Cognitive biases and blindness

Boyes makes a strong and reasonable case for the difficulty of policy making by the state, central planners or the knowledgable elite. Hayek has clearly and I think convincingly presented an analysis in Knowledge and Economics and The Use of Knowledge in Society.

The former essay is directly on Boyes' posting yesterday and, while it would be nice if the elite read and thoughtfully considered this essay (I wonder if Paul Krugman is aware of this nice overview of the limits to science, knowledge and economics) it is worthwhile to consider several key points surfaced by Hayek.

He wrote:

There seems to be no possible doubt that these two concepts of 'data', on the one hand in the sense of the objective real facts, as the observing economist is supposed to know them, and on the other in the subjective sense, as things known to the persons whose behaviour we try to explain, are really fundamentally different and ought to be kept carefully apart. And, as we shall see, the question why the data in the subjective sense of the term should ever come to correspond to the objective data is one of the main problems we have to answer.

Elites fail repeatedly to acknowledge this key distinction. Models and the apparatus that are devised to approximate reality are just that imperfect approximations. The plans, directions and policies of the planner, elite spokesman or policy maker are doomed to be constructed on faculty foundations due to the key distinction between reality and theory.

Moreover, in Economics and Knowledge, Hayek goes on to remind us of a constraint or limit imposed by knowledge that no planner can overcome. In fact, the elite planning that is based upon a model of rationality has observably in the past lead to perverse and unintended consequences.

It is clear that if the concept is to have any empirical significance it cannot presuppose that everybody knows everything. I have already had to use the undefined term 'relevant knowledge', that is, the knowledge which is relevant to a particular person. But what is this relevant knowledge? It can hardly mean simply the knowledge which actually influenced his actions, because his decisions might have been different not only if, for instance, the knowledge he possessed had been correct instead of incorrect, but also if he had possessed knowledge about altogether different fields.

Clearly there is here a problem of the Division of Knowledge which is quite analogous to, and at least as important as, the problem of the division of labour. But while the latter has been one of the main subjects of investigation ever since the beginning of our science, the former has been as completely neglected, although it seems to me to be the really central problem of economics as a social science.*46 The problem which we pretend solve is how the spontaneous interaction of a number of people, each possessing only bits of knowledge, brings about a state of affaris in which prices correspond to costs, etc., and which could be brought about by deliberate direction only by somebody who possessed the combined knowledge of all those individuals.

The enigma for me is why this lesson needs constant repeating. The answer is that we are all human I suppose and that our failings and blindness overwhelm the insights of the past (and present).

Moreover, Boyes and I have blogged and discussed at length the hubris of the intellensia and elites in attempting to dictate plans and policy. Both Hayek and Sowell have analyzed this phenonmon at length and the tendancy of elites (on both the right and left) to argue for planning is evident in our society today. Perhaps it is a "marvel" at the success of these elites in convincing the populace that is worth examining.

I return again and again to Samuel Gregg's work in The Commerical Society - it is indeed through mutually beneficial and voluntary exchange that civility emerges and shapes society - both through discourse and through actual interactions. Emergent institutions develop that support and in fact encourage this civil society. Gregg's subtitle captures part of the problem - Foundations and Challenges in a Global Age. These challenges are the ones that have motivated my participation in this blog and the ongoing work to constructively and civilly engage with those who are diametrically opposed to the assumptions and foundations of a liberal order.

I am thinking about our book discussion of Gordon Woods Empire of Liberty and the blogging on that book here. Jefferson, I think, captures both the essential humanity of our society and the often contradictory behavior that agents engage in. I am thinking of the Louisiana Purchase here - an executive action that Jefferson's entire political philosophy opposed. I appreciate the anguish he may have endured but, in this case expediancy trumped believe and principle, as I suppose it always has and always will. Further if we think we live in an age that lacks civility - the vicious level of attack and smearing that Jefferson and his trained dogs Monroe and Madison vomited was on par with the Federalist invective. So, from an historical perspective perhaps Krugman, Limbaugh, Maddow, Hannity, Obermann (nice parachute) and the other quislings on the right and left in the media are mere posers.

Looking to the current debate - and there is plenty of incivility, anger and hatred to go around - I think at least part of the lack of perspective is due to an absence of participation by elites in commercial society. Most have never worked in the private sector - think academe, corporatist media outlets or NGOs. Paul Krugman, for example, earns his wages from Princeton and a media outlet with an agenda an perspective to be advanced.

These elites have, for the most part, been sheltered from the necessity of participation in a commerical society. Their lack of engagement in this important arena allows for the almost pathological distrust for voluntary exchange.

I believe I blogged here that I long and hope for the day that my grandchildren can go into Wal Mart (or the dominant retail outlet of their day) and decide to not buy heroin.

It is this mechanism of volunatary and individual decision making that lies at the heart of a liberal and responsible society. As Dan Klein argues - our responsibility as economists is to make civil and clear arguments to both the populace and the elites who oppose a liberal and responsible society.

For me this is a challenge that at times is almost unbearable. On the left I encounter pleasant colleagues who now hold as an article of faith that elite planning is not only desirable but necessary. This belief is seemingly unshakeable, and while they "tolerate" my consistent plea for liberty, individual responsibility and voluntary exchange I tend to be ignored at best and belittled at worst. To maintain and really value civility in this environment is so difficult.

That said, if we did live in a free and liberal society with mutual respect and civility we would be in utopia.

Rational

What is it economists mean when they say we assume people are rational? Is it that they have complete and perfect information? If so, then any cognitive biases or any errors in judgment can be considered to be irrational. This is illustrated by the old joke about two economists walking down the sidewalk and one sees a $50 bill on the ground. He begins to reach down and pick it up and the other says, don’t waste your effort. If that were really a $50 bill on the ground, it would have been picked up already. This is the strict form of the rational expectations hypothesis. This is the form that Keynesians attacked as their free market straw man during the recent bubble and crash pointing out that if the world was one of REH, then there could be no bubbles. Since there was a bubble the free market does not make function properly.

While perhaps Robert Lucas or Gene Fama support the strict form of REH, I suspect they and most others agree more with the weaker form. If economists accept the weak form of REH, then they say that people do not have perfect and complete information, but will get that information over time. In this case, temporary errors, perhaps such as a bubble, can occur, but these will definitely be temporary. (Fama says bubbles can not develop because when the bubble is occurring no one knows whether it is a bubble or not. So, it is not really a bubble.) In this camp, it is sometimes argued that errors can persist as long as there isn’t a huge profit opportunity to reduce them. For instance, many behavioral economists argue that systematic biases such as Prospect Theory (bad outcomes are disliked more than good outcomes are enjoyed) or Revenge and Reciprocity may determine the equilibrium, or that the economy can reach a stable equilibrium which is second best or inefficient. But this won’t change unless the cost is large enough. Many economists argue that path dependence or network externalities can lead to long term inefficient equilibria. Others point out that the switch from Wordperfect to Word negates such a claim, as does the explanation of VHS over Beta, the existence of the QWERTY keyboard, etc.

The Austrian school is based on praxeology, the study of human action. It does not make assumptions of rationality except to say that individuals are self interested. Humans will act on information they have and information they collect. They are unlikely to have complete information. They have cognitive biases, they are affected by how others view them, they react to the behaviors of others, in short, they are human. The market collects all the information embedded in human action and reflects it in the price. Spontaneous order is the result. Is this second best or first best? This is the wrong question; it makes no sense. The result has to be what individuals perceive to be in their best interest or they wouldn’t behave as they do. Perhaps we could stand above it all and say, oh that is a wrong choice because they didn’t take so and so into account. But this also is wrong – it is the same as saying “I know better what is good for you than you do.” Moreover, the Austrians look on the economy as one of constant motion, not one reaching a static equilibrium. People are always collecting information and responding to stimuli and seeking ways to be more efficient and more profitable.

The reason I bring up this material is that this past week I got into a debate about whether inefficient stable equilibria could exist with a behavioral economist and a Keynesian. The debate went nowhere. It reminded me of Pratt’s frequent posts about civil discourse. It wasn’t. In thinking about the debate, I don’t think we were even talking on the same plane. Their definition of rational was one wherein people can and do make irrational choices all the time. Only those of us who “really know” can say whether their choice is rational or not. It is frustrating because the pseudo intellectual basis of arguments by economists like Paul Krugman and Robert Frank sound reasonable and impressive to numbers of people. Yet, when broken down, their entire argument is “I know better than you do what is good for you.”

The Debt Limit and Stealth Taxes

“The weak economy and fresh tax cuts approved last month will help drive the federal budget deficit to nearly $1.5 trillion this year, the biggest budget gap in history and one of the largest as a share of the economy since World War II, congressional budget analysts said Wednesday.” See here.

This according to a Washington Post article. According to the media, it is not government spending causing the problem, it is the “fresh tax cuts.”


The tax cuts were not cuts, but rather extensions of existing tax rates. To argue that they are the cause of the deficits when spending has increased at historically high rates is ludicrous. But this is the left-wing or media viewpoint.

The big upcoming test of whether the current Congress is willing to bite the bullet and stop spending is raising the debt ceiling. At current rates of spending, the federal government will bump up against its debt limit as early as March. Treasury Secretary Timothy Geithner warns that it will be catastrophic if Congress doesn't increase Uncle Sam's credit limit. Is he correct? Since 1917, Congress has allowed the Treasury the discretion to issue new debt (i.e., borrow money from other agencies or individuals). Congress didn't want to completely give up its Constitutional requirement to control the purse strings, and so it set a cap on how much total debt the Treasury could owe at any given time. Currently the statutory debt ceiling is $14.294 trillion. As of January, the actual debt stood at slightly more than $14 trillion.

Geithner and other spokespeople for the executive branch argue that the world will end if Congress doesn't give them permission to run up more red ink. In particular, they claim that without the ability to borrow from new lenders, the Treasury won't be able to meet its existing obligations, including interest and principal payments on already-existing debt. The government will shut down. This is not true. If the debt ceiling is not increased, the Treasury can prioritize interest and debt payment to avoid a default and essentially put the government on a stringent pay-as-you-go basis.

Repudiating government debt eliminates future tax liabilities. To the extent that people correctly anticipate those future taxes, a reduction in them should increase the value of private assets (including human capital) over the long run by the same amount that the value of government securities falls. Thus, people will gain or lose depending how closely their wealth is associated with the State. If on the other hand, people underestimate their future tax liabilities, they suffer from a fiscal or "bond illusion" in which Treasury securities make them feel wealthier than they actually are. Debt repudiation will bring their expectations into closer alignment with reality, which should increase saving.

Raising the debt ceiling will not staunch default – just change the form of default. Default will occur either explicitly by reneging on payments, or implicitly by massive inflation — at some point anyway in the next decade or two. The increased debt will be monetized and the increased money supply will lead to inflation at some stage. This is the problem of fiat currency and with the Federal Reserve. They are stealth tax collectors. The danger of fiat currency is invisible to the public, professional investors, and political commentators. The collapse of the economy in 2008 permitted the Congress and Bush and then Obama Administrations to authorize an unprecedented quantity of government spending, which has been and will be funded in large part by trillions of freshly minted fiat currency. There can be no question that this is a seizure of wealth roughly equivalent to one year’s collection of income tax, yet there is more outcry over making a trivial increase in the topmost bracket from 35 percent to 39.6 percent.

So rather than allowing the stealth tax increases, I support not raising the debt limit and forcing Congress and the Administration to choose how to cut spending or raise taxes.

Five Books

I love this site - frequently postings of 5 interesting books on a wide variety of topics - I strongly recommend RSS or following.

A representative example is this post by Robert Schiller

http://thebrowser.com/interviews/robert-shiller-on-human-traits-essential-capitalism?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+Fivebooks+%28FiveBooks%29&utm_content=My+Yahoo

The Bigotry of the Literati - Ludwig von Mises - Mises Daily

Great read that is a superior analysis of what Sowell, Hayek and others have observed about the hubris of elites and, more disquieting, the success that elites have had in "shaping" the message via dominance in many media channels, particularly pop culture. Think here of Hollywood as exemplified by the Daily Show (I do love Jon Daily, but I fear many do not fully internalize that he is a comedian and not a news source).

The Bigotry of the Literati - Ludwig von Mises - Mises Daily

Dollar as reserve currency

I received an e mail from a friend asking about the status of the dollar as the world's reserve currency.

My reply is below:

Great to hear from you and you flatter me - we all have opinions and I am not certain mine is worth any more than anyone else's - particularly predications of the future. I suppose the recent Businessweek article might lead to reasonable questions about the future of both the value of the dollar and the status of the dollar internationally.

That said, in the immediate and intermediate term there is little chance that the US dollar will lose its status as the world reserve currency.

1. What is the alternative? The problems in Europe, particularly in the areas you outline in debt and inflation potential are more severe than in the US.

2. Political and economic stability. While the US faces grave threats, the stability of our institutions is far greater than any other country in the word. Douglass North makes a convincing argument for this in Violence and the Social Orders.

In 2009 the FT had a nice piece that observed

http://www.ft.com/cms/s/0/9df9b2c0-4eda-11de-8c10-00144feabdc0.html#ixzz1C3AzPOaE

A leading Chinese financial official on Monday rejected suggestions the US dollar could be replaced quickly as the global reserve currency, as US Treasury secretary Tim Geithner arrived in China on his first official visit.

“In the short term I don’t think we can find another currency to replace the US dollar,” said Guo Shuqing, chairman of China Construction Bank and former head of the country’s foreign exchange administrator. “The US dollar is the main currency because their economy is number one in terms of competitiveness, in terms of innovation.” Speaking in an interview with the Financial Times, Mr Guo also raised doubts about a proposal from China’s central bank governor, Zhou Xiaochuan, to replace the dollar with a “super-sovereign reserve currency” based on special drawing rights issued by the International Monetary Fund.


3. Ironically, the large levels of US soverign and private debt held by foreign holders - both states and private companies and individuals provides a strong incentive to retain the dollar. Any movement away from reserve status would so devalue the dollar as to reduce the value of these US denominated assets (and in the short run would be a huge windfall for the US government).

Longer term - the dollar will be replaced just like the dollar replaced the pound, the pound replaced gold, and gold evolved over time. The question is when is the long term and no one knows. The pound was the reserve currency for over 100 years, gold for 4 centuries so perhaps the 65 year run of the dollar is nearing a conclusion. But see comment 1 above - there is no replacement and holds of wealth and liquidity are loath to move to a new currency unless there are strong compeling reasons - negative for the dollar and positive for the new currency.

Last year UYS Today (they actually do a nice job of short summary) did a nice piece

http://www.usatoday.com/money/economy/2010-03-12-dollar12_CV_N.htm

For a more detailed overview that I see as objective and with which I tend to agree

http://www.investorsinsight.com/blogs/forecasts_trends/archive/2009/10/20/will-the-us-dollar-lose-quot-reserve-currency-quot-status.aspx

I'll turn it around, if you are the leader of Saudi Arabia or the dictator of China - which currency would you hold if not the dollar?

Now, the debt issue to which you refer, this is the major threat to continued US economic growth and the difficulty that our elected officials have had over the past 20 years in formulating a response is of much greater concern to me in the short and intermediate term. I know you are familiar with Pete Peterson and the Peterson Institute and his research agenda and advocacy should be heard and considered by Americans and our elected officials. The failure to do so echoes the late stages of the Roman and Ottoman Empires and inertia will make life very, very challenging for our children.

The Nordic Welfare State

Boyes writes of the differences in approach toward economic welfare and policy in Sweden v the United States.

Last week on the 17th I blogged on what appears to be, at least at the level of rhetoric, an awareness on the part of some leaders of the escalating cost of the welfare state here in the United States. President Obama's State of the Union last night repeated some of this rhetoric and there were a number of proposals that, while made under previous administrations of both parties (simplifying the tax code, ending earmarks, reducing military and discretionary spending) that make sense. It remains to be seen whether this change in rhetoric translates into any meaningful change in fiscal behavior. I have my doubts and, as Bob Higgs recently reiterated, this administration, like those before it of both parties, continues to foster regime uncertainty. This regime uncertainty has accelerated in the US and, while I am not the most informed observer of Sweden, it would seem that regime uncertainty in that country has declined at the time that US entrepreneurs and actors face in ever changing rhetoric and unknown future government policy and action.

There has been a clear change in fiscal behavior in Sweden.

Last semester, through a bit of luck, I had a young Swedish hedge fund manager speak to my introductory classes. He graduated with undergraduate and graduate degrees in economics from the University of Stockholm and outlined for my class the formal and informal institutions in Sweden, which he contrasted with those in the United States.

The Nordic countries, and Sweden in particular, have reacted to economic events over the past decade an a much different manner than the United States.

In contrast to the exploding deficits and debt in the US, Sweden has instituted a number of measures to move toward a projected budget surplus in 2011.

"The Swedish economy appears to be stronger than in our previous forecast (in June), in particular in 2010. The recovery in Sweden has been stronger than in the euro area and the United States," said the National Debt Office, which is the government's financial manager.

Sweden is now expected to post a budget deficit of just five billion kronor ($726 million) this year, down from the previous forecast of a 14-billion-kronor deficit, the debt office said in a statement.

"The budget is thus almost balanced. This strong development continues in 2011 and 2012 when the forecast indicates a central government budget surplus of 18 billion kronor and 78 billion kronor respectively," it said.

Click here http://www.thelocal.se/30252/20101116/ for the full analysis.

The divergence in approach between the Nordic countries and much of western Europe and the United States is reflected in current and projected economic macro indicators of growth, employment and associated measures of economic welfare.

Click here http://www.imf.org/external/pubs/ft/weo/2010/02/weodata/weorept.aspx?sy=2005&ey=2012&scsm=1&ssd=1&sort=country&ds=.&br=1&c=144%2C111&s=NGDP_R%2CNGDPRPC%2CPCPI%2CLUR%2CGGR_NGDP%2CGGX_NGDP%2CGGSB_NPGDP%2CGGXWDN_NGDP%2CBCA_NGDPD&grp=0&a=&pr1.x=40&pr1.y=6 to view an IMF comparison of reported data between the US and Sweden. For example:


Uemployment

-2005 -2006 -2007 -2008 -2009 -2010 -2011 -2012 Country

7.633 7.042 6.117 6.167 8.300 8.200 8.200 7.700 Sweden

5.083 4.608 4.608 5.817 9.275 9.730 9.589 8.846 USA

The United States leadership has been paralyzed by the approaching fiscal crisis, instead devoting attention to intervention in the market, increased regulation and a general hostility to the business community. This regime uncertainty certainly began in the adminstrations of the 1990s in both parties and accelerated during the Warfare and Welfare expansion of George Bush Jr - think the "conflicts" in Afganistan (our longest lived "war") and Iraq as well as the massive increase in government intervention in the health care market through the Medicare drug fiasco.

This regime uncertainty, unsurprisingly, has continued under the current administration.

On the other hand, it appears that there is considerably less regime uncertainty in Sweden - both the people and leadership seem to reflect a commonality and contentment with government action which as indicated by the macro statistics in the link above (which are reflected in the unemployment figures I pulled out of the report).

More importantly, the fiscal positions of the two countries are moving in opposite directions:

Central government budget close to balance in 2010

The Swedish central government payments resulted in a deficit of less than SEK 1 billion in 2010[1]. The budget is therefore practically in balance. It is a big improvement compared with 2009. This is due to the strong recovery in the Swedish economy, which led to higher tax income, while expenditure growth was moderate.

http://thomsonreuters.acnnewswire.com/article.asp?art_id=41046&lang=1

Note that Sweden's per cent of debt to GDP is in the dark grey = 11-30% while the US is in the light pink (appropriate) 51-70% and growing.

Click on the image below to view the entire world.




So, while Sweden does in fact have a much larger state presence on the fiscal side, why has that country been relatively more successful in managing fiscal accounts? This seems to call into question the notion that economies that are more mixed and less statist respond to economic conditions in a more efficient manner and generate stronger economic performance and resulting welfare measures.

The Swedish speaker last semester suggested a number of key differences between our two countries - Sweden is much smaller and more homoegeous. Further there are a set of informal institutions - beliefs, norms and ethics that privilege egalitarianism and equality.

Taking the first, the smaller geographic area and population of Sweden may allow for a more efficient government - that is there are diseconomies to scale to provision of public goods. I am speculating here based upon my reading of Alesina's The Size of Nations.

A smaller society and state can, perhaps, react more quickly that then large and heterogeous United States. Perhaps this issue of size allows for more rent seeking in the United States which seems tohinder changes in fiscal policies - Sweden, on the other hand, has been much more reactive to the threat of budget deficits and high levels of debt.

The informal institutional framework of the two countries is much different - the norms and beliefs in Sweden seem to be in congruence with an active welfare state that provides a broad safety net. Such a consensus of opinion does not exist in the US, on virtually anything.


That said:

The World Bank ranks Sweden 18th in “ease of doing business” and 43rd in “ease of starting a business” in 2010. Starting a business in Sweden takes 15 days and costs 0.57% of GNI per capita.

The World Bank ranks US 5thin “ease of doing business” and 9th in “ease of starting a business” in 2010. Starting a business in the US takes 6 days and costs 1.4% of GNI per capita.

So, while the US had a clear advantage in ease of starting a business, in an unexpected stat, the US is almost 3 times as expensive in the cost of doing business.

Finally, perhaps due to size and philosophy, Sweden, for whatever this means, has a higher GNI per capital GNI Per Capita (US$) 48,930.00 to GNI Per Capita (US$) 47,240.00 in the US.