Comments on Today's Session

In preparing for our Wednesday class on Objections, I read a few online book reviews of Nudge. From those I garnered that regardless of your views on the recommendations in the chapter on Privatizing Marriage, we should be able to agree that those recommendations are not nudges. The recommendations represent large changes from the current arrangement.

So one wonders why that chapter was included in the book. I don't know Sunstein and Thaler, but I have no problem imagining them being very enthusiastic for their own recommendations as I often get infatuated with ideas I come up with on my own. Then since they were doing this collaboration, shoehorning the ideas into the book might not be too much of a stretch. An editor is supposed to filter out author indiscretions, but when the book is likely to be popular and the authors can go to a different publisher, the authors retain some control.

On my initial reading of the book, it didn't occur to me that the suggestions in this chapter were not nudges. I am not sure what I would have done about it, but quite possibly nothing. That getting married is a time when homo economics is on vacation makes it a relevant topic for the class. In my case, and as a trained economist I am mainly rational about things, when I was dating my not yet then wife, I told her money grows on trees. Even though we still love each other very much, that wasn't a very shrewd thing to say and we both know that now.

That members of the class disagree about the recommendations in the chapter is not surprising. We've had disagreements before, mainly on whether paternalism is acceptable and if so when, also on whether government can be trusted to deliver the goods. The disagreements today were of a different nature. I didn't anticipate that outcome. I wonder if others in the class did, which would put you a few steps ahead of me.

Men Drinking in College - A Theory to Explain Why

Since the topic has come up more than once in class and in th blogging, I thought you might find this one interesting.

1089 Why College Men Drink: Alcohol, Adventure, and the Paradox of Masculinity via kwout

Quite an interesting read

Levin sketches a conservative vision of the future in depth and with considerable thought. One wonders whether nudges will be part of it. One also wonders what his feelings are about the ugly parts of capitalism - they preying on the weak and ill informed. Those omissions notwithstanding, it does make for a good read.

Beyond the Welfare State > Publications > National Affairs via kwout

Some Follow Up on Credit Markets and Today's Presentation

Interest rates were indeed quite high in the late 1970s - early 1980s, but the practice is usually to distinguish between nominal interest rates and real interest rates with the latter equal to former less the rate of inflation. Real rates were quite low in this period (which is typical for an economy in recession). When I was in grad school my classmates and I would often talk at lunchtime about whether the real rates were negative and if that is even possible (it is) and what that would mean. At a macroeconomics level economic growth requires a positive real rate. You can work through the rest. I mention this because the table that was presented for 30 year mortgage rates presented nominal rates only.

One of the things we didn't talk about today is refinancing. It warrants a mention. The underlying economic question is when there is a long term loan and there is a risk that interest rates will vary during the term of loan, who bears the risk? In the case of a fixed rate loan, borrowers make out if the interest rates rise in the future but still during the term of the loan. One might think that it is the lenders who make out when interest rates fall, and if the variation in rates is small, that is true. But with larger declines in the interest rates borrowers might refinance. That means paying off the old loan in full and taking out a new loan (incurring the various origination charges with that) and securing a lower rate in the process. With refinancing a possibility the lender for original loan can't expect to make out when interest rates fall substantially, the same way that borrowers make out when interest rates rise. But now some caveats on that.

Every mortgage I've ever had has allowed prepayment in full at any time during the term of the mortgage without penalty. I take that to be the norm for mortgages with borrowers considered a safe bet to repay the loan. But some mortgages have stiff pre-payment penalties. The ones which have early teaser rates but rates rising in the future may be in that category. This is a way for those lenders to assure they get back the interest they gave away with the teaser rate (and then some). There is nothing fundamentally wrong with pre-payment penalties providing the borrowers understand them and their function.

There is also a second issue about whether the individual can qualify for refinancing (has the requisite income and other desiderata). For many of the troubled mortgages that resulted after the burst of the housing bubble, quite a few of the homeowners couldn't refinance under the existing rules, even as market interest rates declined substantially as the Fed tried to pump money into the economy.

Because of the crisis, one might argue that the typical rules should have been suspended to allow these homeowners to refinance as an alternative to having the bank foreclose on them. There is a very provocative Op-Ed piece in today's New York Times by the former special inspector general for the TARP program, Neil M. Barofsky. Since he just stepped down from that position one can imagine there's quite a lot of inside baseball behind the decision to write that Op-Ed piece. It needs to be interpreted as such. Nonetheless, the message is interesting to read. TARP was supposed to encourage these bad mortgages to be renegotiated, but in may cases it didn't do that.

Let met close with a point about education for using credit wisely. There is a significant question about what is possible in this regard from the point of view of timing the education versus when the need to know arises. If you have classes on this too early, before you are using a credit card with consistency, the education may go for naught. My guess is that the right time for most of you would be between the Freshman and Sophomore years or when people move out of the dorms and get off meal plans. I wonder if a purely voluntary training specifically aimed at using a credit card while staying on a tight budget might have lots of takers. I don't know. It seems to me an interesting possibility. It also occurred to me after listening to you discuss not monitoring your credit card spending, and what I suggest here may be difficult to implement because of the security that's needed, but a smartphone app that popped up once a day with your recent credit card spending might do the trick. If having that were a way to attract customers, the credit card companies themselves might offer it.

Comments/Observations on Issues Raised in Today's Session

Here I want to take up some points that were raised by Adam in the discussion of the Naive Investing chapter. Some of these may be controversial (regulate or not). Others I take to just be common sense. Either way I welcome feedback - publicly as a comment to this post or privately by email if you prefer.

On the time profile of the riskiness of the portfolio

Let me use a metaphor to start on this topic. It is a standard idiom to get right back on the horse after falling off. For kids, in particular, you don't want the pain from failure to harden. On the other hand, if a kid is beginning to learn to ride the kid should start out on a gentle pony, not a bucking bronco. The latter is a good challenge for an experienced cowboy. For the rest of us, it is suicide.

If you are an otherwise experienced investor then it is definitely a true statement that when you are younger you should be taking more risk, because there is more growth potential in that. However, if you are not yet an experienced investor it may be prudent to take a rather safe approach to portfolio selection, try to ensure that early investments do pan out, and build confidence based on that experience. As you learn, your tolerance for taking risk will likely increase. You may then experience a failure in your investments but can better take that in stride and keep at the general approach.

On your own risk attitudes

There is a question of whether you know your own attitudes toward risk. Presumably different people of the same age and general size of the portfolio will nonetheless have different degrees of risk in their portfolio because of their own risk preferences. But how do you know what your risk preference is?

I recall a line from the version of A Random Walk Down Wall Street by Burton Malkiel that I read as an Assistant Professor back in the 1980s, to the effect...

...If your investments are keeping you from sleeping at night, your portfolio is too risky.

I subscribe to that point of view, though I've now reached the age where many things keep me up at night, so the test has lost some of its power. It would be nice if there was a different sort of test for a portfolio that is too safe. I don't have a cutesy story for that but I will say you really only learn about your risk aversion after having lost something. It is very hard to understand your sense of risk in prospect without having been previously burned.

On the government provision thing versus laissez-faire

1. I do have the sense that many of you are bursting on this issue. That's fine. It can serve as motivation. But I would ask please the following based on the sense of this Churchill quote.

“It has been said that democracy is the worst form of government except all the others that have been tried.”

In other words, regulation may very well have issues with it. Adam discussed the capture theory in that regard. Below I will provide some other arguments against. Laissez-Faire, however, may also have issues with it. The book discusses disreputable brokers fleecing ignorant investors. Sometimes medicine is a good thing. Other times the cure is worse than the disease. To determine which is which, you have to look at both scenarios, not just one. It's hard to do that, but it is what we should be doing in this class.

2. There is no getting around that you are students at a Public (i.e., government provided) University and that those of you who are in-state residents are also receiving a rather large subsidy on the cost of your education even as you may be paying substantial amounts in tuition and fees. There is also no doubt that the University is a heavily regulated environment operating under Federal regulations like FERPA (my sense of which is that most people view the goals of this as laudable and that mainly we should work to abide by the regulation), State of Illinois regulations like the mandatory filing of conflict of interest statements (again, sensible in my view) and the mandatory annual ethics training (which I believe to be heavy handed and largely redundant for experienced employees), and its own internal regulations like having an add and drop date for course registrations. Presumably you are here because it dominates the other alternatives that presented themselves to you. So this is one case where you seem to be voting for government provision.

3. There are many different ways to regulate economic activity. One is by altering the tax code and creating "tax preferences." For example, there is the mortgage interest deduction. Another relevant example is that income put into approved retirement vehicles can be tax deferred. Personally, I am the beneficiary of both of these. But I want to note that these incentives, irrespective of their other effects, have an income redistribution consequence where the rich are the primary beneficiaries. Richer people take out bigger mortgages so get a bigger deduction. While IRAs and 401K plans have upper limits, people of modest income might not contribute at all in the absence of tax incentive, while people of higher income will surely save some of it so the effect may merely be to move savings around to get the biggest tax benefit and not change overall saving.

On the other hand, people may view already established tax incentives as a more benign form of regulation than having a government agency regulate the activities. So in class today the argument was put as either for or against, but there may be differences in degree. Some of you might be ok with tax incentives but not OK with putting your trust in the SEC.

4. Here let's focus on some specific financial regulation. One is Deposit Insurance provided by the FDIC. For savers this guarantees their account balances when put into insured accounts. For lenders, to qualify for government insurance there is regulation on reserve requirements. These lenders must keep some assets to back up the loans. Note that the existence of this type of regulation may bias investors toward safer assets. A reason to keep your money in a bank instead of under your mattress is the deposit insurance. But you might also keep your money in the bank instead of putting it into other non-insured securities. One argument for deposit insurance is to deter bank panics. My sense is that it has been largely successful that way. Another argument for deposit insurance is to provide a baseline "safe" asset in the system. (Note that if the interest isn't indexed to inflation, these assets aren't fully safe from risk but they are safe from the default risk we discussed in class today.) I believe this to be a relatively uncontroversial regulation.

Let me turn to one where there is/was more controversy, the repeal of the Glass-Steagall Act. I should make two disclaimers here. One, I'm not an expert on Banking or Finance. Two, I thought it was wrong to repeal the act. Now back to the story. In general regulation proscribes certain behaviors. When a regulated entity (like a bank) feels overly restricted by the regulation, the natural reaction is to lobby to undo the regulation. In this case it is interesting to note that Glass-Steagall was finally done in while Clinton was President. But it was a long time in the making. My interpretation of banking is as a two pronged activity - one is pure intermediation - people save in their checking accounts, savings accounts, and CDs, and those funds are lent out for mortgages and small business loans. In aggregate the activity can be pretty safe, especially if the bank as intermediary acts as an honest cop on which loans should be made. The other prong is much more speculative lending - investment banking - primarily for providing capital to startups, which desperately need the cash but which will have a high failure rate. There is no question that investment banking provides an important function, but the reward for making these type of loans has to be large when they do pay off because of the downside risk. So it is more like equity financing, but before the startups are ready for that. Glass-Steagall kept these activities separate. Under its repeal, they were integrated.

5. I promised some other arguments against regulation or at least against further regulation. Here are three.

a) Regulations are hard to remove once they are in place, but the context may change. So even a well-conceived regulation that was appropriate when written may eventually not make sense yet it persists because there is some beneficiary from it and no general outcry against. I'd put the mortgage deduction in this category, for example. Knowing this is apt to happen, it may make sense not to regulate at the outset.

b) We're not that smart or the law of unintended consequences. The Peltzman paper we read makes this point. Intent in design is far from the same thing as consequence. Usually intent is laudable. Consequence may be much less so.

c) The political process may muck things up. The expression half a loaf is better than none simply may not be true with regard to regulation. A strong regulation or total laissez-faire may each be preferred to a weak regulation, which ends up producing the worst of both possible worlds. If true, but political compromise causes weak regulation, one can be for laissez-faire as the best possible outcome.

On an entirely different note, I feel much better now than I did this morning, where I was much better than yesterday. So I hope to engage the future teams more than I did in today's session, but even better would be to see the class do that on its own.

Could this happen in the U.S.?

What would it take for self-imposed restraint at the individual level to become cool?

Post-Tsunami Japan Turns Away From Excess - NYTimes.com via kwout

Interesting "Debate" about Income Inequality

The quote below is by one of the authors of a study on Americans (under) perception of income inequality. The debate, which is really a variety of perspectives on the issue, follow the release of the study. Note the relationship between issues of income inequality and the low savings rate that we have been discussing in class.

Living Beyond Your Means When You're Not Rich - Room for Debate - NYTimes.com via kwout

A very interesting piece on not spotting errors

This is anecdotal evidence only but it is fascinating. The making of systematic errors in checking validity of a proposition, to the extent it is true, is an obvious way for markets to fail.

The Young And the Perceptive - NYTimes.com via kwout

Humor in long form

In case any of you want to get a doctorate in economics, this essay by Axel Leijonhufvud is priceless. Others might enjoy it too.

Life Among the Econ

If you are looking for justification for our next topic.....

.... this piece from Inside Higher Ed might be revealing.

News: 'The Heart of Higher Education' - Inside Higher Ed via kwout

So much for DiMaggio

I had never heard of this guy and stumbled across the video below by accident. If you very rarely miss on average, it is virtually impossible to tell if you get hot.

Charles Kurault, the interviewer in the piece, was a CBS News reporter. His doing the interview makes it seem this is not a crank.

Fun

Since on Wednesday we are doing how we react to random phenomena, I encourage you to look at something I produced quite a while ago. Have a go at that piece and then download the spreadsheet called Time_Counter. I swear it was much faster back then, when we didn't have dual core processors. Indeed, because of that there are hidden arithmetic functions the simulation does to slow it down.

For our discussion on Wednesday, it really would be helpful to have some acquaintance with the concept known as a random walk. The underlying question is - if you see the consequences of a random walk, do you nonetheless detect a pattern in what you observe? If you do, you are rationalizing randomness.

This other link is entirely unrelated to any substance in our course. It is pure fun. Here I will only say, the puzzle is do-able. But if you try it, it might not seem that way.

More on the study

Selective colleges do better, really not a surprising result.

Learning More at Selective Colleges - Innovations - The Chronicle of Higher Education via kwout

A provocative study....

...and pretty timely for the start of the semester. I wonder if you agree with the assessments the authors of the study are making.

News: 'Academically Adrift' - Inside Higher Ed via kwout