Thoughts on “Thinking, fast and slow”

I couldn’t resist buying a copy of Daniel Kahneman’s best-seller when returning from holidays. Several friends and colleagues told me it was a great book; it got great reviews; and Kahneman’s journal articles are invariably a good read, so I was curious.

Its general message is simple and intuitively appealing: Kahneman argues that people use two distinct systems to make decisions, a fast one and a slow one. System 1, the fast one, is intuitive and essentially consists of heuristics, such as when we without much thought finish the nursery rhyme ‘Mary had a little…’. The answer ‘lamb’ is what occurs to us from our associative memory. The heuristic to follow that impulse gives the right answer in most cases but can be lead astray by phrases like ‘Ork, ork, ork, soup is eaten with a …’. Less innocuous examples of these heuristics and how they can lead to sub-optimal outcomes are to distrust the unfamiliar, to remember mainly the most intense and the last aspect of an experience (the ‘peak-end rule’), to value something more after possessing it than before possessing it (the ‘endowment effect’) and to judge the probability of an event by how easily examples can come to mind.

System 2, the slow way to make decisions, is more deliberative and involves an individual understanding a situation, involving many different experiences and outside data. System 2 is what many economists would call ‘rational’ whilst System 1 is ‘not so rational’, though Kahneman wants his cake and eat it by saying that System 1 challenges the universality of the rational economic agent model whilst nevertheless not wanting to say that the rational model is wrong. ‘Sort of wrong sometimes’ seems to be his final verdict.

Let me below explore two issues that I have not seen in the reviews of this book. The first is on whether or not his main dichotomy is going to be taken up by economics or social science in the longer-run. The second, related point, is where I think this kind of ‘rationality or not’ debate is leading to. Both issues involve a more careful look at whether the distinction between System 1 and 2 really is all that valid and thus the question of what Kahneman ultimately has achieved, which in turn will center on the usefulness of the rational economic man paradigm.

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The economics of government 2.0

{This is the original version of an article that appeared from Dec to February in two installments in the Canberra Times}

Australia has an official policy, pursued by the Ministry of Finance and Deregulation, on the relationship between government and the web that attempts to outline how the government will take advantage of the ‘opportunities’ opened up by the web. Similar undertakings are in progressin many countries where governments are struggling to come to terms with the role of government in the online age. ‘Our’ policy, which is still under construction, has been kicked off by accepting 12 of the 13 recommendations of the ‘Gov 2.0 taskforce’ led by Nicholas Gruen.

In this blog I will attempt to sketch the political economy of the enterprise so that it might become clearer, to those schooled in the language of markets and incentives, what is going on. The three main tenets of gov 2.0 as I see it are to put lots of documentation online, to tap into the free lunch of online volunteerism, and to make money from the government’s unique ability to identify you and tax you. Apart from talking you through these three main tenets, I will also try to dispel some particularly confusing myths doing the rounds about gov 2.0, in particular the idea that gov 2.0 will lead to more ‘participatory democracy’.

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Random odd thoughts I: why is the informal economy so small?

Some things seem to need no explanation, but are not obvious at all on reflection and, if you wonder about them, suggest something of interest about the economic system. Consider the question of why the informal economy is so small, leading to the question of how much more productive the formal economy must be than the informal economy to make sense of how little informal economic activityy there is. See over the fold for the full argument.

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Which production factor gets destroyed in major recessions, part II?

In a post a few weeks back, I raised the question of what additional production factor one would have to include into the current production function framework in order to have a plausible story about the recent crisis.

That post included a set of conditions any candidate would have to pass in order to fit the current crisis and be interpretable as a true factor of production. From the ensuing reactions, two main candidates emerged: a mystery factor that gives a role to lines of credit (suggested by James A); and input and output linkages (suggested by doctorpat, Ian King, and, implicitly, _Tel).
Let us now add more information to this question and see whether the proposed production factors have something to say about other major economic crises that we have known in relatively recent economic history.

The hope is that we need only one factor to generate a reasonable story for several major downturns. If  we’d need a very different new factor to explain each different major economic downturn, then the exercise of looking for new production factors becomes more futile because there is then less hope that having a good  explanation for each of the previous downturns will say anything of much use to inform us about what to do to prevent or cope with the next one.

Below is a graph that summarises the GDP movement of three other major economic downturns.

GDP movement during major recessions in the US, Russia and Indonesia
GDP movement during major recessions in the US, Russia and Indonesia

The blue line shows the Great Depression, in which case the 0 point on the X-axis denotes 1929; the red line shows the collapse of the Russian economy after the changes in 1990; and the green line shows the Indonesian collapse after the Asian Financial Crisis of 1997. In each case, GDP is normalised to be 100 at the start of the crisis and time is re-set to 0 at the start.
The first striking observation is that these three crises are far bigger in magnitude than the current crisis. Indeed, the Russian collapse was so spectacular that I have long wondered how it is possible that our macro-textbooks are not full of insights gained during such a spectacular macro-event. Stiglitz already noted in the 90s that the Russian collapse shouldn’t have occurred under the conditions we still teach as good descriptions of the aggregate economy, but it clearly hasn’t mattered for Western textbooks that a large economy on the periphery did something interesting.
The main question to briefly consider though, is whether the two candidate factors X are known to have been involved in these downturns too? Lines of credit were certainly important in the Russian case (as in the whole of the former USSR), where firms had large amounts of outstanding debt with other firms and the unwinding was a tricky business.

Lines of credit were also important in Indonesia and the Great Depression. Hence credit lines can at least potentially ‘fit’, though it should still be worked out via which actual production factor they affect sold production.

Linkages are clearly of relevance in the Russian case where the whole central coordination mechanism fell away and the ensuing ‘disorganisation’ (A phrase used by Blanchard and Kremer 1997) created many firms who had no suppliers and no clients. Campos and Coricelli in their 2002 Journal of Economic Literature article also point to within-sector reorganisation of links as a probable factor in the collapse.

Whilst linkages are probably relevant in the Asian Financial crisis, it is not well-documented how they might have played a role. We know many city labourers went back to the countryside, however exact numbers are unknown because most people who originally came from the country to find urban employment are unregistered and therefore not included in unemployment and migration data etc (explanation paraphrased from a paper by Tran Tho Dat).
We also know that the capital embedded in collapsing firms was not quickly re-used by others, but there’s no specific account I know of that  discusses the collapse in terms of broken linkages.

For the Great Depression, on which acres have been written, I also do not know of anyone looking at it through the lens of links. One might say it is implicitly there when people talk about the issue of bankruptcy, as bankruptcy to a perfect market economist merely means the freeing up of previously inefficiently used production factors. From a link point of view, the importance of bankrupcy is that people and capital are idle for quite a while before they are ‘re-linked’.

Any ideas on how we should think of disruptions in lines of credit and its impact on the real economy via a production factor in these three crises or the current one? Any anecdotes on links?

A few tidbits

First, from The Australian today on academics and outward influence:

The Core Economics blog founded by Melbourne University economics professor Joshua Gans in 2006 gives him a platform to explain his ideas. And every time people read a post his institution’s brand benefits.

Amen to that. I hope that applies to the Institutions of all those contributing to this blog including those from Monash, ANU, Wharton, Chicago and Wilfrid Laurier.

Second, and coming soon as reported in the Canberra Times.

There will be a few surprised editors and news directors around the country after an Australian National University paper, “How Partisan is the Press: Multiple Measures of Media Slant,” is issued later today. The study was conducted by Andrew Leigh and Joshua Gans. The researchers will name the Australian newspaper with the most Labor-friendly headlines, the TV news station which shows the most bias towards a political party and reveal whether the nation’s newsrooms are really awash with left-wing bias.

Stay tuned although I can’t imagine there will be much interest!

The blogging estate

Don Arthur writes about Australian econo-bloggers and whether they play more than a commentary role: “So even though econo-bloggers … aren’t getting anyone sacked, they’re well worth reading.” He was reacting to an article in The Australian lamenting all of that (but since the article did not mention this wonderful blog I won’t link to it!). But all this discussion got me thinking about whether bloggers can and should do more than sniping commentary.

Truth be told, Australian econo-bloggers are part-timers. Blogging is a very small part of their day (it takes at most half an hour of mine) and so it would be surprising if it could ever result in someone losing their job. That said, I reflected upon a few posts of mine that were supposed to be more than just commentary and I thought I’d list a couple here as a point of interest.

  • In 2006, I woke up one morning and wondered what Telstra told the regulator in New Zealand where it is an entrant and not the incumbent. Here is the post. Amazingly, it not only advocated the entrant case it did it very well and with evidence. This was all in direct contrast to what it had been saying in Australia. I gather that following that post, this inconsistency became understood by our own regulators.
  • In 2007, in my most visited post ever, I noted that Apple’s ads in Australia for Apple TV were suggesting that certain content was available in Australia that was clearly not so. It took a little while but they eventually changed their website.

That said, I think we do serve a role in pointing out inconsistency in the economic statements of politicians. Here is one I got to first on Julie Bishop (similar to yesterday’s on Joe Hockey) and just last night Sam Wylie tackled the PM (actually, Sam is doing this quite regularly). All of this stuff is not just academic commentary but could easily have been things that were tackled first by the mainstream media but, in fact, got there first from this blog.


In Slate today, Eliot Spitzer looks at the reform options for student loans in the US. Turns out we have had his proposal in Australia for two decades. [DDET Read more]

Marketed under the decidedly unappealing name of "income-contingent loans"—how about we call them "smart loans" instead?—the concept is simple: Instead of paying upfront or taking loans with repayment schedules unrelated to income, students would accept an obligation to pay a fixed percentage of their income for a specified period of time, regardless of the income level achieved. Suppose a university charged $40,000 a year in annual tuition. A standard 20-year loan in the amount of $160,000 (40,000 times four) would produce an immediate postgraduate debt obligation of $1,228.50 per month, or $14,742 per year, not sustainable at a salary of $25,000 or anything close to it. Under a smart loan program, the student could pay about 11 percent of his income, with an initial payback of $243 per month, or $2,916 per year, which is feasible at a job paying $25,000. If, after five years, the student’s salary jumped to $100,000, payments would jump accordingly and move up over time as income increases. After 20 years, assuming ordinary income increase, the loan would be paid off.

Interestingly, he claims the origins of this were with Milton Friedman, something I did not know.