Tuesday, August 11, 2009

Biology's Tweak of Adam Smith

July's Scientific American carried a fascinating article "The science of economic bubbles and busts" that summarized current biological research into the economic irrationality of human behavior. At the risk of boring readers whose coverage extends to biological research literature as well as the Wall Street Journal, I thought it worth exploring its implications for how a well-managed economy should be set up. Current institutions, in any case not Adam-Smith-optimized, may need some new tweaks.

Both for biological reasons and because of their millennia hunting woolly mammoths, humans have a number of hard-wired brain impulses that make them economically irrational. One example is money illusion, the impulse to believe they are getting richer when the value of money is declining through inflation. This turns out to be hard-wired into the brain in the ventromedial prefrontal cortex; a recent experiment at the University of Bonn demonstrated that the VMPFC lit up a brain scanner when the subject encountered a larger amount of money, even though its value was no greater. It can be mitigated by careful use of indexation, as was done in Chile, where since 1967 the central bank's "unidad de fomento" has mitigated money illusion even in periods of hyperinflation.

The greatest advance in biological understanding of economics is that economic rationality appears to be an illusion. Vast superstructures have been built upon the assumption of economic rationally, including notably the Efficient Market Hypothesis and all the trading systems, valuation models and investment management paradigms derived from it. As well as money illusion, economic actors appear to be prone to a number of biases. Confirmation bias causes people to overweight information that confirms their viewpoint. Availability bias causes the most recent information to be heaviest weighted. Hindsight bias causes economic actors to "rewrite history" believing for example that they had known all along that housing was a bubble. Finally, investors tend to herd in times of market optimism or pessimism; it becomes increasingly difficult to go against the flow.

A further finding is that happy faces cause investors to be more risk-seeking; thus the prevalence of optimists among stock and mortgage brokers. This column can thus make you richer in bubbles, by helping you to counteract excessive broker optimism!

Given biology's insights into economic behavior, there are some pretty clear policy implications. First and foremost, if investors are biologically wired up to undergo money illusion, it is not surprising that easy money monetary policies are popular. By endlessly inflating the money supply, easy-money Fed Chairmen Alan Greenspan and Ben Bernanke can make the populace doze in a sea of warm contentment, undermining the economy year by year but preserving their own political credibility and preventing major criticism from Congress.

The same is true in Britain also, where even in the face of a recovering economy, the Bank of England has added another 50 billion pounds to its monetization of the British budget deficit, taking its total to 200 billion in less than 6 months. Even taken over a year, the bank is now monetizing over 30% of British public spending, or 13% of Gross Domestic Product (GDP). Over the last six months, it has monetized 60% of public spending. That's a higher level than the 50% monetization of public spending undertaken by the Weimar Republic in 1919-23 and the result will be the same.

In Britain's case, the Bank of England seeks a quiet life from the current government, which is on its last legs and facing a General Election within a year that it is very likely to lose. In the U.S. case, Bernanke wants to get his Fed chairmanship extended beyond January 2010 from an administration that did not appoint him. In both cases, a sloppy monetary policy that devastates savings, rewards shysters on Wall Street and eats away at the foundations of the economy is by far the most popular course. Paul Volcker, the only chairman in Fed history to run an adequately tight monetary policy, is well respected and indeed included in the Obama administration, but his advice, sound on most matters, is conspicuously ignored.

If sloppy monetary policy is inevitably popular, yet economically damaging, it follows that mechanisms need to be designed to prevent the seductions of money illusion, and ensure that monetary policy is kept adequately tight at all times. The Reserve Bank of New Zealand's 1988 idea, of tying the Governor's salary inversely to inflation, so that if prices rose more than 2% he suffered a devastating pay cut, is the kind of incentive structure the system needs. If the Fed does not naturally follow a Volcker policy, and biology suggests there are very good reasons why it does not, then the Fed's statutes must be rewritten so that a Volcker policy is unavoidable.

Far from extending the Fed's remit towards banking supervision, its field of operations must be narrowed, with the employment objective removed from its policy goals, so that its only job becomes that of maintaining monetary stability, following as closely as possible the monetary path that would be dictated by a Gold Standard. Just as a man with tendencies to alcoholism is prescribed a regime of strict abstinence, so the discovery of tendencies towards inflationism in our society means monetary teetotalism must be written into the Fed's statutes, with backsliding and compromise strictly prohibited.

Counteracting naturally occurring biases is also essential. In the case of confirmation bias, policymakers need to be presented repeatedly with information that counteracts their preconceived ideas. The best example of this is Bernanke again. When presented with inflation figures; he switches between different reported statistics, always manages to find one that justifies him in lowering interest rates, and in his belief that the demon of deflation is perpetually lurking nearby.

In their early years after World War II, economic statistics such as GDP and inflation were presented with as much accuracy and straightforwardness as possible. Since their publication did not affect the real world much, the pressure on their producers was modest and so they were generally reliable.

That changed with the inflation scare of 1979, which spooked the bond market and forced the resignation of Fed Chairman G. William Miller and his replacement by Volcker. For a number of years after that event, both inflation and money supply statistics were watched like hawks by bond market economists, and so no fudging was possible. Then in 1993, Greenspan abandoned monetary targets, allowing broad money supply to expand rapidly.

Since politicians also liked rapidly expanding money supply and low interest rates, they "fixed" the price statistics in 1995-96 through the Boskin Commission, inventing the fictitious "hedonic pricing" by which improvements in computer processor power speeds were allowed to feed through directly into lower price indexes. As a result, GDP was inflated, inflation was reduced, reported productivity growth was inflated and the U.S. Treasury began to issue Treasury Inflation Protected Securities based on the new index, confident that bond market investors would accept their inflation protection as genuine.

That tweak of official statistics was so successful in deifying Greenspan and re-electing Bill Clinton that official statistics have been unreliable ever since. They are always likely to be "fudged" generally by modest amounts, to make them more politically palatable. Currently, Bernanke's zero interest rate policy is being propped up by "spurious "seasonal adjustments" in consumer price indexes that deflate "seasonally adjusted" reported inflation figures below the raw data. GDP data over the next few quarters is also likely to be massaged so as to be politically convenient to the Obama administration's preferred narrative.

The combination of fudged statistics and confirmation bias among loose-money-loving policymakers is truly deadly, we will probably need true inflation in double digits for a year or more before interest rates are increased sufficiently to address it.

Availability bias, by which the most recent information is most highly weighted and hindsight bias by which we convince ourselves that "we always knew that," have also been ubiquitous during this economic downturn. Home mortgages that were considered perfectly sound until 2006 are now believed to have been obviously a scam. Dean Baker of the Center for Economic and Policy Research is very good on this subject, questioning why economists, journalists and policymakers who were entirely oblivious of the housing bubble while it was in progress should now be taken as experts on housing.

The best cure for availability and hindsight biases is regular perusal of the conventional opinion of a decade ago. Beliefs that seem foolish now were taken as wholly obvious then, just as beliefs that seem obvious now will be regarded as laughable in 2019. With so much up-to-the-minute information available through the Internet, and pre-1995 information much harder to come by, this problem has become more severe in this generation. By reading the editorials of 2004, 1999 and 1984, we can remind ourselves what was believed by conventional wisdom at those dates. Through doing so, we do not simply enable ourselves to laugh at past shibboleths, but remind ourselves of past truisms that have been forgotten. Thereby we acquire a historical perspective on our economic activities, and are assisted to avoid those that make no sense.

As investors, we are particularly prone to make mistakes that are governed by our biology. We choose the popular, reinforcing our biases by doing so. We listen to the advice of our broker, always cheerful and upbeat about the market. In this respect, previous generations were much luckier. A dour conservative bank manager, rejecting risky ventures firmly and nagging his clients to save more, both gave better investment advice and interacted better with our biological failings than the cheery salesman we rely upon today.

We are also prone to overreaction to our recent investment performance, increasing our portfolio's risk at the top of bull markets and moving into cash when performance has been bad. My own preferred solution to this is to buy a few long-dated out-of-the-money put options on the S&P 500 index, available on the Chicago Board Options Exchange. These cost money in bullish or flat markets, but turn into a bonanza in market crashes. That serves two purposes. It reminds us after crashes that we didn't get everything wrong. And it provides a pool of cash that can be invested at the bottom, just when it is most useful.

Biology is our destiny. In both policy and our daily activities, we had better be aware of its demands, so that we can counteract them and make our world and our own actions more economically rational.

from the bear's lair, by Martin Hutchinson, August 10, 2009

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