I came across this issue of Journal of Economics and Finance Education in perusing my favorite blogs: (hat tip to Peter Boettke at Coordination Problem).
http://www.economics-finance.org/jefe/current.pdf
This issue is focused on Austrian economics. I've read the first two papers and am quite impressed. Although not the easiest of reads, they do convey:
1) Principal economists in the history of the Austrian School
2) Key features of the Austrian perspective to economics
3) How Austrian economics differs from traditional economics
Enjoy!
Wednesday, February 29, 2012
Sunday, February 5, 2012
Free Riding and the Financial Crisis
We've heard many people describe contributors to the financial crisis:
An important economic concept is the notion of "free riding." Free riding occurs when one person's activities provide as a group benefit. It is difficult to make those parties receiving a benefit from the activity from bearing a proportional cost of the activity. An often used example of a free riding problem is police or personal safety. If policing was privatized, those who purchased protection would likely provide some unintended protection to their neighbors. The security guard that would be on watch would prevent crime for the client, and also the client's nearest neighbors as well. Many economists think that the total personal safety expenditures would be smaller than we would actually prefer, because many people would hope that others would purchase protection, allowing them to "free ride." Of course, if too many people feel this way, total expenditures on a valuable service will be quite small.
Free riding can also occur when ambiguity exists. When two or more parties are involved in completing a complex activity, and there is imperfect information between them, often times each of them will attempt to free ride on the others actions. It is inefficient and costly to duplicate work; it is natural to seek to avoid such duplication. The risk becomes when all parties, in the name of efficiency, assume another party is addressing a critical activity in the process. Therefore, unless there is clearly defined responsibility, accountability, and transparency, the potential that all parties are trying to "free ride" exists, so that the activity in question does not get performed appropriately. As the process becomes more complex and involves more parties, the risk of such a free riding problem becomes greater.
I believe the financial crisis was largely subject to such a pervasive free riding problem. Fueled by the issues listed in the bullets above, the mortgage finance industry expanded in complexity and the number of involved parties. For example, the archaic model of mortgage financing is that a bank or savings and loan would make a mortgage loan to a home buyer and then hold the loan until it was paid. On the financing side, there was one party - the bank or savings and loan. In the modern mortgage finance model, the following parties may all be involved:
My takeaway - when processes add layers of complexity and the number of parties involved increases, the risk of free riding increases. If there is clear accountability and transparency in all aspects of the process, free riding is much less likely to occur. Importantly, many times it is in the interest of parties involved to blur accountability and reduce transparency. Doing so allows them increased flexibility and reduced costs, under the veil that another party shares their responsibilities and can be relied upon. In the financial crisis, it took massive losses to illuminate what each of the parties involved in the process were actually doing. Perhaps it's possible to identify environments subject to such free riding problems going forward and thereby avoid participating in the resulting losses.
- Alan Greenspan kept interest rates too low in the mid 2000s
- Freddie Mac and Fannie Mae's quasi government status provided too much easy credit into housing
- A speculative bubble fueled by greed and "animal spirits"
An important economic concept is the notion of "free riding." Free riding occurs when one person's activities provide as a group benefit. It is difficult to make those parties receiving a benefit from the activity from bearing a proportional cost of the activity. An often used example of a free riding problem is police or personal safety. If policing was privatized, those who purchased protection would likely provide some unintended protection to their neighbors. The security guard that would be on watch would prevent crime for the client, and also the client's nearest neighbors as well. Many economists think that the total personal safety expenditures would be smaller than we would actually prefer, because many people would hope that others would purchase protection, allowing them to "free ride." Of course, if too many people feel this way, total expenditures on a valuable service will be quite small.
Free riding can also occur when ambiguity exists. When two or more parties are involved in completing a complex activity, and there is imperfect information between them, often times each of them will attempt to free ride on the others actions. It is inefficient and costly to duplicate work; it is natural to seek to avoid such duplication. The risk becomes when all parties, in the name of efficiency, assume another party is addressing a critical activity in the process. Therefore, unless there is clearly defined responsibility, accountability, and transparency, the potential that all parties are trying to "free ride" exists, so that the activity in question does not get performed appropriately. As the process becomes more complex and involves more parties, the risk of such a free riding problem becomes greater.
I believe the financial crisis was largely subject to such a pervasive free riding problem. Fueled by the issues listed in the bullets above, the mortgage finance industry expanded in complexity and the number of involved parties. For example, the archaic model of mortgage financing is that a bank or savings and loan would make a mortgage loan to a home buyer and then hold the loan until it was paid. On the financing side, there was one party - the bank or savings and loan. In the modern mortgage finance model, the following parties may all be involved:
- Mortgage broker
- Mortgage underwriter and initial lender (bank, thrift, or mortgage finance company)
- Wholesale lender
- Mortgage security underwriter (investment bank, Fannie Mae, Freddie Mac)
- Credit rating agency (S&P, Moody's, Fitch)
- Institutional investors
- The mortgage broker and underwriter were responsible for investigating the borrower.
- The wholesale lender was responsible for performing due diligence on the mortgage underwriter.
- The security underwriter, credit rating agency, and institutional investor were responsible for performing due diligence on the portfolio of mortgages.
My takeaway - when processes add layers of complexity and the number of parties involved increases, the risk of free riding increases. If there is clear accountability and transparency in all aspects of the process, free riding is much less likely to occur. Importantly, many times it is in the interest of parties involved to blur accountability and reduce transparency. Doing so allows them increased flexibility and reduced costs, under the veil that another party shares their responsibilities and can be relied upon. In the financial crisis, it took massive losses to illuminate what each of the parties involved in the process were actually doing. Perhaps it's possible to identify environments subject to such free riding problems going forward and thereby avoid participating in the resulting losses.
Sunday, January 15, 2012
Opposing Cognitive Biases and Rational Behavior
A friend and I were discussing the logical fallacies that often occur when individuals are making decisions or constructing an argument (hat tip to Ryan Miller). We identified a particular fallacy--the gambler's fallacy--that exists when an a sequence of identical outcomes is mistakenly construed as implying the probability of the opposite outcome increases for the next iteration. For example, if the roulette wheel results in black outcomes for 5 spins in a row, there exists a common misperception that the next spin is more likely to land on a red outcome, because overall, red and black outcomes should be approximately equal. According to the gambler's fallacy, red outcomes would need to "catch up" to make equal outcome possible, and therefore red outcomes become "due" when preceded by a series of black outcomes.
We then considered an alternative and opposite bias that can occurs in the exact same situation. Many other gamblers believe that a series of black outcomes implies that black is more likely to occur going forward. From this perspective, black is on a streak, or is the "hot" play. Its common to hear in casinos that certain craps tables are hot, an implicit belief that a series of outcomes is likely to persist into the future.
I find it very interesting that, in certain circumstances like the one described above, we are prone to any erring on either side of the rational conclusion. Its unclear whether a sample of 100 gamblers (each without a favorite roulette color) would be more likely to bet on black or red if they observed five black outcomes in a row.
Behavior finance teaches that humans have natural heuristics in evaluating issues and making decisions that make us prone to certain biases. These biases are generally described as unidirectional. For example, behavioral finance teaches that individuals generally sell winning investments too early, and hold on to losing investments too long. This may certainly be true, in general. However, as described above with the gambler's fallacy, the extent of biases can be more complex, with other possible biases working in the opposite direction. When competing biases exist, the impact of such biases is not clear then. It depends on which bias, among those that exist, dominates in the circumstance. Moreover, it seems odd to me that many finance and economics analyses assume investors act rationally, but for certain biases that can be accounted for. Since we are subject to biases--biases that allow us to err on either side of the rational conclusion--it appears more likely to me to simply accept that humans don't always act rationally.
We then considered an alternative and opposite bias that can occurs in the exact same situation. Many other gamblers believe that a series of black outcomes implies that black is more likely to occur going forward. From this perspective, black is on a streak, or is the "hot" play. Its common to hear in casinos that certain craps tables are hot, an implicit belief that a series of outcomes is likely to persist into the future.
I find it very interesting that, in certain circumstances like the one described above, we are prone to any erring on either side of the rational conclusion. Its unclear whether a sample of 100 gamblers (each without a favorite roulette color) would be more likely to bet on black or red if they observed five black outcomes in a row.
Behavior finance teaches that humans have natural heuristics in evaluating issues and making decisions that make us prone to certain biases. These biases are generally described as unidirectional. For example, behavioral finance teaches that individuals generally sell winning investments too early, and hold on to losing investments too long. This may certainly be true, in general. However, as described above with the gambler's fallacy, the extent of biases can be more complex, with other possible biases working in the opposite direction. When competing biases exist, the impact of such biases is not clear then. It depends on which bias, among those that exist, dominates in the circumstance. Moreover, it seems odd to me that many finance and economics analyses assume investors act rationally, but for certain biases that can be accounted for. Since we are subject to biases--biases that allow us to err on either side of the rational conclusion--it appears more likely to me to simply accept that humans don't always act rationally.
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