So perhaps we need to figure out what we have to offer the Chinese consumer.

From Leigh on Knowing And Making:

"Martin Wolf in Davos

Robert Peston interviewed Martin Wolf in Davos (along with Roger Carr and Richard Lambert, but they needn't concern us at the moment; Lambert did display a useful clarity, requesting nothing but opening of the credit markets). Martin, as always, had some exciting things to say and said them in his unique way. My paraphrasing:

The UK is the most vulnerable economy in the G7 because the financial sector is so important, because the housing boom was so large and because household debt is sensationally high, and we are also highly dependent on the rest of the world which is suffering a recession too. And our underlying fiscal position related to these vulnerabilities is much worse than anyone thought 2 years ago.

It's interesting that the fact of a recession is the problem - that is, a reduction in GDP, rather than the actual level of output or consumption. If the UK has benefited (as it undoubtedly has) from huge growth in the financial sector and housing-related investment over the last ten years, and we now have a brief slowdown from a peak of economic activity, you might think it isn't something to regret.

However, there seems little doubt that negative growth is perceived as a big problem by both consumers and businesses, when compared with a hypothetical scenario of slightly slower but more stable growth. My post from Wednesday discussed this, but in that item I neglected to consider the psychological effects of today being worse than yesterday, and what it implies about tomorrow. So unless we collectively get used to volatility, then Martin is right that over-reliance on an unsustainable financial economy will have intrinsic problems.

And yet... I am not convinced that our finance sector is unsustainable. I have started to build a model to try to work out an optimal level of finance and business services activity in a modern economy. My intuition is that the optimal level is far higher than most people suspect, and that with hindsight we may not blame the City as much as it's now being blamed.

Politicians undoubtedly get that there is a massive cyclical downturn, but people don't get that it's a structural change. 2006 is not coming back with its consumer-led debt boom driven by the English-speaking countries. We might get back to past growth - I hope we will - but the world will have to be rebalanced. Governments are doing a good job of short-term stimulus and saving the banking system. A sensational level of stimulus! But for stability, healthy private sector demand is needed. Lots of changes are needed that China, the US and UK don't yet get, but they are essential in getting back to a healthy economy.

I guess the message here is that China is storing up too many claims on the US and UK economies, which are likely to lead to problems in the future. The US and UK (among other countries) are consuming China's output now, and instead of paying for it now by exchanging our own services, we are exchanging promissory notes to pay later. Fair enough, and the Chinese are willing to let us do it, but there must be a risk in this.

Just as some private borrowers will keep borrowing as long as the lender is willing to stump up, but when it is time to repay, start quibbling. Have you come across those services which supposedly allow you to write off your consumer debt by challenging the terms and conditions under which it was lent? I feel there's something basically dishonest about that course of action, but perhaps there is an analogy.

I suspect Martin is hinting that the overhang of debt between creditor and debtor economies will tempt politicians to these kind of escape routes; and even if they resist, the scale of the debt will automatically cause distortions in trade and investment.

So perhaps we need to figure out what we have to offer the Chinese consumer. China does buy a lot of investment goods from the West - industrial machinery, software and other technology - but fewer consumer goods or services. Perhaps we have expertise in media, well-designed and marketed consumer goods, high quality food and consumer infrastructure that they would be interested in. But I don't know what policy routes Martin would suggest that governments take to stimulate trade in these goods.

[The changes are beyond most people's understanding] We need to protect emerging economies now - change the way we finance them and expand the IMF; and have a serious, intelligent dialogue with the Chinese to make their growth more compatible with the global economy - the US and UK need to change too, and make the world financial system work better - because it has worked terribly.

Again Martin's beautiful turn of phrase and charming voice - Robert Peston may think he's a sensationalist but Martin Wolf can frighten him under the table.

I am very much warming to the idea of supporting emerging economies with the stimulus. I am convinced that the underemployed resources in the Western economies could create something useful for poor countries, if the stimulus is designed correctly. I hope to write something more on that next week.

Other than that, I look forward to hearing just what the Chinese, American and British governments are supposed to do to encourage Chinese consumers to buy more from Western suppliers. Undoubtedly there is a way. Perhaps we need another Martin - Sorrell - to come to the rescue.

Update: Ahem - I just discovered Martin Sorrell is at Davos, also blogging for the FT!"

Don said...

"So perhaps we need to figure out what we have to offer the Chinese consumer."

The younger generation in China were beginning to become spenders as opposed to savers, but this crisis has shifted their perceptions. And that's the big problem: You're asking savers who have seen the spenders bring on a crisis to become spenders. I don't see it.

I think that there has to be some allowed default by the spender countries, either through debt cancellation or allowing us to use inflation to get out of this. Other solutions lead, and I hate to say this, to social disruptions and dislocations. Fortunately, the alternatives we face aren't as bad as in the 30s.

Don the libertarian Democrat

31 January 2009 21:14

"Any new framework gives agents a reason to abandon their anchor to fear; and gives them a chance to reattach themselves to hope."

From Leigh Caldwell on Vox:

"This column argues responses to the recession should not be based on unrealistic expectations of rational behaviour. It argues that models of bounded rationality provide reasons that traditional macroeconomic policy responses may fall short and suggests more sophisticated solutions that could break the crisis’s psychological hold on markets.

Responses to the recession should not be based on unrealistic expectations of rational behaviour( TRUE ). We now know enough about real, flawed human psychology to be able to take some account of it in policy setting( I AGREE. BUT I SEE A PLACE FOR PHILOSOPHICAL ANALYSIS AS WELL. ).

The “homo economicus” model of rational agents, acting to maximise utility in the possession of all available information, is not realistic( TRUE ). It is hardly a credible way to look at human beings – but we tolerate it because it is simple enough( AND USEFUL ENOUGH ) to allow equilibrium analysis which often gives reasonable predictions (TRUE ).

However, these equilibrium models are not serving very well in today’s situation. Standard monetary policy and (to a lesser extent) Keynesian theories are based on rational-actor assumptions. They give broad recommendations about monetary loosening and fiscal expansion – which central banks and governments are rightly trying out. But growth is not resuming.

Bounded rationality is the broad term for behavioural models that do not follow the rational-maximiser formula. There is not yet a generally accepted alternative model. Lots of individual non-rational behaviours have been discovered, but they are grafted onto a rather clunky ‘rational actor with bits’ instead of forming a coherent behavioural model.

However, the best place to test a new theory is often at the edges of the old one, where the existing model breaks down. So the current troubles in the financial and real economy may be a good opportunity to try out some alternative models and see which give a reasonable description of what we see.( GO AHEAD )

Models of bounded rationality

Different models of bounded rationality vary basic assumptions of the rational agent model in different ways. Some of those assumptions are:

• Utility is discounted over time in a consistent way
• People have access to all relevant information
• All relevant information is expressed through market prices
• People can instantly weigh up the change in utility given by any buying or selling decision
• People act to maximise their utility

Therefore, the typical way to create a bounded rationality model is to relax one or more of these criteria.

The first class of model explores different time discount rates. Experiments show that people apply a high discount on utility( OR SAFETY ) in the present – they prefer £100 now to £120 next year – but a lower one in the future – they prefer £120 in four years to £100 in three (Loewenstein and Prelec 1992). This, arguably, contributes to explaining recent huge variances between overnight and three-month interest rates.

Perhaps our psychological instincts reflect a pragmatic sense of the risk of a promise not being fulfilled, and the modern financial system has evolved to provide a confidence in the future that does not come naturally. If so, then the financial markets are no longer successfully filling that role. This short-long imbalance is an important cause of disappearing credit( OK ).

A second kind of bounded rationality reflects the idea that people do not have access to all relevant information. Danielsson and de Vries (2008) discuss an important example – information asymmetry – and an interesting solution – enforced transparency( CATE. IS THIS YOUR IDEA? ). Many agents, short of crucial information, have had to make guesses; clearly this has led to many of the write-offs we have seen in the last 15 months.

A third approach relaxes the constraint that prices express all the information needed to make decisions. This classical assumption works only when there is a sufficiently liquid market, with defensible property rights. If enforceability is at risk (for instance when there is a significant chance of bankruptcy) then we can use derivatives or insurance to provide secondary price information about the risk of default( A GOOD USE OF CDSs ). If the market for these derivatives is not big enough or does not trade publicly, we lose that price signal.( OK )

In these situations, we need to use non-price signals to make economic decisions, and we do not have good models for interpreting those messages. This leads to inconsistent or irrational decisions on resource allocation.( OK )

A fourth category of model removes the assumption that people can make an accurate calculation of the utility that a decision will provide. These models include satisficing (Simon 1956) and rational ignorance (Downs 1957). Another is the concept of anchoring or habit – which suggests that we rely on familiar choices( OR NARRATIVES FROM HISTORY ) to avoid the mental effort and risk of picking alternatives. This behaviour can be seen in the credit markets, where an aggressive conservatism appears to be in control of lending decisions.

The fifth alternative to the rational model is to ask what happens if people do not act to maximise utility. Indeed, is there any single quantity called utility? Alternative models of decision making include multi-dimensional (“vector”) utility functions (for example Rios 1987), value modelling (Gordijn 2001) and psychological attempts to understand subconscious mental drivers – which have rarely been explored in economics. My own research suggests that a concept called “local utility gradient” drives behaviour.¹

Intuitively, the current financial environment seems to expose a lack of rationality in market participants( MY POINT ). The task for researchers is to find whether specific irrationalities provide evidence to support any particular behavioural models( YES ).

Policy implications

Whichever model of behaviour is assumed, policymakers should ask what the models indicate for macroeconomic policy. This question has been considered in a conference on “behavioural macroeconomics” at the Boston Federal Reserve in 2007.² No doubt the old solutions will work, given enough time. But today, with a much better understanding of economic behaviour, we could design more sophisticated solutions which would work faster.

A clear example comes from the concept of anchoring. Anchoring creates a tendency to fixate on one option too long when we might profitably switch to another –it limits the effects of all kinds of quantitative changes in policy. If a bank is scared to lend at a spread of 2.5%, anchoring implies it is unlikely to start lending when the spread increases to 3% or even 4%. This demands a qualitative change in conditions so that the bank can no longer make a simple marginal comparison but is forced to re-evaluate( EXACTLY. THIS IS THE POINT OF TARGETING INCENTIVES THAT CAN ALLOW A REASSESSMENT OF RISK. ) its likely returns from scratch.

The same effect is at play with fiscal easing. When state borrowing breached the government’s self-imposed 40% debt ceiling, the anchor was broken and little credibility may be given to promises of future prudence as debt reaches 45%, then 55% of GDP and beyond. However if a new anchor is created, say at the Eurozone’s 60% level, this creates a qualitative limit – immediately more credible than an arbitrary quantity. This anchor in turn can change behaviour in the government debt market because it gives agents( YES ) a new focus for their decisions.

If the utility gradient model is correct, it is better to enter the recession sharply – even at the cost of a big immediate reduction in GDP – if it creates an expectation that we have hit the bottom. When people believe it can only get better from here, they will act accordingly – investment and spending will start( A GOOD POINT ).

I do not suggest that behavioural and psychological considerations are the only cause of the crisis. But they make a substantial contribution to its persistence( OK ).

The paradoxical conclusion is that it may not matter what new institutions or new rules are designed – as long as something is done. Any new framework gives agents( YES ) a reason to abandon their anchor to fear( EXACTLY MY POINT ); and gives them a chance to reattach themselves to hope. This – the converse of Keynes’ paradox of thrift – is what will ultimately rescue the world economy.

References

Danielsson, Jon and Casper de Vries, “Money Market on Strike”, Financial Times Economists’ Forum 9 November 2008
Downs, Anthony. An Economic Theory of Democracy. New York: Harper, 1957.
Gordijn, Jaap and Hans Akkermans. “A Conceptual Value Modeling Approach for e-Business Development”. Proceedings of the Workshop Knowledge in e-Business, pp 29-36 (2001)
Loewenstein, G. and D. Prelec, “Anomalies in Intertemporal Choice: Evidence and an Interpretation”, Quarterly Journal of Economics 107, no. 2 (May 1992), pp 573-597
Rios, S., “An Interactive Sequential Approach to Multicriteria Decision Making”, Extracta Mathematicae 2, no. 1, pp 26-28 (1987)
Simon, Herbert. “Rational choice and the structure of the environment”. Psychological Review, 63, pp 129-138 (1956).

---

1 This research is underway and not yet published, but will be published as “Multidimensional utility and a model of bounded rationality”, by Intellectual Business in 2009. A summary of this and other ongoing research is available at http://www.intellectualbusiness.org/
2 Janet Yellen’s speech to this conference provides an excellent summary of relevant literature."

An excellent Human Agency Explanation approach.