"Nudging" Markets Towards Efficiency

A very interesting initiative is being done within the US and Britain that attempts to improve our lives by making markets more useful, productive, empowering, and efficient--based on the theoretical models of leading behavioral economists. These initiatives are excellent examples of how governments and private market actors can work in cooperation to create an economic system that benefits society, not just a small group of dominant actors. Below is an article from Richard H. Thaler, professor of economics at University of Chicago GSB, describing a number of these initiatives.

NEW YORK: Governments have learned a cheap new way to improve people’s lives. Here is the basic recipe: Take data that you and I have already paid a government agency to collect, and post it online in a way that computer programmers can easily use. Then wait a few months. Voilà! The private sector gets busy, creating Web sites and smartphone apps that reformat the information in ways that are helpful to consumers, workers and companies.

Not surprisingly, San Francisco, with its proximity to Silicon Valley, has been a pioneer in these efforts. For some years, Bay Area transit systems had been tracking the locations of their trains and buses via onboard GPS. Then someone got the bright idea to post that information in real time. Thus the delightful app Routesy was born. Install it on a smartphone and the app can tell you that your bus is stuck in traffic and will be 10 minutes late — or it can help you realize that you are standing on the wrong street, dummy. It gives consumers a great new way to find out when and where the bus is coming, and all at minimal government expense.

Another example involves weather data produced by the National Oceanographic and Atmospheric Administration. The forecasts you find on the Weather Channel, or on the evening news or online, use the agency’s information. Again, the government produces and releases raw data, and the private sector transforms it into something useful for the public.

Several other departments in the Obama administration are looking to expand the use of such techniques. On data.gov, you will find huge amounts of downloadable data that had heretofore been inaccessible. As a sign of the importance that President Obama has attached to this approach, he put it on the government’s agenda on Jan. 21, 2009, his second day in office. (Disclosure: My book, “Nudge,” published in 2008, advocated this broad idea; Cass R. Sunstein, co-author of the book, is now administrator of the White House Office of Information and Regulatory Affairs.)

Now the administration is pushing to use this concept as a tool for regulation, and as a method of avoiding more heavy-handed rule making. The idea is that making things more transparent can immediately turn consumers into better shoppers and make markets work better. One might think that such an initiative would receive nearly universal support — after all, who could be against openness and transparency? But it turns out that some people are.

Two cases are under discussion right now.

First, the Department of Transportation is considering a new rule requiring airlines to make all of their prices public and immediately available online. The postings would include both ticket prices and the fees for “extras” like baggage, movies, food and beverages. The data would then be accessible to travel Web sites, and thus to all shoppers.

The airlines would retain the right to decide how and where to sell their products and services. But many of them are insisting that they should be able to decide where and how to display these extra fees. The issue is likely to grow in importance as airlines expand their lists of possible extras, from seats with more legroom to business-class meals served in coach.

Electronic disclosure of all fees can make it much easier for consumers to figure out what a trip really costs, and thus make markets more efficient, without requiring new rules and regulations. (As someone who once bought two tickets on a discount airline from London to Dublin for the advertised price of £1 each, then ended up paying hundreds of dollars for the privilege of bringing along two heavy suitcases, I acknowledge having a sore spot on this issue.)

Another initiative has been proposed by the Consumer Product Safety Commission. In 2008, Congress overwhelmingly passed and President George W. Bush signed legislation mandating an online database of reported safety issues in products, at saferproducts.gov. The Web site ran for a few months in a “soft launch” and went into full operation on Friday.

But a majority in the House of Representatives passed an amendment last month that might have stopped this initiative in its tracks. The amendment, sponsored by Representative Mike Pompeo, a Kansas Republican, would have prohibited the agency from spending any further money to start the site. One goal, of course, was to cut the budget, although proponents of the amendment also argue that the Web site might include information that is erroneous and damaging to the businesses that sell children’s products.

Yet several provisions in the final rules protect manufacturers from false or malicious statements. Consumers have to include identifying information and sign an affidavit testifying to the truth of their complaints. Furthermore, manufacturers will be able to see complaints before they are posted, and can then correct mistakes or add comments.

ALTHOUGH this amendment was passed in the name of deficit reduction, the requested money for the site is a puny $3 million a year. If we want to reduce the cost of government regulation, this is exactly the kind of effort we should be applauding and expanding.

Compared with the tiny costs, the benefits of this program could be enormous. Thirteen years ago, two of my dear friends experienced the nightmare that parents dread most. They were called at work by their child-care provider and told that their 18-month-old son had died in a crib accident. Imagine their anguish when they later learned that other children had died in this model of crib, and that still others had died in cribs with similar design. Yet there was no easy way for any parent or child-care provider to know that.

In a recent three-year span, some 265 children under the age of 5 died in accidents related to nursery products, the government has reported. If this program could reduce that number even slightly, the cost would seem amply justified.

Moving the government into the 21st century should be applauded. In a future column, I will explain how the release of some kinds of data can even help consumers better understand themselves. (read more)

Man vs. Machine on Wall Street: How Computers Beat the Market

William D. Cohan--the author of House of Cards: A Tale of Hubris and Wretched Excess on Wall Street (2007) and Money and Power: How Goldman Sachs Came to Rule the World--has an insightful article in The Atlantic that investigates the increasing role of computer modeling by quants in the financial markets. The ubiquitous use of technology and complex algorithmic modeling--which are often executed by computers themselves--to beat the market brings a number of socio-logically interesting questions to mind: 1) are computer driven models more likely to experience large swings; 2) are computer driven models more likely to exhibit social contagion and cause negative effects for the larger society; 3) can this technology be regulated by the State; and 4) can technology be guided so as to benefit capital allocation throughout the market, and the broader society.

The Atlantic--With the winter's second blizzard raging outside, Cliff Asness sat in his relatively modest office in Greenwich, Connecticut, surrounded by three of his partners, his PR guru, an impressive collection of unread books, and a sea of foot-tall hard-plastic replicas of Spiderman, the Incredible Hulk, and friends. "Let me be technical," he said. "It all sucked."

Asness--intense, bald, and bearded, with a $500 million fortune and a doctorate in finance--was reflecting on the dark days of 2008, when capitalism seemed to be imploding, when Bear Stearns and Lehman Brothers had collapsed and the government had hastily arranged bailouts of Merrill Lynch, Morgan Stanley, Goldman Sachs, and AIG, among others.

His own business, Applied Quantitative Research--one of the world's leading quantitative-investment, or "quant," funds--had also suffered painfully. The money his team managed fell to $17.2 billion in March 2009, from a peak of $39.1 billion in September 2007, as clients headed for the exits with what was left of their cash. Such losses can be fatal for fund managers like AQR, since sophisticated investors pay them big fees for exceptional performance and, understandably, have little patience for anything less. As AQR's founders felt the tremors from Wall Street rippling through their offices, Asness said, "we worried about the stability of the financial sector, the stability of the economy, and the stability of society." To Bloomberg Markets magazine, last fall, he was even more explicit: "I heard the Valkyries circling. I saw the Grim Reaper at my door."

Yet they survived. And AQR--which makes its fortune, like other quants, by using high-speed computers and financial models of extraordinary complexity--has made a stupendous recovery in the past two years. At the end of 2010, AQR had $33 billion in assets under management. Its funds' performance was up nearly 20 percent last year, after being up 38 percent in 2009.

This is all the more striking because many analysts believe the quants helped cause, or at least exacerbated, the meltdown by giving traders a false sense of security. The risk-control models these firms pioneered encouraged Wall Street to take on excessive leverage. Their trading strategies, which deliver excellent returns in normal times, functioned poorly in the irrationality of a financial panic, and reinforced a frenzy of selling. Although predictions of the death of AQR and its ilk, by the writer and investor Nassim Taleb, among others, turned out to have been greatly exaggerated, worries linger, even as some high-profile quants have surged back. Taleb and the other critics think their overreliance on computers gives quants excessive confidence and blinds them to the possibility of seemingly rare economic catastrophes--which seem to be not so rare these days. (This was the theme of Taleb's best-selling book, The Black Swan, which examined the effect of the "highly 
improbable" on markets, and on life.) As Exhibit A, they point to the extraordinary events of May 6, 2010, when the Dow dropped by nearly 1,000 points in a few minutes after an algorithmic program executed by the investment firm Waddell & Reed, in Kansas, triggered a terrifying blitz of automated buying and selling by other financial computers. The market quickly recovered, but many worry that the episode was a preview of greater turbulence ahead as machines gain control of more and more trading.

Scott Patterson, a former Wall Street Journal reporter and the author of the 2010 book The Quants, told me he can envision a world, not too far away, in which artificial intelligence could vanquish human trading altogether, just as it has Garry Kasparov on the chessboard. "I'm not totally against quants at all, because I think they are a very powerful way of investing," Patterson said. But, like a number of other critics, he thinks they might encourage a cycle of booms and busts, and possibly intensify the next crisis. "Go to a trading room, it's just guys on computers," he said. "And a lot of times it's not even guys, it's just the computer running the machine. I don't want to demonize it. I think there has to be a happy medium. But I'm personally worried that it can run off the rails."

As much as anyone else, Cliff Asness has shaped and 
embodied this world of automated high finance. And though his experience--from academia to Wall Street to Greenwich--has been marked by recurring crises, and though he admits that no one can predict when the next big one will hit, he's more confident than ever in the power of data and mathematical models, in his hands, to beat the market consistently over the long term. And, once again, the data are telling him he's right. (read more)

Offshore Banking and Tax Havens are Central to the Global Economy

As millions of Americans prepare to file their income taxes ahead of Monday’s deadline, this report looks at how corporations and the wealthy use offshore banks and tax havens to avoid paying taxes and other governmental regulations. "Tax havens have grown so fast in the era of globalization, since the 1970s, that they are now right at the heart of the global economy and are absolutely huge," says British journalist Nicholas Shaxson. "There are anywhere between $10 and $20 trillion sitting offshore at the moment. Half of world trade is processed in one way or another through tax havens." Shaxson is the author of the new book, Treasure Islands: Uncovering the Damage of Offshore Banking and Tax Havens. (read more)

The Post-Crash: Wall Street Won

The April 18th issue of New York Magazine titled "The Post-Crash: Wall Street Won...
So why is it so worried?" investigates the effects of the 2008 financial crisis on the minds of Wall Street bankers, financiers, and money managers. Three articles, in particular, shed light into the ecstatic, neurotic, and perhaps deluded psychology of the post-crash financier. The articles raise a number of interesting points, which in-turn lead to a number of interesting questions: 1) what have financial organizations and entrepreneurs learned from the 2008 financial crisis?; 2) will there be any changes in the cultural norms on Wall Street?; 3) how can regulators attempt to reign in a financial sector that has return to its pre-crisis power?; and 4) if individuals on Main Street once again see that their pensions and retirement portfolios are increasing in value, then will they support strong legislation that restricts the financial sector?

The following is an excerpt from "The Wall Street Mind: Triumphant…" At the end of March, Neil Barofsky, on his final day as the special inspector general of the Troubled Asset Relief Program (TARP), published a scathing indictment of the program over which he’d served as watchdog since its inception in that awful, apocalyptic autumn of 2008. On the op-ed page of the New York Times, Barofsky argued that TARP had “failed to meet some of its most important goals”: protecting home values, easing the foreclosure crisis, alleviating the credit crunch—helping Main Street, in other words. Indeed, only when it came to aiding Wall Street had TARP worked like a charm. “Billions of dollars in taxpayer money allowed institutions that were on the brink of collapse not only to survive but even to flourish,” he wrote. “These banks now enjoy record profits and the seemingly permanent competitive advantage that accompanies being deemed ‘too big to fail.’ ”

Without necessarily intending to, Barofsky’s op-ed provided the perfect coda for the era of bailout rage—a two-and-a-half-year spasm of populist fury that promised, or threatened, to inflict enormous changes on the financial sector. In the political realm, Wall Street faced the prospect of root-and-branch reregulation, up to and including the potential nationalization of the industry’s largest players, and in the cultural realm its transfiguration into a kind of pariah state. Once upon a time, the Street’s leading lights had been glamorized and admired to the point of worship; now the likes of Robert Rubin, Lloyd Blankfein, and Richard Fuld were relentlessly pilloried and demonized. Once the megabanks were seen as indomitable powerhouses and sources of “financial innovation” (whatever the hell that was); now the greatest and most fearsome of them all, Goldman Sachs, was recast—by a famous and infamous Rolling Stone screed—as a “great vampire squid.”

Yet today on Wall Street, all of that seems a very long time ago. Not only are the banks rolling in dough again, but their denizens’ customs and sense of self-esteem have largely reverted to the status quo ante. With the enactment of a ­financial-­reform law that is widely seen as toothless, the peril posed by government intervention has receded, and with it the industry’s concerns about the vicissitudes of public opinion. Vampire squids? That’s so 2009—an eon ago in Wall Street time. We won, you lost, get over it, is the prevailing attitude.

A mixture of indifference to and disdain for the views of outsiders has, of course, always been a feature of Wall Street culture—an inevitable outgrowth of the industry’s profound insularity. “Most bankers haven’t a clue what the rest of the world thinks of them,” says Henry Blodget, the fallen ­Merrill Lynch analyst now reborn as a bumptious web entrepreneur. “Wall Street is its own world, with its own tribes, its own customs, and its own pay scales, which are otherworldly. Once you’re in that world, what matters most is your place in that world, not what the rest of the world thinks of you. Given their druthers, bankers would not choose to be loathed and ridiculed. But in the hierarchy of priorities, this concern comes at the end of a long list of concerns that starts with this year’s bonus.”

Now, you might think that, given the gargantuan havoc they wreaked on the global economy and the vicious backlash it inspired, the bankers might have engaged in a modicum of self-scrutiny over these past months—and in the process arrived at, if not enlightenment, then at least a mildly less exalted conception of their own value and virtue. But this supposition presumes at once a degree of reflectiveness never much in evidence on Wall Street and a sense of culpability for the crash that was equally unapparent even at its depths.

“This is a profession with a lot of smart people, but who aren’t necessarily terribly introspective,” says one of the city’s most prominent private-equity kingpins. “They think they actually deserve to make all this money. [And] they created for themselves a narrative where the irrational actions by a few people caused the meltdown. None of them were sitting there saying to themselves, ‘I was responsible for this crisis. Shame on me.’ ”

None of which is to say that the bankers were utterly impervious to the loud calls for their decapitation. “The crisis momentarily alerted Wall Streeters to the fact that the rest of world is flabbergasted and appalled by how much money everyone makes,” Blodget says. “This revelation was startling to Wall Street, and with the threat of incarceration [and reregulation] on the table, it led to a temporary focus on relative decorum. But that’s all over now, so Wall Street has cheerfully gone back to doing what it’s great at.” (read more)

A Shifting Economics Paradigm?

The 2008 financial crisis shook the foundations of our society and how we think about the interconnectedness of economy and society. An important force in shaping how we think of the economic system is the economics discipline. Economics has historically built the conceptual and theoretical models that have influenced economic policy by our nation's leaders and central banks, and firm's strategies in the market. These dominant ways of thinking--paradigms--hindered most economists from accurately predicting the near-collapse of the financial markets and the broader shocks to the credit and housing markets. As a result, many argue that the profession is partly responsible for the crisis and must re-evaluate how it approaches the study of the economy. The dominant paradigm of the economics profession has been called into question. There is, however, a new community of scholars who are trying to nudge the economic's profession in a new direction and to shift the dominant paradigms that underlie it forward--The Institute for New Economic Thinking.

INETeconomics--It’s time everybody recognized that our 20th century economic thinking is not fit for life as we know it in the 21st century.

The prevailing thinking, that the economy is an idealized system of perfectly rational, optimizing individuals and institutions, who, by trading in markets, bring the economy to a balanced, efficient equilibrium has been rendered obsolete by developments in recent years.

Markets are global. Money moves instantaneously 24/7, and is now a raw material for financial innovations. Regulators are fallible and market participants frequently fall below the standard of being perfectly rational.

Economic thinking has not kept up with these and other developments that now define us, and that fact deeply affects everyone – as we learned in our most recent global financial crisis.

Spurred by the financial crisis and recent developments in the economics field, a far more realistic view of the economy is emerging that takes into account imperfections in individuals, institutions, and information, as well as the existence of complex global networks of interaction, and the dynamism of innovation.

This “new economic thinking” has the potential to profoundly impact society in areas ranging from government policy and financial system reform, to solving climate change, poverty and inequality, and driving sustainable growth in the long run. In other words, new economic thinking can enable a better world for all.

The Institute for New Economic Thinking’s mission is to nurture a global community of next-generation economic leaders, to provoke new economic thinking, and to inspire the economics profession to engage the challenges of the 21st century.