Richard Thaler: No Regular Economist

Richard Thaler of the University of Chicago has been awarded the 2017 Nobel Prize in Economic Sciences “for his contributions to behavioural economics”. This column, written by his first behavioural collaborator, provides a personal perspective on the development of three key areas of research to which the new laureate has been a major contributor: people’s limited rationality, their perceptions about fairness, and their lack of self-control.

 

A bowl of cashew nuts inspired Thaler to a thought experiment in behavioural economics. Picture/Credit: Altayb/iStock.com

A bowl of cashew nuts gave Thaler the idea of performing a thought experiment on self-control. Picture/Credit: Altayb/iStock.com

 

Behavioural economist Richard Thaler is the 2017 recipient of the economics Nobel Prize. Yet, despite having been president of the American Economic Association (AEA) in 2016, he is no regular economist. In fact, Stanford economist and past AEA president Robert Hall once characterised Thaler as his “favourite offbeat economist”.

The award marks Thaler’s transition from the fringe to the mainstream. But it is instructive to look back at the time when his views were regarded as offbeat by mainstream economists. To be sure, Hall is a mainstream economist and an excellent one at that. As chair of the Business Cycle Dating Committee of the National Bureau of Economic Research (NBER), Hall often makes the call on when the US officially enters and exits recessions. His academic work teaches us how to establish equitable and efficient consumption taxation in a world of rational actors.

By contrast, Thaler’s academic work teaches us to beware of the limits of assuming that the world is populated by rational actors. The Royal Swedish Academy of Sciences identified the following three areas to which he has been a major contributor: limited rationality; perceptions about fairness; and lack of self-control.

In the mid-1970s, I began to work with Thaler on two of these issues and eventually applied his insights to the third. With this as context, I would like to provide a personal perspective on how these three key ideas developed.

Before getting down to details, I need to say something about what Richard Thaler does better than any other economist: he constructs simple and incisive thought experiments. Most economists, including me, are trained to think in terms of formal models. Thaler is more of a qualitative thinker. As I will explain, he is able to pierce through the formality to get right to the soft spot of where those models are unrealistic in key ways.

Lack of Self-Control

Cashew nuts are calorie-rich – and I like them a lot. I have in my office a bowl of cashews, which look very tempting, but fortunately for me, these cashews are not real, but ceramic. I got them as a souvenir at a gathering to celebrate Thaler’s 70th birthday. There is a self-control story behind the cashews.

In the 1970s, Thaler and his wife threw a dinner party for some friends. Before they served dinner, they placed a large bowl of cashews in front of their hungry guests. The guests began to devour the cashews and soon realised that continuing to do so would interfere with their ability to enjoy dinner. But they couldn’t stop. The cashews were too tempting. So they begged Thaler to take the bowl away.

What would you do if you were really hungry, the cashews were in easy reach and you knew that continuing to eat them would ruin your dinner? To a neoclassically trained economist, asking that the cashews be removed is puzzling – and Thaler was trained as a neoclassical economist.

Classical Greek philosophers taught that rational human beings choose the best means to achieve their desired ends. The neoclassical approach formalises ‘choosing the best’ as a problem in mathematical optimisation. In the neoclassical approach, people are assumed to optimise without effort. If they think that eating more cashews is not optimal, they don’t need somebody else to prevent them from doing so; they can costlessly choose to do something other than eat more cashews.

Thaler realised that his dinner guests were not acting rationally in the face of temptation, at least not rationally in the sense of being neoclassically rational. He engaged in one of his thought experiments, asking himself what would prevent him from reaching for more cashews when he didn’t want to eat more cashews. That question led him to think about an internal dialogue within his brain between the part of his brain that was ‘planning’ to stop eating cashews and the part of his brain that was actually ‘doing’ the reaching and eating.

Like Thaler, my interest in self-control also stemmed from issues about eating. But in my case, it was because I became intrigued by my wife’s research on the role of healthcare professionals in treating eating disorders – not as compelling as the cashew story!

In any event, Thaler and I managed to find each other and began to collaborate on a formal economic model that would capture how people make decisions when their internal planners and doers fail to agree (Thaler and Shefrin 1981, Shefrin and Thaler 1988).

Limited Rationality

Some credit unions offer a programme called Christmas Clubs. People who join such a club regularly deposit funds during the course of a year into a special account, with the goal of having a balance at year-end that will fund their Christmas gifts.

When Thaler and I first worked on our self-control model, Christmas Clubs were more popular, offered by many banks and, moreover, did not pay interest, even though interest rates on savings accounts were much higher than they are today. This meant that people who used the clubs to save for gifts earned less interest than they could have by just using a regular savings account.

From a neoclassical perspective, someone who joins a Christmas Club and forgoes interest is operating in the interior of his or her budget set, a clear violation of neoclassical rationality. Were these people that stupid?

Some people choose to have too much of their income withheld to pay income tax, in order to get a large tax refund. Less money withheld means more money to invest for a return. Do people not understand the time value of money? Are they that stupid? How about you? Would you withhold at the lowest rate allowable by law?

In a neoclassical world, the answer to the previous two questions is yes, people are that stupid. But hold on a minute. In a world where planners need to deal with difficult doers, which can lead to a lack of self-control, it might be perfectly sensible for people to join Christmas Clubs and for people to have too much tax withheld in order to receive large tax refunds.

Both behaviours might lead to higher savings than would otherwise occur and, if higher savings is the goal, then such behaviours might be eminently reasonable. In theory, the behaviours might not be neoclassically rational, but in practice they might well be ‘good enough’; and as the late economics Nobel Laureate Herbert Simon noted, going for what’s good enough is “satisficing behaviour” that is “boundedly rational”.

Christmas Clubs and tax over-withholding are not foolproof. People can rob their Peters to pay their Pauls. Someone with a severe self-control problem might borrow heavily during the year using her credit card, to the extent that when the year-end arrives, she finds herself compelled to use the proceeds from her Christmas Club to pay her credit card balance rather than to purchase gifts. Perverse? Yes. Boundedly rational? I don’t think so.

People need enough impulse control to prevent perverse behaviour. There are at least three ways for doing so:

  • The first way is using willpower. Of course, if willpower were easy to exert, then there would be no need for Christmas Clubs or tax over-withholding.
  • The second way is through external enforcement: no credit cards at all, which raises all kinds of issues, not the least being the consequences of not having a credit history.
  • The third way is through internal enforcement, using habits.

Planner-doer theory suggests that people segregate their wealth into separate ‘mental accounts’, such as take-home pay, liquid assets, future income and home equity. Mental accounting habits are ‘pecking order’ rules that specify the order in which different accounts are accessed.

Many people find it easiest to spend first from take-home pay. If they wish to spend more than their take-home pay, the first place they go is to their liquid assets (such as checking or savings account balances, bonds and stocks). If these are insufficient, then people can borrow or, as a last resort, dip into their home equity by borrowing or selling their property.

Mental accounts can be somewhat arbitrary. Their levels are not finely tuned. Therefore, following mental accounting rules can lead people to appear as if they are not operating at the margin. But operating at the margin is not the goal – someone can operate at the margin and overspend very easily.

Thaler pointed out that people use all kinds of mental accounts. One of his thought experiments involves a person who mows their own lawn, but would never mow any part of their neighbour’s lawn for compensation.

Thaler suggests that such behaviour is unlikely to involve operating at the margin by setting marginal benefit equal to marginal cost. By this he means that the property line is arbitrary and, in a neoclassical sense, he might be right. But people might use boundaries as rule parameters, just as much as they use boundaries to separate types of wealth (take-home pay, liquid assets, etc.).

Thaler wrote: mental accounting matters (Thaler 1980, 1985). Now mental accounting might not be neoclassically rational. But given the limits of the human mind, it might be sensible – and good enough. Moreover, striving for perfect rationality might be counterproductive, with the end result being an outcome that is not good enough.

Perceptions of Fairness

In the late summer of 2017, a series of hurricanes struck the Caribbean, the Gulf of Mexico, Houston and Florida. After Hurricane Irma, which struck Florida, local residents registered over 8,000 complaints of price gouging with the state Attorney General’s office. These complaints mostly related to excessive prices being asked for water, ice, food and fuel.

Why are Florida residents complaining about price gouging? Do they not realise that keeping a lid on prices in these circumstances means that demand will exceed supply and that, as a result, some would-be purchasers will be rationed? Do they not realise that keeping a lid on the prices of these items lowers incentives to increase supply? From a neoclassical point of view, preventing the increase of prices to perceived gouging levels, irrationally induces rationing and insufficient supply.

Thaler, together with his colleagues Daniel Kahneman and Jack Knetsch, suggest an alternative way of thinking about market clearing prices (Kahneman et al. 1986a, 1986b). The alternative stems from Thaler’s concept of ‘transaction utility’ – the psychological pleasure or pain associated with how good of a deal a person associates with a transaction.

In the fairness framework, people have notions of reference transactions that they deem to be ‘fair’. Media reports indicate that some Florida hotels doubled their hotel rates in the wake of Hurricane Irma. Paying double for the normal price of a hotel room generates the experience of loss – negative transaction utility, if you like – if there is no corresponding increase in the costs that the hotel incurs as a result of the hurricane.

According to the fairness framework, hotels that charge double but do not incur higher costs are acting unfairly. In contrast, hotels that charge double to cover higher costs and do not reap additional profits as a result are acting fairly.

These are the rules of fairness that people follow. Fairness matters, just as mental accounting matters. Many people would rather be rationed and arrange for alternative accommodation than be gouged. If they feel pain from perceived unfair treatment, it is by no means obvious that the maintenance of fair prices that do not clear markets is necessarily irrational.

Conclusion

Psychologist Daniel Kahneman received the 2002 economics Nobel Prize for his work on ‘prospect theory’, a way of understanding how people make decisions under conditions of risk and uncertainty. The Royal Swedish Academy of Sciences noted that Kahneman had done this work together with the late Amos Tversky. Prospect theory, first published in 1979, was foundational for the development of behavioural economics and finance. That said, without Thaler, I am not sure that prospect theory would have had the traction it ultimately had.

There is much to say about Thaler’s accomplishments, beyond the three specific issues discussed above. Thaler was the first economist to reach out to Kahneman and Tversky, and he did so in the mid-1970s. It was Thaler who saw the connection between his fledgling thought experiments, such as the lawn-mowing example, and prospect theory.

 

Richard H. Thaler. Picture/Credit: By Chatham House, CC BY 2.0

Richard H. Thaler. Picture/Credit: By Chatham House, CC BY 2.0

It was Thaler’s entrepreneurial talents that found ways to bring open-minded economists together with Kahneman, Tversky and their psychology colleagues. In part, he did so through his efforts to secure support from the Sloan Foundation, the Russell Sage Foundation and eventually the NBER.

It was Thaler who wrote an ‘Anomalies’ column for the Journal of Economics Perspectives, which regularly piqued economists’ interest about the shortcomings of neoclassical thinking.

It was Thaler who, together with Shlomo Benartzi, ingeniously applied our work on self-control to help people save more, through their Save More Tomorrow (SMT) programme.

And it was Thaler who, together with Cass Sunstein, extended insights gained from SMT to develop ‘nudging’, the idea of using ‘choice architecture’ based on behavioural insights to induce people to make better decisions. This concept has had widespread influence in both US and UK public policy.

Richard Thaler’s accomplishments certainly merit his being awarded the 2017 economics Nobel Prize. For those accomplishments, we are all the better.

 

References

Kahneman, D, J L Knetsch and R H Thaler (1986a), “Fairness and the Assumptions of Economics”, Journal of Business 59(4): S285-300.

Kahneman, D, J L Knetsch and R H Thaler (1986b) “Fairness as a Constraint on Profit Seeking: Entitlements in the Market”, American Economic Review 76(4): 728-41.

Shefrin, H M and R H Thaler (1988), “The Behavioral Life-Cycle Hypothesis”, Economic Inquiry26(4): 609-43.

Thaler, R H (1980), “Toward A Positive Theory of Consumer Choice”, Journal of Economic Behavior and Organization 1(1): 39-60.

Thaler, R H (1985), “Mental Accounting and Consumer Choice”, Marketing Science 4: 1999-214.

Thaler, R H and H M Shefrin (1981), “An Economic Theory of Self-Control”, Journal of Political Economy 89(2): 392-406.

 

This article was first published by VoxEU.

Integrating Economics With Psychology – Prize in Economic Sciences 2017

Richard Thaler of the University of Chicago has been awarded this year’s Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel ‘for his contributions to behavioural economics’.

‘Thaler’s contributions have built a bridge between the economic and psychological analyses of individual decision-making’, the members of the Prize Committee said in their announcement of this year’s laureate. Speaking by telephone to the press conference, Thaler summarised the main impact of his work as being that ‘Economic agents are human and economic models have to incorporate that’. When asked whether he will act ‘humanly’ in spending the prize money, he joked ‘I will try to spend it as irrationally as possible!’

 

Econ FeatureRichard H. Thaler, laureate of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel 2017. Picture/Credit: Nobel Media, Illustration by N. Elmehed

 

Thaler’s research incorporates psychologically realistic views into analyses of economic decision-making, relaxing what was once the standard assumption that everyone in the economy is rational and selfish. The Nobel citation focuses on three areas of achievement: ‘by exploring the consequences of limited rationality, social preferences and lack of self-control, he has shown how these human traits systematically affect individual decisions as well as market outcomes’.

Limited rationality: Thaler has developed the theory of mental accounting, which explains how people simplify financial decision-making by creating separate accounts in their minds. He also showed how ‘loss aversion’ explains why people value the same item more highly when they own it than when they don’t.

Social preferences: Thaler has shown how people’s concerns about fairness may stop firms from raising prices in periods of high demand, but not in times of rising costs. With colleagues, he devised the ‘dictator game’, an experimental tool for measuring people’s attitudes to fairness.

Lack of self-control: Thaler has demonstrated how succumbing to short-term temptation is an important reason why we fail in our long-term plans to save for old age or make healthier lifestyle choices. His idea of ‘nudges’ is intended to help people exercise better self-control.

 

 

Originally from East Orange, New Jersey, Thaler attended Case Western Reserve University, where he received a bachelor’s degree in 1967. Soon after, he attended the University of Rochester where he received a master’s degree in 1970 and a PhD in 1974. Since 1995, he has been at the University of Chicago Booth School of Business, where he is Charles R. Walgreen Distinguished Service Professor of Behavioral Science and Economics and director of the Center for Decision Research.

Alongside Robert Shiller, co-recipient of the 2013 Nobel Prize in Economic Sciences, Thaler is co-director of the Behavioral Economics Project at the National Bureau of Economic Research, funded by the Russell Sage Foundation. He is co-author with Cass Sunstein of the bestselling book Nudge: Improving Decisions about Health, Wealth, and Happiness (2008) in which the concepts of behavioural economics are used to tackle many of society’s major problems. And he has even made an appearance in a Hollywood film, explaining the ‘hot hand fallacy’ in The Big Short.

The Lindau Nobel Laureate Meetings offers sincere congratulations to the new laureate and hopes to hear from him in person about his research at the next Lindau Meeting on Economic Sciences in 2020.

Towards a Nuclear-Free World


 

The Nobel Peace Prize 2017 is awarded to the International Campaign to Abolish Nuclear Weapons (ICAN) “for its work to draw attention to the catastrophic humanitarian consequences of any use of nuclear weapons and for its ground-breaking efforts to achieve a treaty-based prohibition of such weapons”.

 

Press release by the Norwegian Nobel Comittee:

“We live in a world where the risk of nuclear weapons being used is greater than it has been for a long time. Some states are modernizing their nuclear arsenals, and there is a real danger that more countries will try to procure nuclear weapons, as exemplified by North Korea. Nuclear weapons pose a constant threat to humanity and all life on earth. Through binding international agreements, the international community has previously adopted prohibitions against land mines, cluster munitions and biological and chemical weapons. Nuclear weapons are even more destructive, but have not yet been made the object of a similar international legal prohibition.

Through its work, ICAN has helped to fill this legal gap. An important argument in the rationale for prohibiting nuclear weapons is the unacceptable human suffering that a nuclear war will cause. ICAN is a coalition of non-governmental organizations from around 100 different countries around the globe. The coalition has been a driving force in prevailing upon the world’s nations to pledge to cooperate with all relevant stakeholders in efforts to stigmatise, prohibit and eliminate nuclear weapons. To date, 108 states have made such a commitment, known as the Humanitarian Pledge.

Furthermore, ICAN has been the leading civil society actor in the endeavour to achieve a prohibition of nuclear weapons under international law. On 7 July 2017, 122 of the UN member states acceded to the Treaty on the Prohibition of Nuclear Weapons. As soon as the treaty has been ratified by 50 states, the ban on nuclear weapons will enter into force and will be binding under international law for all the countries that are party to the treaty.

The Norwegian Nobel Committee is aware that an international legal prohibition will not in itself eliminate a single nuclear weapon, and that so far neither the states that already have nuclear weapons nor their closest allies support the nuclear weapon ban treaty. The Committee wishes to emphasize that the next steps towards attaining a world free of nuclear weapons must involve the nuclear-armed states. This year’s Peace Prize is therefore also a call upon these states to initiate serious negotiations with a view to the gradual, balanced and carefully monitored elimination of the almost 15,000 nuclear weapons in the world. Five of the states that currently have nuclear weapons – the USA, Russia, the United Kingdom, France and China – have already committed to this objective through their accession to the Treaty on the Non-Proliferation of Nuclear Weapons of 1970. The Non-Proliferation Treaty will remain the primary international legal instrument for promoting nuclear disarmament and preventing the further spread of such weapons.

It is now 71 years since the UN General Assembly, in its very first resolution, advocated the importance of nuclear disarmament and a nuclear weapon-free world. With this year’s award, the Norwegian Nobel Committee wishes to pay tribute to ICAN for giving new momentum to the efforts to achieve this goal.

The decision to award the Nobel Peace Prize for 2017 to the International Campaign to Abolish Nuclear Weapons has a solid grounding in Alfred Nobel’s will. The will specifies three different criteria for awarding the Peace Prize: the promotion of fraternity between nations, the advancement of disarmament and arms control and the holding and promotion of peace congresses. ICAN works vigorously to achieve nuclear disarmament. ICAN and a majority of UN member states have contributed to fraternity between nations by supporting the Humanitarian Pledge. And through its inspiring and innovative support for the UN negotiations on a treaty banning nuclear weapons, ICAN has played a major part in bringing about what in our day and age is equivalent to an international peace congress.

It is the firm conviction of the Norwegian Nobel Committee that ICAN, more than anyone else, has in the past year given the efforts to achieve a world without nuclear weapons a new direction and new vigour.

Oslo, 6 October 2017″

Kazuo Ishiguro Awarded Nobel Prize in Literature

Nobel Prize Literature 2017 Ishiguro

The Nobel Prize in Literature 2017 is awarded to Kazuo Ishiguro “who, in novels of great emotional force, has uncovered the abyss beneath our illusory sense of connection with the world.” Ishiguro, born 8 November 1954 in Nagasaki, Japan, grew up in the United Kingdom, where he first graduated in English and Philosophy at the University of Kent, and later went on to study Creative Writing at the University of East Anglia. His first novel A Pale View of Hills was published in 1982. Already in his early works, his writing deals with the themes of memory, time and self-delusion. Among his most renowned works are the novels The Remains of the Day (1989) and Never Let Me Go (2005), which were turned into films, as well as When We Were Orphans (2000). In several of his works, including in his collection of short stories Nocturnes: Five Stories of Music and Nightfall (2009), music plays an important role. Ishiguro published his seventh and latest novel The Buried Giant in 2015.

This post is based on the biobibliographical notes provided by the Swedish Academy.

 

Only as Strong as the Weakest Link: Global Food Supply Chains

This article appeared in a shorter form in the German newspaper Handelsblatt on August 24, 2017.

A ‘Marshall Plan for Africa’ – 300 million Euro in total. This is Angela Merkel’s bold development promise ahead of the Federal election. Germany has also placed Africa at the heart of its G20 presidency. So the future chancellor, whoever it is, needs a solid development strategy. This strategy should put farmers’ needs first and leverage the scientific expertise of companies, like Mars, that are networked throughout Africa through their supply chains.

As Bill Gates has said, “if you care about the poorest, you care about agriculture.” This is why I am joining the best economists in the world at the Lindau Nobel Laureate Meetings in Germany 22—26 August. We are convening an event to discuss economic inequality, agriculture and the role of businesses.

 

I was discussing economic inequality at the 6th Lindau Meeting on Economic Sciences with economists Romesh Vaitilingam, Eric Maskin (Nobel Laureate) and Devaki Ghose.

I was discussing economic inequality at the 6th Lindau Meeting on Economic Sciences with economists Romesh Vaitilingam, Eric Maskin (Nobel Laureate) and Devaki Ghose.

 

Why is this such an important issue? Over 475 million of the world’s 570 million farms are smaller than two hectares. Even though these smallholder farms produce over 80% of the world’s food, 80% of the global population deemed “chronically hungry” are farmers. This is the 80-80 paradox.

Agricultural supply chains in food-insecure regions like Africa need an upgrade — but this won’t happen without a concerted and long-term effort. Look at China, where they managed the ‘structural transformation’ from a mostly farming to a mostly industrial economy well. From 1952 to 2004, the structure of China’s economy shifted, from agriculture providing half the country’s GDP to providing only 14% in 2004. During this transition, the non-farm rural sector boomed – services, transport, processing, etc. The rural non-farm sector went from providing almost none of the GDP to more than one-third. Importantly, the Chinese government sent engineers and scientists into the countryside to transfer knowledge and technology to farmers and encourage non-farm business growth. Knowledge sharing combined with better infrastructure linkages between small farmers, processing facilities and retailing companies lies at the core of China’s success.  

Yet, while we can take inspiration from China, replicating the transformation process of a highly regulated, state-managed economy is not feasible elsewhere. Many governments do not have the capacity to effect these changes. I believe multinational corporations can fill this void. Companies need to be part of the international development strategy and leverage their unique position at the apex of global supply chains to share technical skills and cutting-edge innovation.

Indeed, this is already starting to happen. For example, the staple food crops grown by African smallholder farmers are finally getting attention. Traditionally, crops suited to Western climatic conditions, like potato, wheat and corn, have received all the scientific investment. Their yield, for example, has increased by a factor of five or six since the 1930s. The yield of traditionally African crops, on the other hand, is much the same as it was 100 years ago.

 

The average yield of maize and wheat has tripled since 1961 whereas the yield of millet, a crop traditionally grown in areas of Africa and India, has only increased by 50 percent

The average yield of maize and wheat has tripled since 1961 whereas the yield of millet, a crop traditionally grown in areas of Africa and India, has only increased by 50 percent.

 

Through a lack of R&D, finger millet, Bambara groundnut, teff and other staple African crops are still vulnerable to disease, pests and drought. The resulting low yields mean that African farmers have too little food to feed their families. It is no wonder that 80% of the global population deemed “chronically hungry” are farmers.

When we saw that this was happening, a group of uncommon collaborators came together for one of the most ambitious projects in the history of plant science. Mars, NEPAD, Illumina, BGI, WWF, the UN Food and Agriculture Organization, the World Agroforestry Centre and others partnered to sequence 101 African orphan crop genomes to accelerate breeding programs and improve food security for the farmers who depend on these crops. The genomes are being made available to the public so that plant breeders everywhere can breed new cultivars of the African crops with higher yields and more resistance to disease, pests and climate change. Better crops create jobs and can stimulate the rural non-farm sector in Africa. African seed companies will spring up to distribute the new cultivars to farmers; transport companies will bring surplus to markets; processors will take on the role of making food ready for the consumer, and so on.

 

Taro is a traditional crop in areas of Africa and one of the 101 crops whose genomes we are sequencing to improve nutrition, yield and resistance to drought, diseases and pests. Picture/Credit: karimitsu/iStock.com

Taro is a traditional crop in areas of Africa and one of the 101 crops whose genomes we are sequencing to improve nutrition, yield and resistance to drought, diseases and pests. Picture/Credit: karimitsu/iStock.com

 

We welcome the German government’s initiative to boost development aid to Africa, but to maximize the impact of taxpayers’ money, we need more inclusive private-public partnerships to play their role and bring the Marshall Plan for Africa to life. An inclusive approach is the only way to address one of the travesties of our age: people who grow food that don’t have enough to eat.

Young Economists Comment on the ‘Post-Truth’ Era

The economic consensus on such matters as the benefits of trade, technology and global integration has taken a political battering recently. We asked young economists of #LiNoEcon about their perspectives on what is often referred to as a ‘post-truth’ era, and what they think economists could or should do to combat it.

 

67th Lindau Nobel Laureate Meeting, 25.06.2017, Lindau, GermanyI think it is hubris to think that the economic consensus has ever played a role in influencing the man on the street. While the effects of trade nationalism may be catastrophic in economic dimensions I feel that in other research disciplines (e.g., climate research) the stakes are much higher. Consequently, we should stay resilient, persistent and join our fellow researchers from other fields speaking up in the name of truth.

        Chris Flath from Germany

 

 

 

 

 

 

        Photo/Credit: Julia Nimke/Lindau Nobel Laureate Meetings           

 

 

67th Lindau Nobel Laureate Meeting, 25.06.2017, Lindau, GermanyEconomists and other academic researchers are often wary of over representing their findings, which does not make it easy to communicate the complexities of these problems to the public.

Sarah Quincy from the US

 

 

 

 

 

 

 

 

 
 

 

           Photo/Credit: Julia Nimke/Lindau Nobel Laureate Meetings

 

 

67th Lindau Nobel Laureate Meeting, 25.06.2017, Lindau, GermanyI think that this fact is mainly the outcome of the financial crisis and, more importantly, of the growing inequality in our societies.

        Dimitris Papadimitriou from Greece

 

 

 

 

 

 

 

 

 

 

 
 
Photo/Credit: Julia Nimke/Lindau Nobel Laureate Meetings           

 

 

HelenaPolitical instability worldwide associated with migration flows and the financial crisis of 2008 (and thus rising income inequality) might be responsible for the development of extreme political and economic attitudes across society, especially in Europe.

Helena Chytilova from the Czech Republic

 

 

 

 

 

 

 

 
 
 
           Photo/Credit: Julia Nimke/Lindau Nobel Laureate Meetings

 

 

6th Lindau MeetingI don’t think that this ‘post-truth’ phenomenon is a reaction against truth or science, but against ideology-based opinions disguised as facts.

        Pedro Degiovanni from Argentina

 

 

 

 

 

 

 

 

 

 

 

           Photo/Credit: Julia Nimke/Lindau Nobel Laureate Meetings           

 

 

6th Lindau Meeting on Economic SciencesCommunicate, communicate, communicate. We need to better explain our work and results, and actively engage in a discussion with the greater public.

Sofie R. Waltl from Austria

 

 

 
 

 

 

 

 

 

 

 
 
           Photo/Credit: Christian Flemming/Lindau Nobel Laureate Meetings           

 

 

6th Lindau MeetingI believe we as economists need to do a much better job of communicating ideas, basic economic concepts and research findings in a manner conducive to being easily understood by lay persons.

        Farooq Pasha from Pakistan

 

 

 

 

 

 

 

 

 

 

 

           Photo/Credit: Julia Nimke/Lindau Nobel Laureate Meetings          

 

 

67th Lindau Nobel Laureate Meeting, 25.06.2017, Lindau, GermanyThe tackling of anti-intellectualism should follow from building a consensus that is capable of better foreseeing the consequences of the policies justified by it. Additionally, economists would be in a much better position to address anti-intellectualism if we embraced natural sciences, and built the profession as a natural offspring of other major disciplines.

Benjamin Leiva from the US

 

 

 

 

 

 

 

 

           Photo/Credit: Julia Nimke/Lindau Nobel Laureate Meetings           

 

 

 

6th Lindau MeetingIn my opinion, the dissemination of information is the best way to combat the ‘post-truth’ mentality. Economists and researcher in various fields of study should try to connect their work with people; the debate should come out of closed circles, be more interactive and open to the dialogue in various areas of society using simple and easily accessible communication tools.

        Giovanna Zeny from Brazil

 

 

 

 

 

 

 

 
           Photo/Credit: Julia Nimke/Lindau Nobel Laureate Meetings           

 

 

67th Lindau Nobel Laureate Meeting, 25.06.2017, Lindau, GermanyWhile I believe it is important to speak in terms everyone can understand when explaining economic ideas, economists should not simplify so much as to say ‘trade is always good’ when we know that trade creates winners and losers.

Andrew Jonelis from the US

 

 
 

 

 
 
 
 
 
 
 
 
           Photo/Credit: Julia Nimke/Lindau Nobel Laureate Meetings           

 

 

67th Lindau Nobel Laureate Meeting, 25.06.2017, Lindau, GermanyOur policies should have in mind the poorest, neediest, and least educated citizens in our societies. We need a Europe that takes care first of all of those citizens who do not travel abroad and do not speak any other idiom than their native language. Once we’ll have that Europe, we will be dramatically closer to a truly united Europe.

        Alessandro del Ponte from Italy

 

 

 

 

 

 

 

 

 

           Photo/Credit: Julia Nimke/Lindau Nobel Laureate Meetings           

Blockchain Technology: ‘Proof-Of-Work’ Versus ‘Proof-Of-Stake’

Bitcoins. Photo/Credit: skodonnell/iStock.com

Bitcoins. Photo/Credit: skodonnell/iStock.com

 

Cryptocurrencies like Bitcoin and the blockchain technology that underpins them are gradually becoming household words. Although peer-reviewed research is only just beginning to develop on the topic, the cryptocurrency ecosystem is growing at an exponential rate. Everyday, new businesses, investors and researchers enter this dynamic space.

At the University of Liechtenstein, I have been working on an experimental blockchain project with Professor Dr Martin Angerer and Jonas Gehrlein, MSc from the University of Bern. Our research on blockchain technology has been an educational, demanding and exciting journey.

The terms ‘blockchain technology’ and ‘distributed ledger technology’ refer to a variety of different technologies that attempt to solve different problems. Cryptocurrencies and blockchain technology emerged after the 2007/08 global financial crisis. The most popular example of these technologies is Bitcoin.

Bitcoin is a decentralised and open-source digital currency that stores transactional data in a distributed database that is maintained by computers all around the world. The creator of Bitcoin, who is still unknown but goes by the pseudonym Satoshi Nakamoto, wanted to provide a decentralised, private and secure means of transferring value online that did not rely on trusting sovereign entities, central banks or financial intermediaries.

A major discussion in the cryptocurrency realm relates to the optimal algorithm for achieving a collective agreement on which transactions are valid and which are invalid within a distributed network. Currently, the two most popular methods are known as ‘proof-of-work’ and ‘proof-of-stake’.

Bitcoin’s proof-of-work algorithm uses large quantities of energy and hardware equipment, which have been estimated to cost approximately $400 million per year. Proof-of-stake is a newer invention that has not been rigorously tested in the market.

When my colleagues and I began our research project, we wanted to investigate the differences between these two consensus mechanisms in a laboratory environment. Our motivation was simple: if both systems achieve the same outcome but one system (proof-of-work) incurs a negative externality on the environment, then why are people still using it?

Despite the seeming superiority of proof-of-stake, market participants prefer proof-of-work. Using market capitalisation as a proxy for demand, the highest market capitalisation coins all rely on proof-of-work. But proof-of-stake is gaining popularity: Ethereum, the second largest market capitalisation coin, is expected to switch from proof-of-work to proof-of-stake during the next year.

Our research uses game theory and behavioural economics to study the strengths and weaknesses of these two competing systems in a lab environment with students.

Our first step was to boil down the complex nature of these consensus mechanisms into abstract concepts that could be easily modelled in a lab. We spent months reviewing the research literature and brainstorming possible set-ups for the experiment.

The lab setup for proof-of-work was relatively straightforward. We planned to draw from the public goods literature on network externalities. Students would be given the option to use a medium of exchange that incurred an internal personal cost or a medium of exchange that incurred an external cost for the environment.

Essentially, this represented the current fiat system versus the energy-guzzling Bitcoin. At this point, we were very excited about the direction of our research and about the contribution that it could make to the fields of economics and information science.

Unfortunately, our research hit an insurmountable obstacle when we tried to model proof-of-stake: we could not find a way to do it easily in a lab. We discussed potential drawbacks of the proof-of-stake system such as 51% attacks, deflationary spirals and uncertainty stemming from ambiguity. But we came to the conclusion that Bitcoin’s proof-of-work suffered from the same drawbacks, albeit to a lesser degree.

During my own reflection on the differences between proof-of-work and proof-of-stake, I came to the conclusion that these systems resemble our transition from a gold standard to a fiat standard. Like gold, Bitcoin uses electricity and capital equipment to mine new coins. The probability of randomly being chosen to create a block and receive a reward is equal to each miner’s amount of mining power divided by the total amount of mining power on the network.

On the other hand, proof-of-stake allows the users with the largest holdings to create coins out of thin air. In a proof-of-stake system, the probability of receiving a reward is equal to the fraction of coins held by the user divided by the total number of coins in circulation.

Following this logic, proof-of-stake would appear to be superior to proof-of-work because economic theory argues that the fiat system is superior to the gold standard due to deflationary spirals caused by hoarding. (Note, however, that my late uncle, the American economist Larry Sechrest, argued in his 1993 book, Free Banking: Theory, History, and a Laissez-Faire Model that the problems associated with the gold standard actually stemmed from regulation and not from the scarcity of gold.)

To date, my reflections have not helped us find a suitable set-up for the lab experiment: we have been unable to find a major setback of the proof-of-stake consensus mechanism. The only problem that I could find was quite philosophical in nature and too complicated to be easily modelled in a lab.

The twentieth-century Austrian logician, Kurt Gödel, argued that no system can prove its own correctness from within itself. In reference to proof-of-work and proof-of-stake, the former appears to solve Gödel’s incompleteness theorem while the latter relies on external truth to achieve consensus.

In a proof-of-work system, anyone can join the system and immediately determine the correct history of transactions in the blockchain because the correct chain is the longest chain by default. In comparison, proof-of-stake has not developed a method for ensuring that every computer in the network comes to the same conclusion on the correct history of transactions from within the system.

Instead, proof-of-stake relies on an external third party or host of third parties to establish agreement on the history of transactions. In plain terms: proof-of-stake establishes truth by appealing to an external anchor while proof-of-work establishes proof from within. Although the introduction of counterparties may not be a problem in every case, the original goal of the blockchain technology was to create consensus without intermediaries.

In the end, we could not find a suitable way to model proof-of-stake in a lab with humans. In our own analysis of this problem, we realised that there was a fundamental problem with the premise of our study: we were trying to model a lab experiment with humans based on a technology that was designed to minimise human interaction.

Although we have encountered this major setback in our study, we have learned a tremendous amount about blockchain technology and about our own strengths and weaknesses as researchers. Instead of giving up, we are going in a new direction with our blockchain research. After all, the journey for pioneers is never paved.

Is Economic Policy Ready for the Next Crisis?

The economics profession took a big hit in the wake of the global financial crisis. Why did macroeconomists with their fancy models not see it coming? Should governments inject money into the economy to boost demand or cut spending to reduce record public deficits? And why have zero interest rates and ‘quantitative easing’ not done more to improve anaemic rates of growth?

These questions and many more were up for debate at a panel of three Nobel Laureates and a young economist at the 6th Lindau Meeting on Economic Sciences on Friday 25 August. The participants considered the new conditions for monetary policy – cutting interest rates and rescuing banks – and fiscal policy – changing taxes and spending public money.

They also asked why, before the crisis, policy-makers seemed to have paid insufficient attention to financial markets in their models. Mario Draghi, the President of the European Central Bank, used his keynote speech [link to video on LindauNobel site that I can’t access] that launched the Lindau meeting on 22 August to admit that there was a ‘notable absence’ of a role for banking and finance in these models.

 

Panel discussion during the 6th Lindau Meeting on Economic Sciences. Picture/Credit: Julia Nimke/Lindau Nobel Laureate Meetings

Panel discussion during the 6th Lindau Meeting on Economic Sciences. Picture/Credit: Julia Nimke/Lindau Nobel Laureate Meetings

 

Martin Hellwig, the panel chair and director of the Max Planck Institute for Research on Collective Goods, started the discussion by highlighting that a debate over the effectiveness of fiscal stimulus policies in the US had been matched by one over austerity policies in Europe that involved doing the exact opposite.

Peter Diamond, co-recipient of the Nobel Prize in 2010, said that the decision by the US government to pursue an active fiscal policy, which lessened the depth of the recession, helped to explain the gap between growth rates in North America and Europe since the crisis.

But he acknowledged that the time lag involved in passing the legislation to push through fiscal measures, as well as concerns over what the money was spent on, had undermined people’s faith in the policies.

‘The depth and length of the Great Recession put both tax cuts and spending back on the US agenda although they were insufficiently used’, he said. ‘As the recession went on, the political will to do more was gone. The failure to follow up reflected a lack of appreciation by politicians and the general public of the value of suitable stimulus policies.’

Edward Prescott, co-recipient of the Nobel Prize in 2004, took a different view in a presentation with the title ‘The Unimportance of Monetary Policy and Financial Crises on Output and Unemployment’. He cited financial crises that saw countries experiencing contrasting outcomes at the same time: the US and Asia in the 2008 crisis; Chile and Mexico in 1980; and Scandinavia and Japan in 1992.

‘Financial crises do not impede development,’ he claimed. While the 2008 financial crisis was localised in North America and the euro area, there was a short recession and quick recovery in Japan, Taiwan and South Korea and no recession in Scandinavia and Australia. ‘Countries where fiscal policy was irresponsible had problems’, he maintained. ‘Fiscal responsibility is crucial: to spend is to tax and to tax is to depress. That’s what happens every time.’

Christopher Sims, co-recipient of the Nobel Prize in 2011, agreed that responsible fiscal policies were always required. But he went on to say that a responsible fiscal policy in the face of a major recession, in which inflation is falling below target, is ‘to expand and convince people that the expansion, via either additional spending or tax cuts, does not imply future taxes or spending cuts.’

‘You are doing this because you want inflation to go up,’ he added, referring to the struggle that central banks have had to drive inflation up from current levels of close to zero.

Sims urged young economists to fill in the ‘gaps’ in the major directions of monetary and fiscal policy research. But he also warned that many current research projects that simply seek to add extra elements to the standard ‘dynamic stochastic general equilibrium’ (DGSE) models, which were seen as having failed to spot the 2008 crisis, were just ‘fighting the last war’.

‘Right now, the biggest confusion that policy-makers have is that we have had low inflation below target for years despite the drastic measures that independent central banks have taken,’ he said. ‘We don’t have models that explain how we got stuck at this point for so long.’

Sims acknowledged that this was a new area where the paths have not been laid out and that empirical work that connected fiscal policies with the paradoxes of inflation was a ‘risky project’ for a PhD. But he concluded: ‘Precisely because of that, it might earn you the Nobel Prize.’

The Myth of the Independent Central Bank

In today’s fiat money world, money has no ‘intrinsic’ value. People value fiat money because other people value it. As long as everyone agrees that fiat money has value, then it does have value: but if enough people suddenly decide that fiat money has no value, it becomes worthless.

In hyperinflationary episodes, confidence in a fiat currency evaporates and people dump it in favour of assets, commodities and even other fiat currencies. Printing more of it only makes matters worse.

Macroeconomic models involving (fiat) money are thus inherently models with multiple equilibria. In one equilibrium, the value of money is stable: but in another, inflationary dynamics become explosive and money becomes either worthless (hyperinflation) or infinitely valuable (Fisherian ‘debt deflation’).

In such models, the economy can suddenly jump to an explosively inflationary equilibrium without any change in policy. In effect, they imply that there can be a ‘run on the central bank’.

Central banks can, of course, always meet demand for their own currency, since they can create it ex nihilo. But if there is always the risk of a sudden switch to an explosively inflationary or deflationary equilibrium, they can’t guarantee its value.

Nobel Laureate Professor Christopher Sims argues that it is fiscal policy that guarantees the value of fiat money. Central banks thus can never be independent of government. The ‘independent central bank’ is a myth.

But what about the European Central Bank (ECB), whose independence from government is guaranteed by treaty? The original concept of the Eurosystem assumes that there is a sharp distinction between monetary and fiscal policy, and that monetary policy does not give rise to fiscal transfers.

We now know that all monetary policy actions have fiscal consequences: for example, interest rate rises shift wealth from countries with more debt towards countries with less. Buying government bonds according to a ‘capital key’ reduces the borrowing costs of larger and richer countries.

 

Laureate Christopher Sims during his lecture at the 6th Lindau Meeting on Economic Sciences. Picture/Credit: Christian Flemming/Lindau Nobel Laureate Meetings

Nobel Laureate Christopher Sims during his lecture at the 6th Lindau Meeting on Economic Sciences. Picture/Credit: Christian Flemming/Lindau Nobel Laureate Meetings

 

The euro’s very existence was threatened by fiscal distress in Eurozone countries, to which the ECB was forced to respond. Thus, even the ECB is entwined with government.

Not only are central banks not independent of government, but they are also dependent on governments running appropriate and plausible countercyclical fiscal policy. As Professor Sims says, ‘if people understand that fiscal policy will try to slow the expansion of deficits in periods of high inflation, and will expand deficits when interest rates are at or near the effective lower bound, sunspots and multiple equilibria are eliminated’.

The ‘fiscal theory of the price level’ says that to keep the value of fiat money stable and prevent switching to an unstable inflationary dynamic, fiscal policy must actively maintain the real value of government debt over the long term. The fiat money ‘confidence trick’, in which – like Tinkerbell – it has value as long as people believe in it, thus depends on the credibility of fiscal policy as much as monetary policy.

Central banks’ ability to act as lenders of last resort in a crisis depends on their fiscal backing. When a central bank is actively buying assets, it can become technically insolvent if those assets fall in value. Several central banks around the world currently have negative net worth at market prices: some of them (such as the Chilean central bank) have had negative net worth for a long time.

There has been a considerable debate about whether the solvency of central banks makes any difference to their credibility as lenders of last resort or their ability to control inflation. Arguably, it does not – provided fiscal authorities can support them.

Often, the net present value of future seigniorage receipts is sufficient to cover any asset and liability mismatches at market prices. But if seigniorage is insufficient, then tax receipts will be needed to plug any gaps. In practice, this implies that the net present value of projected future primary surpluses must be sufficient to recapitalise the central bank without increasing government debt.

What happens if the fiscal authority is unwilling to recapitalise its central bank? This would be unthinkable in countries such as the US, where the currency is backed by the ‘full faith’ of the US government.

But in the Eurozone, the central bank is not only fully independent of government, but there are also 19 governments of varying degrees of fiscal credibility. Maintaining the stability of the euro depends on the willingness of all these governments to recapitalise the ECB.

To be sure, their willingness has already been tested. Since the ‘whatever it takes’ remarks of ECB president Mario Draghi at the height of the Eurozone crisis in 2012, the ECB has been to some extent cast in the role of fiscal institution, actively buying the government debt of Eurozone countries to keep bond yields down.

Had it not done so, some of those countries would undoubtedly have been forced out of the euro. It has arguably done this at the price of its own solvency – yet there has been no ‘run on the ECB’, as might be expected if markets thought fiscal support for the ECB would be found wanting.

But the ECB could still be forced to buy the government debt of countries with ‘irresponsible’ fiscal policies, if not doing so meant partial unravelling of the euro. Some Eurozone countries might balk at recapitalising a central bank that in their view was actively supporting governments that were breaking fiscal rules, especially as the ECB lacks the democratic legitimacy to make such decisions.

The Eurozone thus still lives in a world of multiple equilibria, even though the likelihood of a sudden switch to explosive inflationary dynamics appears remote at present.

Professor Sims says it would be better if there were a democratically accountable, Eurozone-wide fiscal institution with the power to raise taxes, which could take over the buying and selling (or issuing) of government debt. ‘But I don’t know how you organise that,’ he concluded.

The US knows how you organise it. They call such an institution a ‘federal government’. Sadly, we seem to be some distance from introducing such an institution in the Eurozone. Multiple equilibria and sunspots seem likely to remain the order of the day for many years to come.

 

The Puzzle of Global Inequality

During a Science Breakfast at #LiNoEcon moderated by Romesh Vaitilingam (left) laureate Eric Maskin, young economist Devaki Ghose and Howard-Yana Shapiro, Chief Agricultural Officer, Mars, Incorporated, discussed how to address global inequality.

During the Mars Science Breakfast moderated by Romesh Vaitilingam (left) laureate Eric Maskin, young economist Devaki Ghose and Howard-Yana Shapiro, Chief Agricultural Officer, Mars, Incorporated, discussed how to address global inequality.

 

New policies are needed to tackle the surprising rise in inequality within developing countries, even as they have become more integrated into the global economy. That was the core message of a panel of researchers speaking at a science breakfast sponsored by Mars, Inc., on Thursday, 24 August at the 6th Lindau Meeting on Economic Sciences.

The fact that the dramatic growth in average income in large developing countries like China and India has led to increased inequality is ‘deeply troubling’, according to the opening speaker, Nobel Laureate Eric Maskin.

This seems to contradict the long-established theory of comparative advantage, which predicts that relative wages of unskilled labour should rise as their trade increases. It also contrasts with what happened in previous periods of globalisation, for example, in the late 19th century.

Professor Maskin explained that what has changed is that the production process has been internationalised. Communications technologies now allow companies to establish just-in-time global supply chains, and to employ skilled workers around the world, so that the gains of trade are no longer distributed on a countrywide level.

Domestic migration is also fuelling inequality, he added. There is a growing gap between the city and the countryside in developing countries. Those who move to the cities have improved opportunities for education, jobs and income, while the countryside is increasingly impoverished.

Panel member Devaki Ghose, of the University of Virginia, one of the young economists attending the Lindau meeting, drew on her experience of research in India to reinforce these points.

She noted that India’s high-tech sectors, such as its IT outsourcing business, which has been a huge international success, employ only a small percentage of the Indian workforce. It is only open to a small proportion of the population – under 6% – who are both computer-literate and English speakers. She also said that these high-tech firms are concentrated in just a few states in India where they have close links to universities.

In contrast, 60% of the Indian population works in agriculture, where they face problems of low productivity, poverty and lack of investment in modern production techniques.

Dr Ghose cited a personal example, where a large family she knew from a tribal area was unable to farm all the land they owned, but were too poor either to hire extra labour or to buy expensive inputs like fertiliser to improve crop yields. What’s more, the legal system in India, which seeks to protect poor farmers’ land ownership rights, prevented them from selling part of their landholdings to others who could make more productive use of it.

Genetic scientist Dr Howard-Yana Shapiro, chief agricultural officer at Mars, Inc, argued that now was the time for action. What we need, he said, is ‘a change of theory, not a theory of change.’

He pointed out that 37% of the population in rural Africa is malnourished at birth, as are 43% of Indian children. There is a moral obligation to tackle the problem of chronic malnutrition in countries where farmers cannot produce enough food to feed themselves. He said that only an inclusive approach, which could both discover solutions and scale them up would work, using the skills of industry, universities, NGOs and governments alike.

Mars is committed to developing new crop varieties with increased yields that can be freely distributed to farmers. Dr Shapiro said that although the yields on the ten major food crops may have reached their natural limits, there are great gains to be made by genetic modification of 100 less widely grown food crops in Africa.

In India, Mars is working with farmers to improve the yields of chick peas, one of its major food crops yet a commodity for which continuing low yields means it still has to be imported from abroad. Mars has also mapped the genetic sequence of cacao to breed a higher yielding, disease resistant tree, which can also produce tastier chocolate. The company has made the genome data freely available to growers in developing countries.

Professor Maskin suggested that higher crop yields alone would not be enough to tackle rural inequality, as early adopters would gain at the expense of those who could not or would not take up the new crop varieties.

There was considerable discussion about the incentives that might motivate companies to take actions that tackle poverty and inequality, including improving human capital through training. Professor Maskin expressed scepticism that many companies would do so on their own initiative without government incentives such as tax breaks.

Dr Shapiro commented that although Mars had an advantage as it is a privately held company that is not subject to short-term pressure from shareholders, other companies, such as rivals Nestle and Unilever, were following in its footsteps, in their own long-term self-interest.

He added that tackling climate change was another area where companies, such as Mars, were increasingly willing to act on their own to develop a zero carbon footprint, independent of government actions such as the US decision to withdraw from the Paris agreement on climate change.