The Monkey Market for Skills

For those of us who have felt at one point in our professional lives that a monkey could be trained to perform the same tasks at work that were assigned to us, here is some food for thought on the origins of skills shortage among primates that possibly translate into human labour markets.

http://economix.blogs.nytimes.com/2009/10/28/monkey-economics/

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.

Deal or No Deal Part 2

I received a curious comment to the last post Revenue Write-Down: Deal or No Deal:

Rudd's budget strategy exhibits extreme political risk aversion. It would be a mistake to view it in economic terms.

This is in line with what many commentators have said was the way the budget addressed the economic recession in the near-term while avoiding the hard choice of dealing with the long-term structural imbalances identified by the Federal Treasury in its budget papers.

In part 1 of this entry, I had contended that Prospect Theory explained the way the Labor government was behaving in assessing the risks associated with the budget allocation decisions on spending and taxation. The theory predicts (accurately in my view) that faced with losses, the government would increasingly become risk-seeking as shown by its having thrown caution to the wind and engaging in deficit spending.

I failed to mention another aspect to this risky decision. This has to do with what US Defense Secretary Donald Rumsfeld made famous: the “known unknowns” or the things that we know we don’t know. In a word it’s called ambiguity.

As it turns out, the human brain has a bias against it, an aversion. When faced with a decision involving risk where the probabilities attached to events are unknown, humans prefer not to decide or to postpone a decision until the known unknowns turn into known knowns even when the risky decision involves a higher expected value. Ambiguity aversion has been shown to exist when the decisionmaker is experiencing the fear of negative evaluation (FNE) from others.

Here is a neat video explaning the theory of ambiguity aversion in relation to the Ellsberg paradox posted by another blogger.

Getting back to the comment, perhaps it was not a case of political risk aversion, but a form of ambiguity aversion. The government has in effect postponed the decision to rein in tax cuts, given the FNE associated with reliving the Keating Labor government’s experience in the last recession. And given that one single event assumed in the budget would resolve the issue for them (this is the GDP growth projection of 4.5% over six years) the probability of which was (and will remain for some time) unknown, it probably felt justified in delaying this hard choice.

As neuroeconomics shows, this is a powerful, evolutionary response that fits in perfectly with the human condition. Until ample evidence arises to clear the ambiguity or reduce the FNE associated with the structural adjustment task, we cannot reasonably expect the government’s response to be otherwise.

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.

Discounting Human Nature

Why governments and voters in resource rich countries fail to horde boomtime windfalls for future economic contingencies and what to do about it.

"Australia's net debt will be the lowest of any major advanced economy in the world for the next decade. It is responsible for us to have embraced such a strategy to deal with the challenges presented to us and other economies with the global recession, and to do so within that responsible framework."

-Wayne Swan as quoted in The Australian, 9 May 2009.

“Young people have got to know this; that they have been put into hock for a very long period of time by this government and they’ll be paying for it through their taxes probably for generations.”

- Peter Costello as quoted in The Australian, 13 May, 2009

Governments today wish they had the equivalent of a Joseph, the biblical hero, appointed to Pharaoh’s court whose prudent advice spared the land of Egypt from hunger during seven years of severe famine. The thing is: there were josephs in our midst; they are known as economists who predicted the current crisis and the severity of its impact (Nouriel Roubini being one of them).

Apart from Norway and Chile, a country long considered a model of policymaking no other country seems to have taken the lesson of this biblical story to heart. Regarding Chile, The Economist reports

As a small, open economy it (Chile) is uncomfortably exposed to the world recession—the price of copper, its main export, has fallen by almost two-thirds since mid-2008 … The government forecasts this year’s fiscal deficit at 2.9% of GDP, but it can easily afford this. That is because it has stuck to a rigorous fiscal rule … requiring it to save much of the revenue gained when the copper price rises. Not only is public debt minimal (4% of GDP in December), but the government has also piled up $20.3 billion (about 12% of GDP) in a sovereign wealth fund which it can now spend.

Why aren’t other countries, particularly resource rich ones in the developed world, following the Chilean countercyclical example? Well, the answer depends on whom you consult, for example:

Political economists will point to the “Dutch disease” phenomenon that afflicts resource rich countries. During boomtimes, GDP accelerates past the long-run steady state of the economy. This windfall tempts governments of the day to increase spending on social services (as in the case of Holland in the 1980s) or reduce taxes or a combination of both (as in the case of Australia). When the boom ends, growth moves below the steady state, making the contraction all the more painful as social services are cut, taxes raised, etc. In fact, Jeffrey Sachs has built a general equilibrium model that mimics this phenomonen in action in the Venezuelan economy.

Institutionalists will identify the agency costs associated with the exercise of control over windfall profits. Especially in developing economies with weak judicial systems and endemic corruption, decision-making with regards to such wealth becomes diabolically problematic.

Behaviouralists will point to the lack of rationality and self-control that creates perceptual biases that prevent a proper assessment of the risks involved by not saving. Planners could suffer from optimistic or hindsight bias as a result.

A rational observer might comment that these explanations aren’t good enough. Anyone with common sense would intuitively sense that “all good things eventually come to an end” and see the wisdom in “saving for a rainy day”. As it turns out, neuroscience is helping to uncover the reason for this irrational behaviour.

Any standard economic model would use exponential discounting to determine the optimal amount of consumption and saving a household or government should engage in. This only works when temporal or time preferences are consistent. If humans were completely rational, they would follow this mode. It now appears that our preferences for rewards change depending on the length of time being considered. This has led to the method of hyperbolic discounting which takes into account our being “present-biased”.

So it would seem that when faced with two options of having a reduction of taxes in the long-run through savings made in the short-run versus receiving a short-term benefit in the form of a one-off payment/increased social services paid for by higher taxes in the future, that taxpayers will by and large opt for the latter even if in the long-run, they would benefit more from the former. This is by the way the reason why households over-consume and over-borrow. Given that their governments suffer from the same imperfection in judgement, it is not surprising that they would give in to this populist urge.

On the other hand, a paternalistic State such as Chile, would recognise that given our flawed judgement, the necessity of enactomg legislation that automatically sets aside above average fiscal benefits in the short run to smooth over shortfalls in the long-run. This would reduce the need to go into debt when markets head south and unburden future generations from interest payments. This, to me, seems the only sensible way to go about discounting our very nature.