Asymptosis

Scott Sumner nods with approbation toward this Ychuan Wang post at Noahpinion. For which hat tip I must thank him because Wang so clearly explicates what he calls the “canonical” understanding, and illustrates so perfectly the wackiness and incoherence of of the Walrasian view:

Prices don’t always adjust instantly, so we can have excess supplies and excess demands. However, economists do have a way to constrain what this non-clearing state looks like. In particular, according to Walras’ law, assuming everybody spends all of their wealth, if there are excess supplies (i.e. too much produced) in some markets, then they must add up to excess demands (i.e. too little produced) in other markets. In other words, even if supply does not equal demand in each market, supplies must add up to demands across markets.

The requirement that everybody spends their endowment is crucial. It means that Walras’ law doesn’t apply just to the market for apples. Not everybody spends all their wealth on apples. Instead, some people may put their wealth into money. But once we include the money market, we do have the condition that everybody spends their endowment, and therefore Walras’ law does apply to the entire macroeconomy of apples and money.

In case you missed it, the legerdemain here hinges on the word “spend,” and on the hidden assumption that “spending” on stock or bond purchases is equivalent to spending on carpenters or clams. (I sure wish “oyster” started with a C. But the clam/dollar thing is a nice play…)

Wang doesn’t seem to understand some basic facts about national accounting. Viz:

Purchases of financial assets (including existing homes) don’t count as “spending.” Those are asset swaps, and are not included in the national accounts.

“Investment” in financial securities is not the same thing as (has a quite vexed and complex relationship to) real investment spending on drill presses and such as tallied in the national accounts. It’s not “spending.”

If people use all their income or wealth to buy bonds, they are not “spending” all that money.* So Wang’s stated precondition for Walras’ law to be true is not met. So Walras’ law does not apply to the entire macroeconomy of apples and money.

* Though many will seek to convince you that it is effectively so, all worked out by the magical, instantaneous, Walrasian auctioneer. This is equivalent to the widespread fuzzily held belief that when you purchase a share of Apple stock, that money is instantly funneled into real investment.

Cross-posted at Angry Bear.

Unlearning Econ:

The story goes like this: an Israeli day care centre found that parents were picking up their children too late, so they introduced a small charge of $3 to try and disincentivise lateness. However, instead of discouraging this behaviour, the payment served to legitimise it and buy the parents piece of mind. The result was that lateness actually increased. Bizarrely, the Freakonomics duo decided that this story is consistent with economist’s way of thinking, and used it as an introduction to the idea that “incentives matter”. They argue that people actually face three different types of incentives: economic, moral and social. The idea is that the charges “substituted an economic incentive for a moral incentive (the guilt)”, with the implication that the daycare centre simply didn’t get the amount right. However, if this were true, treating guilt would be as simple as paying somebody that you had wronged.

The way people respond to incentives is in fact highly complex and unpredictable. Incentives that are too big or too small can have perverse effects. What’s more, how people will respond to any incentive depends on the perceived motives of the person offering it, and the implied motives of the person receiving it. Studies show that incentives can easily backfire if these motives are questionable, something that has had an impact on the field of organ donation: when people were offered money for donating, donations decreased. People simply no longer felt that they were helping people, only that they were making a bit of money. The Freakonomics guys do not engage with any of these well established psychological tendencies; they simply select three arbitrary and incommensurable concepts and proceed as if their analysis were obviously true.

It’s only obvious to a thirteen-year-old boy who knows that he’s being “objective.”

“Incentives matter” is just used as a claim and a rhetorical hammer: “I, clear-eyed, objective realist that I am (unlike all those fools out there), understand all the incentives that are at play here, which ones are important, and how they interact. See? It’s obvious.”

Even Buchanan understood this, intermittently…

Cross-posted at Angry Bear.

DIN. We should print up lapel buttons.

I suggested this campaign some time ago:

This would:

• Transfer relative purchasing power (hence power) from holders of financial assets to holders of real assets — from Wall Street to Main Street — and from (relatively few) creditors to (many more) debtors.

• Spur both consumption spending and investment spending (on real assets) by individuals and businesses — driving our economy toward its full capacity and employment potential.

• Deflate the country’s massive overhang of under-collateralized business, personal, and government debt. (Debt that is not backed up by sufficient quantities of real assets.)

If managed properly, it could even result in wages rising as fast as prices (or even — pas possible! — faster) without the dangers of the bogeyman “wage-price” spiral (of which there is zero sign at this time).

Read Ryan here:

Business cycles: Demand more inflation | The Economist.

Cross-posted at Asymptosis.

No, not that kind of “special.” Though it sure is tempting…

Paul Krugman, Scott Sumner (seemingly unlikely bedfellows, but…), and most other mainstream economists want to argue that banks are not special — that there’s no reason for economists to understand and analyze their operations in detail, or incorporate those understandings in their (mental and formal) economic models.

Their essential position is that borrowers’ and lenders’ incentives and reaction functions are symmetrical, interacting opposites. (This is the very essence of the Krugman/Eggertsson 2010 patient/impatient-agents paper.)

Either:

1. Banks are transparent intermediaries between real-sector lenders (“savers”) and borrowers.

Or:

2. The machinery of market portfolio allocation (i.e. as described by Tobin) allows us to model the economy as if #1 were true. cf. Krugman/Eggertsson.

So, in Steve Randy Waldman’s words, “Everything that matters is captured by the portfolio preference of nonbanks.” We can ignore the banks.

Steve, Cullen Roche, Scott Fullwiler, and many others suggest otherwise (and at length) — that banks are special and that it is necessary to model that specialness.

I’d like to explain, in brief, why they are special:

Banks aren’t optimizing intertemporal consumption preferences. Unlike real-sector actors, when banks lend they’re not “saving.” The incentives and reaction functions of the economy’s dominant lenders are completely orthogonal to those of the economy’s borrowers.

Now you could argue (back to #2, above) that the inexorable forces of the financial markets force banks (at least in aggregate) to act as if they were optimizing intertemporal consumption preferences (for their borrowers? their shareholders? their lending officers? their directors? their creditors? their depositors?). But I think many will agree that that argument is quite a stretch.

If economics, as I have suggested, is ultimately the study of human (individual and group) reaction functions, it seems irresponsible and misguided to ignore the incentives and reaction functions of some of the most powerful and influential actors in the economy, simply brushing them under the rug.

Mainstream theory tells us we don’t need to understand how banks work. To understand why that theory is wrong, you need understand how banks work.

Cross-posted at Angry Bear.

Says John Aziz, “Economics, broadly defined, is the study of human action and interaction.” Which reminds me to post this, which has been long brewing in my head.

More carefully and precisely defined, I posit the title of this post: Economics is (should be) the study of how individuals and groups react to changing circumstances (which circumstances include the reactions of others and other groups).*

The old saw is that economics is the study of scarcity. But that’s insufficient; it also studies abundance and surplus. How do people and groups react when there’s a bumper crop of corn? How do bankers react (individually and in aggregate) when there’s a superabundance of bank reserves?

Calling economics the science of scarcity inevitably turns attention to competition, even while some economists will acknowledge in passing that cooperation is a darned good adaptive response to scarcity as well — what got us to the top of the food chain, no?

If this focus on reaction functions is safe, it adds another voice to the question that many have asked: why has Kahneman and Tversky’s Nobel-prize-winning Prospect Theory been so studiously ignored in mainstream economists’ models? Why is the discipline devoted to armchair-theorized models, instead of studying what people do in the field? Why isn’t economics a true social science? (Yes, there’s a lot of that kind of work; but tenure at prestige institutions and publication in the big journals is all about mathematical models, not field research.)

At the very least, to quote the ever-sage Yoram Bauman (from memory): economists should be spending a lot less time on price theory and a lot more time on game theory.

* Group and individual reaction functions are obviously very different. If you know a bird’s flocking reaction functions (if you’re on the outside and the bird next to you moves away, follow it), you don’t necessarily know how the flock will behave and react.

Cross-posted at Angry Bear.

Gentle Readers: I remember learning many decades ago that Fama and French’s seminal research had demonstrated that very few trades and very few traders are necessary for a market to achieve “efficiency.” (Either strong form — “the price is right” — or weak form — “individual traders can’t tell if the ‘the price is right,’ so can’t beat the market.”)

But I’ve searched multiple times, and have been unable to find this research. Can anyone give me pointers?

It can be tough to articulate a cogent argument against high-frequency trading in the context of highly liquid, efficiently functioning securities markets, but I think Rajiv Sethi has done so (riffing off Michael Lewis’s typically scathing and revealing article on Goldman’s recent bad behavior).

In brief, in my words:

1. Value investors are trying to buy shares in truly productive firms, which activity indirectly, over the long term, allocates real resources to those firms. This is A Good Thing.

2. When these investors trade in any volume, those trades are broken into multiple batches. A buy order for 1,000, 10,000, or 100,000 shares rarely finds a single sell order for the same amount at the same time.

3. A micro-instant after the buy order appears, HFTers jump in front of a bunch of the value investor’s trades, pushing up the price that the value investor pays.

In Sethi’s words:

their private information is effectively extracted early in this process

Here’s his explanation at more length, emphasis mine:

Effective prediction of price movements, even over such very short horizons, is … essentially a problem of information extraction, based on rapid processing of incoming market data. The important point is that this information would have found its way into prices sooner or later in any case. By anticipating the process by a fraction of a second, the new market makers are able to generate a great deal of private value. But they are not responsible for the informational content of prices, and their profits, as well as the substantial cost of their operations, therefore must come at the expense of those investors who are actually trading on fundamental information.

It is commonly argued that high frequency trading benefits institutional and retail investors because it has resulted in a sharp decline in bid-ask spreads. But this spread is a highly imperfect measure of the value to investors of the change in regime. What matters, especially for institutional investors placing large orders based on fundamental research, is not the marginal price at which the first few shares trade but the average price over the entire transaction.

Since value investors have no choice but to place buy and sell orders that HFT algorithms can see and react to instantly, they are inevitably giving away  their private value/fundamental research for free to the HFTers. They can’t not. This inevitably (incentives matter) results in less fundamental research, so poorer allocation of resources.

The HFTers aren’t paying the cost of that externality.

If you’re looking for solid economic, theoretical, justification for a Financial Transactions Tax, I don’t think you’ll do much better than this one from Sethi.

Cross-posted at Angry Bear.