it were like an individual managing their own finances. The next main difference involves the effects of infinity.

If a household were like a government, then that household would have to effectively live forever. A household led by someone with eternal life and effectively a guaranteed stream of income would be a very safe household to lend money to, and in effect, it would never have to be out of debt because rolling over its existing debt when it came due would be straightforward. The need to be out of debt at some point is a product of finite lifespans. (This is not an argument for always being in debt; just a statement of the fact that always being indebted is feasible.)

Infinity has other weird properties that come into play in working out what different patterns of consumption and investment have over time for a society — in particular, whether we are impoverishing our children by running deficits. With a society of finitely-lived people (I.e. society lasts forever, but individual humans have finite lives as usual), with each generation owning an “endowment” of goods at birth, if we could have each generation give an equally-sized gift of some of their endowment to the older generation, then the oldest generation is better off, and each later generation is no worse off.

This is an example of the weirdness of infinity, where now we are considering an infinite number of generations rather than a single immortal human. Of course, to engineer such a transfer from younger to older requires something akin to a debt transaction; but a more realistic evaluation of the impacts of transfers across generations of this kind involves thinking about (long-lasting) capital goods, population growth and more. UCLA economist Roger Farmer helpfully lists key contributions to the academic literature in this area. Two unsurprising conclusions emerge: first, the analysis is necessarily technical and very difficult for beginners to follow; and second, the answer to the question of whether current debts will cause economic hardship to future generations is ambiguous and depends on the interplay of a number of variables.

Infinity has weird properties. And since nobody knows when a government is going to bring down the shutters and have to clear all its debts — and nobody knows when society will eventually collapse, in which case debts denominated in official currencies are likely to be moot — lenders to the government (buyers/holders of its bonds) simply want to know that their debts owed by the government will be honoured in their lifetimes. A stable government can pay any individual creditor back on a due date by rolling over that debt; effectively, other creditors step in to repay the first.

The fact that people willingly purchase “consols” (bonds without redemption dates, promising an eternal stream of payments) indicates quite clearly that people regard the likely duration of sovereign states as being longer than their own lifetimes.

5. Government budgets are not like household budgets. Seriously. (Part 3. Printing press)

A third reason government budgets cannot be compared directly to household budgets is that government’s can print their own currency. This is an astonishing power that households don’t have.

Printing one’s own currency — and have it be legal tender, and have it be required for payment of taxes owed to the government — is an enormous advantage, which admittedly doesn’t come without consequences, although there are debates about what those consequences actually are and at what stage things become tricky.

Moreover, governments within federated systems (like Australian state governments) and government belonging to monetary unions (like governments of EU states) do not control their own currencies, and have greater restriction on their actions than do governments of independent nations. (Their budgets still should not be regarded as comparable to household budgets, for the previous two reasons.)

6. Conclusions

Where does this leave us?
  1. There is no reason to think we are nationally living beyond our means at the moment. “Living within our means” is a far harder concept to pin down for a government — and for the society it governs — than it would be for a single household. It is not meaningfully understood (let alone measured) by the outcome of a single annual budget. It is also not meaningfully understood by the simple existence of public debt. There are surely better ways to spend the money we’re spending, and different and better ways to raise (more) revenue than we’re currently raising, but it’s hard to have that kind of sensible conversation in a state of alarm.
  2. There is no “debt and deficit disaster.” Debt is one aspect of public finance (and I’ve glossed over much detail around the balance between taxation, borrowing, and money printing, because this post is too long and detailed already), and it’s a thing to be managed sensibly, not a thing to panic about. If we could have that conversation, it would be a significant improvement.
  3. Debt does not mean we (the current generation) are ripping off “our children and grandchildren” (future generations). The choice to finance some activities via debt rather than taxation has distributional consequences, but it’s not obvious that these can or should be cast simply as inter-generational effects, with later generations losing out as a result of our profligacy. Money and assets and liabilities are moving around the place, but the real resource implications (from e.g. infrastructure investments, sectoral adjustments, regional distributions, demographic transitions, productivity implications) are contingent upon subsequent policy choices made.
  4. It’s the real things that finally matter. Whether we’re living beyond our means, and whether the standard of living of future generations will rise or fall, depends on what we deplete and what we improve as we move through time. Our productive capacity, as well as our resource base and environmental quality. If we’re avoiding making productive investments out of a fear of debt—let alone we’re avoiding dealing appropriately with climate change—that’s the clear and present danger for the well-being of people in the future.