On Liberatarian Paternalism 2 - Response to Trisco

Here are my comments on Trisco's "On Libertarian Paternalism" , which were too long to fit in the comments box. It just meant to be casual musings in reply to Trisco's question about economists and is in no way meant to be a serious post.

Nice reaction, Trisco! Good point about the apparent contradiction. I'll like to know more as well.

My thoughts on economists being closer to politicians than scientists: Could economists be “scientists" (I had to put quotes, sorry), who are biased to the extreme? It’s no secret in academia that *most* scientists aren't really interested in the nature of reality...if the nature observed is not the nature they *set out* to observe. i.e., a result is probably not worth pursuing in full glory if it doesn't agree with what they wanted to observe. Perhaps you will agree that this is more significant in industry research, but I digress. What is interesting is what happens when the effect observed is the effect proposed. Then even scientists in the fundamental sciences are extremely prone to *advocate* and *advertise* the effect - "e.g., trapped photons must behave similar to trapped electrons, so let us look for the effect there". Well, economists are scientists with extremely real-world problems with real world implications, and unfortunately, with their only true laboratory being the real world. Therefore, I imagine the tendency to advocate and push their models on the real world (hoping their proposed effect would happen) is amplified much more than in scientists in fundamental sciences: a. that’s the only way they can test it, and b. their theory might just save the world. Note that most scientists, regardless of how what they propose in their grants, understand the evolutionary, as opposed to the revolutionary, nature of their research; perhaps this is not so true in economics, thereby moving them closer to politicians?

Disclaimer: This is a very general statement trying to explain overall trends in behavior among scientists in different fields. So it is served with a grain of salt, please take it as such.

On Libertarian Paternalism

I'd like you to do me a favor. Read the following article by Richard Thaler, one of the authors of Nudge. It is a response to an academic colleague, Professor Whitman and Rizzo. The article is labeled a Reaction Essay, presumable because its a response to Whitman and Rizzo, but I had quite a reaction to it myself. Since Behavioral finance is part psychology, I almost wonder if he is referring to the reaction in readers. I'd like to hear about others reactions to this article. I've given mine below, but make sure to read the article before being contaminated by mine.

My Reaction
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I have to say, the ratio of insults to rational arguments is quite high here. This supposed reply might make Thaler feel better, but its not going to convince anyone who doesn’t agree with him. I don’t know what the rest of this discussion between thaler and whitman looks like, but this is certainly not the dispassionate rational discourse one would hope for between academics. Like the referee who seems to only see the retaliation, I might be laying blame on one side, when it belongs on both. Indeed, coming from a hard sciences background, I find it a bit disturbing. Thaler sounds more like a politician than a scientist…. Come to think of it, many noted economists sound more like politicians then scientists. I wonder why that is? (for some reason when I read this question it sounds rhetorical, but I mean it. Why do famous economists seem to view themselves, and behave more like politicians, than like scientists trying to explain the economic world?)

In fact his main claim, that “we call a policy paternalistic “if it tries to influence choices in a way that makes choosers better off, as judged by themselves.” (The emphasis is in the original.) ” is not only completely unsupported, but directly contradicted in his discussion of health care where he says there is no other choice, but for the choice architect to choose what SHE thinks is best for everyone. This is not surprising as its hard to imagine how a central authority/choice architect would be able to solve two apparently unsolvable problems and both read the minds of each individual and then nudge each individual in the direction they themselves would like to go.

I'd also like to point out that this definition is in contradiction to what I think most people would regard as the definition of good parenting. A parent make decisions that they think are best for their child, because the child does not know enough to make their own decisions yet. Later say in teenage years, a parent might guide instead of decide, but they guide towards what experience has taught them their kids will wish they had wanted ten years from now, not what they actually want now. (Hmm you know you'll meet just as many girls at college as you will on tour with your garage band...) I think why I and others react so strongly to the idea of libertarian paternalism, is that it implies that yet never comes. We are never really able to make our own decisions and we need help from our betters. How are those betters defined... Who get to do the nudging...

I find it hard to imagine how Thaler could so blatantly ignore what is supposedly the central point of the article. This is why I'm curious if I'm reading through colored glasses. Did I miss some support for this definition? If so, or if not, can someone even explain how it is possible to nudge each person to what they themselves want without a) mind reading and b) the number of necessary nudges being proportional to the number or people?

Dr. Trisco :P

By the way I came across the above article through the fabulous Simoleon Sense. A great content aggregater for behavioral finance and investing that links and previews more great articles and videos then one could possible read. Though somehow, I suppose Miguel, the man behind the site actually does.

Keynes Vs Hayek: Fear the Boom and Bust

I will try to fill in this post with a short explanation of the Austrian business cycle theory as some point. For now just enjoy this sweet rap video that explains it all better then I could anyway :P




PS: Here is a link to the people that made the video. Their cite contains some good background on these two economic giants including pod casts.

Check out this extremely interesting article on religion and it's impact on the economy:

Satan, the great motivator

Here is a tidbit that should interest everyone:

"... Their results show a strong correlation between economic growth and certain shifts in beliefs, though only in developing countries. Most strikingly, if belief in hell jumps up sharply while actual church attendance stays flat, it correlates with economic growth. Belief in heaven also has a similar effect, though less pronounced. Mere belief in God has no effect one way or the other. Meanwhile, if church attendance actually rises, it slows growth in developing economies."

If that doesn't motivate you to read the entire article, i don't know what will!

Frankly, banks own the place!

Some time ago, in a breathless freak-out over Bailouts (If I get to thinking about it, I practically hyperventilate with anger and frustration at the sheer multi-leveled injustice of it all, so lately I try not to.) I asserted that your congress and senate are bought and payed for. I gave you links to some undigested data to figure this out for your self.

Now straight from Senator Dick Durbin (D-IL):

"Frankly, banks own the place."

And from Collin Peterson, Chairman of the Agriculture Committee:

“The banks run the place. I will tell you what the problem is — they give three times more money than the next biggest group. It’s huge the amount of money they put into politics.”

If its not enough to hear it straight from the horses mouth, this morning on The Big Picture, I came across some truely great linkage (Seriously, read this and follow a few links!) that more obviously makes the case.

I would just like to highlight something:
This is not freedom. This is not laissez faire. This is not capitalism. This is people buying government interference on their behalf to protect them from competition and their own failures. If we want to keep our freedom, bailout can not be tolerated.

A few of my favorite bits:

Also here is a excel file with that shows how much TARP recipients gave to congress, with a calculation of their absurd return on investment.

The Bank Job: Part II

In the comments to The Bank Job, which by the way contains our first derivation (thanks Guy!), Dan was wondering, given the fractional reserve system, how do banks handle bank runs. He quite reasonably assumed that they took out insurance which is the smart way to handle high cost, low probability events. The following is my attempt to explain my understanding of the situation.

Your reasoning is quite correct. Insurance against this sort of thing would be prudent, and as long as you were talking about protecting against runs on individual banks, as opposed to the whole system, it could probably be written profitably. But your thinking suffers from a malady with which I am myself often afflicted. I haven’t quite nailed it down, but it’s something like the assumption, “if this is so obviously the way the world ought to work, it must be that way.”

Sadly, its not.

Banks have come up with a much better solution, from their point of view. In the event that they need more cash then they have, they have the Federal Reserve print it. It essentially comes out of all of our pockets through inflation. Now I’m about three books ahead of you in understanding this mess, so I’m no expert either, but here is roughly how it works. If a particular bank is in need of cash, due to withdrawals, they simply borrow it from other banks. If other banks don’t have it to spare, there is one Meta-bank. That bank is the Federal Reserve, which is tasked with being the lender of last resort. Since the FED, simply prints money it can lend all the banks need, completing the counterfeiting cycle by finally printing the cash we’ve all been pretending existed. Of course, as soon as people calm back down, and put their money back in the bank, this new money is considered excess reserves, promptly lent out, and ends up itself multiplied by ten.

Now in the event that a bank is technically bankrupt, that is its assets are less then its liabilities, as opposed to simply being short cash on hand, then it is taken over by the Federal Deposit Insurance Corporation or FDIC (a bank would be technically bankrupt if, for e.g., half the loans went bad, so now there are not enough loans supporting deposits). “A ha! So there is insurance.”

Well sort of. It works a lot like an insurance company, but is not insurance. Banks pay a premium of sorts, that is a fixed percentage of their deposit base. The difference between this and insurance is in the utter lack of even an attempt to avoid moral hazard. As Apos, could explain better than I, its important in any insurance contract that the insured retains some motivation to avoid the catastrophe being insured. For example with car insurance, not only would I hate to get in an accident, but I don’t even want to risk a speeding ticket, for fear that my premium will go through the roof. But with premiums depending only on the size of deposits, banks are encouraged to push risk to the limit to get their moneys worth. It would be like if my car insurance only depended on what the car cost… lets just stay I’d get places faster! If the FDIC insurance were instead allowed to be replaced with an insurance industry trying to earn a profit, risk in banking would be largely reduced, since lower risk would be reflected in higher profits, from lower premiums.

There is another important sense in which the FDIC is different from an insurance company. When the “premiums” are paid to the FDIC, they are deposited in the FDIC’s account at the Treasury. The government then spends the money and replaces it the IOU’s. I know I know sounds crazy! But here is it straight from the former FDIC Chairman William Isaac:

When I became Chairman of the FDIC in 1981, the FDIC’s financial statement showed a balance at the U.S. Treasury of some $11 billion. I decided it would be a real treat to see all of that money, so I placed a call to Treasury Secretary Don Regan:

Isaac: Don, I’d like to come over to look at the money.
Regan: What money?
Isaac: You know ... the $11 billion the FDIC has in the vault at Treasury.
Regan: Uh, well you see Bill, ah, that’s a bit of a problem.
Isaac: I know you’re busy. I don’t need to do it right away.
Regan: Well ... it’s not a question of timing ... I don’t know quite how to put this, but we don’t have the money.
Isaac: Right ... ha ha.
Regan: No, really. The banks have been paying money to the FDIC, the FDIC has been turning the money over to the Treasury, and the Treasury has been spending it on missiles, school lunches, water projects, and the like. The money's gone.
Isaac: But it says right here on this financial statement that we have over $11 billion at the Treasury.
Regan: In a sense, you do. You see, we owe that money to the FDIC, and we pay interest on it.
Isaac: I know this might sound pretty far-fetched, but what would happen if we should need a few billion to handle a bank failure?
Regan: That’s easy — we’d go right out and borrow it. You’d have the money in no time ... same day service most days.
Isaac: Let me see if I’ve got this straight. The money the banks thought they were storing up for the past half century — sort of saving it for a rainy day — is gone. If a storm begins brewing and we need the money, Treasury will have to borrow it. Is that about it?
Regan: Yep.
Isaac: Just one more thing, while I’ve got you. Why do we bother pretending there’s a fund?
Regan: I’m sorry, Bill, but the President’s on the other line. I’ll have to get back to you on that.

Once upon a time, there was indeed a segregated FDIC fund. During the Johnson Administration, someone had the bright idea to put the FDIC into the federal budget as a way to reduce the deficit. This was in the good old days when the FDIC always produced a surplus. Putting the FDIC on budget reduced the deficits being created by spending on the Great Society programs in tandem with the war in Vietnam.

The reality is that there is no FDIC fund. Anything the FDIC lays out to handle a bank failure must be borrowed by the Treasury, which adds to the federal deficit. The total amount of the current outlay is charged against the federal budget even if recoveries are expected in the future, as problem assets are collected by the FDIC. That’s the case whether the FDIC’s nominal balance at the Treasury is positive or negative.

(The above text is an excerpt from a document that used to be here, but has apparently been removed. One wonders if he was asked to remove it. A more charitable possibility is he just couldn't handle all the traffic. Luckily it was so funny I had saved it.)

So at the end of the day the FDIC also gets its funds from the Federal Reserve, or in other words from the rest of us through inflation.

The Bank-Job: A real-life thriller

This is one of those things that you'd like to assume is an urban legend; one of those little facts about the world that as the potential to totally blow your mind. I haven't been this astounded that the world works this way since I found out peoples wages aren't indexed to inflation. This is the story of how banks, quite legally, counterfeit money and charge you interest on it. Hey, it’s a great job if you can get it…

Imagine a small town out west somewhere that has been living peacefully without a bank all these years. When the bank comes to town they are all happy to have a place that will protect there money AND pay them to do it! Life is hard out here and they’re a little suspicious of a free lunch, but after word gets out that you don’t have to sit through a sermon everyone piles in and is happy to be rid of Jimbob. (Jimbob owns the gun shop and used to charge a small rent to let people keep their savings in his safe.)

Let’s see what happens to the money after the bank gets a hold of it. We’ll follow the $100 that Tom deposits. Well, Tom comes in with his money and they assure him it will be safe in their big fancy vault. They show him the 10 inch thick doors and the absurdly large wheel you use to open the door. Then they tell him he can come and get his money whenever he wants, or he could just spend it with these here checks. Tom likes the sound of that and hands over his hard earned dough. As soon as Tom turns around the bank carefully places $10 of his money in the vault, and throws the other $90 in the “For Loan” pile. You see banks operate under what they call a “Fractional Reserve System”, as Jimmy Stewart famously explained in “It’s a Wonderful Life”, the bank keeps some fraction of the deposits on hand incase you as for it, in this case 10%, and loans the rest out.






Now the bank makes a $90 loan to little Billy and charges him 8% interest. They give 1% to Tom and keep the rest for all their hard work right? Well, yes, but what Jimmy didn’t explain is what the late, great Paul Harvey would call The Rest of the Story:

Now Billy spends the $90 of a new bike for his paper route. Then Sam, who owns the bike shop, deposits it in his new fangled account. At which point the banker carefully puts $9 in the vault and throws the other 81 in the “For Loan” pile. Did you catch what just happened there?








Now, where before the there was 100 dollars, there is promise of 190 dollars! They claim both Tom and Sam can come get their money whenever they want and the bank is earning 8% interest in 171 dollars! Of course that 81 dollar loan is spent as well and finds its way back to the bank who keeps a portion of it in the safe and loans the rest out at 8%. This process goes on with the money always finding its way back to the bank to be re-loaned. After awhile the situation might look like this:






















And this process continues until eventually, inevitably, Toms entire real $100 is consumed as “reserves” to support $1000 in deposits and $900 in loans on which the bank is earning 8% interest. $900 x 8% = $72. 1% of this they pay to depositors, leaving $63 for the bank! That’s a 63% return for all the money the town puts in the bank!

More importantly there is now 1000 dollars in deposits that the bank claims you can come and get whenever you want. And the problem isn’t just that the money is loaned out “to support your community” as is claimed in “It’s a Wonderful Life”, it’s that 900, of the 1000 dollars does not even exist!

Talk about false advertising! Is there any other business allowed to exist, that is so premised upon a lie? It is an impossibility that your money can be both in your account at your disposal, AND loaned to someone else. It’s a scheme that would make Ponzi blush, but like all good marks were blinded by the promise of something for nothing.

Worst since the Great Depression!

Some times people use words to fool us. (Gasp!!) I know, I know, old news right. How about this one: Sometimes people use true statements to lie to us. One form of this is making a comparison between two things that are on a vastly different scale, to imply that they are on the same scale. Like saying Bill gates is the richest guy since John D Rockefeller who was the richest person EVER! It might be technically true, but old John D. could buy Bill Gates about 6 or 7 times over. In fact to equal the inflation adjust fortune of John D. Rockefeller, you’d have to add together the fortunes of the 13 richest people in America today.

You see the statement is technically true, but it doesn’t really convey the proper scale. The form of this linguistic abuse that’s been bothering me most it the constant refrain by politicians and talking heads that “it hasn't been this bad since the great depression." By many measures it’s a true statement, but it conveys a lie. Our current economic situation is not even in the same league as the great depression. Have you seen any breadlines?

The graph below is courtesy of Barry Ritholtz at The Big Picture. It’s a great blog that every now and again features a graph that really lives up to its namesake.

I won’t even comment on the graph. It speaks for itself. Next time you hear this statement, ask yourself what they are really trying to convince you of.