Book Review: The Price of Everything

While The Price of Everything is a work of fiction, its subject matter is economics and its author is an academic economist. The book was the subject of a recent podcastby author Russ Roberts as part of his regular EconTalk series. So while he chose to package his message in a fictionalized setting, the subject matter is clearly economic. In this sense he follows a path previously followed by the aptly-pseudonymed Marshall Jevons, whose economic murder-mysteries have been around for some years. I remember one of them being assigned reading in an undergraduate economics course. The fact that I remember in itself suggests that fiction may be an effective means to communicate economic ideas.

Roberts' point is that decentralized systems can give rise to emergent order. Through the character if Ruth Lieber, Stanford provost and professor of economics, he lays out the case for the efficiency of prices as system of conveying information. This argument closely follows Hayek's 1945 AER article that everyone should read at least twice. The plot follows two elite Stanford athletes (who are, of course, madly in love with one another, and who apparently are so good that they needn't practice or travel to competition as much as I remember or one would suspect) as they are introduced to and eventually won over by the advantages of market interactions as advocated by the charismatic Lieber.

Roberts scores points on two fronts. First, his underlying point is of course an excellent one. Today smart people around the world are constantly arguing for intervention for one thing or another without fully recognizing the advantages of the decentralized market. That is, change for the sake of change, not change because we can actually expect to improve on the current outcome. Second, he manages to do this in far less verbose fashion than other authors; for example Ayn Rand, who can and does address this topic, would attempt it in no less than 350 pages. See Atlas Shrugged.

That said, while fiction proves a useful vehicle to Roberts, as a piece of literature I am reminded of an English prof who taught possibly the most instructive class that I took in college. I believe that he would have described the structure (and details) of the narrative as "putrid." I agree. This is not good fiction, let alone literature. However, to harp about the tree and miss the forest is a tragedy in this case, since part of the emergent systems argument is based on the advanatges of specialization. Roberts is a full professor of economics at George Mason. If his calling were as a novelist, his life likely would have played out differently.

Book Review: Origins of Virtue

Matt Ridley's entertaining panorama of life on Earth boasts a variegated cast of charcaters ranging from desert seedharvest ants to bottlenose dolphins, Polynesian island communities to Petra, and Prince Peter Kropotkin to Robert Frank. The thrust of the book is that individualism is innate and selected for in nature. Even though we sometimes observe apparently altruistic behavior, Ridley argues that this is typically of a "selfish gene" type, in which individuals sacrifice themselves or their intersts for those of close relatives. Without socially-oriented bahvior, we might fear that societies are threatened. However, stunning relationships that benefit both parties arise despite the apparent lack of coordination and competition between individuals. Economists deal with such relationships often enough to have a special name for them--markets. Ridley argues that cabals among groups of chimpanzees and dolphins are little different in an evolutionary sense from groups of humans who cooperate in order to trade. But trade is not the last of it--Ridley also explores connections to conflict and ecology.

At times the connections are a bit abrupt, although the worst of these come in the final chapter which is advertised as drawing sudden and rash conclusions. Ridley does largely resist the urge to force connections to demonstrate his underlying point. He lets the evidence speak for itself. The book holds up well (it was first published in 1997). Ridley is working on a new project that elaborates on how humans have managed progress over the course of history. I saw him present a seminar on the material for the new book, which promises to be just as entertaining and thought-provoking as The Origins of Virtue.

Book Review: Discover Your Inner Economist

Tyler Cowen's contribution to the recent spate of pop economics books that started with Steven Levitt's Freakonomics is these best of the bunch. The dangling carrot on the dustjacket symbolizes Cowen's view of economics: incentives matter. While other of these books pose interesting conundrums to the layman and professional economist alike and do much to put a sexier shine on the field than many practitioners are able to do (remember the worst economics class you ever took, including graduate school), none is able to constructively challenge doctrinaire economic thinking and connect with the intuition that all people have--their "inner economist."

For example, getting the dishes washed is not a problem best solved by paying one's kids or significant other. Instead, it is probably best tackled by giving the victim/washer incentives other than monetary. Cowen recognizes that homo economicus maximizes in multiple dimensions simultaneously--we respond to both strong and weak incentives, some of which affect our earnings, but many others that don't. Art, literature, culture, vanity, and most importantly, control are central topics in the book. There are a lot of ways to control your life without paying everyone to do what you want--in fact, that strategy is unlikely to yield the results you desire. The notion of a person who only cares about one thing, money (or a person all of whose cares can be translated into money), is rejected by Cowen. He appeals to the humanity of his reader, who knows this intuitively, but who may still want to figure out how to get a waitress to optimize a dining experience in a restaurant or reward his dentist for her great service. It is no surprise that Cowen's insights on gustatory pursuits are excellent. He even gives some tips on home cooking.

Like other books in the genre, Cowen's offers wonderful antecdotes for the prospective economics teacher. His treatment of complex issues is thorough but understandable. While the conclusion is weak by comparison, the perspective of a very capable practitioner outside the mainstream of economics lends a stimulating perspective on choice and scarcity to all readers.

Beer in the fridge, eh?

Denise Young's Energy Policy piece about the social costs of second refrigerators in Canada has spurred plenty of public interest by varied outlets, ranging from the CBC to Bob and Doug MacKenzie. She has three points:

1. Some Canadians choose to keep old refrigerators when they buy a new one
2. Old refrigerators tend to be less energy-efficient than new ones, sometimes dramatically
3. Policies that target energy-efficient appliance use have room for improvement.

The comical pejorative usage of the term "beer fridge" in quotes throughout the article aside, these are valid and interesting points. Durable goods purchases are sticky in the sense that people hang on to them, and refrigerators appear to be stickier than some other appliance purchases. So older appliance vintages likely persist longer for refrigerators than we might otherwise expect.

Canadians demand refrigeration (or perhaps warmth in much of the Great White North) for any number of reasons. Perhaps they need to store game meat, or increase capacity to capitalize on buying in bulk at warehouse stores, or to reduce resupply trip costs. Demeaning the demand for refrigeration doesn't seem like a valid strategy--if refrigerators are of a size that is inadequate for all refrigeration demands (perhaps because larger fridges increase transport costs prohibitively), why shouldn't someone have more than one? Perhaps the cost of refrigerators is such that most people are unable or unwilling to buy them two at a time. The paper dismisses the demand for refrigeration by assumption. The paper adopts a viewpoint of substantial cold beer reserves as a superfluous luxury indulged in by people callous to the impacts of their actions. My guess is that price elasticity estimates of beer demand are fairly low (but perhaps sensitive to income). While the paper does a fine job of estimating the total costs of additional use of older, inefficient refrigerators, it does not speak at all on the demand, and therefore the pertinent societal tradeoff. Perhaps we should engage in a study of the external costs associated with second televisions. Obviously anyone who keeps the old set in the shop to tune into the hockey game is an irresponsible Canadian (but perhaps not if they watch David Suzuki).

The paper is interesting and a little cute. But it misses the point that optimal tradeoffs depend on both costs and benefits, and deriding benefits a priori isn't productive.

Cognitive Connection

http://www.businessgreen.com/business-green/news/2211278/report-urges-government

Game Theory as Tool

This story reminds me of a tenet of practical game theory: your best response should take into account the mistakes you believe your opponent will make. Fixed-points likely played no role in the analysis that lead Britain to employ an astrologer during the war, but this is an example of game theory, to be sure. Since Hitler consulted an astrologer, so did Britain, to discover what Hitler was likely to do. I love it.


http://www.news.com.au/story/0,23599,23317116-38200,00.html

Hg Monitoring

If this post is true (I suppose that they can tag isotopes of mercury and be reasonably sure of where it came from (?)) then it seems that the "we need a carbon tax to control global energy use" crowd needn't fight the carbon doubters anymore. Pretty much everyone agrees that atmospheric mercury is anthropocentric and potentially harmful to people. So we'll just get the Chinese to sign the ______ Protocol (please pick a pleasant location for the conference--maybe the tropics in winter). I'm sure they will.

Oh. Wait. Maybe they won't. Maybe the strategic/geopolitical dimension of carbon taxation is something that 99.9% of environmental economists are either oblivious or choose to ignore because it isn't in the model.

Note: the French still come out looking good here. Nuke plants still don't emit Hg.

The Academy as Business

From Stanley Fish's article in the Times:

But in the academy there is no product except knowledge, and that may take decades to develop, if it develops at all. The concept of market share is inapposite; efficiency is not a goal; and there is no inventory to put on the shelves. Instead the norms are endless deliberations, explorations that may go nowhere, problems that only five people in the world even understand, lifetime employment that is not taken away even when nothing is achieved, expensively labor-intensive practices and no bottom line. What is an outsider to make of that?

http://fish.blogs.nytimes.com/2008/02/24/wanted-someone-who-knows-nothing-about-the-job/?8dpc

Book Review: A Demon of Our Own Design

Richard Bookstaber has been in some interesting places that have given him a sage perspective on financial markets and innovation: he watched the 1987 market crash from Morgan Stanley; joined Salomon Brothers for the high-flying early 1990s and stayed until the arb trading unit was shut down after the Citigroup merger; watched his fellow MIT grads (and Salomon colleagues) blow up LTCM from a front-row seat; and then he managed to work for "hedge funds" before Congress knew what they were. All those qualifications led Congress to ask him to testify about the currrent mortgage/credit mess last fall. Since he has spent a career trying to figure out what portfolios of derivatives mean in the real world, he seems like a good choice. He has no less than three basic observations about financial markets today.

1) Liqudity is the defining characteristic of financial markets and provides a pertinent contrast to other aset markets. Liquidity allows leverage, which has abetted recent financial crises. Traders leverage assets because they can and because they need to to make small-return bets worthwhile. But liquidity can disappear in a crisis, squeezing those in leveraged positions.

2) Financial derivatives are good insofar as they allow risk to be borne by those more willing to bear it. However, exotic derivatives create additional layers of complexity in financial markets. In concert with tight coupling resulting from leverage, this complexity can lead to instability. Bookstaber suggests that a less sophisticated market structure might be more robust in times of crisis--like a cockroach, which has a very coarsely evolved survival strategy.

3) Accounting practices are antiquated and cosntructed with illiquid markets in mind. Without sufficient statistics for the types of exposure, strategies, and positions that financial firms face, standard accounting practices are not useful in assessing risk. It should come as little wonder that firms like Enron and Tyco were able to manipulate accounting concepts in the context of far more dynamic strategies.

Bookstaber's background as a risk manager lends some interesting context to the above observations. Citing Knightian uncertainty, he emphasizes unknown risks as the primary blind spot of markets, in subtle contrast to Taleb's fat tail risks. While unforthcoming on how to deal with unknown risks (just as Taleb is coy about living with fat tails), this observation should catch the attention of any quantitative trader. The narrative is generally very good, but does lag in places. He is less windy than Taleb, but also takes time to relate personal stories, some of which are illuminating. On the whole an interesting read, and Wendy deserves credit for finding it.

What will liberals read?

Those readers who have a strong affinity for The New York Times might want to read this. It appears as though Schumpeter was right when he said, “Technology is not kind. It does not wait. It does not say please. It slams into existing systems… And often destroys them." Indeed. It is most likely to destroy those least equipped to adapt to it, even if they are staid and respected institutions that have henceforth generated something nearing $1b per year.

The best line in this by far is, "Now, normally, beating up on someone like this isn't very much fun. But we are talking about a profession that specializes in passing judgment, often snide, on everyone else. And so, onward..." How apropos in the case of the NYT.

And more...

Book Review: More Sex Is Safer Sex

Steven Landsburg’s contribution to the recent flood of pop economics books, More Sex Is Safer Sex, focuses attention on the concept of spillovers and endorses a strong application of cost-benefit analysis. Like other recent books in the genre (Stephen Levitt’s Freakonomics, Ian Ayres’ Supercrunchers, or Robert Frank’s The Economic Naturalist) it is quick reading, and while the reader may or may not agree with all Landsburg offers, he must surely agree that it is thought-provoking and entertaining. Drawing on material from his years as a columnist for Slate, Landsburg delivers a collection of antecdotes with poignant economic insights. This material would be very useful to anyone seeking to enliven an introductory economics class or a cocktail party.

The book begins with the titular chapter, claiming that if the pool of prospective sexual partners is larger, then all participants are less likely to contract an STD. Recreational sex is welfare-enhancing, and aside from the spillover of infection, Landsburg hypothesizes that more people would participate in it. In order to lure otherwise bashful prospective partners from the sidelines and increase the size of the pool, Landsburg suggests that used condoms should be exchangeable for a reward (this is because even at zero cost, a less than socially optimal number of condoms would be used). Thus more people have sex, reducing the chances of infection. But wait, doesn't condom use reduce the risk of infection? Presumably wider-spread condom use would also mitigate the risk of infection just as surely as lerger numbers of uninfected partners. It's also not clear to me that sexual pairings are random. In any event, sexual relationships are evidently a scale-free network, so it's not clear that adding a whole lot of nodes is the way to attack the problem of infection. It seems that attacking the hubs is the way to do it. Landsburg has clearly achieved his goal, since I had to understand his argument in order to come up with that.

Landsburg continues to sling economics curveballs throughout the book. A few examples give the spirit.

• Underpopulation (not overpopulation) is the world's most pressing problem since people solve problems. With more of them, more problems will be solved. (Steve, did you know that only stupid people are breeding?)
• Juries should be paid for correct verdicts and fined for incorrect ones. SURPRISE! The legal system doesn't get the incentives right.
• As a miser, Scrooge was actually among the most generous of people by producing valuable goods and services but not consuming any--at least, until the end of The Christmas Carol. (This smells like pecuniary externalties to me.)
• People (except tycoons with potnetially endowment-changing contributions) should donate to a single charity rather than to multiple charities. Corrollary: Maimonides' Rule is a crock.
• Patents should be purchased by the government and held in the public domain. This rewards innovation and allows public use of knowledge.

All in all, it's a worthy collection of thoughts, logic, contrarianism, and jokes. Landsburg deserves a lot of credit for owning up to the internal conflicts between his fee market training (Chicago) and proclivity and his enthusiasm for selected government interventions (like the condom bounty) in economic life. One sidenote that comes up three or four times during the book: Landsburg has a hardon for Robert Frank of Cornell. Apparently the claim to be the top dog in pop economics is valuable. A cage match sounds like a good idea.

Rare occurrence

Reading the new JEL that came in the mail yesterday and I happened upon a first (for me, at least). DiNardo ("Interesting Questions in Freakonomics"; a misleading title since he argues forcefully that there are less of these than one might think) rocks a double-footnote! That's right, kids, he footnotes footnote # 29 with footnote #30, which is an all-star move if you ask me.

This would be nothing more than a neat, unusual occurrence if the section (and the footnotes) weren't so good. DiNardo uses Freakonomics, and for those who've read it, it's preoccupation with correlation vs. causation, as a jumping-off point to discuss randomized controlled trials and the assumptions needed to assume that RCTs can give good estimates of a treatment effect: "...in an RCT, the answer should be insensitive to the addition of additional controls."

This is a recommended piece of work.

Fed Uncertainty

The following is excerpted from John Mauldin's weekly newsletter, You can count on the blockheads in Congress to botch almost anything for political gain.
Continued

Good friend and fishing buddy David Kotok recently brought a very disturbing item to my attention, and feel I need to pass it on. Senator Chris Dodd, Democrat from Connecticut, he who aspires to be president, is seriously hampering the ability of the Fed to respond to the current crisis and threatening the independence of the Fed in the process, all for a little partisan gain. His fellow Democrats are going along with him.

Basically, there are two vacant seats on the Fed. President Bush has nominated two very qualified people with distinguished records and backgrounds who have hands-on experience in real-world banking, as opposed to being academicians. These are not political appointments, but serious economists.

Dodd refuses to allow these nominations, or any others, to move forward. Plus, Dodd has let it be known that he will not hold a confirmation vote on current Fed governor Randy Krozner, whose expertise is mortgage markets, when his term ends January 3.

Under current rules, since there are now just five Fed governors instead of the normal seven, you cannot have just three governors on a conference call, as that would be a violation of the public meeting rules, since three would constitute a quorum and potential majority. That clearly makes communication difficult. It also means that the current governors, who already have tight schedules, have to take on extra duties.

Why would Dodd do this? He has made it clear that he is not happy with Fed policy, as has his counterpart in the House, Barney Frank; so some of this is just personal pique. They want the Fed to respond to their political goals. But some of it is clearly partisan. If there is a Democratic president, they would be able to immediately nominate three new governors, and would not have to reconfirm Ben Bernanke as chairman, which means he would leave and the new president would appoint the chairman.

Dodd clearly wants a say in this, and wants a Fed that will pay attention to his politically driven needs. This would mean the Fed would be short-staffed for at least another 18 months, which is not a good thing. The Fed does more than just hold eight meetings and set monetary policy. They have real work that needs to get done.

Whoever the new president is, they will get to nominate who they like as governor terms come to an end. But to act as Dodd is currently doing threatens the independence of the Fed, which is a critical part of the economic world. You can criticize the Fed and their policies, and I often do, but every right-thinking person agrees that Fed policy should not be set in Congress and subject to political whim. The last time we had a Fed chairman who let politics suggest policy was William Miller under Jimmy Carter, and that did not turn out well.

Dodd is sending a message that is not appropriate. These should not be political appointments. These appointments have serious economic consequences. Shame on Dodd for holding hostage an economy which is in crisis for his own political advantage, and shame on a Democratic Senate leadership which goes along with him.

Is the Tail now Wagging the Dog?

And as economists, should we be happy with that?

The recent Fed auction had a clearing rate of 3.95% when the overnight rate was still at 4.5%: http://www.federalreserve.gov/newsevents/press/monetary/20080115a.htm

The Fed comes out this morning (1.22.08) and lowers the overnight rate to 3.5% stating a weakening economy (more likely just trying to stave off the negative bounce from the foreign markets): http://www.federalreserve.gov/newsevents/press/monetary/20080122b.htm

Are those rates coincidental, or is the Fed out-sourcing some rate setting power?

On one hand, as economists we have to side with any use of the market to gleam information. On another, the market is notoriously fueled by behavioral impulses. Though it isn't clear how exactly the Fed decided on the rate, my take is that the Fed shouldn't be taking so many hints from its auctions.

Fed Auctions

I think we all can accept why this happened: the Fed wanted to provide an opportunity for banks to get money at a rate lower than the 4.75 discount rate, possibly staving off worries on banks runs and generally providing some economic credit grease, if you will. What I think is interesting is to consider, is what information may be gained from the results. That is, assuming coalitions are not formed, what does it mean if the auctions result with the Fed lending out the first $20B at 4.25 or something drastically lower than 4.75 (and that is a big what if considering the banks may be able to turn around and sell the debt at least at 4.75)? What does it mean to place so much monetary policy power at the hands of the market? Could this result in a signal of how the market views the large scale growth of the global economy? I am not a macro-economist and am far from able to yet form a coherent post-worthy thought on this but hope these brief questions spur further discussions. Swing at will and lets get som discussion going as this is an opportune learning situation on many fronts.

Info from Fed: http://www.federalreserve.gov/monetarypolicy/files/TAFfaqs.pdf

For an old example of the Treasury's take on uniform price auctions, see: http://treas.gov/offices/domestic-finance/debt-management/auctions-study/upas2.pdf

Using Macros in STATA

If you are programming in Stata, or using macros for any reason, be careful when squaring.
Try the following if interested (commands in italics), though you can see the result:

gl check = -.01
di $check-.01
di $check^2
-.0001
di ($check)^2
.0001

This was done on Stata 8.2 but I also found this to issue on Stata 9.

Remembering a Legend

Today, even Chuck Norris sheds a tear.

Explaining Quants' August Meltdown

This essay does a nice job of explaining what happened to quant funds in August and why some were crushed while others managed to survive.

Schumpeter on Academics

"The layman thinks he knows what a professor is. However, this term denotes a group of people who differ widely in type, function, and mentality. There is the academic administrator; the university politician; the teacher in the sense of a man who imparts current knowledge; the teacher in the sense of a man who imparts distinctive doctrines or methods; the scholar in the sense implied by 'learnedness'; the organizer of research; the research worker whose strong point is ideas; the research worker whose strong point is skillful technique, experimentation and its counterparts in the social sciences. And all of those--and others--are very different chaps and hardly ever fully understand and appreciate one another. Yet it takes all of them to make a modern university and it takes recognition of all these types and the way they cooperate or fail to cooperate in order to understand what a university is and how it works. And he who insists on merging them into a unitary professorial type and leaves it at that will obliterate not only secondary details but essentials."

Possible Classic Papers

Alchian, A. 1950. Uncertainty, Evolution and Economic Theory. JPE 58: 211-221.

Friedman, M., and Savage, L. J. The Utility Analysis of Choices Involving Risk. JPE 56(4): 279-304.