Category — Books

Farjoun and Machover’s classic on Probabilistic Political Economy is now available for free download, you lucky sods. Just click the image below to get the .pdf. Thanks to Dr. Ian Wright for putting this up for everyone, it’s a pure public good.

Image by Getty Images via Daylife

This is the second part of the course, where we look at strategic behaviour under uncertainty. Lectures one, two, three, and four were all about establishing the theory of demand under certain conditions. We don’t live in a world of certainty, but its exact opposite, so we must change the theory to account for the presence of the unknown in economic life. We have not been too successful at this, but the theory remains, and we will learn it.

The mainstream theory of how we deal with choice under uncertainty and our interactions with others is built on probability theory. 

Definition (Probability). The probability of an event occurring is the relative frequency with which it occurs. 

Example. Toss a coin a large number of times, and the likelihood you get Heads will be 1/2. Roll a dice a large number of times, and you will roll a 6 on average 1/6 of the time.

Definition (Expected Value). The expected value of a game with several uncertain outcomes is the size of the prize the winner will get, on average. It is the average outcome from an uncertain gamble. 

Example. In a 2-player game of tossing a coin and predicting whether it comes up heads () or tails (), with payoffs to each player being +1 and -1 respectively, then the expected value of the game is 

So in this game, neither player would make out too well over time. 

Risk Aversion. People prefer less risk, especially when the stakes are quite high. The reason is the interaction of the potential payoff (the above) and the probability of obtaining that payoff. We say there is diminishing marginal utility from the consumption of further and further amounts of risk. In terms of pricing risk, we can look at Figure 1 below:

Here we see the utility associated with a certain level of risk is concave to the origin—meaning when things get more risky, the person is less likely to derive a correspondingly high utility from that risky situation. If the person were truly risk-neutral, then they would pay for a gamble, but they don’t, because for them, the bet simply is not worth it. As the HET site writes:

Notice by comparing points D and E in Figure 1 that the concavity of the elementary utility function implies that the utility of expected income, u[E(z)] is greater than expected utility E(u), i.e. u[pz₁ + (1-p)z₂] > pu(z₁) + (1-p)u(z₂). This represents the utility-decreasing aspects of pure risk-bearing. We can think of it this way. Suppose there are two lotteries, one that pays E(z) with certainty and another that pays z₁ or z₂ with probabilities (p, 1-p) respectively. Reverting to our von Neumann-Morgenstern notation, the utility of the first lottery is U(E(z)) = u(E(z)) as E(z) is received with certainty; the utility of the second lottery is U(z₁, z₂; p, 1-p) = pu(z₁) + (1-p)u(z₂). Now, the expected income in both lotteries is the same, yet it is obvious that if an agent is generally averse to risk he would prefer E(z) with certainty than E(z) with uncertainty, i.e. he would choose the first lottery over the second. This is what is captured in Figure 1 as u[E(z)] > E(u).

We have many ways to cope with this type of risk, but the three most common are:

1. Insurance
2. Diversification
3. Options

We’ll go through each of these in class with a demonstration about the market for used cars. 

Not that there is always and everywhere a fundamental uncertainty—we can’t know what we don’t know. For more on this, see The Black Swan by Nassim Taleb, or my review of that book here. 

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Click below to watch Robert Kennedy talking about Gross National Product and its flaws, more than 40 years ago. EC4004 students should pay particular interest. It’s a lovely piece of film.

Via Economist’s View via via the other EV

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I’ve just finished Robert Shiller’s Subprime Solution: How Today’s Global Financial Crisis Happened, and What to Do about it.

The book is a short, sharp taste of Shiller’s trademark clarity as a writer, polemicist, and thinker, and he makes some interesting points.

First, he thinks the subprime meltdown had more to do with psychology and sociology than economics. People believed themselves into a bubble, to the point where even rational, conservative people like the heads of Fannie Mae and Freddie Mac couldn’t forsee price drops of more than 13.4% in the housing market.

There is a strong theme of irrational responses in the face of fundamental uncertainty in this book, something The Black Swan author Nassim Taleb (who wrote a blurb for Shiller’s book) has a lot to say about. Most of the leaders of the day couldn’t see the subprime crisis as it happened, simply because they didn’t think these issues could ever get that bad.

Shiller spend a lot of time comparing the housing bubble in the US from 2000-2007 to the housing bubble which existed in the 1920’s just before the stock market crash of 1929 and the ensuing Great Depression. Then, as now, people let prices of houses outstrip the prices of building those houses, and people borrowed cheap money, knowing the interest rates wouldn’t stay so low, in the hopes of flipping the house or re mortaging it later on based on continually rising house prices. People bought to flip, and in that Ponzi game type scenario, when there are no more willing buyers, the bubble collapses, as we can see from the Case-Shiller (yep, that Shiller) index below:

Shiller devotes a lot of time to setting out his stall for the `irrational exuberance‘ argument for manias, panics, and crashes (to rob a term from Charles P. Kindleberger), concluding the economics of the situation were clouded by a story we all told ourselves enough to believe it beyond the point where it was smart to do so. We fooled ourselves, so shame on us.

The historical narrative Shiller threads through the opening part of his book is both enlightened and well placed, but I don’t think experts on the Great Depression would agree it was primarily caused by a housing boom. There might be an element of Whig history to the professor’s argument here, but nonetheless, it makes sense, and isn’t wrong, per se.

So Shiller sets out his stall: there is a deep seated problem in the economy reaching from the US real economy through to the US financial sector, across the world via a highly interwoven financial industry, and back again to the US real economy. There are striking parallels between the current situation and the conditions which preceded the Great Depression. We are in trouble.

Fine. I agree. But how to solve the problem?

First, Shiller is in favour of bailing out those worst affected right away, and on a massive scale. Think Dobb-Frank on steriods. Shiller wants to stop millions of people getting thrown out of their homes, because to allow this would be an injustice. A bail out seems, in my opinion, to me an enlightened policy.

Second, Shiller wants policy makers to change regulatory environments and financial institutions in the same broad sweeping reforms we saw after the Great Depression. Shiller wants a New New Deal. For example, changing the rules on selling variable rate mortgages to people who most likely will default would kill the subprime crisis. People in the financial industry knew this would happen, but no one wanted to tell them this, because they weren’t legally obliged to do so. The incentives weren’t set correctly, and those are what Shiller wants to change through institutional reform.

(It seems to me Shiller wants a more efficient information transmission mechanism, ala Joseph Stiglitz and George Akerlof, but the likelihood of getting such sweeping reforms through the US Congress seems overly optimistic. The institutional innovations (Fannie Mae and Freddie Mac amongst them) spurred on by the Great Depression occurred in a period of political optimism and also crisis, but without the neo-liberal influence and increased financial and economic globalisation which characterise the modern era.)

Third, Shiller wants us to understand the psychological nature of the crisis: over-confidence created the crisis, but under confidence made it worse.

Fourth, the subprime crisis is a truly global financial crisis, perhaps on the scale of the Great Depression, but the problems generated by the crisis’ effects like the credit crunch can be solved before they are allowed to worsen.

Overall, I enjoyed reading this book, I’ll read it again, and I’ll make it part of my EC4024 financial economics course next semester as background reading. The Subprime Crisis might, in 100 years’ time, be seen in the ranks of the great policy-relevant polemics of economics like Keynes’ Economic Consequences of the Peace. I won’t be around to see it, neither will Shiller, but if people take on board some of Shiller’s suggestions, they might have the luxury of looking on all of this as a historical episode, an artifcat of an undeveloped financial regulatory infrastructure, and a curiosity to be studied by economic historians. Or they might be getting booted out of their houses. Either way, history will prove Shiller right or wrong, as it did Keynes

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