Chris Dillow's Blog, page 107

Not seeing luck

I claimed the other day that those of us who are in the global 1% are apt to under-estimate our good fortune. There is, in fact, quite robust evidence from other contexts that we tend to under-rate luck and over-rate skill and causality.

For example, this recent paper says:

Retail day traders in the Forex market attribute random success to their own skill and, as a consequence, increase risk taking.

This is probably because of a self-serving bias: we want to believe we are smart, and the wish is father to the thought.

However, other research shows that people also see skill where none in fact exists even in other people. Here's a study of unit trust investors:

They fail to understand that, in large populations of mutual funds, a few will outperform by pure chance...In addition, investors do not sufficiently account for volatility and are thus likely to confuse risk taking with skill. In large mutual fund populations, this can lead to an over-allocation of capital to lucky past winners.

This sort of behaviour has been confirmed in laboratory experiments. Jordi Brandts and colleagues at the Autonomous University of Barcelona got a group of students to guess the outcome of five coin tosses. They then asked other students to bet on who of the first group could best predict future coin tosses. They found that 82% of students were willing to pay to back the individual who had been most successful in predicting the first five tosses. This is consistent with other experiments by Nick Powdthavee and Yohanes Riyanto, who conclude that "an average person is often happy to pay for what could only be described as transparently useless advice."

All this tells us that people under-rate the importance of luck even when doing so costs them money; this is true in both real world and laboratory settings. It's even more likely, therefore, that they will under-estimate luck when they have incentives to do so - because they want to think that their wealth is deserved and want to oppose redistributive taxation.

I suspect that this is part of an older-attested phenomenon - that people under-rate randomness and over-rate causality, which is one reason why we draw overconfident inferences from noisy data. As Kahneman and Tversky said (pdf) in one of the early papers in cognitive biases research:

[People have an] irresistible tendency to perceive sequences of events in terms of causal relations, even when the perceiver is fully aware that the relationship between these events is incidental and the imputed causality is illusory...[This leads to] major errors in prediction and explanation, which reflect the deep contrast between intuitive reasoning and the normative theory of evidence.

You might see this as an echo of David Hume's claim, that our ideas about causality result merely from custom and habit and so are fallible.

It also, I suspect, helps explain a claim made by Hume's good friend. If we over-rate causality and under-rate luck, we will exaggerate the extent to which the wealthy deserve their fortune. As a result:

We frequently see the respectful attentions of the world more strongly directed towards the rich and the great, than towards the wise and the virtuous. We see frequently the vices and follies of the powerful much less despised than the poverty and weakness of the innocent...The great mob of mankind are the admirers and worshippers, and, what may seem more extraordinary, most frequently the disinterested admirers and worshippers, of wealth and greatness. (Theory of Moral Sentiments, I.III.29)

The oblique path to growth

Ryan Bourne's defence of economic growth against the Archbishop of York's call for a "just, sustainable and compassionate society" poses the question: is there really a trade-off here?

I'm thinking of two things. One is that, as Ben Friedman has shown, a healthy economy and a good society usually go together - because prosperity makes us more tolerant. It's no accident that the squeeze on real incomes since the financial crisis has increased anti-immigration feelings. Maybe prosperity does give us greedy bankers, but poverty gives us Boko Haram - and bankers are angels compared to them.

However, it might also be the case that policies aimed at fostering community, well-being and equality might also promote growth. Ryan says:

The desire for enrichment is a natural human ambition, and the best way to achieve it in future is to embrace precisely the values and economic liberty which enable robust economic growth.

History, however, suggests this is questionable.Between 1830 and 1914 - the era of small government - UK real GDP grew by 2% per year. But in the social democratic era of 1946-79, it grew 2.5% per year. Some economic liberty is necessary for growth - but the historic record suggests it might not be sufficient.

What Ryan is missing here is the idea of obliquity. As John Kay has said, pursuing goals directly might be self-defeating. Recent governments have tried to raise growth and this had led them to dole out favours to every special interest group that claimed to be able to create jobs. The upshot is sclerotic cronyism, not a healthy dynamic economy.

Instead, it might be that a government which aimed at John Sentamu's goals of equality and community might - as a happy by-product - also raise growth. I'm thinking of several mechanisms here:

 - More equality might raise productivity in several ways.

 - Stronger social ties can help people find work, and find better matches between skills and vacancies.

 - Happier workers tend to be more productive - and one way to make them happy is to give them a share of profits and more control at work.

 - One of the best things governments could do to promote happiness would be to minimize unemployment, for example by having a serious jobs guarantee. This, though, could also promote long-run growth by reducing the tendency for the unemployed to suffer a loss of skills, demoralization and employability.

- Equality (pdf) and healthier communities should increase trust. And trust is necessary for economic growth.

What I'm trying to do here is bang heads together. If growth and a compassionate society go together, Mr Sentamu and Mr Bourne might have common ground. My suggestion for Mr Bourne is that he consider that there are some policies on top of economic liberty that might promote both community and growth. To Mr Sentamu, I'm saying: you don't need to argue against "rampant consumerism" to want more egalitarian and communitarian policies.

Precisely which policies would promote both growth and better societies is a big and open question. If we had some serious politicians, it would be at the top of their agenda.

The 1%, c'est moi

I tweeted yesterday that there are more Guardian readers in the top 1% of the global rich than there are billionaires. This is because net wealth of $798,000 (£528,000) gets you into the top 1% (p99 of this pdf). This means that many people who have enjoyed 20 years of London house price inflation are in the global rich, whereas there are only 1645 billionaires.

If you want a picture of the global 1%, a bien-pensant 50-something in a house in north London might be more accurate than a billionaire hedge fund manager.

My point here, though, wasn't intended to be a cheap snark. This factoid illustrates four things.

1. The world is poorer than we think. Branko Milanovic has estimated that over half the world's population has an income of less than $5.70 a day (£1380pa). Simon's right to say that the world has made great progress away from poverty - but there's still a hell of a way to go. As Jason Isbell sings:

You should know compared
To people on a global scale
Our kind has had it relatively easy

2. People under-rate their privilege. It's the grit in the shoe that gets noticed. James Blunt gave us a nice example of this yesterday when he whined that "Every step of the way, my background has been AGAINST me succeeding in the music business." In a global context, this is of course highly concentrated horse shit; tell it to Malian musicians who are being crushed by Islamists.

This neglect of our own good fortune matters in two senses. First, it generates a sense of entitlement among people (often rich white men) who convince themselves that they are victims. Secondly, it leads to passing the buck; we convince ourselves that the rich and powerful are other people, not us.

3. Inequality is not a neoliberal conspiracy by a tiny minority. Suzanne Moore writes today that "Inequality is not inevitable, it’s engineered." (See too some of Adam Curtis's wilder imaginings). This gives elites too much credit. Many of the processes that have driven up London house prices - a global hunt for "safe assets", falling crime, financialization, low interest rates because of secular stagnation and so on - haven't been consciously engineered. Inequality is an emergent process, which has benefited not just plutocrats but also people like Suzanne. As the man said:  

Men make their own history, but they do not make it as they please; they do not make it under self-selected circumstances, but under circumstances existing already, given and transmitted from the past.

Suzanne's right to say there's nothing inevitable about inequality. We can do something about it. But doing so - especially on a global scale - might mean reducing our own privilege, not others'.

4. Luck matters. I am one of the 1%. This is not I'm hard-working or talented. It's simply because I was lucky enough to have been born in a rich country at a time when my modest abilities have been in demand. Almost all my income and wealth is due to luck. The idea that rich westerners deserve their wealth owes more to a mental disorder than it does to political philosophy.   

Jose Mourinho vs methodological individualism

Jose Mourinho yesterday issued a challenge to methodological individualism. When asked about Diego Costa, he replied (15'30" in): "I like my team more than my players."

This is a very reasonable attitude to have to a team that includes John Terry and Diego Costa. But it expresses an important truth - that collective entities can have a property (likeability) that its component individuals do not.

This corroborates something I've said before. The most successful football managers have a collectivist mentality: the decline of British football managers and rise of individualism might be related.

But there's another point here. Mourinho's paradox applies widely.   

In football, for exmaple, good individual players do not add up to a good team; think of England in the 00s. Conversely, mediocre individuals can make a decent team; Stoke have achieved mid-table respectability despite have several players who refute the hypothesis that Neanderthal man has gone extinct.

The same is true of financial markets. Sometimes, rational individuals can produce a market than looks irrational*.This happens if rational but ill-informed traders chase noise, or in beauty contest-type behaviour, where individuals worry that others will worry. And conversely, experiments in agent-based economics show us that stupid individuals can produce rational markets. "Mr Market" is a misleading metaphor.

The same can be true in other contexts.Granovetter's riot model (pdf) shows us that violent disorder can emerge not because all individuals are violent but simply if large numbers imitate a few others. Adam Smith's invisible hand theory says that a benign social order can emerge from individual self-interest. Marx's theory of exploitation shows how Christian Victorian gentleman can produce a viciously inegalitarian economy. Schelling's spatial segregation model shows how ethnic segregation can happen even if people aren't especially racist. And I suspect that non-sexist individuals can also generate a patriarchal society.

All these are examples of what Mourinho said - that aggregates can have properties which individuals do not. This can happen - as in my examples - because of emergence. Or - as in Mourinho's case - it can happen because a coach consciously shapes a team. And in other cases, it might be a mix of the two: Irving Janis's examples of groupthink, I suspect, arise partly from bad luck and partly bad leadership.

All this is a challenge to methodological individualism; what's the point of studying individuals' motives and rationality if these are not necessarily related to social phenomena?

I suspect the question can be answered. Careful studies of actual individual behaviour, for example, can tell us how prone they are to the sort of peer effects that can cause aggregate fluctuations or mispricing. And they can also help in the design of better incentive mechanisms: they show us, for example, that big financial incentives can backfire.

I don't have conclusive answers here. My point is rather that, not for the first time, football managers have done a better job of drawing our attention to big issues of social theory than so-called serious thinkers.

* I'm glossing over the question here of whether we can apply descriptions of individuals (such as rational or irrational) to impersonal things. 

Against Pensioner bonds

Which interest rate would you rather borrow at - 4% or 0.6%? It sounds like a moronic question. Not if you're the Chancellor, it's not. In launching pensioner bonds yesterday which pay 4% pa over three years, he is choosing to borrow at a much higher rate than the 0.6% charged by the gilt market.

This is costing the tax-payer money. If, as is likely, all of the £10bn bonds on offer are bought, the government will be paying almost £300m a year more in interest than it would if it borrowed in the gilt market*.  

To put this in context, it is three times as much as the government is saving from the cap on benefits. And it is almost as much as it is saving from the bedroom tax.

In this sense, Osborne is redistrbuting wealth from the poor to the rich. According to the ONS (pdf), the typical household has only around £12,000 of financial assets. Only a wealthy minority, therefore, can afford to take full advantage of the £20,000 pensioner bond offer.

Pensioner bonds, though, aren't just regressive. They are anti-conservative, in three ways.

First, in paying more interest than necessary, Osborne is wasting the tax-payers' money.

Secondly, he is undermining monetary policy. He claims to be a "monetary activist". But one channel through which monetary policy works is that low interest rates are intended to force investors to buy riskier assets such as corporate bonds and equities, which reduces the cost of borrowing and hence raises capital spending. Osborne is (albeit partially) blocking this channel; paying high rates on government borrowing is a form of crowding out - about which Conservatives have long complained.

Thirdly, he is rejecting the concept of individual responsibility. Most older, wealthier pensioners voted for austerity. And a vote for austerity is a vote for low interest rates. In giving pensioners a higher rate, Osborne is protecting them from the consequences of their own actions.

What's going on here is simple. Osborne is channelling tax-payers' money to a favoured client group. There's a word for this - corruption. This is the sort of thing we expect in Uzbekistan or Nigeria, not a western democracy.

In saying this, I don't deny that pensioners are discomforted by low savings rates. But there's a simple solution to this that would benefit almost everyone - a looser fiscal policy.

* Assuming £5bn of the three year bonds are sold with an interest rate of 4% rather than the 0.6% gilt yield, the annual cost would be £170. And £5bn borrowed for one year at 2.8% rather than the 0.33% changed by the gilt market would cost another £123m.

Doubts about TV debates

It's not often I agree with David Cameron. But although his reluctance to take part in TV debates is motivated by base partisan considerations, I have some sympathy for it. I'm not at all sure that leadership debates are a good thing.

The problem with them is that the medium shapes the message. Mere verbal communication, without graphs, equations, hyperlinks or tables of data can distort messages; for this reason, I almost never talk about economics with non-economists.

Debates favour glib but silly metaphors over lengthier but correct analysis; in a debate, it's easier to prate about "the nation's crerdit card" than to explain the maths of debt sustainability. They favour shallow certainty over an awareness that social phenomena are complex. And they allow speakers - at least in the studio - to get away with erroneous claims; the Clegg vs Farage debate on Europe contained many inaccuracies.

Televised debates, then, select for confidence and plausbility rather than for deeper intellectual virtues.

This is not necessarily a bad thing in the US. Part of the job of being President and head of state is to look the part, to present a figure that's inspiring and reassuring.

Nevertheless, I suspect it has drawbacks. One is that it might entrench class inequality, by favouring politicians from public school backgrounds. Another is that, in a parliamentary system, presidential qualities are less significant, and others which are not so evident in TV debates are more desirable - such as dull competence or ability to manage a team.

All this is just a hunch. What about evidence?

The hard evidence we have comes from the 2010 leadership debates. These seem to have won Nick Clegg at least goodwill if not (pdf) actual votes. But many voters now regret extending him that support. This might be a particular instance of a wider trend in the west - that confidence in politicians generally has declined in the TV age. This might reflect an X Factor-type phenomenon - that, especially where preferences are ill-defined, popularity won on TV might not be long-lasting.

Let's put this another way. Tony Yates and Simon Wren Lewis know vastly more about economics than Cameron. But would this superiority really come across fully in a TV debate? (I'm not making a partisan point here: righties can compare their favourite rightist thinker to Ed Miliband).

Or try casual introspection. Think about the individuals you've met whom you'd most want to have in positions of power. Are they really the sorts that would come across best in TV debates? I suspect not, in many cases. For that matter, would successful politicians from an earlier era have done well in them? LBJ ducked out of a debate in 1964 for a reason. And would Attlee or Gladstone have become PM if TV debates existed in their day?

Now, all this is tentative. If TV debates were part of a move towards more deliberative democracy, they would be a good thing. They'd also be welcome if they exposed charlatans to the fate experienced by Steven Emerson. The question is, though: do they help select in favour of desirable qualities or against? I'm not sure.

Finance & the left

Anna Hedge says the left must understand finance better. I wholly agree. I'd add three reasons why it should do so.

First, financial markets right now are corroborating two big leftist positions. Long-term real interest rates are negative and, given the shape of the yield curve, are expected to stay so for some time.

This tells us two things. One is that markets don't give a toss about government borrowing. Negative interest rates are a strong argument against austerity. The other is that low rates reflect low growth expectations - secular stagnation (pdf) if you will. This is consistent with the Marxian claim that capitalism has run out of oomph, that the relations of production have become fetters on the economy, perhaps because inequality holds back growth.

Secondly, the markets should teach us humility. Anyone who's worked in them for more than a few moments know that trades go wrong, that regulations backfire and that we are often surprised. Most unit trust managers under-perform (pdf) their benchmarks, and the performance of many hedge funds is mediocre.

You might infer from this that most finance "experts" are just empty suits. I'd prefer another inference - that the economy is a cussed complex thing that doesn't conform to our expectations or manipulations. We should therefore be cautious about policy prescriptions, about the potential for improving capitalism for the better.

Thirdly, behavioural finance teaches us that people can make systematic errors of judgment. For example:

 - They are overconfident, perhaps (pdf) because of high testosterone.

 - They cling too much to their prior beliefs, and so under-react to news. This can generate post-earnings announcement drift and momentum effects more generally.

 - They can mistakenly follow others, thus amplifying bubbles and crashes.

 - What purport to be sober, rational judgements are in fact shaped by subconscious psychological impulses. Fund managers and CEOs who are conservative in their politics are also conservative in their business strategies, because the pstchological makeup that generates conservative politics also affects investment decisions. And share prices are strongly seasonal because risk aversion is.

And here's the thing. If people can be systematically mistaken when there's big money on the table, they are also likely to be mistaken in other areas. There's a close connection between behavioural finance and a Marxian theory of ideology; both can be rooted in the research in cognitive biases.

When I write about behavioural finance in the day job and then blog about ideology, I feel no dissonance at all.

And this generalizes. I've worked in and around finance all my working life - and I feel no conflict between this fact and my Marxian ideas. 

Austerity & debt stabilization

Alex is right. David Cameron's speech on the deficit yesterday consisted of "intellectually lazy lies". This, in particular, is dubious:

The choice is clear: staying on the road to recovery – or choosing the path to ruin. Competence or chaos.

To see what's wrong with this, remember the basic maths of government debt dynamics. This tells us that the primary deficit (that is, the deficit excluding interest payments) necessary to stabilize the debt-GDP ratio is:

d * [(r-g)/(1+g)]

where d is the debt-GDP ratio, r the real interest rate and g the real GDP growth rate.

d is currently 0.804: debt is 80.4% of GDP. Real long-term interest rates are around 1%, and the OBR estimates potential output growth over the next five years to be 2.2%. Plugging these numbers into our equation gives us minus 2.5%. In other words, we can stabilize the debt-GDP ratio with a primary deficit of 2.5% of GDP. This is a slightly higher deficit than the OBR expects next year, and much higher than the surplus of 3.2% the government plans by 2019-20.

In other words, more borrowing than the government plans would be quite consistent with stabilizing the debt-GDP ratio at around 80%.

What's more, if the government can borrow at less than four per cent - and nominal ten year gilt yields are now only 1.6% - then debt interest payments would be under 3.2% of GDP. That means we'd spend less as a share of GDP on debt interest (pdf) than we did in the Thatcher years.

This is not chaos. We can achieve debt stabilization with much less austerity than Cameron plans.

Of course, things will be different if borrowing costs rise sharply. If they do, though, it would come as a big surprise to the gilt market. The real yield curve is quite flat, which implies that the market is pricing in negative yields for a long time. It's odd that a Conservative government should be basing policy upon the idea that the Man in Whitehall knows better than the markets.

Now, this does not necessarily mean that there's no case for fiscal tightening. You could argue that a debt-GDP ratio of 80%, even if stable, is an unfair burden on future generations - though it's odd that a government which charges £27,000 for a university place and which presides over huge house price inflation should worry so much about intergenerational justice. And you could argue that such a ratio gives us less room to relax fiscal policy when the next downturn comes.

It's not clear, though, that these arguments are a case for a lot of austerity soon. As Frances says:

The aftermath of a severe negative shock is no time to be worrying about "structural" deficits. Better to restore the economy first, by every means available. Dealing with what would be better named the "residual" fiscal deficit is a job for the good times.

Murdoch's common error

That tweet by Robert Murdoch has been widely condemned. But nobody has pointed out that Murdoch's error is not confined to either him or to Islam's critics.

Murdoch said:

Maybe most Moslems [are] peaceful, but until they recognize and destroy their growing jihadist cancer they must be held responsible.

The inconsistency here is obvious. Murdoch did not, AFAIK, hold right-wingers responsible for the cancerous beliefs that led Timothy McVeigh or Anders Breivik to commit mass murder. Nor did he consider sexually frustrated men responsible for Elliot Rodger. So why hold Muslims responsible for jihadism?

The difference is that, in Murdoch's mind, Breivik, McVeigh and Rodger - to name but three - are atypical of white right wing men and are isolated instances. But, he thinks, Muslims and jihadists have more in common. So, whereas right-wing men are not to blame for the sins of others, Muslims are.

There's a name for this. It's the outgroup homogeneity effect, or the "they are all alike; we are diverse" bias.

And here's the thing. Murdoch is by no means alone in this error. Like all cognitive biases, it's a widespread one. We see it, for example, when: some feminists claim that all men are rapists; when critics of orthodox economics fail to see how diverse the subject is; when lefties attack "greedy bankers"; when people think they are experts on a country because they have visted it a few times; when right-wingers think that because I'm a Marxist I somehow endorse Stalinism; or when torture is claimed to be "inconsistent with our values" when our side does it but typical of "them". And so on.

You might object that there is a strand of violence within Islam. Maybe, but so what? There is also a tendency towards violence in maleness or in several political ideologies - including Mr Murdoch's and (yes) mine. But there is a massive diffence between those who reject that tendency and those who embrace it. Failing to see this difference - and failing to see that Muslims were also victims and heroes last week - is just stupid.

There is, though, a way to guard against the outgroup homogeneity effect.  Whenever we see something, we should ask: from what sample is that drawn? Is it typical, or an outlier? Merely asking this question reminds us that human beings are a very diverse bunch.

Heterodox economics & the left

Simon and Tony's impatience with heterodox economics makes me wonder: what is the link between this and political leftism?

To see the force of this question, consider the following:

 - Conventional economics tells us that austerity depresses output at the zero bound.

 - More open borders would not make British workers worse off; this is factor price equalization.

 - Thousands of high-paid financiers are overpaid charlatans; this is the implication of the efficienct market hypothesis, which says that stock-pickers can't beat the market in risk-adjusted terms.

 - The diminishing marginal utility of wealth implies that progressive taxation is welfare-enhancing.

 - Drug legalization would improve the lot of young black men; this follows from the presumption that markets work less badly than state interventions.

 - Complaints by Owen Jones and Aditya Chakrabortty about crony capitalism are  consistent with basic public choice economics - that political power will go to the highest bidder.

 - My scepticism about managerialist hierarchies owes more to Hayek's point about the limitations of centralized knowledge and control than it does to my Marxism.

All these points imply that you can adopt a position well to the left of the Labour party whilst being a quite orthodox economist. You can be left-wing whilst being wholly ignorant of Marx, Kalecki, Sraffa or Minsky. (Equally, you can be heterodox and right-wing, as some Austrians are.)  

This is not necessarily to agree with Noah that economics in general is on the left, although many of the authors of orthodox economics such as Arrow, Solow, Tobin and Samuelson were. It's just to say that there's no tension between orthodox economics and leftism.

Which prompts the question: why do so many on the left feel the need for heterodox economics?

One perfectly good answer is that there is, in fact, a lot wrong with the orthodoxy. My personal beefs would be, among others, that: representative agent models eliminate important network effects; that preferences aren't always exogenous and well-defined; that the idea that wages equal marginal product is deeply dubious; and that power and exploitation are serious issues.

I fear, though, that there might be less respectable reasons why some lefties are so quick to reject economic orthdoxy.

One is an ignorance of what the orthodoxy is; there's a tendency to equate economics with the view that markets always work - when in fact, as Simon says, "mainstream economics is all about market failure".  (My view is that whether markets work or not is an empirical matter in which precise institutional details are crucial.)

Another is a form of halo effect. People who are radical in political often want to be radical in other ways: they tend to use "edgy" and "transgressive" as terms of commendation. This leads to an interest in heterodox ideas.

What I'm trying to do here is to take a little heat out of the orthodox vs heterodox debate. This should not be regarded as a necessarily left vs right political matter.