Does it matter whether markets are efficient?

Reading the series of New Yorker articles with Chicago economics/finance faculty, I was struck by how frequently the idea of of efficient markets came up.  Something like, "How does the recent financial crisis influence your thoughts about market efficiency."  And the general response seems to be "Not very much."

There's a lot of criticism of academics and their rigid beliefs.  For example, you could stroll around the Motley Fool discussion boards and find numerous references to critiques of the theory.  It's a lot of wasted words, oftentimes with people talking past one another and arguing over semantics rather than ideas.  But my two pervasive thoughts on this are:

1. It would generate much less disagreement to describe markets as extremely competitive rather than as describing them as "efficient" or "inefficient".
2. Believing that markets are efficient is much less likely to cause troubles in your life than believing that markets are inefficient.**  If you're going to insist on a black-and-white world, you're better off believing in perfect efficiency.

**Not true if you are a credit analyst relying on spreads for your ratings.

Did the stimulus work? Make sure your priors are consistent

Lots of people have criticized the stimulus package and it’s hard for me to know whether the type of stimulus package we saw was likely to have helped us in the recent financial crisis.  But I have seen a couple of arguments pretty frequently that I think are inconsistent with one another.  And it seems to me, although I’m not positive, that these two arguments are made by the same types of critics. Of course, given that support of the stimulus (outside of those like Krugman who argued it should be larger) fell largely along liberal/conservative lines, it's not surprising that criticisms would come from one side of the aisle:

1. The stimulus package couldn’t have been successful because the bulk of it hasn’t even been spent yet.  (Perhaps represented by this type of article:  http://www.cnsnews.com/news/article/57617)
2. The Ricardian equivalence argument that every dollar of stimulus spent by the government dissuades a dollar of private investment because people rationally believe that the government’s spending will necessitate future tax increases. That anticipation causes people to save more to finance the future spending.  (This seems in line with John Cochrane in his recent New Yorker interview, here:  http://www.newyorker.com/online/blogs/johncassidy/2010/01/interview-with-john-cochrane.html.)

I don’t know if people rationally anticipate future inflows and outflows or if they don’t. The cheap answer (but one that’s probably right) is that they do sometimes or to some degree.  But if you’re trying to make a logical economic argument for why the stimulus couldn't have worked (rather than an empirical stab at measuring whether it *did* work), it’s a cheap argument to say that people sometimes anticipate the future and sometimes don’t.  If you have to hold or drop your belief about rationality depending on how well the implications fit your priors, that’s a bad sign.

So to be clear, if you believe that the stimulus couldn’t have worked because the bulk of spending hasn’t occurred yet, it seems that you don’t believe people anticipate the net present value of future stimulus, and act accordingly.  That is, they only change their current consumption and investment decisions when they receive the stimulus funds (e.g., as a worker or supplier).  Until they cash the check, they remain hunkered down in a state of capital preservation.

If you believe that stimulus perfectly crowds out private investment/consumption because of the expected future taxation, it seems you do believe that people anticipate future inflows/outflows and change their current behavior appropriately.  The second seems in line with the idea of people adjusting their behavior in line with changes in the anticipated permanent income.

Although I don’t have a quick example off-hand, I feel like I’ve seen both of these arguments coming out of the same corner.

Safety nets and whatnot

Over on Felix Salmon's blog, I made the following comment:

I think this is exactly right. If you want people to take more risks, you can either:

A. Increase the benefits they get from successful outcomes (which I view as the generally Republican view, such as reducing capital gains taxes or inheritance taxes)

B. Decrease the costs they bear from unsuccessful outcomes

C. Increase the probability of a successful outcome

I think all of these are plausible goals, but in my eyes if you want me to walk a tightrope, making the wire more stable and adding a safety net is going to jack up the probability much more than adding some gold to the pot on the other side.

As Greg Mankiw or Charlie Munger would say, incentives matter.  But there are often a variety of (changes in) incentives that would induce the same (changes in) behavior.  I left at least one alternative out:
D.  You can make the existing situation (e.g., current job, retirement system) more risky

In any event, it's easy to find examples of people arguing that bigger payoffs encourage more risk-taking.  Some interesting quotes from a 2002 article that does it (not sure why the Hawaii Reporter was the first google result, but who cares?):

President George W. Bush renewed his call for permanent repeal of the estate tax on March 19. "It is unfair, patently unfair, for any entrepreneur ... to develop her own business and have that business taxed twice as she tries to leave her assets to whomever she chooses," Bush told a Women's Entrepreneurship Summit in Washington, D.C. "We must make the repeal of the death tax permanent. I call upon Congress to do this immediately."

 "I do not believe the role of government is to create wealth," the president told last Tuesday's group at the Ronald Reagan Building and International Trade Center. "The role of government is to create an environment that encourages risk taking, an environment that facilitates the flow of capital, and an environment in which people can realize their dreams. ... And that's exactly what I intend to do as the President."

So why is it that I see so much push towards increasing payoffs to investment, but relatively little on enhancing the safety nets for failed outcomes?  I mean, it's understandable to think about the successes, but we can't ignore the "risk" in "risk-taking".  If we truly want to encourage people to take more risks, with the belief that risk-taking promotes economic growth, shouldn't we be using a full mix of incentives?  In other words, why so much "Incentive A" from above, but so little "Incentives B & C"?  Especially since, in my personal view, the likelihood that my future huge estate will be taxed upon my death is an infinitely minor reason for me not to strike out on my own.

One thing I find interesting is that "Incentive D" is in accord with Greg Mankiw's argument for negative real interest rates - make the status quo less desirable to push people into more investment.

Also, as I noted on Felix's blog, I recently saw Man On Wire, which I thought was fantastic.  Hat tip to Tyler Cowen for that.

Can this possibly be true?

On the nytimes website, Randall Stross writes:

I LOVE my iPhone. I just wish it were matched with Verizon Wireless, the carrier with the most envied reputation as fast, ubiquitous, reliable, nigh perfect.

I find myself saying this about 8 times a day.  But it turns out that Randall and I could be directing our angst at the wrong target.  

Consumer Reports has just released its annual survey of cellphone service, and its respondents collectively agree with me about the rankings: AT&T occupies the bottom and Verizon, the top.

[...]

And the iPhone itself may not be so great after all. Its design is contributing to performance problems.

I don't have any particular commentary to add to this, other than the fact that I'm absolutely stunned.  A few consequences:

1. I have an iphone now and had long ago decided that I was switching to Verizon as soon as they started offering the iphone.  Not so much now.
2. I have to acknowledge the fact that I don't know jack about technology and I should perhaps stop having such strong opinions about technology-related products.  
3. I already have a hard time thinking about what my next cell phone will be (I'm definitely upgrading - I've got a first generation iphone), and this confusion is going to make it harder for me.

So, I guess, sorry AT&T for my absolute-but-maybe-not-deserved hatred of you for the past few years?

Housing as an investment 2

The discussion on rortybomb continues, so I thought I’d add some more thoughts.

As humans, we are effectively short food and shelter for the rest of our lives, and you could probably add in insurance/medical care.  (I think Mike at Rortybomb made this point a while ago, but I couldn’t easily google it.)  That means that we need to somehow structure our earnings, consumption, and investment to satisfy those expected needs (future payments), bearing in mind that in our later years we’ll be doing very little earning and investing, and lots of consumption.

However, we have a choice on how we satisfy those needs.  One way is to prepay them while we are working, which is what one commenter suggests for our housing needs:

My view of the housing market, and why I think a lot of this anti-housing as an investment is silly, is that it’s a consumption good you will always need to consume. You’re not going to suddenly decide in 2027 that you might do without housing for a while. On that basis alone then it’s quite sensible to store it up for when you have no income, ie in retirement. It’s an almost perfect hedge of a large chunk of your consumption needs.

The commenter is right in one regard – we certainly do need to store up for our future consumption, when we’ll have no income.  However, the choice is not whether to save for the future, but in what vehicle.  Specifically, the above comment seems to argue that we should be prepaying for our housing needs.  Paraphrasing:  “Buy a house now so that you’ll have one when you’re not employed.” 

While I certainly agree with the need to save for future consumption, I don't see any reason that we should prepay our housing needs in the form of a single, non-diversified asset with large transactions costs.  Similarly, I think we can effectively save for our future food needs without filling our basements with cans of vegetables, soup, and spam.  (And beer!  Don’t forget the beer.  Some, especially stouts and barleywines age very well.)

So the choice isn’t save or don’t save for future housing consumption.  But rather, in what form.  Putting aside some very important factors (differences of housing types available for rent or sale, other payments like property taxes, maintenance, possible rent increases), it's an economic tradeoff between two different-looking cash flow streams.  In the same way that annuities can be easily converted into lump sums (and vice versa), it's straightforward to compare renting (effectively a negative annuity) with buying (a one-time lump sum).  It's inappropriate (in my opinion) to imply that buying is somehow different (and better) than renting because of the timing of the payments.

My impression of this debate is that most people arguing for housing as an investment view the purchase of a home as qualitatively better than renting a home (for reasons that are often poorly articulated), while the other side views it as more of a straightforward evaluation of the timing and magnitude of the cash flows.

Housing as an investment

Over on the fantastic rortyblog, Mike gets involved in a conversation on housing.  Specifically, he discusses the notion that housing is a good investment decision, as argued by Adam Ozimek.


I largely agree with Mike's broad point - too often people overvalue the notion that housing is an investment.  My particular bete noir is the idea that "rent is throwing money away" while mortgage payments are building up equity.  I think it's pretty intuitive that the decision to rent versus buy any asset hinges upon the relative cost of doing each.  Historically, it's been a very good idea to buy in most markets, especially considering that labor mobility wasn't as important as it is today and people were able to stay in one place for longer periods of time, avoiding the significant transaction costs associated with moving.


In any event, I fall in Mike's and Felix Salmon's camp of thinking that housing as an investment is generally a bad idea.  But I actually disagree (I think) with one of Mike's comments:

Felix notes: “DanHess and Matt Turner make the point that buying a house is a great way of forcing people to save over the long term.” There are no free lunches of course, and the reason it is a great way of forcing people to save over the long term is that it is incredibly expensive and difficult to get any money out of it.

I think the more straightforward reason is behavioral.  You've gotten people to commit to saving in a way that isn't transparent, so they're not actually aware they're doing it.  It's just that, 30 years later, they get to put a mortgage document on their grill and have a party when they realize how much equity they've built up.

It doesn't seem terribly different (to me, of course) from:

- withholding social security payments involuntarily

- automatic 401(k) enrollment

- the new programs where employees can commit that future raises will go toward retirement contributions (are these just hypothetical?  I feel like I've read about the idea many times, but haven't seen any actual examples)

In all of these cases, it strikes me that saving is made easier because there was something automated about the process, where the individual doesn't feel the "pain" of foregone consumption. 

(You could also point out that the mechanism of withholding income taxes accomplishes the same thing - reducing the public's understanding of how much in tax they actually pay.)

So overall, I actually do think it's a free lunch, in much the same way that a lot of valuable internet content is a free lunch.  Of course there's a cost - individuals truly are foregoing consumption, and internet contributors truly are laboring to create content without compensation.  It's just that in those cases, the people bearing the cost don't seem to mind as much as they probably should.

That didn't go as planned

So Jennifer left Top Chef last week, but I think my predictions had some merit.  First, I think the time off did Jennifer well - she seemed to be much stronger (both in attitude and in hair) than she did at the end of the regular season.  She performed well in the quickfire and seemed* to do well in the elimination challenge.

Mike V. also lived up to my expectations, in terms of making ostensibly risky decisions (the 63 degree egg, which led to the awesome "it's up to the egg at this point" statement).

The big disappointment for me was in the show's editing.  Leading up to the final announcement, it seemed that Michael's dish was not strong (i.e., the risky egg decision had backfired AS I PREDICTED LAST WEEK) and Jennifer seemed to have done well.  When they announced that Jennifer would be packing her knives, I was a bit surprised.  Then, reading Tom's blog I read:

"It may not make sense to you but it was clear to us immediately that it would be Jen who would be going home. What it came down to was that both of her dishes were way too salty. Jen’s overseasoning of both her dishes stood out to the judges like a sore thumb. We had our conversation at Judges' Table about whom to send home, but it was pro forma; we already knew and were in complete accord."

OF COURSE IT DIDN'T MAKE SENSE TO ME AS THE EDITORS SEEMED MORE INTENT ON KEEPING UP A MYSTERY THAN ON PROVIDING AN ACCURATE CHARACTERIZATION OF THE JUDGE'S DISCUSSIONS.

Meh.  I still vote Kevin for the win, as does apparently ever other person on the internet.

Other notes:
This is a relative statement, but Padma didn't look nearly as attractive as she historically has.  The bangs looked somewhat ridiculous.

I had the Daisy Cutter Pale Ale, which gets insanely high ratings on beeradvocate.com, higher than Alpha King even.  I don't get it.  It smelled fantastic, like a thick and rich double IPA, but it tasted very, very thin.  I didn't care for the disconnect at all - for that taste, I wanted something much richer and velvety.