On Economics Education

One of my favorite economics stories relates to textiles in New York City.  Decades ago the big apple was a major hub of the textile industry. The government wished to promote the industry further and therefore changed the depreciation schedule for textile machinery, thus reducing their tax burden.  This then led to firms purchasing far more machinery due to the favorable depreciation rates.  However, as factory floor space to house the machinery was prohibitively expensive in New York the firms quickly moved out of the city in order to have room for their new machines.  Thus, a tax modification meant to promote a healthy industries growth ended up driving it out of a city completely.

This is the sort of story that economists are bred upon.  Tales of unintended consequences adorn the syllabuses of economics professors in universities throughout the nation.  Yet, at times it's difficult to find what real world application such stories hold.

Let's back up a moment and talk about what economics does right.  Firstly, any decent economics program is going to expose students to a large variety of mathematical tools.  These tools are useful for solving an enormous variety of problems from profit maximization to crafting employee benefit packages.  This portion of economics curriculum is beyond reproach.

Secondly, economics programs generally offer highly specialized courses such as healthcare economics, economics of technology and innovation and labor economics which delve deeply into how economics is applied to certain topics or industries. These classes in general are useful and informative for someone going into a specific field.  For example, healthcare economics details how hospitals function, important regulations regarding hospital construction, different insurance methods, how insurance functions, the difficulties that arise due to insurance, etc.  These are all clearly topics that a hospital administrator or insurance executive would find applicable to their work.  However, these courses generally don't translate well into other arenas.  Health insurance and auto insurance do share some similarities but it's difficult to make a case that auto insurance leads to massively higher auto collisions whereas it's relatively easy to show health insurance leads to massively higher healthcare costs and utilization.  Similarly hospital construction regulations have little to do with monetary policy or unemployment rates.

Economics programs also effectively promote critical thinking skills.  Our textile story given above endeavors to this end.  A professor may present the first part of the story to the class and ask, "What are the expected ramifications of accelerating the depreciation schedule for machinery?"  A student will correctly answer that accelerating the depreciation rate will encourage firms to buy more machinery.  Then the instructor reveals the unintended consequence of the change thus demonstrating that policy makers must think beyond the obvious ramifications of their decisions. Hopefully students learn that sound policy decisions must be thoroughly examined for any potentially unwanted repercussions.

But herein lies the difficulty, we give no context from which to draw conclusions. Give an enthusiastic economics student a real world problem and they'll likely be able to give you a great deal of useful information.  They'll very correctly tell you that universal healthcare eliminates the problems of adverse selection while likely increasing healthcare utilization, but their conclusions regarding whether the Affordable Care Act will help reign in healthcare costs will likely be based on which news channel they watch.  They'll accurately inform you that a depreciation of Greece's currency would greatly improve their global competitiveness, but they won't be able to tell you if Greece would be better off leaving the Euro.  Economists cultivate a great deal of skill identifying the direction of different forces acting upon individuals, firms and economies.  However, we often fail at identifying which force is greater.  Only historical context can inform such questions and it is a topic often ignored in economics education.

Largely this is due to the fact that economics is an ever changing field in an ever changing world.  Why discuss the tulip bubble of the 1600s when we can demonstrate similar lessons from the more recent housing bubble?  For the most part this logic holds up. The housing bubble is more recent and generally more relevant to the economy of today.  However, there are differences between the two events which make both worth study.  Tulip bulbs for example were mostly sold during only four months of the year with transactions during the rest of the year taking place in a futures market.  Additionally, tulips were easily traded, more than quadrupled in price over the space of under six months before eventually collapsing, and had little intrinsic value.  In contrast homes and mortgages are sold year round, are often complex to buy or sell, took far longer to rise in price and are always worth at least the land they're built upon.  Which bubble is then a more apt comparison to the recent rise of the bitcoin market?  Inherently valuable, real world real estate or popularity based, easily traded tulips?

A stronger tie to historical examples would help economics students draw conclusions of what was likely to happen in similar modern scenarios.  It would provide a basis to draw from which can then be modified by the application of critical thinking. However, the current paradigm of teaching students to speculate all the potential ramifications without giving a mechanism to reduce those ramification into a final conclusion leads to a lack of applicability in practice.

That's all for this week. Until next time stay safe and rationale. 

A Five Year History

It's been over five years since the heart of the financial collapse.  The cleverly named "Great Recession" sits well behind us and the economy seems well on it's way towards recovery.  Yet, it's often difficult for individuals to get an idea of what direction the economy is trending.  A variety of groups try to promote the economy as either flagging or healthy depending on their own political agenda. In hopes of bringing a little clarity to the issue here are some unbiased metrics of our progress over the past five years.

Unemployment

Before the financial collapse US unemployment levels were on the decline from 6% and bottomed at approximately 4.5%.  The collapse cause unemployment levels to rise rapidly to nearly 10% in late 2009 to early 2010.  Since then unemployment has fallen to current levels of 7.3%.  

Clearly we're still well above the low unemployment that was enjoyed in the mid 2000s.  However, seemingly we've made it almost half way back to where we were before the fall of Lehman Brothers.  While, the declining rate does seem encouraging there is a large caveat.  Approximately 3% less of the American public is working or attempting to find a job as compared to 2008.  Thus although less people are unable to find a job, less people are trying as well. Therefore the decrease in the unemployment rate is not quite as positive as it first appears.

GDP

Between 2008 and 2010 the US experienced negative growth in five out of eight quarters.  In the subsequent twelve quarters (including projections for the current quarter) the US economy has retracted one quarter, experienced essentially no growth one quarter, and grown at a rate of over 1% for the remainder.  

This amounts to rather unequivocally positive news.  In comparison France has had growth rates of under 1% in nearly every quarter over the same period including several periods of negative growth. Australian growth rates have been largely positive but again under 1% for the same period and Japan experienced growth rates over 1% in seven out of twelve quarters (again with several quarters of negative growth). In comparison to other developed nations the US has shown comparatively strong growth over the past three years. 

Arguably the strength of recent US growth is in large part due to the depth of the plummet in 2008 and 2009.  As the US economy suffered far more during this time period it is not unreasonable that regression to the mean would appear as a strong recovery.  There is merit to this idea, however the reason for the recovery is irrelevant when attempting to establish the state of the economy in comparison to itself five years ago. 

Inflation

The most commonly cited indicator of inflation or deflation in economics is the consumer price index.  The CPI is an attempt to measure price levels of a general basket of goods.  If the price levels of these goods rapidly rise than inflation is thought to be a problem. Similarly if the prices rapidly fall than deflation is a concern.  Many groups have attempted to make a case that the governments current loose monetary policies would lead to a runaway inflationary spiral.

Although current monetary policy remains very loose (meaning the cost of money is very low and the supply very high) there is no evidence that inflation has risen to levels that are cause for concern.  Going forward continued monetary easing may or may not lead to inflation. However, at this point inflation rates are not alarming and are in fact essentially where economists would hope they would be.

Summary

Overall the US economy seems to be on the path to a slow but consistent recovery. Changes to the countries health care system are the largest looming issue but otherwise little gives cause for real concern in the near future.  Especially in comparison to most other developing counties the United States seems to be doing well.  Consumer confidence remains lower than mid 2000 levels but has been trending upward since 2009 and if trends continue will return to pre crisis levels around 2015.  

While caution is always wise, particularly during a delicate recovery, there seems to be more reasons to be bullish than bearish.  As always the political climate could send trends askew, but failing that my expectation is that economic indicators will continue to show improvement.

That's all for this week. Until next time stay safe and rationale. 

Prudent Investing

If there is one piece of advice you take away from this posting I hope it's this: go play Chartgame.  It plays in your browser without any downloads and the experience will be more impactful than anything I could possibly say.

Chartgame is a simplistic game wherein you're presented with a random stock chart from the S&P 500. You must then predict whether the stock will go up (buy) or down (short) based on the stocks historical chart.  Your result is compared to a standard buy and hold strategy. Even understanding how little predictive power is inherent in historical price data I was amazed by how inaccurate my guesses were.

Chartgame illustrates a principle that many people refuse to believe. Trying to "time the market" is just dressed up guessing.  Stock charts are nice to look at but bring little actually useful information to a trader.

Recently, a study published in Neuron indicated that a highly activated dorsomedial prefrontal cortex while viewing asset activity during a bubble is significantly correlated with being tempted into investing during the inflated value period.  To quote the author of the study Camerer, "The data suggest that during financial bubbles, participants are taking into account the intention of other players in the market(or of the market as a whole) while updating their value estimates, and that this effect is mediated by the interaction between the dorsomedial prefrontal cortex and ventromedial prefrontal cortex."  Or in other words, those who are more likely to attempt to extrapolate what others are thinking are also more likely to be tempted by financial bubbles. 

The science of Camerer's work is excellent.  While his research is unlikely to make you rich, it may help keep you from losing your shirt.  Here are the important lessons to take away.  

1. Too much information can be harmful.  Sound investment should be done on the basis of fundamental data, not on the behavior of others.
2. If you're prone to attempting to figure out what others are thinking, be particularly cautious of financial bubbles.  
3. Try to isolate your investment decisions from past performance of an asset. Performance can be informative in context (for example if a company began to perform poorly after a management change) but should not be the basis of a decision.  

It's interesting to note that attempting to figure out other trader's strategies is often, but not always harmful.  For example, Bruguier has shown previously that individuals who can better derive others intentions are also better at detecting insider trading and act more cautiously in markets with information asymmetries. 

Camerer's article is available for free here. Notably Camerer was recently granted a MacArthur "genius" award for his contributions to understanding financial behavior.  

That's all for this week. Until next time stay safe and rationale.