Does anyone deserve to be poor?

The Nobel winning economist, Gary Becker, whose work on human capital I deeply admire writes a piece called Deserving and Undeserving Inequality in the blog which he shares with Richard Posner. In it he distinguishes between good inequality (deserved) and bad inequality (undeserved) saying

The great majority of people in different cultures do not object to someone who has made lots of money when they have superior abilities and talents, and they work hard at producing what are considered useful goods or services.

The meritocratic society with upward and downward social mobility would be in Becker’s view the most acceptable form. In this just society, the cream always rises to the top. He cites actors like Tom Hanks and Jennifer Anniston, entrepreneurs like Bill Gates and Steve Jobs, and skilled professionals like transplant surgeons who have grown rich by applying their exemplary talents and skills.

In contrast, Becker poses the problem society seems to have with hedge fund managers who make use of arbitrage (momentary bargains unnoticed by the market) to make huge sums of money. He lumps them together with speculators, Russian oligarchs and monopolists who enrich themselves through unfair, uncompetitive means (the latter two through government fiat).

Becker of course uses human capital theory as his framework for addressing this issue. Under its framework, individuals who acquire knowledge and skill through education and training (one cannot gain it any other way as it cannot be inherited or passed on) deservedly earn private returns in the form of higher incomes over the remainder of their working lives.

A meritocratic society should in Becker’s view reward the investments made by individuals in themselves and not rely on some other criteria. Elitism, the polar opposite of meritocracy rewards individuals for investing in other things (social standing or being raised on the right side of the tracks, marrying into the right family, etc).

It all sounds rational and justified, which is why Becker says “the great majority of people in different cultures” accept the legitimacy of a certain form of inequality. The wisdom of crowds is evident, until we start to consider the actual “merit” of the argument.

Economic, behavioral and neuro scientific research has demonstrated for instance that when it comes to employment, so many other factors aside from talent and intelligence determine the outcome of a hire/fire decision. Tall, handsome, Caucasian males for instance tend to earn more than their peers of equal and (as labor economist Daniel Hamermesh demonstrates) of even higher educational attainments.

If you are a plump woman working alongside office waifs, then you are more likely to be laid off during an economic downturn compared to your skinny female counterparts. In fact, studies in the US and replicated in other parts of the world show that job applicants could even be screened out simply because their names sound ethnically diverse (those with names such as ‘Tamika’ for instance got less callbacks from recruiters compared to those who had typically Anglo-Saxxon names like ‘Sally’).

The ‘good-bad’ dichotomy looks awefully strained at this point.

Reflecting on this a bit, I begin to wonder, how much of our lot in life really depends on our own actions, and how much of it depends on chance. In fact, beyond just the narrow hedonic enjoyment of earning more money, if the pursuit of happiness were to be the ultimate measure of success, then we could find an even bigger divide opening up.

About 50% of our ability to have a pleasant life depends on our genes, which is not very modifiable, according to psychologist Martin Seligman (other studies suggest this could be as much as 60%). This would not be good for those who weren’t born with the right disposition.  Of course, for those who are disadvantaged in this way, they can still influence their level of happiness by focusing on the residual aspects of life that can be modified to produce happiness, a mere 15-20%. That is if they can afford to pay for therapy which again disadvantages those who happen to be residing at the bottom of the economic ladder.

As James Kwak who recently re-read John Rawls’ A theory of Justice, has said

well-educated, hard-working people did not deserve to make more money than other people, at least not as a normative (as opposed to a utilitarian) matter.

Kwak quotes the passage from Rawls’ treatise to support his claim

[The liberal conception of the second principle of justice] still permits the distribution of wealth and income to be determined by the natural distribution of abilities and talents. Within the limits allowed by the background arrangements, distributive shares are decided by the outcome of the natural lottery; and this outcome is arbitrary from a moral perspective. There is no more reason to permit the distribution of income and wealth to be settled by the distribution of natural assets than by historical and social fortune. . . . Even the willingness to make an effort, to try, and so to be deserving in the ordinary sense is itself dependent upon happy family and social circumstances.

At work, I am currently involved in developing and implementing a pilot project that seeks to help socially disadvantaged groups improve their learning and employment outcomes through a range of interventions. Social disadvantage comes in many forms. The issues encountered by our case officers usually involve multiple and complex needs such as drug and alcohol abuse, inter-generational poverty, lack of economic opportunity where they live, sexual abuse, abandonment, domestic violence, discrimination, disability both physical and mental.

Unfortunately much of Australian mainstream society sees these individuals as “bludgers” or people who leech off the tax and welfare system. The mainstream of society cannot really see why they can’t just find work in a country where there are skills shortages in many industries. I must admit, I used to subscribe to this way of thinking too.

This is reflective of meritocratic aspirations Aussies share with their American and British counterparts. A study by Dan Ariely and featured recently by PBS finance correspondent Paul Solman demonstrates this. Respondents were given three pie charts resembling the spread of wealth in unnamed countries. The first showed an equal distribution of wealth. The second showed a slight advantage to the two top quintiles. The last showed a very disproportionate concentration of wealth to the top 40%.

They were asked to specify which country they thought the US represented. Most went for the pie chart that showed a slight skewing of wealth to the upper classes. They were unaware that it was actually the third chart which they thought represented a third world country which represented the US. And yet, as the piece by Solman suggests, there is a lack of appetite among voters for tax reforms that would correct such a lopsided distribution of income and wealth.

At least in affluent countries, there is a system for attending to marginal groups. In less developed countries, the problem of addressing poverty, inequality and social disadvantage is harder because of scarce resources. Even in countries like China and India which have lifted millions out of poverty, this mostly depends on where people live. Those who reside along coastal provinces in China tend to have higher incomes than those that live in the interior whose incomes are closer to some countries in Sub-Saharan Africa.

In a middle income country such as the Philippines that has experienced growth but not a lot of change in its distribution of wealth, the experience has been that such growth has not been inclusive. Not only is economic opportunity not evenly distributed in the population, but this distribution itself seems to be perpetuated by laws and policies of successive governments.

I say this because the sorts of reforms that have been proposed to address disadvantage, namely tax reform, land reform, and reproductive health have been held back or denied the kind of support, moral, political, and financial, required for them to be implemented correctly. There are two kinds of attitudes that might be responsible for this:

1. Self serving bias is the tendency to claim more responsibility for successes than failures. Thus, those who are well-off tend to think they deserve their successes.
2. Just world phenomonon is the tendency for people to believe that the world is just and therefore people "get what they deserve." So those who hold this belief look at poverty and social inequality and think that those who suffer from them deserve to be where they are.

These forms of ‘cognitive bias’ may lead us to misapprehend the problem of social disadvantage and inequality to the point that we may even claim self-righteously that certain outcomes are just when in fact they are not. I certainly have come to reconsider my views on this. What about you? 

Angels and Demons in Our Heads

For those attempting to diet, quit smoking or save regularly, but find it impossible, recently concluded research has unlocked the inner workings of the human brain affecting the exercise of self-control, or what movies and cartoons have popularised as being our better angels and lesser selves.

Ever wonder why it is so harder for some and easier for others to stick to a diet, quit smoking or avoid spending money? The answer lends credence to the adage that “it’s all in the mind”. An interesting experiment performed at the California Institute of Technology (Caltech) has pointed to an area of the brain known as the dorsolateral prefrontal cortex (DLPFC) which acts as a modulator of our desires when undertaking value laden decisions—such as what food to eat.

Using magnetic resonance imaging, they have shown that it is this region that lights up when individuals exercise self-control. This area represents our “better angels”. The other region which is responsible for making us act on our impulses and desires is the ventromedial prefrontal cortex, or vmPFC. This represents our “indulgent” selves. Science Daily reports

"After centuries of debate in social sciences we are finally making big strides in understanding self-control from watching the brain resist temptation directly," says Colin Camerer, the Robert Kirby Professor of Behavioral Economics in Caltech's Division of Humanities and Social Sciences and another of the paper's coauthors. "This study, and many more to come, will eventually lead to much better theories about how self-control develops and how it works for different kinds of temptations."

Improving welfare

In relation to welfare economics, the study of maximising consumer welfare, the findings of this research challenges the notion that revealed preference always indicates the optimum choice. In other words, to maximise welbeing, policy should take its cue from what people say they intend to do (their reported preference), as opposed to what they actually do (their revealed preference).

The use of personal trainers as vividly portrayed in reality gameshows like The Biggest Loser to act as a constestant’s conscience demonstrates the necessity of adhereing to this principle. It has been shown in one study that providing cash incentives to subjects for a period of time to exercise makes the habit of going to the gym stick following the withdrawal of such rewards. Even in cases where their reported preference ex-ante goes against the preferred outcome, say for those who profess that their obesity is their lifestyle “by choice”, the ex-post preference might agree with the decision to lose weight.

It admittedly is more difficult to argue in favour of programs that would coerce people to do things for their own good. Civil libertarians will protest against this paternalistic violation of people’s rights. Hopefully with a little nudging, people could opt willingly to undertake certain behaviours:

For instance (as proposed by Todd Hare, postdoctoral scholar) it might be possible to kick the DLPFC into gear by making the health qualities of foods more salient for people, rather than asking them to make the effort to judge a food's health benefits on their own. “If we highlight the fact that ice cream is unhealthy just before we offer it…maybe we can reduce its value in advance, give the person a head start to making a better decision."

A combination of consumer watchdogs, mandatory labels in packaging and healthy competition does go a long way in framing choice towards the better outcomes. The deterrence of unseemly pictures on cigarette packets though might influence first time smokers, but not long-term ones. Perhaps, in the case of the latter, a shove, rather than a nudge, will be needed.

Smells like “Animal Spirits”

Neuroscience is helping to settle the debate over what caused the Great Recession: was it imperfect information or irrational behaviour?

A very amusing tussle among two high profile economists and an appellate court judge has been featured in The New Republic (available online). I am speaking of George Akerlof and Robert Shiller whose book, Animal Spirits, was harshly reviewed by Richard Posner.

The book addresses the question what causes asset bubbles to inflate and burst. Animal spirits, a term used by John Maynard Keynes has come to mean in its current incarnation “variations in the level of trust, storytelling and human interest, perceptions of corruption or unfairness, anger and optimism, social epidemics causing changes in gut instincts and feelings”.

A long list—which is why Posner’s critique that a reliance on such as set of specific contextual exemptions to the standard rational macroeconomic model is unnecessary. He contends incomplete information is sufficient to explain mistakes made by rational actors in assessing the risks and rewards of investing. Ironically, if anyone should be making this argument, it ought to be Akerlof who pioneered the study of asymmetric information for which we won the Nobel Prize along with Mike Spence and Joe Stiglitz.

Which view is worth its salt then?

Lately, the blogosphere has been buzzing with news of a study out of the University College London or UCL in which researchers have identified a gene that affects our economic decisions or perceptions of financial risk.

Previous studies have identified the amygdala (the same area of the brain used in processing emotions) as being involved in considering such decisions. The purpose of the current study was to determine if a particular gene known as the serotonin transporter, vital in affecting nerve connection in the amygdala, helps respondents deal with something called framing.

Generally, individuals are loss averse. For instance, being told that there is an 80 percent chance of surviving an operation would be the same as saying there is a 20 percent chance of dying. A person might decide differently based on whether the positive or negative side of an argument is used as a frame of referrence.

Susceptibility to this framing effect could be exploited by slick salesmen, mortgage brokers, credit officers, and the like to the detriment of investors and buyers (think of the sub-prime mortgage mess). For this reason, Colin Camerer and others recommend “cooling off periods” in which buyers could essentially renege without cost to them. This would remove the incentive for firms to engage in high pressure sales tactics.

The study found that individuals with a certain variant of the gene were more susceptible to framing. The good news is that genetics only accounts for 10 per cent of the variations in decisions. The remainder could be explained by life experiences, in other words, by personal and social learning.

The bottomline is that "animal spirits" a theoretical construct to explain irrational behaviour seems to find concrete verification in this study. With neuroscience, the behavioural argument that irrational decision making comes into play in market failures finds strong support.

A Nudge State, Nanny State or No State?

The public service has often been portrayed as either ineffectual or overbearing. It either produces nothing of value or worse it extracts from the dynamism of markets. With the advent of a new theory of the state, could things be about to change?

It was David Brooks who proclaimed the rise of the “Behavioral Revolution” back in October 2008. He was speaking of the way regulatory frameworks are now taking account of imperfect rationality in much the same way that they took account of imperfect competition and imperfect information as part of the natural progression of relaxing assumptions about "efficient markets". The purpose of such regulatory reform is to protect consumers from schemes that exploit their lack of rationality or self-control.

The structure of any decision-making process is neatly depicted here. Imperfect rationality means that faulty perceptions lead to false risk assessments lead to poor decisions by rational actors. These perceptual biases as described by Kahneman and Tversky provide the rationale for "nudges" or even "shoves" by the state to guide the most vulnerable in society to make good decisions without imposing harm on the rest.

The term coined by Colin Camerer for this philosophy was asymmetric paternalism or libertarian paternalism as adapted by Thaler and Sunstein. Cognitive psychology and neuroscience is helping to confirm the dominance of human emotions in swamping reason under certain conditions. Consider a decision you have made in the past involving any one of the following:

• Credit and savings
• Houses and cars
• Education
• Careers
• Marriage
• Addictions
• Child bearing
• Health

Any one of these decisions involves a certain amount of emotional content. The infrequency of these decisions makes it improbable that individuals benefit from personal learning. And they have long lasting even intergenerational consequences. Social learning from family and friends as well as public education campaigns may help. But to the degree that people are subject to confirmation or self-serving bias (where we seek out information that confirms our position), forgetfullness, and a high correlation across groups, we witness their decisions having a cumulative or even contagion-like effect on financial markets, public health, industrial competitiveness and so on.

For those of us who provide analysis and advice in the public service or as part of political staff (whom we in the public service jokingly call the "dark side"), this means rethinking the way we design policies in the coming years. The dichotomy is no longer between letting free markets work or imposing big goverment interventions. It means that the profession of public policy so often derided for not producing enough value or distorting its creation now has a way of enhancing value for the benefit of both markets and society.