Warning ubernerd thread: Imperfect Knowledge Economics

[graphrix_IHB]

Here at IHB, <a href="http://cowles.econ.yale.edu/P/au/d_shiller.htm">Robert Shiller</a> is one of the more well known behavioral economists. A very simplistic break down of of behavioral economics is the study of human behavior, researching that behavior, and quantitatively modeling that behavior. It has been very successful, and the theory has several Nobel prizes to prove it. I think most here agree, that Shiller is one we highly respect.





I read an article, at <a href="http://www.economist.com/finance/displaystory.cfm?story_id=10172461">the Economist</a>, on Roman Frydman's and Michael Goldberg's book <a href="http://www.amazon.com/gp/product/0691121605/">"Imperfect Knowledge Economics".</a> Then, I stumbled on a <a href="http://www.project-syndicate.org/commentary/frydman16">recent commentary</a> by them, calling for a more open Fed and ECB.





<em>While this proposal shares some features with inflation targeting, it may actually achieve its goals more effectively. Both involve announcing benchmark levels. In both cases, central banks attempt to affect macroeconomic outcomes directly as well as by influencing market participants’ expectations. As Milton Friedman emphasized, however, the links between monetary policy and inflation are “long and variable.” </em>

<p><em>By contrast, the link between official intervention and exchange rate movements is much more direct and potent. Given massive trading volumes, direct intervention can alter supply and demand for currencies only on the margin. But the limit-the swings policy may amplify intervention’s effects by diminishing market participants’ desire to push the exchange rate away from PPP. </em></p>

<p><em>Our proposal to reduce ­­– but </em><em>not eliminate – swings from parity recognizes that price fluctuations may be crucial for markets to ascertain the price of assets with an uncertain payoff. But currency swings, if too wide and protracted, can hurt competitiveness and require costly resource allocation. These effects often lead to calls for protectionist measures, which may reduce the benefits from international trade and real economic activity. Only by acknowledging the limits to knowledge can monetary and exchange rate policies have a better chance of succeeding.</em> </p>

It is an interesting idea. And, I am not qualified to say which theory is better, but I am hoping it can open up some discussion. I mean, when I first heard about regression models, I thought that meant Kate Moss was back in rehab. So, while I am an ubernerd, I am not ubernerdy enough to have a firm opinion on the subject. I will say, it takes a certain amount of gut instinct in trading. As much as I believe in quantitative models, fundamentals, and technicals, I think that the next irrational behavior will be different than the past irrational behavior. In trading, I think models would have to be consistently tweaked with these changes. Shiller's past studies of the housing bubble didn't expect this bubble to exceed the past like it has. The irrationality of this bubble, exceeded well past the parity, and kept going.





Sorry for the ubernerdiness, but I warn you, I will only become more of an ubernerd in the future. Just wait for when I do understand the quantitative models. Now that will be uber ubernerdy.

 

[IrvineRenter_IHB]

<em>"Shiller's past studies of the housing bubble didn't expect this bubble to exceed the past like it has. The irrationality of this bubble, exceeded well past the parity, and kept going."</em>





Any financial bubble needs structural support. This particular bubble would have run out of steam in 2004 if not for the innovation of Option ARM loans. The irrational exuberance in any bubble is only contained when resources can no longer be put toward driving prices higher. Even now, the psychological forces behind the bubble are still in tact, but it is the elimination of financing options that is preventing the bubble from going even higher. Only after some extended period of time of lower prices does the psychological grip of bubble fallacies wane. We are not there yet, and we probably will not be until the end of 2008. By then even the most hard-core will lose their ability to stay in denial.





I am starting to come to the opinion that financial bubbles are a necessary evil in the system. When a bubble is first forming, there is no way to gauge whether or not the initial rise in prices is justified by fundamentals or not. Prices must be given the freedom to chart their own course, or the inefficient use of capital will result. Of course, bubbles create their own inefficient utilization or resources, but I think the problem will be even more acute if we try to manage market price fluctuations. Futures markets attempt this by putting trading limits on the amount of price change allowed on any given day. This has the effect of slowing price changes, but it also diminishes liquidity which is one of the primary reasons for a markets existence.





In my opinion the only real solution to tempering the impact of financial bubbles is to prevent situations where institutions cannot enable the process. We had large scale institutional enabling in the most recent housing bubble. Investors did not create this bubble with equity but with debt. Debt and credit expansion is at the core of most financial bubbles, and it is here where the solution must be found. I think it is probably impossible and certainly undesirable to regulate equity flows to prevent financial bubbles, but it is certainly possible to regulate the creation and flow of debt to prevent these problems. In fact, one of the changes in lending that came out of the S&L fiasco was higher equity requirements. This prevented commercial real estate bubbles from forming for over 20 years. Of course, now that we have more complex financial instruments which blur the line between equity and debt, we may have created another Commercial RE bubble too, but as a general rule, high equity requirements stop lender driven financial bubbles from forming.

 

[profette_IHB]

<p>Economic View (NY Times)</p>

By

<person idsrc="nyt-per" value="arts,automobiles,books,business,college,dining,education,fashion,garden,giving,health,jobs,magazine,movies,multimedia,nyregion,obituaries,realestate,science,sports,style,technology,theater,travel,us,washington,weekinreview,world:::more articles about robert j. shiller.:::http://topics.nytimes.com/top/reference/timestopics/people/s/robert_j_shiller/index.html"></person>

<alt-code idsrc="nyt-per" value="shiller, robert j"></alt-code>ROBERT J. SHILLER

<p>Published: November 25, 2007</p>

<p><a href="http://www.nytimes.com/2007/11/25/business/25view.html?_r=1&oref=login">A Time for Bold Thinking on Housing</a></p>

<p>"WE have to consider the possibility that the housing price downturn will eventually be as big as that of the last truly big decline, from 1925 to 1933, when prices fell by a total of 30 percent.</p>

<p>As of this August, domestic home prices were already down 5 percent from their peak 14 months earlier, according to the S.& P./Case-Shiller Composite Home Price Index, and prices were falling at a faster rate in the months leading up to August. (Updated data will appear on Tuesday.)</p>

<p>This crisis should be an occasion for some inspired thinking about fundamental changes in our real estate institutions. The actions that have already been taken are not impressive. The housing market is worsening, and more and more home owners are getting into trouble with their mortgages. </p>

<p>The public response to the housing downturn of 1925-33 provides an important lesson in what government and private institutions can accomplish. Back then, people weren’t content with temporary palliatives. They were thinking big, and revolutionary changes were made in real estate institutions. Without those fundamental changes, the Great Depression would have been much worse than it was, and we would be in a more vulnerable situation today."</p>

 

[profette_IHB]

<p><strong>Don't believe in behavioral economics? Check this out:</strong></p>

<p><strong><a href="http://news.yahoo.com/s/nm/20080304/hl_nm/placebos_dc">Expensive sugar pills work better than cheap ones</a></strong> </p>

<p>WASHINGTON (Reuters) - Want a sugar pill to work really well? Charge more for it. </p>

<p>A study published on Tuesday shows the well-known "placebo effect" works even better if the dummy pill costs more.</p>

<p>Dan Ariely, a behavioral economist at Duke University in North Carolina, and colleagues at the Massachusetts Institute of Technology tested 82 volunteers.</p>

<p>All got a light electric shock and were offered what they were told was a painkiller.</p>

<p>Half were given a brochure describing the pill as a newly approved painkiller that cost $2.50 per dose and half were given a brochure describing it as marked down to 10 cents.</p>

<p>Writing in a letter to the Journal of the American Medical Association, Ariely and colleagues said the effects were unexpectedly strong.</p>

<p>Eighty-five percent of volunteers who thought they were getting a $2.50 pill said they felt less pain after taking it, compared with 61 percent of those who thought they were getting a discounted drug.</p>

<p>The results fit with other studies that show charging more for something makes people value it more. But Ariely said the combination with the placebo effect was especially interesting.</p>

<p>"The placebo effect is one of the most fascinating, least harnessed forces in the universe," Ariely said in a statement.</p>

<p>The word placebo comes from the Latin word for "I shall please." Placebos, or sugar pills, are routinely used in trials of new drugs to see if they really work.</p>

<p>"How do we give people cheaper medication, or a generic, without them thinking it won't work?" Ariely asked.</p>