Sunday, November 30, 2008

When will they stop banning things?

Jim rang me yesterday and said he had been reading my blog and wanted to talk to me about something. So we arranged to meet. After we bought our drinks and sat down, a young woman with green hair walked in and sat at a nearby table with a scruffy looking young man.

The young woman obviously made a big impression on Jim. “It’s just not natural”, he said. I asked him what he was talking about. “Green hair”, he said quite loudly. “Humans aren’t meant to have green hair”. I told him to keep his voice down to avoid causing offence. “What about the offence she is causing me?” he said. “It’s bad enough when young women make themselves look unattractive with rings in their noses and tattoos everywhere, but green hair is beyond the pale.” I suggested that it was just a matter of taste and offered to swap seats so that Jim would not have to look at the green hair.

After Jim had settled down he said: “You libertarians don’t like banning things do you.” As I agreed he added: “But I get the impression that you might not be too keen on legalization of drugs.” I responded that I didn’t really have much to say about drugs beyond making the general point that people should be allowed to live as they please as long as they don’t interfere with the rights of others. I mentioned that I thought people should even be allowed to have green hair if that is what they want.

I thought that Jim might have been able to manage half a smile, but there was no sign. He said: “I thought that the reason that I can’t find much on your blog in favour of legalization of drugs might have something to do with concerns about the effects legalization might have on vulnerable people.” I acknowledged that I was concerned about children. I admitted that when my children were in their teen years I was in favour of prohibition because I thought this would make it more difficult for teenagers to obtain drugs.

Jim said: “So, now your own kids have grown up you have changed your mind? I explained that I now think that, like a lot of parents, I had been allowing my desire to protect my children from harm to get in the way of a rational assessment of how they could best be protected. I now think that the risk of drugs falling into the hands of children can be better managed if drugs are legalized because that will make it easier to identify suppliers.

Jim then asked: “Aren’t you also concerned about vulnerable adults who experiment with drugs and end up addicted?” I suggested that prohibition seems designed to make life hell for people who become addicted because it raises the price of drugs, which induces a lot of addicts to do desperate things to finance their habit. After a moment of thought, Jim said: “But if the price of drugs goes down more people will experiment because the costs associated with becoming addicted will be lower.”

I was surprised that Jim seemed to know about the rational addiction hypothesis. However, he was beginning to annoy me so I decided that the time had come to give him a blast about the disadvantages of making protection of vulnerable people the be all and end all of everything. I suggested that we should be encouraging vulnerable people to learn to be less vulnerable because if we keep going down the path of banning things to protect everyone who is vulnerable to anything, we are going to find that just about everyone is vulnerable to something. I told him that as a businessman he should be aware of the pressure for governments to ban and regulate a lot more things including mixed alcoholic drinks, tobacco, gambling, pornography, vitamin supplements, fatty food, and high calorie food and drinks. I said he should be particularly concerned about pressure for governments to do more to protect people who are vulnerable to advertising and the debtaholics who can’t resist spending up to their credit card limits.

I made the point that once vulnerable people have been protected from all these things we will probably discover more vulnerabilities and there will be pressure for more things to be banned. One day we will wake up and discover that we have lost a lot of our capacity to make decisions affecting our own well-being. I then started to talk about the blog post on whether push-pin is addictive, in which I discuss the importance our capacity to make strategic decisions affecting our own individual well-being.

At that point Jim interrupted: “Yeah, the way we are heading the whole society will end up being run like a nunnery." I nearly fell through my chair. Jim must have seen my surprise. He added: “I hope you didn’t think I would be the kind of person who would ban green hair and everything else I didn’t like!”

Friday, November 28, 2008

What do we mean by market efficiency?

I ran into Jim again yesterday. Actually it would be more true to say that he ambushed me. I turned a corner and there he was. After the way he treated me in our first discussion (reported here) I was not particularly looking forward to talking to him again.

Jim said: “I enjoyed our last discussion”. I nodded agreement as I wondered why I wasn’t shaking my head the other way. Meanwhile, Jim was saying: “I heard that you wrote up our last discussion on your blog”. I must have looked a bit concerned because Jim said: “That’s OK. I don’t mind helping you with your blog, as long as you are accurate in reporting what I say and don’t make me look stupid”. I told Jim that might not be easy, but I could tell from the way he was looking that he obviously didn’t think it would be a joking matter if I made him look stupid - even though I wasn’t using his correct name on my blog. So I added that I was not going to report his expletives. Jim said that was OK. He claimed that he didn’t swear in any case, but if I wanted to I could use some bleeps now and then just to add emphasis. He said: “I won’t mind if you use a bit of poetic licence now and then, as long as you don’t make me look stupid”.

After he had bought me a beer Jim said that wanted to ask me something else. He said: “You believe that free markets are perfect don’t you?” I responded that I wasn’t quite sure what he was getting at. I told him that in my view all markets are imperfect, but when governments try to regulate them they often make matters worse. Jim said: “No, that’s not what I mean. I’m talking about capital markets – share prices and bond prices. Do you think those markets are close to perfect?”

At that point I explained to Jim that what he was talking about was the efficient markets hypothesis that prices always reflect all relevant information. I said it seemed to me that investors have the strongest possible incentive to make informed decisions because their personal wealth is at stake – and equity prices reflect the information on which investors base their decisions.

Jim said: “I’m not sure I understand. Are you saying that individual investors all have the same expectations about future prospects of particular firms?” I acknowledged that individuals have a lot of different views about the future. I suggested that even though a lot of investors think they can beat the market, the market averages out these different expectations, so those who do better than the market tend to be balanced by those who do worse than the market.

Jim nodded for me to continue. I explained that people who invest in funds with low management fees, whose weightings of individual shares in their portfolio are similar to a share market index, often do better than those who pay high management fees to funds that undertake a lot of research.

Jim said: “I suppose if someone has just lost half their capital on the share market they will not feel so bad if the value of their portfolio has fallen in proportion to the index and they have been paying low management fees.” I agreed.

Then Jim asked: “What do you think of Warren Buffett’s view that it is possible to beat the market because people are often irrational – they let greed take over and then they panic when fear takes over”. I said that I like Buffett’s approach to investing, but I wasn’t too keen on his politics.

Jim ignored the latter remark and asked: “So what advice do you think the Oracle of Omaha would give to novice investors about where to put their money?” I said that I imagined that he would tell them to put their money into Berkshire Hathaway. Jim replied: “Well, you don’t know everything! Buffett says that novice investors should stick with low-cost index funds.”

I checked to see whether or not Jim had just made this up. Warren Buffett actually gave this advice in April this year (reported here).

Tuesday, November 25, 2008

Can budget deficits cure the debt problem?

When I first met Jim (that is not his real name) a few days ago he seemed like a fairly harmless businessman. But when he heard that I was an economist, he said that there was something he wanted to ask me.

I had the feeling that I would not like Jim’s question, so I mentioned that I had retired. Jim pretended not to hear. He said: “The current financial crisis was caused by too much debt wasn’t it? Before I could respond, he had added: “So, tell me how the world’s governments are going to solve the problem by having bigger budget deficits and more debt?”

I tried to get out of answering by saying that I didn’t know much about short-term macro-economic management. That response didn’t satisfy Jim. He said: “Come on, you must have some idea about what governments are trying to achieve.”

I started my explanation by going back to the cause of the problem. Making my explanation as simple as possible, I said that the problem had arisen basically because lending institutions in the U.S. thought that it was safe to lend a high proportion of the value of houses because they felt that house prices would continue to rise. This meant that when the bubble burst and house prices fell, a lot of borrowers had debts that were greater than the value of their houses. So defaults started to increase and that created big problems for banks.

At that point Jim interrupted. “I know all that”, he said, “what I don’t understand is why the governments didn’t just let the rotten banks fail”. I explained that the financial system had become like a house of cards, built on the expectation that some financial institutions were too big to fail. When the U.S. government let one bank collapse, this led to a crisis of confidence in the whole financial system.

Jim looked skeptical. “You still haven’t answered my question”, he said. “How can governments solve the problem by creating budget deficits? Doesn’t this just make the problem worse for countries that have been living beyond their means. Shouldn’t they be living within their means rather than going further into debt?”

I told Jim that I thought that was a good point, but the problem was how to get from where we are now to where we want to be. I suggested that the idea behind what governments were attempting to do was not stupid because they were trying to restore confidence and to avoid increased unemployment. I said that if you look at an economy and see a lot of people becoming unemployed and a lot of spare capacity emerging, this suggests that consumer demand is too low, not too high. I also explained that governments don’t actually have to go into debt to fund their deficits. They have the power to create the additional money that they spend.

Jim then looked alarmed. “Do you mean that they might use the printing presses like Robert Mugabe does? So we could end up with hyperinflation like in Zimbabwe?”

I tried to calm Jim down by telling him that at the moment a lot of economists – those who know about these things - seem to be more worried about deflation than inflation. They are worried that we might get stuck in a situation like that in Japan in the 1990s, with falling prices and economic stagnation. I said that the policy aim was to give economies just enough of a boost to restore economic growth without inflation.

Jim seemed to understand. He said: “So what these economists are trying to do is a bit like getting a satellite into the right orbit – they just want to give the economy the right amount of thrust?” I acknowledged that the policy problem could be a bit like that.

Jim smiled before he added: “Yeah, well I reckon that’s the problem with you economists. You think you are f***ing rocket scientists!”

Saturday, November 22, 2008

What is the rate of economic growth implied by current equity prices?

There is a standard joke among economists that equity markets have predicted about 10 of the last 5 recessions. As the joke acknowledges, equity prices embody predictions of future earnings and this implies that they also embody predictions of economic growth rates.

So, what is the rate of economic growth implied by current equity prices?

A good way to think about this is to consider why there is a difference between the current average dividend yield (annual dividends per share as a percentage of the current share price) and the real bond yield (bond yield minus expected inflation rate). This difference is required to cover two elements: the equity risk premium and the expected future rate of growth in dividends. If it is reasonable to assume that the expected rate of growth in dividends will be equal to the rate of economic growth over the longer term, the market’s expected rate of economic growth is given by:

y = (r – p) + x – d

where: y = expected real GDP growth rate;
(r – p) = real long term bond yield;
x = the equity risk premium; and
d = dividend yield.

So, it is a simple matter to calculate y if we know r, p, x and d. Unfortunately, however, there are a couple of thorny issues that need to be considered regarding appropriate numbers to use for the real bond yield and the equity risk premium.

When I last looked at this question (about five years ago) I decided that it would be more appropriate to use a long term average real bond yield than a current real bond yield. If the current bond yield is used, the results seem to become unduly sensitive to current monetary policy settings. In my calculations for Australia I used a real bond yield of 4.5 percent.

What rate of equity risk premium is appropriate? The equity risk premium is one of the few topics for which it could actually be reasonable to claim that if you laid all economists end to end, they still would not reach a conclusion. To cut a long story very short, I used the average equity risk premium implied by the relationship between GDP growth rates, average real bond yields and average dividend yields in Australia over the previous 20 years. This implied an equity risk premium of about 3.3 percent. (I am prepared to make available an unpublished paper discussing the methodology to anyone requesting it by email.)

When I did the arithmetic with the dividend yield prevailing in August 2003 (4.3 percent), I came to the conclusion that the expected real GDP growth rate for Australia implied by then current equity prices was 3.5 percent per annum. Since this was only marginally above the average growth rate for the previous 20 years, it did not seem to me to be unduly optimistic.

When I do this arithmetic now, with the current average dividend yield (6.6 percent on 18 November, 2008), it suggests that the expected real GDP growth rate for Australia implied by current equity prices is 1.2 percent per annum. That seems to me to imply that current share prices in Australia embody an unduly pessimistic view of longer term economic growth prospects.

Health warning:
There is a rumour going around among former work colleagues that when I was living off my earnings as an economic consultant I was heard to say, more than once, that free economic advice was not worth much. That rumour is true, but I have since changed my opinion. There is no truth at all in the rumour that I have been heard expressing the view that there are three kinds of economists: those who can count and those who can’t. I tried to say that once, but I ended up saying that I didn’t know whether I should be considered to be in the first or second category.

Tuesday, November 18, 2008

Does the free market corrode moral character?

The Templeton Foundation recently asked 13 leading scholars and public figures to provide their answers to this question (here).

It seems to me that the main points in the answers can be summarised (very briefly) as follows:
· Free markets are inherently good because they reflect personal choices.
· Other systems, e.g. provision of goods via political processes, tend to result in worse moral outcomes because they lack competitive disciplines and are more prone to corruption.
· The outcomes of market processes reflect (and perhaps amplify) the values that people hold. Moral decadence is not the only possible outcome.
· Participation in mutually beneficial exchange encourages trustworthy behaviour and increased trust. Markets tend to reward diligence, good judgement and prudence.
· Market incentives and competitive pressures sometimes encourage people to act imprudently and to break moral codes.
· Markets tend to undermine some traditional values.
· Markets widen our circle of empathy. As a result of globalisation people in different parts the world come to view each other as business partners and friends.

Some of these points are more valid than others, but all seem familiar. In a contribution on his blog, however, Will Wilkinson sketched out what seems to me to be a new way of thinking about some of these issues (here). My interpretation of his argument is that shifts in the moral norms that are required as the means to achieve moral ends (longevity, health, wealth, happiness etc) are inevitable as the market system finds ways to achieve these ends more effectively. The process is analogous to technological innovation, except what is involved is a shift in the socio-economic structure that is the means of achieving moral ends, rather than a change in technology. Market processes corrode traditional moral norms, but this is an integral part of moral progress.

Loyalty could be an example of a traditional norm that has become less valued in many contexts. There was a time when tribal loyalty was of the utmost importance to the survival of kith and kin, but this has become irrelevant in modern societies. With increased mobility, loyalty to particular communities and employers is probably not as important as it once was. Greater value may be placed on such characteristics as emotional intelligence or ability to adapt to different social and work environments.

However, it seems to me that the corrosion of traditional moral norms by markets cannot always be viewed as benign. For example, I doubt whether anyone ever benefits from allowing modes of thought and action characteristic of the market (e.g. strict reciprocity) to contaminate their most intimate relationships. As Jerry Muller has shown, concerns that market norms might permeate all human behaviour have been a common cause of concern about free markets over the last few centuries (previously discussed here).

* * *

In any case, why should every real or imagined tendency toward undesirable corrosion of moral character be attributed to free markets? The obvious point that many people do not seem to recognise is that we do not have free markets. With regard to the current financial crisis, can the imprudent behaviour of major lending institutions be attributed to free markets when there has been a long history of bailouts of financial firms whose failure could possibly have threatened confidence in the financial system? Can the short-termism associated with senior executive remuneration packages be attributed to free markets without considering the effects of tax considerations on the way these packages have been structured?

Tuesday, November 11, 2008

Is our inner nature good?

Abraham Maslow suggested that humans have an inner nature or core which is good. According to Maslow this inner core is “potentiality, but not final actualization”. He argued that in principle our inner core can easily self-actualize, but this rarely happens in practice due to the many human diminution forces including fear of self-actualization and the limiting belief in society that human nature is evil (“Toward a Psychology of Being”, 1968, chapter 14).

The view that humans have inherent potentialities that are good has a long history. For example, Aristotle argued that humans have inherent potentialities that it is in their nature to develop. He suggests, however, that for most people the virtues remain undeveloped unless they are actively cultivated:

“Now some think that we are made good by nature, others by habituation, others by teaching. Nature's part evidently does not depend on us, but as a result of some divine causes is present in those who are truly fortunate; while argument and teaching, we may suspect, are not powerful with all men, but the soul of the student must first have been cultivated by means of habits for noble joy and noble hatred, like earth which is to nourish the seed” (“Nicomachean Ethics”, Book x: 9).

J.S. Mill made it clear that he didn’t think there was more than a mere germ of good in human nature:

“Allowing everything to be an instinct which anybody has ever asserted to be one, it remains true that nearly every respectable attribute of humanity is the result not of instinct, but of a victory over instinct; and that there is hardly anything valuable in the natural man except capacities - a whole world of possibilities, all of them dependent upon eminently artificial discipline for being realised” (“On Nature”, 1874).

Over a century before, David Hume presented a much more positive view of the relationship between morality and the inner nature of humans:

“Take any action allowed to be vicious: Wilful murder, for instance. Examine it in all lights, and see if you can find that matter of fact, or real existence, which you call vice. In which-ever way you take it, you find only certain passions, motives, volitions and thoughts. There is no other matter of fact in the case. The vice entirely escapes you, as long as you consider the object. You never can find it, till you turn your reflection into your own breast, and find a sentiment of disapprobation, which arises in you, towards this action. Here is a matter of fact; but it is the object of feeling, not of reason. It lies in yourself, not in the object. So that when you pronounce any action or character to be vicious, you mean nothing, but that from the constitution of your nature you have a feeling or sentiment of blame from the contemplation of it”. (“A Treatise of Human Nature”, 1739, III, I, i).

Hume’s view of the matter has received a considerable amount of support in recent years from psychological research (e.g. observing affective reactions to stories involving harmless taboo violations even though people had difficulty defending their moral judgments), neuroscientific evidence of emotional involvement in moral judgments, and studies that suggest that non-human primates and human have some similar moral instincts.

This evidence supports the social intuitionist view of Jonathan Haidt and Fredrik Bjorklund that moral beliefs and motivations come from a small set of intuitions that evolution has prepared the human brain to develop and that these intuitions then enable and constrain the social construction of virtues and values. This means that children have a preparedness to acquire certain kinds of moral knowledge and a resistance to acquiring other kinds (here).

Our instinctive morals don’t necessarily provide us with good guidance about how to behave towards strangers in the modern world because they evolved to protect self, kin and clan rather than to enable us to obtain the benefits of specialization and trade. I have previously suggested, following Hayek’s view, that our instinctive morals often cause people to argue for government intervention that gets in the way of the mutually beneficial exchanges among strangers that are necessary for human flourishing (here).

Nevertheless, Mill went much too far in asserting that nearly every respectable attribute of humanity is the result of victory over instinct. It seems to me that Maslow was much closer to the truth in asserting that the inner nature of humans is good.

Monday, November 10, 2008

Is there a positive intention behind every behaviour?

I hope that by the time I finish writing this piece I will have made up my mind whether I think there is a positive intention behind every behaviour. I can accept that the ultimate end of human action is nearly always the satisfaction of some desire of the acting person, but it seems to me that lurking behind some behaviours – for example, some self-destructive behaviours – there is probably a physiological problem of some kind rather than a positive intention.

Before going further I should acknowledge that the intention of NLP practitioners in suggesting that there is a positive intention behind every behaviour is to get people to “try on” this proposition to see whether it is a helpful way of thinking and perceiving. If a person can find a positive intention behind some unwanted behaviour (e.g. a phobia or an addiction) this might set them free to resolve the problem that they are experiencing.

Robert Dilts argues that the proposition that there is a positive intention behind every behaviour is an epistemological presupposition (here). What he means by this is that it has an epistemological status like that of the fundamental concepts of Euclidian geometry – it can’t be proved or disproved. He demonstrates that it is an implication of two fundamental epistemological presuppositions: “the map is not the territory” (human perceptions of reality are not reality); and “life and mind are systemic processes” (they are based on self-organizing principles and naturally seek optimal states of balance or homeostasis. These presuppositions imply that:
“People make the best choices available to them given the possibilities and capabilities that they perceive to be accessible within their model of the world. Any behavior no matter how evil, crazy or bizarre it seems is the best choice available to that person at that point in time” (here).

I have no problem in accepting Dilts’ interpretation of the idea that there is “a positive intention behind every behaviour”. It seems to allow that a person could be making the best choices available even if they display bizarre behaviour that is ultimately attributable to physiological rather psychological causes. An example that comes to mind is Antonio Damasio’s discussion of Phineas Gage, who suffered an horrific brain injury in 1848. Prior to this injury, Gage had a strong sense of personal and social responsibility, but afterwards he no longer showed respect for social convention or concern about his own future (“Descartes Error”, 1994: 10 – 12).

It seems to me that there is a lot to be said for considering what lies behind choices that result in unwanted behaviours. It makes sense that the possibilities and capabilities that people perceive to be accessible are often distorted by hidden frames of meaning about themselves, their personal powers, their relationships with others, time (their past performance and expectations) or about the way the world works.

When I began writing this piece I thought I might end up considering the question of whether the inner nature or core of humans is good. By following Dilts’ approach I avoided this, even though I think our answers to this question are an important component of the models of the world that we carry around with us. I will consider different views on this question in my next post.

Saturday, November 1, 2008

Should the virtues be revered?

When people are conscious that they are doing good they sometimes feel that they are serving something larger than themselves. It has been suggested that this feeling of elevation is necessary to have a meaningful life. For example, Martin Seligman defines a “meaningful life” as “using your signature strengths and virtues in the service of something much larger than you are” (“Authentic Happiness”, 2002: 263).

Such feelings of elevation do not always have to be present for people to behave morally. As Lynn Stout has pointed out, civilized life in urban societies depends to a large extent on passive altruism – people do not generally steal, even when there is a very low probability of being caught (‘Taking conscience seriously’, in P Zak (ed), “Moral Markets”, 2008: 157). We feel elevated or inspired only when doing good involves some effort or sacrifice.

In the final chapter of his book, Seligman speculates that human history is a process that is heading ultimately towards “nothing less than omniscience, omnipotence and goodness”. He suggests that the best we can do as individuals is to be a small part of furthering this progress: “this is the door through which meaning that transcends us can enter our lives” (260).

However, it seems to me that issues relating to historicism are more relevant to people whose aim in life is to be on the winning team – history’s hastening agents – than to those who want to live a meaningful life. I find it hard to see how it could be elevating to choose to do good just in order to be on the winning team.

I think it would be better to view the impulse to serve a good purpose in challenging circumstances as the door through which meaning that transcends us can enter our lives. Seligman discusses evidence earlier in his book (chapter 8) which suggests that the concept of goodness is ubiquitous rather than relativistic. We all tend to have similar views about what constitutes goodness despite differences in our individual tastes, social conventions and religious beliefs. Six virtues are endorsed by almost all religious and philosophical traditions: wisdom and knowledge, courage, love and humanity, justice, temperance, and spirituality and transcendence.

Is it possible for meaning that transcends us to enter our lives if we do not believe that the virtues are the result of divine intervention? I don’t see why not. We can view the expression of goodness as a potential of all humans while remaining agnostic about the source of this potential. The expression of goodness may be viewed as a natural part of what it means to be human. The actualization of this potential is a transcending experience for each individual because it requires us to move beyond the consideration of personal pleasure and pain. At the same time, because of our nature, the actualization of potential is an individual experience requiring the exercise of practical wisdom – there is a universal potential, but no universal recipe for the expression of that potential.

If we view the expression of goodness as a human quality, does this mean it cannot be revered? Why not? If we feel inspired by the virtues of others and elevated by our own efforts, surely be can permit ourselves to feel reverence for the potential for good that resides within every one of us.

William Wordsworth captured something of the feeling of reverence I have in mind in a poem written in 1802:

My heart leaps up when I behold
A rainbow in the sky:
So was it when my life began;
So is it now I am a man;
So be it when I shall grow old,
Or let me die!
The Child is father of the Man;
I could wish my days to be
Bound each to each by natural piety.
(Source: here)