That used to be you

This evening, I attended a talk through the Hudson Union Society given by Thomas Friedman and Michael Mandelbaum about their recent book That used to be us: How America fell behind in the world it invented and how we can come back.

Those of you who read Friedman’s New York Times column, may be familiar with some if the main points of the book. Namely that there is a global trend towards overpopulation, increased communication and dwindling resources. And that while many predict China may be on the rise to power and the US has mismanaged its economy and slowed on innovation, America should look back at its successes in the past and return to the policy that made it strong while keeping up with communication and green technology.

The book ends with Freidman and Mandelbaum’s ideal 2012 presidential platform. They are advocating that an independent candidate take up issues of investment in infrastructure and education, spending cuts to Medicare and Social Security and tax increases – perferably related to fuel usage.

Of course in a situation like this, topdown change often has the greatest impact. However, I would like to take one of the major questions of the evening and apply it to the individual, in particular the 9.1% of Americans that are unemployed. The question to ask is “What were you doing in the past that worked?” When you think about the good things you’ve done it can focus your energy towards repeating those habits and outcomes. There is something very powerful about putting a positive spin on your assessment of the past. Understanding what you have done well can help you make decisions on where you can add the most benefit. Yes, top down change is going to be necessary to change the direction the US is headed, but bottom-up change and a need for individual innovation and reinvigoration is also going to be crucial to our recovery. This isn’t about glossing over what may have gone wrong – but if you’ve had success in the past chances are you can pinpoint what went right and harness that into more future success.

Is Robert Shiller writing for 30 Rock?

In his new book Animal Spirits, Yale economist and noted behavioral finance expert Robert Shiller looks at the role of human psychology in driving financial markets. Clearly someone at "30 Rock" has read his work:

This is a terrific episode that takes a satirical look at how a financial panic can spread--in this case, by the semi-literate, profoundly crazy character Tracy Jordan.

I recently attended a panel discussion with Shiller at the New School for Social Research, which focused on the current crisis and the degree to which markets became "irrational". Shiller has been challenging the efficiency of financial markets for most of his career, and is likely to gain more prominence in the coming years.

For a non-fictional (but still entertaining) account of the current financial crisis, check out this PBS Frontline documentary posted at Freakonomics.

Making a deal with our future selves.

Alan Kreuger points out two separate challenges that must be solved at once: first is the "paradox of thrift", in which jobs are lost, causing people to cut back on spending, which causes more businesses to close, which causes more jobs to be lost, which causes... well you get the picture. The second is that the US long-term budget outlook is downright scary.  Stimulating the economy will likely help the first problem, but will greatly exacerbate the second problem. Conversely, cutting spending in an attempt to balance the budget might just send the economy off a cliff.  Fortunately, Kreuger has an idea:

"Here is a suggestion to address both the short-run and long-run problems. I pose it only as a suggestion for serious discussion; I’m not sure it is the best way to go. But here goes: Why not pass a 5 percent consumption tax to take effect two years from now?

...In the short run, the anticipation of a consumption tax would encourage households to spend money now, rather than after the tax is in place. Along with the rest of the economic recovery package, this would help jump-start spending in the economy and thereby increase production and employment.

In the long run, a 5 percent consumption tax would raise approximately $500 billion a year, and fill a considerable hole in the budget outlook. In addition, a consumption tax would encourage more saving in the long run. Many economists consider a consumption tax an efficient way of raising tax revenue, especially in a global economy. The prospect of greater revenue flowing into federal coffers would probably help lower long-term interest rates because the government would need to borrow less down the road, and further bolster the economy."

There's certainly something to this plan.  My main concern would be whether the government could credibly commit to a future tax increase.  It's like promising yourself you'll go on a diet starting tomorrow...err the next day.  Unless consumers really believe that a consumption tax is coming in a few years, they won't change their spending behavior.

It would be interesting if Congress could put a stipulation on a bill like this that any amendments would require a 2/3 majority vote, or some other provision that would make it more likely that the law would actually stand when it comes time to pay up.

"Efficient" doesn't necessarily mean "accurate"

Robert Skidelsky has an interesting article in this week's New York Times Magazine Section on the relevance of John Maynard Keynes in today's economy. However, Skidelsky makes an odd mistake for an economist, stating:

"Greenspan must have believed something like the “efficient-market hypothesis,” which holds that financial markets always price assets correctly. Given that markets are efficient, they would need only the lightest regulation. Government officials who control the money supply have only one task — to keep prices roughly stable."

That's not exactly what the "efficient market hypothesis" says. Rather, the idea is that market prices contain all relevant information about assets, which means that no one can consistently make above-average financial returns. There's a weak form of the argument (prices reflect all past information about the asset) and a strong form (prices reflect all present and future information about the asset). But no matter which form, the argument does not preclude the possibility that the information is wrong. It simply says that all the available information is reflected in the price. Princeton Professor Burton Malkiel, author of A Random Walk Down Wall Street explains:

"...it is important to make clear what I mean by the term “efficiency”. I will use as a definition of efficient financial markets that they do not allow investors to earn above-average returns without accepting above-average risks.

A well-known story tells of a finance professor and a student who come across a $100 bill lying on the ground. As the student stops to pick it up, the professor says, “Don’t bother—if it were really a $100 bill, it wouldn’t be there.” The story well illustrates what financial economists usually mean when they say markets are efficient.

Markets can be efficient in this sense even if they sometimes make errors in valuation, as was certainly true during the 1999-early 2000 internet bubble. Markets can be efficient even if many market participants are quite irrational. Markets can be efficient even if stock prices exhibit greater volatility than can apparently be explained by fundamentals such as earnings and dividends. Many of us economists who believe in efficiency do so because we view markets as amazingly successful devices for reflecting new information rapidly and, for the most part, accurately. Above all, we believe that financial markets are efficient because they don’t allow investors to earn above-average risk-adjusted returns. In short, we believe that $100 bills are not lying around for the taking, either by the professional or the amateur investor."

Markets are really, really good at aggregating information. However, if the information is bad, then prices will not reflect the "true" value of goods. In computer science terms, markets can be victims of GIGO.

Explaining why the market got so "crazy"

In the past week, two interesting articles about the financial crisis have pointed to the limits of mathematical modeling in finance and the role of group psychology in the market.

Yale economist Robert Shiller blames "groupthink" for why many economists were not outspoken about the housing bubble until it was too late. In explaining the phenomenon, Shiller says:

"The field of social psychology provides a possible answer. In his classic 1972 book, “Groupthink,” Irving L. Janis, the Yale psychologist, explained how panels of experts could make colossal mistakes. People on these panels, he said, are forever worrying about their personal relevance and effectiveness, and feel that if they deviate too far from the consensus, they will not be given a serious role. They self-censor personal doubts about the emerging group consensus if they cannot express these doubts in a formal way that conforms with apparent assumptions held by the group."

Shiller is a proponent of "Behavioral Economics," which looks at the underlying psychological factors behind our economic decisions. In this case, behavioral approaches can help explain the "irrational exuberence" people experienced in the housing market, which caused housing prices to jump far beyond what could be explained by economic fundamentals. Shiller also charges that behavioral economics is still considered a "fringe" field within the discipline and that groupthink makes it harder for economists to advocate behavioral approaches in public.

Steve Lohr also talks about another way that human error contributed to the crisis. Financial institutions were built on complex mathematical models of risk, which were supposed to prevent just these types of crises. Mathematical models are prevalent throughout economics and are truly invaluable tools in both theoretical and empirical work. But it's really important to recognize their limits:

"'The Wall Street models', said Paul S. Willen, an economist at the Federal Reserve in Boston, 'included a lot of wishful thinking about house prices'. 'But', he added, 'it is also true that asset price trends are difficult to predict. The price of an asset, like a house or a stock, reflects not only your beliefs about the future, but you’re also betting on other people’s beliefs,' he observed. 'It’s these hierarchies of beliefs — these behavioral factors — that are so hard to model.'"

Emanuel Derman, a physicist who developed a number of financial models, put it more simply:

“To confuse the model with the world is to embrace a future disaster driven by the belief that humans obey mathematical rules.”

The current crisis may cause more people to change their approach to modeling financial markets. I think it's likely that behavioral economics and social psychology will play a larger role in understanding why markets become so irrational sometimes. This is probably a good thing, which will add to our understanding of how financial markets work. But we shouldn't throw the baby out with the bath water. Emanuel Derman notes that these models are simply tools that can be used incorrectly or inappropriately. Complex financial models will retain their important place within the industry and in academia. But we need to do a better job understanding the assumptions behind these models and how they relate to real human behavior.

Did you know the word gullible isn't in the dictionary?

We voters are a generally gullible group. But there's something about Barack Obama that makes people willing to believe anything. And there's only so much one can do to dispell the myths: yes, he's a Christian; yes, he's an American citizen; yes, he believes in Israel's right to exist.

Now there's a new one to grapple with: no, Obama is not the Anti-Christ.

Apparently John McCain's attempts to woo the Christian-right has led to some confusion:

"...a not-insignificant number of Americans, after viewing John McCain's Web ad The One, with its Messianic overtones -- come away thinking that Barack Obama has been sent from Hell to Earth to turn its citizens against God. For inspiration, some of these people seem to be drawing from the fictional Left Behind series, which posits a dystopian future where the Anti-Christ comes to Earth as a charismatic politician.

The book's author's, Tim LaHaye and Jerry B. Jenkins, have insisted they don't believe Obama is the Anti-Christ, although they can't resist taking a dig at the candidate in the process...

'I can see by the language he uses why people think he could be the antichrist,' adds LaHaye, 'but from my reading of scripture, he doesn't meet the criteria. There is no indication in the Bible that the antichrist will be an American.'"

How does this happen? Well the media doesn't help. Rather than ignoring the story as unworthy of discussion, CNN's Newsroom broadcast a report on the issue, with the caption "Obama the Anti-Christ?" in bold at the bottom of the screen (to view the video, click the link above the proceeding quote).

But beyond the media, it may be our own brains that are playing tricks on us. According to neurobiologists Sam Wang and Sandra Aamodt, the quirky way we process information causes us to believe some pretty unbelievable things:

Our brains tend to remember facts that accord with our worldview, and discount statements that contradict it. In one Stanford study, 48 students, half of whom said they favored capital punishment and half of whom said they opposed it, were shown two pieces of evidence. One confirmed the claim that capital punishment deters crime, and the other contradicted it. Both groups were more convinced by the evidence that supported their initial position, a phenomenon known as biased assimilation.

This is one reason that propagandists can be effective simply by creating confusion. Unscrupulous campaign strategists know that if their message is initially memorable, its impression will persist long after it is debunked.

The human brain also does not save information permanently, as do computer drives and printed pages. Recent research suggests that every time the brain recalls a piece of information, it is "written" down again and often modified in the process. Along the way, the fact is gradually separated from its original context. For example, most people don't remember how they know that the capital of Massachusetts is Boston.

This phenomenon, known as source amnesia, leads people to forget over time where they heard a statement - and whether it is true. A statement that is initially not believed can gain credibility during the months that it takes to reprocess memories from short-term to longer-term storage. As the source is forgotten, the message and its implications may gain strength. Source amnesia could explain why, during the 2004 presidential campaign, it took some time for the Swift Boat Veterans for Truth campaign against Senator John Kerry to affect his standing in the race.

In another Stanford study, students were exposed repeatedly to the unsubstantiated claim that Coca-Cola is an effective paint thinner. Those who read the statement five times were nearly one-third more likely than those who read it only twice to attribute it to Consumer Reports (rather than the National Enquirer), giving it a gloss of credibility. Thus the classic opening line "I think I read somewhere," or even reference to a specific source, is often used to support falsehoods. Similarly, psychologist Daniel Gilbert and his colleagues have shown that if people are distracted from thinking critically, they default to automatically accepting statements as true.

So the CNN story intended to dispel a ridiculous rumor may have simply propagated it.

Much as we'd like to believe that people stand in voting booths rationally weighing the pros and cons of different candidates, it is simply not the way things work. And worse, this is not a problem that can be solved by people getting "more informed"; that could exacerbate things.

At the risk of sounding pessimistic, we may have to accept this fact of democracy. Voters do not have a great enough incentive to rationally evaluate their political decisions; instead we allow the emotional, reactive part of our brains to take over.

Beyond that, we should encourage Journalism schools to heed Wang and Aamodt's advice for the media:

1. State the facts without reinforcing the falsehood. Repeating a false rumor can inadvertently make it stronger. In covering the controversy over a New Yorker cover caricaturing Barack and Michelle Obama, many journalists repeated the charges against the candidate - often citing polling data on how many Americans believe them - before noting that the beliefs were false. Particularly damaging is the common practice of replaying parts of an ad before debunking its content.

A related mistake is saying that something is newsworthy because "the story is out there." Reporting on coverage by a less credible source such as The Drudge Report, even with disclaimers, will inevitably spread the story. False statements should not be presented neutrally since they are likely to be remembered later as being true.

2. Tell the truth with images. Nearly half of the brain is dedicated to processing visual information. When images do not match words, viewers tend to remember what they see, not what they hear. Karl Rove has said that campaigns should be run as if the television's sound is turned down.

Television journalists should avoid presenting images that contradict the story. One recent CNN report on autism was accompanied by images of concerned mothers, vaccines, doctor’s offices, and autistic children - even though the voiceover reported a scientific finding that debunked a link between vaccines and autism. Another recent story featured a threatening swarthy face subtitled "Obama the Antichrist?" - a statement that CNN would presumably not claim to be true.

3. Provide a compelling storyline or mental framework for the truth. Effective debunking requires replacing the falsehood with positive content. A good response to the McCain rumor, for example, would tell about his adoption of his adopted Bangladeshi daughter Bridget, thereby accounting for photographs of him with a dark-skinned child.

4. Discredit the source. Ideas have special staying power if they evoke a feeling of disgust. Indeed, brain pathways dedicated to processing disgust can be activated by descriptions of morally repellent behavior. The motives of the purveyors of falsehoods can provide a powerful story hook. A recent example is the press coverage pointing out Obama Nation author Jerome Corsi's motivations and past of racist Web commentary and allegations of Bush Administration complicity in the 9/11 attacks.

To avoid contributing to the formation of false beliefs, journalists may need to re-examine their practices. In 1919, Supreme Court Justice Oliver Wendell Holmes wrote that "the best test of truth is the power of the thought to get itself accepted in the competition of the market." Our brains do not naturally obey this admirable dictum. But by better understanding the mechanisms of memory, perhaps journalists can move their modern audience closer to Holmes's ideal.

Too Scary to Watch?

Dan Ariely asks a provocative question: are we overreacting to the price of gas?

No other price has as strong a political effect as the price of gas. Some presidents have been brought down by it. But while the price of gas is indisputably an important variable in our economy, it is not the only consumer good that has increased in price, nor is it the one that has increased the most.

Gas, however, is unique in that when we buy it, we stare at the running meter. As a result, we experience the increased cost of gas more vividly than other price increases. Similarly, there seem to be psychologically-relevant price thresholds for gas. The price increase from $3.50 to $3.90 per gallon is not as salient as the increase from $3.90 to $4.10 because the latter increase has crossed the $4 mark.

Judging by the letters to the editor, Ariely's argument hasn't been well received. As one woman wrote, "If Dan Ariely’s purpose in writing his Op-Ed article was to make me like the fact that I am now paying more than $4 a gallon for gas, he is mistaken."

But there may be something to what he's saying. Areily, a well known behavioral economist, is oriented to look for economic situations where people systematically deviate from the rational price theory model. A rational agent wouldn't care about arbitrary price thresholds or whether they watched the price climb as they pumped; rather he or she would only care about the price of the good, the price of substitute goods and their budget constraint.

In this week's NY Times op-ed podcast, Areily discusses anecdotal evidence of people taking thousands of dollars of losses selling their gas-guzzling SUVs in an attempt to save money on gas. This does not make universal economic sense. Consider the example of a Cadillac Escalade owner, which Areily uses in the podcast. He bought this behemoth less than a year ago for $54,000, back when the price of gas was more reasonable. Now he's stuck getting 14 mpg with gas prices over $4.00 a gallon. However, in an environment of high gas prices he can't get anywhere near what he paid for the car. In Areily's example, the SUV owner sold the car at roughly a $20,000 loss. Does this make sense? Well, if he drives 15,000 miles per year and gas increases from $4.00 per gallon to $5.00 per gallon, then his gas bill will increase by $1,072 per year. That's a lot. But it will be years before he recoup the loss on the car, assuming he even owns the car that long.

Bryan Caplan made a similar point. He observes that people have been searching harder to find cheaper gas than they did when the price was lower. While gas everywhere is more expensive, there has been no increase in the variability in gas prices. The difference between the highest and lowest gas prices is no different than it ever was, which means that the savings from searching is also the same. On the other hand, driving around searching for cheap gas is relatively more expensive.

Of course both examples are anecdotal, but they highlight some of the irrationality people exhibit when the price of gas goes up. High gas prices have caused real pain for people. But we shouldn't make things worse on ourselves.

Dance, Dance, Evolution

For those of you who have read my previous postings, you've probably gathered that I'm not very cool. It's okay, really, I've come to accept it. No where is this point clearer to me than at clubs. Dance music induces a powerful, deer-in-headlights reaction and I spend most of the night close to the bar, moving just enough so that people watching closely think I'm dancing. So, perched in my hiding spot in the land of the nerds, I made a casual observation: clubs tend to be populated by aggressive guys. And, contrary to what women say they want, these guys tend to go home with someone on their arm.

The club/bar scene is a strange place. For one thing, it's one of the only places in public life that has an enforced gender ratio. A few years ago my girlfriend and I attended a birthday party at a New York club (I won't say the which, but it was named after a common non-sexual bedroom object). We arrived on time (not cool, I know) and got right in. But the male guests (who were on an invited list) who arrived after 11pm were not so lucky. By that time, too many males had entered the club--leading to the dreaded "sausage fest"--and the bouncers weren't letting any additional males unless they came in with at least one female. It's hard to fault bar owners from a business perspective. Men are more likely to buy women drinks than the other way around, so having more women than men makes sense for a profit-maximizing bar owner.

So what is it about bars and clubs that lend themselves to aggressive guys? Part of the answer is simple self-selection. Shy guys are more likely to eschew the club scene, while their aggressive counterparts grind with strangers. But another important factor has to do with the club environment itself and its affect on signaling behavior. In economics, signaling is a means of overcoming the problem of "asymmetric information," where one party knows more about their end of the transaction than the other. Dating is fraught with asymmetric information: you do not know whether the person chatting you up is interested in the long-term or simply a one-night stand, whether they're crazy and will end up stalking you when the relationship ends, or whether the decision to sleep with them will necessitate a course of penicillin. People overcome this problem through signaling. Men signal wealth by paying for women's drinks, women signal sexual availability by showing cleavage, and everyone tries to signal interest through humor. You're much more likely to laugh at attractive people's jokes.

However, many avenues for signaling are cut off in the club scene. Clubs and bars tend to be dark, loud, and crowded. As a result, it's harder to signal intelligence, humor or sensitivity, since these are all signaled through conversation. It's easier to signal wealth (through clothes and buying drinks), or to signal interest through aggressiveness. So in addition to self-selection, the existence of aggressive guys at clubs is a function of natural selection: the only guys that can signal affectively in clubs are the ones who are aggressive. This creates an incentive for men to be aggressive. The club environment, in essence, leads to the extinction of the shy male.

What's interesting is that the enforced gender ratio may mitigate this, somewhat. By restricting the supply of males, the club reduces the degree of competition by the lucky men who gained entry. In practice, however, this effect seems to be overwhelmed by self-selection and the environmental incentives.

What does this mean for women in clubs? In a sense, you get what you pay for. Women who go to clubs to dance with their friends will have to suffer through cheesy come-ons, relying on the strategy of safety in numbers. For women looking to meet guys, well, buyer beware!

Beyond signaling, though, there's another strategy that can be successfully employed in clubs. Both men and women can exploit the human bias known in Behavioral Economics as "anchoring". Anchoring refers to the tendency of relying on a specific (and sometimes arbitrary) value and making comparisons based on that. MIT Professor and noted Behavioral Economist Dan Ariely provides the following example:

"An audience is first asked to write the last 2 digits of their social security number, and, second, to submit mock bids on items such as wine and chocolate. The half of the audience with higher two-digit numbers would submit bids that were between 60 percent and 120 percent more, far higher than a chance outcome; the simple act of thinking of the first number strongly influences the second, even though there is no logical connection between them."

So what can you do in a club? Make sure you show up with a friend of the same sex that's not as good looking as you. When approaching members of the opposite sex, make sure this friend is by your side; it would probably be better if the friend started the conversation. This will set an anchor, making you seem more attractive by comparison. Unfortunately this will only work if your friend doesn't know the plan. Once he discovers your real reason for hanging out with him, he'll probably be offended, and then (if he's smart) find another friend less attractive than him.

For more information about Behavioral Economics and the strange biases that people have, check out Predictably Irrational by Dan Ariely.