Behaviorial economics is futile so far

Neoclassical economics has taken a lot of flak recently, I think unjustly, for failing to predict the last economic crisis. For many critics, behavioral economics is the next big idea, because it is much more closely tied to empirics and has a special focus on irrational behavior. But beware of fads, of which there are unfortunately too many in Economics.

Nathan Berg and Gerg Gigerenzer say that behavioral economics is just as bad as neoclassical economics because they are both full of ad hoc assumption and build on axioms that are not tested. In particular, the deviations from rationality are never evaluated in how costly they are, for example whether people are then poorer or less happy. This is important as if those deviations are costly, people would likely do something about them and they may become less important. In other words, behavioral economics if far from being mature enough to be the panacea some are seeing in it.

On the emergence of money

Why are we using money? The answer we give to undergraduates is that money facilitates transactions and can be use as a store of value. But how do we get there? For money to be used, especially fiat money, there needs to be an agreement among many people that a particular commodity is the right one, and that we should all accept it for payment. How do you get there? If you look at the economic history of humanity, the use of money is in fact only a very recent phenomenon, and many previous attempts at introducing money failed. What makes money stick? All these are questions that are really difficult to answer and that will keep scholars busy for a long time. What we have so far are partial answers that are mostly of anecdotal nature.

Xue Hu, Yu-Jung Whang and Qiaoxi Zhang use a trading post approach to understand the emergence of money. A trading post economy includes households with heterogeneous endowments and wants who go to particular locations to meet and trade, and each trading post deals with only two goods. Under a monetary equilibrium, all trading posts deal with the same good, and another one that is different for each. The question is how to get there. The classic paper here is by Peter Howitt and Robert Clower, which was criticized for not having any maximization: this happened by pure chance, but eventually almost all experiments resulted in monetary equilibria. Hu, Whang and Zhang add to this utility maximizing households, but add substantial frictions to prevent convergence from happening too fast. These assume that there is a tâtonnement process that allows only 20% of households how want to switch trading posts to do so.

The conclusions are similar to Howitt and Clower, though. The good most likely to become money is the one that is the most saleable, either because there are large endowments and want for it, or because its trade is less costly. They also find that the absence of double coincidence of wants, traditionally used to justify the existence of money, actually makes the emergence of money more difficult. When money has not yet emerged, why would you experiment in trading your good for something you do not want?

Smokers and the smoking ban: some hate it because they quit

One of the most unusual and criticized theories in Economics is that of rational addiction, which states that smokers and druggies choose their addiction under full rationality and information. This can be rather surprising to a non-economist, but one can find data that supports (well, does not reject) such theory.

Timothy Hinks and Andreas Katsaros provide some evidence that could further validate the rational addiction theory by looking at public smoking bans in England, Wales and Northern Ireland. Using the British Household Panel Survey, which includes questions about happiness and smoking, they find that those who reduced their smoking show no change in happiness compared to those who did not change their smoking. But once public smoking bans were imposed, those who reduce smoking, in particular heavy smokers, exhibit decreases in happiness. In other words, they were forced to reduce smoking by being chased away from public places, and feel worse for it. That is consistent with the rational addiction theory in that imposing an unanticipated constraint makes people worse off. But one could also imagine irrational addiction theories that would be consistent with that result. Indeed, the critical aspect here is that you are locked into a state (addicted smoker). Whether you got there rationally or irrationally does not matter.

Breastfeeding and cognitive skills

Breastfeeding is now almost universally promoted as the healthiest way to feed a baby. And indeed, while breastfed babies are a little smaller and than bottle-fed ones and gain a little less weight, they are healthier, it is thought mainly because the mother milk transmits antibodies and relevant nutrients. But not every mother breast feeds, maybe because not every mother realizes all the benefits, or because some of the costs are high (time management for working mothers or aesthetic issues). Or there are some other benefits that are not well known.

Maria Iacovou and Almudena Sevilla-Sanz report that breastfeeding has significant positive impacts on cognitive skills (reading, writing and mathematics). While this correlation is well known, it may be spurious because mothers who breastfeed are more likely to be well educated (Irish example), and their children are also more likely to be well educated as well. The obvious way to overcome this statistical issue, a randomized trial, is not feasible on ethical grounds. What Iacovou and Sevilla-Sanz do is use propensity score matching, which essentially matches babies that have the same characteristics but breastfeeding and then compare their cognitive skills. What is particularly impressive in this study is that the retained characteristics are very broad beyond baby demographics and health, including parent characteristics such as education, job, income, and even pre-birth attitude towards breastfeeding or home and neighborhood. And even after controlling for all these variables, the impact of breastfeeding is still significant on babies from Bristol (England), and it may even grow with age.

Unskilled workers stay unskilled

Learning is a lifelong experience, as one has to adapt to new technologies and circumstances. Those who are the most flexible in the acquisition of human capital do best. This is not only a private benefit, employers also realize that it is important that their workforce continues training and give opportunities for training to their employees. While employers appear to give equal opportunities for such training to high and low skilled workers, it turns out low skilled workers disproportionately do not take advantage of them. Why so?

Didier Fouarge, Andries de Grip and Trudie Schils find this has nothing to do with lower returns, in fact returns to training are about the same for high and low skill workers, at least in the Netherlands. It appears it has much more to do with personal preferences. Low skill workers have in particular a higher preference for leisure (or, they do not like their job as much), exhibit more exam anxiety and dislike trying new things. In other words, they find it welfare reducing to get more training. Should policies still try to get them into training?

How not to distribute research funds

Citation counts are often used to proxy for the quality of an article, researcher or journal. They are not a perfect measure, everybody agrees on that, but they have proven to be a useful starting point for evaluation. Sometimes they are taken very seriously, too seriously, for the distribution of funds and pay. But at least this is done within a field, as it is obvious that citing conventions and in particular frequencies differ from field to field.

Javier Ruiz-Castillo goes further in trying to infer how budget priorities should allocated across research fields by using citations counts. Of course, for this one first needs to have a good understanding of how citations are distributed. Roughly, citations are distributed following power laws with fields and subfields. This means that few articles garner a lot of citations, while many go empty (especially in Business, Management and Political Science). And if I understand the paper right, one can apply readily a multiplier to compare the citation frequencies across fields. And these multipliers then make it possible to compare researchers or research units across fields within, say, a country, as long as one assumes that an adjusted citation is equally worth citing. For example, is political science worth the same support as biomedical engineering after using these multipliers, to take two randoms fields? And the "size" of the field is important as well. Here the author makes an attempt at some definitions of size which I frankly did not understand.

That said, I wonder why I forced myself in reading this paper. First is it indigestible because it is poorly written and uses very bad analogies. Second, because trying to compare fields and use citations for the allocation of funds or prizes across then is impossible because you have no identification: in statistical speak, the fixed effects capture all the variance. You can only compare how well a field does in a country compared to the rest of the world, but this cannot measure how important the field is. You need more information than just citations.

Optimal aging

While there is some amount of uncertainty in the length of our lifetime, we have the means of influencing it with various choices, such with different diets, occupations, investment in prevention and physical activities. But as these choices all have a cost, whether monetary or in utility, people face trade-offs and there is something of an optimal age. How should we think about it?

Carl-Johan Dalgaard and Holger Strulik make a first attempt at answering this question by positing an "aging law of motion" that defines how a human body become more frail over time and how this can be influenced by various costly choices. They use some recent insights from medicine and biology on the speed of aging and build a model that is able to replicate the impact of medical progress on life expectancy, or the relationship between labor productivity and life expectancy, or cross-country differences in life expectancy. This is all exciting stuff, but I am puzzled that individuals have only utility from consumption. One would expect that the value of life goes beyond just consumption, and empirical studies confirm this. This is not important when the lifetime is fixed, but when someone can influence it, it becomes critical. I am looking forward to a revision of this paper.

Revenue sharing in rock bands

Rock bands are often volatile associations. While there may often be conflicts about the creative orientation of the band, conflicts are too often about jealousies regarding free riders or members who attract too much attention. Fundamentally, these are issues about contracting who does what and who gets what. In particular, when a band member is doing more creative work, should he also be getting a larger share of income (to reward creativity) or the same as the others (to avoid some jealousies)?

This is the question that Cédric Ceulemans, Victor Ginsburgh and Patrick Legros ask. The trade-off is clear: you want to attract more creative band members for its success, and you want to give them credit for this by giving them a larger share of the pie. So you may want to associate one creative musician with less creative ones (in a complete contract) or only creative ones (in a incomplete, uniformly sharing contract) depending on what it means for the probability of achieving a hit, and the type of contract will determine who wants to form a band and whether the band will outsource song writing (and how much effort each member puts into it). The theoretical analysis shows that under a complete contract, the more disperse the credits are, the more successful the band is (reflecting very much the winner-takes-all features of show business?). The relationship is negative for incomplete contracts, which is apparently true in the data. This means that bands are driven to write incomplete contracts.

Spain: how to mess with the labor market

Spain has long been a puzzle because of its abnormally high employment rate, in particular among the young. But things seem to have rectified themselves somewhat since Spain got more integrated into the European market, which unemployment rates comparable to France. But the last recession turned out to be a disaster, with the unemployment rate increasing by 11% points, compared to 2% points in France. What is wrong with Spain? For one, there was a spectacular drop in activity in th construction sector, which initially accounted for a sixth of GDP and was basically divided by six.

Samuel Bentolila, Pierre Cahuc, Juan Dolado and Thomas Le Barbanchon claim that there is also a serious issue with labor market institutions. While both France and Spain have extensive employment protection legislation, and severance pay is formally higher in France, Spain requires, for example, administrative approval for collective dismissals of over 10% of the workforce. Such approval can only be obtained by collective bargaining and much higher severance pay. While severance pay is usually not problematic (it is accounted for in wages), it is the red-tape associated with this and the hoops firms that firms need to go through to dismiss that become economically relevant, because these are transfers that captured by a third party: administration. This makes it then very costly to hire someone, given expected firing costs, and especially so in uncertain times.

Using a search and matching model, Bentolila, Cahuc, Dolado and Le Barbanchon find that the unemployment gap between France and Spain would have been reduced by 45% had Spain adopted French labor market institutions. And I surmise it would be much more with other laws, as France has quite high employment protection in international comparison. No wonder that Spain recently scrapped much of its employment protection regulation in the midst of a deep recession, which may sound counter-intuitive at first. But if you want firms to hire in a recession, they should not have to commit for long-term employment.

Towards better growth accounting

There are some literatures that I find very frustrating, and the empirical growth literature is among them. The initial idea to take a production function to see the contribution of labor and capital to the average growth rate of an economy and then also to compare this way differences in income levels was initially very instructive, in particular because it highlighted how total factor productivity was important. It went all downhill from there, as people started wildly regressing whatever they could get their hands on across countries, mostly with poor data. TFP can be influenced by many things, and there is no way one can identify anything without applying some structure, even with good data.

Gino Gancia, Andreas Müller and Fabrizio Zilibotti use a model to distinguish the contributions of factors (labor, human capital and physical capital), barriers to technology adoptions and technology inadequate for local conditions. The results are interesting, too. Removing these barriers would increase per capita income by 24% in the OECD and 36% elsewhere. And given that a model was estimated, it can be used for various scenario analyses. For example, they find that globalization increases skill premia and thus world income disparities, but this can be reversed by coupling trade liberalization with a reinforcement of intellectual property rights. These latter results are somewhat counterintuitive, but are justified by the fact that with stronger IP rights, there can be a transfer of technology to the South.

Should food prices influence monetary policy?

Central banks care about inflation, but not about the inflation people care about. Because energy prices are volatile, they are not included in the price index a central bank typically looks at, because including it would made the indicator less informative. At they also include food prices, because those fluctuate a lot as well, in particular because of seasons. That can make sense for a rich country, where food represents only a small portion of the budget. For poorer countries, excluding food is more controversial.

Luis Catão and Roberto Chang note that world food prices seem to cause worldwide inflation, and this should have implications for inflation in small open economies that take food prices as given. The question is then whether central banks should react to such terms of trade shocks. For a net food importer, Catão and Chang find that including food in the price index relevant to the central bank is welfare enhancing. The reason is that if food has a larger weight domestically than in the rest of the world, the real exchange rate and the terms of trade can move in opposite directions following a food price shocks. The welfare improvement comes from a change in the correlations in aggregates leading to smoother consumption, but it possibly results in higher inflation and higher volatility of output and employment. It is thus not obvious including food prices would then be an easy sell.

Do professional sports teams belong on the stock market?

Professional sports clubs exist to win, but this often requires money. Different models have developed in this regard. The US model is private ownership of clubs within a cartel, where private ownership is meant to be a single person, or a small group of people. The European model is broad membership with few benefactors who do not own the club, and clubs operate within an open league system (promotion and relegation based mostly on sport results). But over the last two decades a good number of European clubs went public and are now listed on stock markets. This highlights a change of priorities, profits over sport results, although the two are clearly correlated. But how well do these clubs fare?

Michel Aglietta, Wladimir Andreff and Bastien Drut note that the performance of sports stock is rather weak, and thus has not attracted institutional investors as was probably hoped for. This weak performance is not that surprising, I suppose many hold such stock to frame it above the TV set. It may also be due, as the authors argue, to the fact that sports clubs have poor governance. So, maybe the next step is to run them like a business where the objective is to maximize shareholder value, and make sport results only a means to generate these profits.

Journal editors are poor selectors of best papers

Journal editors are thought to be exceptional scholars who are capable of identifying the best papers and in particular those that will have the largest impact, typically measured by citation counts. But editors have considerable help: first peer reviewers make reports that should be informative, second authors to some extend self-select in the submission process, they would not send a paper where it has no chance of getting published. But it is difficult to evaluate whether an editor is doing a good job. However, when editors choose to put as lead paper the one they consider the best in the issue, one can in retrospect check whether these papers are cited the most. As I reported earlier, editors turn out not to be particularly good.

What about those papers that get the "best article of the year" award? Tom Coupé does a similar exercise and finds that they are more cited than the median article, and slightly more than the runner-up articles, but they are rarely the most cited in a year. You just cannot trust editors, even though they are even supported by a committee for such awards.

The psychology of the equity risk premium

There is a huge literature on the equity risk premium that probably could sustain its own journal, trying to document it or explain it. But somehow, people keep finding new ways to look at the equity risk premium, so it sometimes worth checking out what they last came up with.

Georges Prat looks at the equity risk premium at various horizons and studies how and why they evolve differently. The study highlights that there is a time-varying term structure of equity risk premia, and that it depends on interest rates (expectedly) and a hidden state variable that the author attributes to psychological factors. Now, it is easy to blame changes in tastes for anything one cannot explain, but this is hardly convincing, here or elsewhere. The study uses the S&P 500 index and Treasury bonds and calculates premia at one and ten year horizons. If taste shocks make that risk tolerance of some people changes, they may get completely out of particular maturities. Looking at big aggregates is then not appropriate to measure how risk-averse they are. For example, if I find that long term risk is getting too high for me, for example because I am approaching retirement, I will get out of the blue chip stocks I was holding and into ten-year government bonds. Blue chips will then be priced by a different demand. There is thus a composition effect, that is, the risk tolerance of those holding these stocks is different, but it is because these are different people. That is not psychological, this is demographic.

Are wars rational?

There are few circumstances where wars are globally welfare enhancing. One can imagine that wars can be individually optimizing, for example when we consider the old land-taking or enslaving war. But casual empiricism indicates that quite often fools engage in wars, like minnows tickling obviously overpowering giants (Irak, North Korea) or others who have little objective chance of winning (South Ossetia, Caprivi, Falklands). Is it because some belligerent are poorly informed or even irrational?

Clara Ponsati and Santiago Sanchez-Pages use Markov games with fully rational players to characterize wars, and even chronic wars. A country can lay a claim on another country, leading to bargaining or war, and it can only end if one surrenders. The problem is that parties do not know their relative strengths and can only learn about them by engaging in war. Add a dose of optimism, and you have a recipe for war. Were one to add some political economy (or populism) to this model, outcomes would be really depressing and worrisome. But I still have some faith in humanity.

Interest-only mortgages and house price bubbles

Bubbles are annoying. First because they are difficult to identify, second because they indicate that prices do not reveal the "proper" information, and third because they lead to misallocation of real resources and much hardship when they burst, which they inevitably do. You want to prevent bubbles from happening, but again they are really difficult to identify, especially in real time.

Gady Barlevy and Jonas Fisher may have figured out a clever way of identifying bubbles in house prices. Using some theory, they find that interest-only mortgages should only be used if there is a bubble. Turning to data, they find that the use of such mortgages is rather sparse through time and space, and when it is used, it corresponds pretty closely to episodes where we suspect bubbles could be happening. In particular, interest-only mortgages mere mostly used in areas with inelastic housing supply, which are more prone to bubbles.

Is there really no selection bias in laboratory experiments?

Whenever you read about a survey or an experiment, the first worry one should have is whether there is some selection bias in the studied example. As I have argued before, experimental economics is almost exclusively on a sample from a minority of the world population. But assuming that we are only interested in this minority (and unfortunately we are), is there still some selection bias.

Blair Cleave, Nikos Nikiforakis and Robert Slonim did some experiments in the classroom with over 1000 students, and then invited them for more experiments in a laboratory setting. Those that followed the experiment did not have different characteristics, which is reassuring. However, this only partially alleviates my worries. Indeed, students are only a small minority of the current population, one that is more educated, coming from a richer background, younger, etc. I am looking forward to a broader study...

Time for an agricultural revolution in Africa?

When you think about income differences across the world, Africa is really depressing. It seems nothing is making a lasting impact in terms of policy for it to catch up with the others, and seeing how Asia managed to transform itself makes you wonder what is fundamentally wrong. While one may think this has to do with misguided policies, so much has been tried that something ought to have stuck. But no. One thing that helped Asia is that evolution in rice brought an agricultural revolution that freed human resources for manufacturing, so could such a revolution also happen in Africa?

Donald Larson, Keijiro Otsuka, Kei Kajisa, Jonna Estudillo and Aliou Diagne claim that several areas in Africa are suitable for rice, but local diets and tastes are too diverse for rice to have the success it had in Asia. The productivity of other crops needs to improve as well. So it does not look like there is a ready-made solution that will kick-start the agricultural revolution soon, despite some very localized successes.

That said, why insist of improving agriculture on a continent that is visibly not appropriate for this? Much like telecommunications in Africa jumped over landlines directly to mobile telephony, why not bypass agricultural development straight to manufacturing? One argument against this is the large transportation costs that make local agriculture essential and manufacturing away from the ports unprofitable. But why insist on keeping the population on the countryside? Why not develop coastal cities and take advantage from returns to scale there, like Singapore and Hong Kong did, and

An analysis of the oldest auction in history

Homo economicus is not a recent phenomenon. Not only that, he design market mechanisms early in history that appear to be very subtle. The oldest known auction was designed by Illyria in Babylonic times. This is a marriage markets in its true sense, as it is about auctioning off potential brides. All eligible girls are assembled, and an auctioneer offers them to the highest bidders, starting with the one expected to fetch the highest price. Proceeds are used to sell the least attractive brides to the poorest men assembled.

Michael Baye, Dan Kovenock and Casper de Vries analysis this auction in a two-player environment and claim that there is something paradoxical. Assume complete information, which means the auctioneer will always earn zero profit. Then is appears players can earn a much larger surplus by playing a mixed strategy than with a pure strategy. And there a continuum of these mixed strategies, and the expected payoff for both players is arbitrarily high, but finite. The problem is the solution procedure used to solve for symmetric mixed strategies breaks down here, because it selects strategies that are not part of Nash equilibria. We should learn from that to be very careful when applying standard theorems. A similar reasoning applies to incomplete information where the bidders do not know how much the other player values the potential brides.

There is no recent literature on this auction. However, it was mentioned on the back cover of the August 2006 issue of the Journal of Political Economy. I suspect this is what inspired the authors to work on this. They could have mentioned this and acknowledged the submitter, Costas Meghir.

Markets under-value fuel economy for new cars

Is it worth it to buy a fuel efficient car? If you ask an economist, he will look at the fuel consumption, the cost of gasoline, and calculate the cost benefit of a fuel efficient car, probably also factoring in a resale value and a discount rate. But a non-economist customer?

David Greene says the literature is really unclear, as customers seem to be under-valuing and over-valuing fuel efficiency depending on how you look at the data. Surveys seem to indicate that car buyers consider a very short horizon for the payback, 1.5 to 2.5 years. That makes it very difficult for fuel efficient cars, hence the need for subsidies, or better taxes on the inefficient cars (see why). But this provides little theoretical insight where car buyers differ from the economist I described above. Greene thinks this has to do with risk aversion about future gasoline prices, or loss aversion (being afraid of having taken a poor decision). But clearly, this requires more research.

Having said this, I am puzzled at how little hybrid cars have been adopted in Europe, in particular compared to the United States. The cost of European gasoline is very significantly higher, and the environmental consciousness is also more pronounced. Is it because the alternatives to hybrid cars, the small fuel efficient sedans, are much better than in the US?

Are payday loans any good?

Payday loans are small loans that are offered with very short terms, usually until the next payday. But because they imply exorbitant interest rates, into the hundreds of oercent in annualized rates, they are severely criticized. Yes, the payday loan industry is thriving, obviously responding to a strong demand. So it would appear that payday loans are welfare improving, or people would not use them, just as much as credit card loans are welfare improving. But many people worry that payday loans, more so than credit card loans, lead borrowers into a vicious cycle of financial dependence. So, should they be regulated out of existence or not?

John Caskey writes that the issue is really about separating two kinds of people. There are first those who fully understand the terms and the cost of the loan, but happen to face a very short term liquidity crisis, having exhausted or having no access to other forms of credit. This can happen to the best people, and happened to me. For them, the payday loan is valuable and clearly welfare enhancing as it fills some market incompleteness. And there are other people who are tempted by the easy cash and immediately face long term issues in paying the loan back. The policy maker would want to prevent the second category to get such loans, but one may ask whether the payday loan industry would want to grant them business as well: they are clearly much riskier. The loaner would want to find a way to discriminate, in particular because this allows to reduce the interest rate on the good borrowers and thus attract more of their business.

But the data indicates the second category is worryingly big. Only one sixth of payday customers borrow once a year or less. And it is estimated 5% of the population would use those loans if they were freely available in every US state, like it is currently the case in some. That would be worrisome. But when Oregon regulated the payday loan industry away, people felt more constrained. And states with payday loans have significantly fewer checks bouncing, although they also have more bankruptcy filings. The paper offers plenty of other examples from the empirical literature, but overall, there is no clear sense whether payday loans are welfare improving or not. Maybe better discrimination of customers is the way to go.

Another year of blogging

How quickly that year passed, and I am once more amazed at the quantity I have posted. One hardly notices when you write a couple of paragraphs each day, but it sure accumulates: 271 posts during the year, 40 more than the previous year, reflecting the lack of vacation time...

Should I continue? I still like doing it, even though it takes much more time to write even two paragraphs about a paper than simply reading it. While I do not have credible statistics to back it up, I have the impression that I have a rather loyal (and mostly silent) readership. There are over 700 subscribers on the Google Reader I use, probably more elsewhere and through various relays. I only wish there were more discussions, although I understand it can be difficult to participate.

Comments averaged at two a post, a rather modest number. But some posts attracted a lively discussion. Here are the ones with the most comments:

1. Why criticize modern macro when you do not follow modern macro?
   
2. The economics of compartments
   
3. On the dangers of penny auctions, an example
   
4. Is democracy really worth it?
   
5. About this obsession with lawns
   
6. Doing Calvo all wrong
   
7. About the state of US higher education
   
8. Smoking bans versus tobacco taxation

And which were the most popular posts of the year?

1. The economics of compartments
   
2. Worker overconfidence and unemployment duration
   
3. What is an MBA worth? (from 2008!)
   
4. How to increase employment, and at what cost (from 2009)
   
5. On the dangers of penny auctions, an example
   
6. Is the US a third world country?
   
7. Posting calories in restaurants is Pareto improving
   
8. The AEA is missing a golden opportunity
   
9. The problem with experimental economics: people are weird
   
10. Household size heterogeneity and the representative agent

Anyway, here come another year of blogging on research in Economics.