Wednesday, October 30, 2002

Deflation

This week on Life Matters with Geraldine Doogue I discussed deflation, as I had on The Business Show on SBS TV on Sunday.

If you haven't thought much about deflation, that's okay. Many Australians hadn't thought much about inflation back at the start of the 1970's. They needed to be convinced that it could be a problem. That's the sort of situation we are in now with deflation. It is happening. Price indexes are falling in China, Japan, Singapore, Hong Kong and Taiwan. They are on the edge of falling in Europe, and may soon fall in the United States. But is it a problem?

Japan's problems are well known - but there's more than deflation involved. The argument is that falling prices encourage consumers to put off spending in the expectation that prices will fall further, which encourages producers to cut prices to try to sell goods. And so on. Also loans become harder, not easier, to repay over time, forcing investors to sell assets, which pushes down the value of houses etc. in another downward spiral.

Well, that's the argument. On Life Matters and on the Business Show I asked whether deflation was really that bad, just as skeptics asked the same about inflation in the early 1970's. The answer may be that it is a question of degree. Mild inflation (two or three per cent) probably doesn't encourage consumers to bring forward spending, just as mild deflation probably doesn't encourage them to postpone it. As the macroeconomist Barry Hughes asked me: If you save $200 on the price of a $20,000 car by delaying buying for a year, would you do it?

And the downward asset price spiral caused by the inability to pay off loans is probably unlikely to take hold while interest rates are falling.

Which brings us to the real fear about deflation - seen in Japan, that it'll be impossible to get out of by cutting interest rates. In Japan they are already at zero.

The US Fed has studied what happened in Japan and it finds that there's a fundamental asymmetry in the management of prices. Interest rates can always be pushed high enough to kill inflation, but they can't necessarily be pushed low enough to kill deflation. Therefore it says central banks should err on the side of caution when deflation is a possibility. It's better to have prices moving up too much than it is to have prices moving down too much. You can always correct inflation. You can't always correct deflation. It is a message Australia's Reserve Bank is probably taking on board.

So, does Australia need to worry? Our CPI looks healthy - it is moving up at the rate of 3.2 per cent a year, but within that, the price of goods is scarcely moving at all. The price index for private sector goods moved up only 0.1 per cent in the September quarter. And this after three years in which our dollar has devalued against the US by about 30 per cent. So deflation is clearly knocking on our door. But against that most of what we do in Australia is not particularly affected by the price of manufactured goods. Australia specialises in mining, agriculture and services. We may be one of the last countries in the world to succumb to worldwide deflation should it take hold. Although we would certainly be affected by any worldwide recession that resulted.

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Friday, October 25, 2002

The limits to economics.

On Life Matters with Geraldine Doogue last week I discussed what the Bali tragedy and others like it tell us about the limits to economics and pricing.

After September 11 last year Allianz Insurance specifically excluded from its travel insurance policies cover for consequences of acts of terrorism.

Yet as soon as an act of terrorism took place that exactly fitted the criteria for exclusion, Allianz waived the exclusion.

Many Australian travelers to Bali chose not to take out travel insurance, knowing that their cost of travel back home would not be covered if something went wrong.

And yet within hours of the Bali tragedy the Australian government said it would help out anyone who wasn't insured.

Which might make you wonder whether there is any point in treating the wording on insurance policies seriously...

I am told (perhaps unreliably) that the first-class tickets for passengers on the Titanic entitled them to guaranteed access to lifeboats. Not so for the third-class tickets.

And yet when tragedy struck the clearly-defined rules fell apart.

Tragedy shows up the limits to economics and pricing.

As do religious matters. In 1990 Clive Hamilton headed research at the Resource Assessment Commission. He attempted to put a financial value on the worth of preserving Coronation Hill at Kakadu. He used to ascertain how much money Australians would be prepared to pay to have Coronation Hill not mined. He told me later that he lost his faith in such surveys when he asked himself how it would sound if he asked the same questions to an aboriginal people with spiritual ties to the land. Even to ask the questions would be offensive, and would degrade the religious attachment it was attempting to measure.

That's the concept I dealt with on Life Matters, quoting from a paper entitled Taboo Tradeoffs: Reactions to Transactions that Transgress the Spheres of Justice.

The Abstract says:

"Taboo trade-offs violate deeply held normative intuitions about the integrity, even sanctity, of certain relationships and the moral-political values underlying those relationships. For instance, if asked to estimate the monetary worth of one's children, of one's loyalty to one's country, or of acts of friendship, people find the questions more than merely confusing or cognitively intractable: they find such questions themselves morally offensive."

God, life and death, and love appear to be among the entities that pricing is not only bad at handling, but to which it can do enormous damage.

The authors Fiske and Tetlock attempt to explain why this is, and suggest ways how, in the absence of prices, we can rationally make the tradeoffs that we have to between say, mining and god, or prices and life.

I agree with them that prices are useless and actually cause damage in many circumstances, I think their explanations of why this should be the case are reasonable, but I find their suggested solution unsatisfying. Having said that, I can't think of a solution at all. How can you trade off apples and oranges if you can't use prices?

Worth a read.

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Tuesday, October 15, 2002

More (maybe less) happiness

Returning to happiness once more (it is after all a research area of one of the winners of this year's Nobel Prize for Economics), Don posts this interesting comment:

"A lot of people have seized on this research because they like the conclusions it seems to lead to - things like wealth and income redistribution, direct job creation and high taxes on luxuries.

These people ought to stop and think.

Try these thought experiments:

1. A neuro-psychologist invents a therapy which she guarantees will instantly resolve feelings of bitterness and injustice and induce long lasting feelings of contentment and well being. She suggests administering it to Indigenous land rights campaigners and members of the stolen generation. If it makes everyone happier then what's the problem?

2. Imagine that new research demonstrates that people who are poor in relative terms are only unhappy because they know that others are better off. This leads to contentment sapping cognitions of unfairness. Should we improve their level of happiness by banning media portrayals of wealth? Could we improve their standard of psychological well being by segregating poor people so that wealth disparities are concealed from them?

3. Imagine that researchers discover that some people are using opera, classical music, and listening to Radio National as positional goods ('cultural capital'). They choose these things in order to set themselves apart from ordinary folks who prefer things like action movies, Kylie Minogue, and Alan Jones. Should we abolish government subsidies to opera, orchestras, and Radio National?

Could it be that there's more to life than being happy?"

My response: A very good point.

I said (on ABC Radio National) some years ago that the ultimate goal of life had to be more to life than merely happiness.

Otherwise we would all take a happiness drug or connect ourselves to electrodes that stimulated the happiness parts of our brains.

We need struggle, we need to be unsatisfied, we need stress in order to make life truly rich.

As I say to my daughter, stress, even anguish is like salt. We need some, but not too much in order to make life truly taste good.

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The Nobel Prize for Economics

That was my topic of conversation with Geraldine Doogue on Monday.

The most interesting winner isn't even an economist. He is the psychologist Daniel Kahnerman. The most interesting thing I have read about him is in this article by Jason Zweig in the US magazine Money in May 2001.

"Kahneman was born in Tel Aviv in 1934, but his French parents returned home to Paris when he was three months old. Six years later, as Kahneman was finishing first grade, the Nazis invaded France, and his family was forced to wear the yellow star that marked Jews for deportation to the death camps. His father, a research chemist, was taken away but then released because he was considered useful to the war effort. The family escaped to unoccupied France and spent the rest of the war in hiding and on the run. His father died in 1944, and 12-year-old Danny moved to Palestine with his mother two years later.

Kahneman thought of becoming a physicist or economist, but he ended up studying math and psychology at Hebrew University in Jerusalem. He finished his B.A. at the age of 20. Having survived so many horrors, he had already developed a deep distrust of things that others take for granted--the notion that humans are rational, the confidence that knowledge can solve all problems, even the belief that there's a God. He entered the work force as an unorthodox thinker determined to challenge the status quo."

There is much, much more. As I said, it is the best account, and it was written 18 months ahead of the Nobel.

Here are two quizzes:

Quiz One:

600 individuals contract a severe illness. There exist two options:
A. Definitely saving 200 people;
B. There is a 33% chance of saving all the patients and a 66% chance that all will die.

Which would you choose?

Quiz Two:

600 individuals contract a severe illness. This time, the two options are:
A. 400 patients will definitely die.
B. There is a 33% chance that nobody will die.

Which would you choose?

Kahneman found that

Quiz One: 72% of subjects chose the first option.
Quiz Two: 78% of subjects chose the second option.

You may have noticed by now that Quiz One and Quiz Two are the same.

It felt a bit funny to be talking to Geraldine Doogue about such matters on Monday. Everything feels strange at the moment.

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Monday, October 07, 2002

The law of small numbers

Today on Life Matters I used the excuse of the grand finals to speak to Rebecca Gorman about what psychologist Amos Tverski calls "The Law of Small Numbers.''

It is an ironic reference. The so-called law of big numbers states correctly that when an experiment such as a coin toss is repeated (say) thousands of times, heads will come up about half the time.

Tverski finds that people wrongly believe this bo be the case for very small numbers as well.

If a couple has two children, both of them girls, people attach significance to this. It must be in the man's genes. Yet this is highly likely (25 per cent) to happen just by chance.

When it comes to runs of heads, they are far more likely than we think. If you toss a coin 20 times, a run of 4 heads in a row (somewhere in the sequence) is extremely likely - the probability of that happening by chance alone is about 50 per cent!

But Tverski thinks that because we are victims of belief in "the law of small numbers" we feel the need to attach significance to a run of four wins in a row.

In sport in the US, this is called belief in "the hot hand". Tverski has shown that for basketball in the US the hot hand seems not to exist. Sone study reports that after a run of successes a certain player had a 75 per cent chance of having another success. After a run of failures the player also had a 75 per cent chance of success.

Neither players nor their supporters believe this.

We seem to have an almost programmed-in need to look for meaning in what might be meaningless noise....

Even the Australian Bureau of statistics publishes trend estimates, some of which are meaningless. I remember in 1993 that the direction of the trend for the current account deficit used to point up in some months, down in others. In reality the underlying movement in the current account deficit probably wasn't changing at all.

Which brings us to the Australian Securities and Investments Commission and its position paper on the advertising of investment returns. ASIC wants the rules governing the advertising of past performance tightened up.

It has commissioned a survey from the Financial Policy Research Centre which examines 100 surveys of the performance of funds managers over time. It says about half of the studies found no correlation at all between good past and future performance. "Good performance seems to, at best, a weak and unreliable predictor of good performance over the longer term."

There are all sorts of reasons why this should be the case. Without knowledge that the market doesn't have (which is illegal in equities) it should be impossible to consistently better predict where the market will end up than the market itself. An investment style which works in one set of market conditions may not work in the next. Successful funds managers will face a run on their staff, everyone will copy them, they will believe their hype. (Remember BT?)

I said on Life Matters that if a firm wins "Funds Manager of the Year" two years in a row, ditching it might be as good advice as keeping it.

Tverski points out that for sport there is no reason why a run of wins shouldn't signal something, it is just that the statistics show that it doesn't.

I must say that I personally found Tverski's findings about perception challenging. Until now I must have believed (subconsciously) that "god's hand" manipulates the outcome of a coin toss to ensure that a run of heads is always followed by a run of tails. I now see (late) that that isn't how it happens. A run of heads isn't reversed by the hand of god, its effect is diluted over time by other results, so that when the number of tosses gets very large the results are about 50-50. (If you toss a coin and get five heads in a row, and then keep tossing until you have tossed 1,000 times in total, probablity theory does not predict that the total number of heads will be 500, it predicts that the number will be about 502.)

Actually I still find the workings of probability hard to get my head around. Perhaps because I know from quantum physics that the hand of god does manipulate the results of wave/particle experiments to give us the result it wants us to see. So maybe our intuitive belief in a hand of god isn't so wrong after all.

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Tuesday, October 01, 2002

The mathematics of inequality

That was the title of this week's discussion on Life Matters with Geraldine Doogue.

Two French physicists believe they can explain why in every society the distribution of incomes follows the same mathematical pattern.

The arguments are best sumarised in New Scientist.

There is not a lot to add except that it'll pay to follow the work of the new "econphysists" closely.

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