Perverse Consequences

Two nights before the first communion, Father Antonio Isabel closeted himself with him in the sacristy to hear his confession with the help of a dictionary of sins. It was such a long list that the aged priest, used to going to bed at six o’clock, fell asleep in his chair before it was over. The interrogation was a revelation for Jose Arcadio Segundo. It did not surprise him that the priest asked him if he had done bad things with women, and he honestly answered no, but he was upset with the question as to whether he had done them with animals. The first Friday in May he received the communion, tortured by curiosity. Later he asked Petronio, the sickly sexton who lived in the belfry and who, according to what they said, fed himself on bats, about it, and Petronio answered him: “There are some corrupt Christians who do their business with female donkeys.” Jose Arcadio Segundo still showed so much curiosity and asked so many questions that Petronio lost his patience.

“I go Tuesday nights.” he confessed. “If you promise not to tell anyone I’ll take you next Tuesday.”  (Gabriel Garcia Marquez, One Hundred Years of Solitude)

The purohit who did my upanayana when I was 8 was very wise. He confined himself to forbidding me from throwing stones at dogs.

The Chinese Stock Market

In late 2007, the Shanghai stock market was going through a boom. A Professor of Economics was visiting China and there he learnt that everyone, everyone was expecting the stock market to crash after the Olympics in September 2008. In other words, they assumed the market to keep rising like a Diwali rocket till then, and then fall dramatically.

The professor was amused that no one had reasoned backwards from there. Everyone expected the market to fall in September. So, what would happen in August? Wouldn’t they think, “Hey, I don’t want to get too greedy. I know that the index will rise another month, but what if it suddenly starts falling  and I am caught short? I had better sell right now and book my profits.”

Now, if many people think so, prices will fall, not in September, but in August. But if everyone knows that everyone else is thinking that way, why would they wait till August? Won’t they start selling in July? And so on, by induction, if people expect the market to tank in September, prices should fall right now.

This is what traditional economics suggests. Behavioural economics argues that the professor’s analysis is incomplete. Obviously, not everyone will decide to sell in August, but some people will. What will happen in the market is the classic battle between greed and fear. Some people, overcome by greed, will hold on in the hope of making even more gains, while some people, overcome with fear, will sell. At some point, fear will overcome greed and the market will crash.

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Responses

Venu says

I find it worrisome that you are making quite strong claims (global warming can be handled by markets alone) and then casually stating that you don’t have any evidence for them.

No! I didn’t say that.  All I say is that we will not act on Global Warming at the optimal time. To use an overworked analogy – Hitler. Perhaps there was a time at which he could have been tackled without the enormous carnage of WWII. My view is that given what human nature is, this was unavoidable. We aren’t good at foreseeing and agreeing to act on uncertain threats in the distant future. We are, however, good at getting our act together in the face of a crisis. When we do try to fix problems too distant in the future, we make a lot of mistakes and there is a good chance that we make things worse. So, I propose that we go with the flow and not do anything about Global Warming, and leave things for our children to fix. When we do fix it, we will probably not rely on the market entirely, but we will still be relying on market-like mechanisms.

Ritwik says

Isn’t the market nothing but an aggregation of human behaviour? If you’re agreed in theory and premise with the behaviourists (about hyperbolic discounting, etc.), how are your recommendations so different from the ones they make – why do you (and others like you) consider subject matter expertise to be so important in say, science, but not in policy?

Because behaviourists have not yet come up with practical and actionable recommendations. I know that you have written out the theory of how behavioural economics will prove the EMH wrong. But behavioural economics, while it explains very well why bubbles form, is still unable to tell us the exact, or even approximate moment at which the bubble will burst. Without that, we do not know how to profit from the irrationality of the stock markets.

Likewise, all their “policy recommendations” amount to:

  1. Here is a behavioural quirk that causes ordinary human beings to behave in a way not predicted by standard economic theory
  2. Here is a policy recommendation that fixes the above, which we will assume, for the purposes of simplicity, will be put in place by detached technocrats not subject to the quirks above.

We do not yet have a model of human behaviour that can be used to make predictions about the impact of specific policies when all behavioural traits are considered, and when the fact that even policy-making and implementation is subject to the same quirks is considered. Given this, I did the only scientifically responsible thing possible – I used behavioural psychology to understand (science) but not recommend (policy)

Not everything reduces to incentives, at least in the way that we formally study them. Incentives are great at explaining the average truth, the usual explanation for why something happens. They fail miserably when explaining fringe behaviour or initiatives to tackle fringe issues. By fringe here, I mean not unimportant, but at the edge of our knowledge, efforts and motivations. Of course, one can use a slippery definition of ‘incentives’ and then everything can be considered a function of incentives.

What has this got to do with my post?

And at the end of it all, I am still wondering what your point is. Is it that we won’t be able to ’solve’ global warming, assuming that it is a problem in the first place?

See above – that we will not be able to solve Global Warming at the “optimal” time, and that we shouldn’t try to solve problems too much in advance.  Also, correcting for market failure is not a simple thing.

Markets and the Long Term

The Economist has an article on the problems of aligning the CEO’s interests with those of the shareholders. The obvious solution to this  is to ensure that a large proportion of the manager’s compensation is in the form of shares or stock options. But it turns out that during the recent financial crisis, the more shares of a bank its CEO held, the worse the bank performed.

I believe that this is confounding two different problems. The agency problem relates to aligning an incentives of the agent (i.e. the CEO) to that of the principal (i.e. the shareholders).  The second problem is that of translating long term goals into short term actions.

Human beings are not very good at solving the second problem even when the principal and agent are the same people. We aren’t good at planning our own diet and exercise so that our long-term health is maximized. The challenge is not only the intellectual one of long-term planning, it is also one of the incentive to execute the plan. Who wants health food and rigorous exercise when fried stuff and indolence are so pleasurable?

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Heuristics at 10 Months

My son has a rather instrumental view of parental love. As far as he is concerned, the affection felt by his parental units is a means for him to achieve certain ends. At 10 months, his main objectives are to be fed when he is hungry and to be taken out of the house so that he can see cars zipping by. In seeking the second objective, he has learnt that  when one of the parental units says “Let’s go Tata”, they often follow  it up by opening the door and taking him out, but sometimes they cheat him and do not take him out. Worse still, the PU pretends to take him out, but then cheats him by leaving him with the other PU and goes tata all by himself. So, he now applies the following  heuristics:

  1. The male parental unit is more likely than the female parental unit to take him out to tata.
  2. The parental unit that is putting on footwear is the better bet.
  3. The parental unit that is standing at the door is more likely to take him tata.
  4. Once the parental unit has gone out through the door and closed it, it means that he will not be taken tata now, but sometimes wailing loudly opens the door.

These heuristics have served him well so far, but sometimes strange things happen when they come into conflict. For example, today, the male parental unit was putting on footwear, while the female parental unit decided to say “Tata” to him and go out. This brought two of his rules into conflict, but he stuck with rule nos 1 and 2 and stayed  calm. Then, after the MPU seemed ready with his footwear, it turned out that the FPU was at the door, offering to take him Tata, so he lunged for her. Then, to his surprise, he found that the positions were now reversed and the MPU was at the door pretending to go Tata all by himself.  A quick wail soon corrected the situation.

The August Pragati

Have you picked up the August 2009 issue of Pragati yet?  It is good. The focus this time is on legal and regulatory reform and it has been guest-edited by Shruti Rajagopalan.  My favourites are this piece by Ajay Shah about the changes in legal regime required for  further Financial Reform, Aadisht’s article on the widespread prevalence of retail corruption in India, and Jaivir Singh’s article on Labour Laws and Special Economic Zones.

A little more about that last piece. The common wisdom is that we need to reform our labour laws to make life easier for our companies. The theory is that if employers know that they can lay off workers without getting mired in red tape, they will be more willing to hire workers.  Now, many people argue that labour inflexibility is not actually much of a burden on employers and that they get around restrictions by hiring contract labour or by “persuading” labour inspectors to be more flexible.

Labour laws do hamper employers when the workers have lots of market power anyway and there are strong unions, as was the case in the Bombay of the 60s and 70s, but when companies set up textile mills in remote areas of Tamil Nadu and Gujarat where employment is scarce and the low wages they offer are still better than the alternatives, they are pretty much useless. In other words, labour laws are ineffective precisely where they could be of use to Labour.

Jaivir Singh points out that instead of changing the law to provide a little more flexibility to employers, opposition to the relaxation   has forced government to adopt a subterfuge wherein they are ignored almost entirely within SEZs. Incidentally, Aadisht’s article is also about why India’s preferred mode of corruption is one where industries buy lax enforcement of the law, rather than lobbying to have laws changed.

Senility and Justice

Commenters have suggested that Justice Iyer is getting senile. Not really, it is Justice that has suffered  from an onset of senility. Amartya Sen  will be writing a book about what V R Krishna Iyer has already put in practice. Justice, acording to Sen, will not be achieved by identifying specific principles that are to be upheld, violation of which would constitute injustice. Instead, like pornography, we will know injustice when we see it. So, Justice Iyer saw injustice in hanging Dhananjay Chatterjee, so he opposed hanging him. He sees injustice in dowry harrassment, so he supports hanging those who drive women to death for dowry. The relevant principles can be thought up after we figure out which side we are on.

Five Years is a Long Time

The New Indian Express, July 29, 2009:

Asking for July 29 to be observed as the ‘death sentence day’ for dowry harassment across the world, Justice V R Krishna Iyer, former judge of the Supreme Court on Tuesday said, “The Indian Dowry Prevention Act is still inadequate. Not a single person has been sentenced to death for dowry harassment till date.” (Hang Dowry Seekers: Ex-Judge) 

The Hindu, August 13, 2004:

The former judge of the Supreme Court, V.R. Krishna Iyer, writer Khushwant Singh and eight other prominent personalities have appealed to the President, A.P.J. Abdul Kalam, to stop the execution of Dhananjoy Chatterjee following the dismissal of the petition by the apex court seeking a stay of the execution fixed for tomorrow.

…

They drew the President’s attention to the fact that there had been a general shift worldwide towards total abolition or towards the non-use of death penalty.

They said the International Criminal Court set up in 1998 by 120 countries did not allow itself to hand down death sentence even though it oversees large-scale heinous crimes including rape, murder, crimes against humanity and genocide. The United Nations Security Council had also disallowed death penalty by the International Criminal Tribunals trying crimes in Rwanda and the former Yogoslavia. As many as 79 countries had abolished death penalty completely, 15 had abolished for all except wartime crimes and 23 have it in law but not in practice for the last 10 years (Krishna Iyer, others appeal to President )

The Dangers of Labeling

I was going to write a post on this today, but coincidentally, Wired’s piece on 100 Things Your Kids May Never Know About has “Toys actually being suitable for the under-3s” as one of those things.   The United States of America faces a dystopian future where no child under 3 will have a toy he or she can play with.

I got a taste of this future back in November, at a Toys R Us outlet in New York. I was searching for something to buy for my then 2 month old son to show people what we got from phoren. Sadly, the only thing that was available was some cuddly soft toy that hummed tunes when its tummy was pressed. Indian children at that age have rattles and other toys to play with, but not their American counterparts.

I am back in India, and my son is now a few months older. I have managed to find some toys for him, but attempts to buy high-end ones usually fail. Companies like Fisher-Price attempt to follow the same standard for labeling toys as they do in the US, and sadly this means that any interesting toy is labeled “Not suitable for children under 3”, because apparently those toys invariably have small parts that cause a choking hazard.

We were planning to buy an inflatable rubber tub to pour water into and let him splash about. Just as I took out my credit card, we saw the choking hazard warning. It took some detective work, but we finally figured out that the small part in question was the lid covering the inlet for air.  The lid was attached to the tub, and it was exceedingly unlikely that a child would swallow it. In any case, responsible parents who will let 6 month old kids play in water will watch over them all the time. The warning label was obviously intended, not to protect children from choking, but manufacturers from lawsuits.

The danger from this defensive labeling is that either children will be left with no toys to play with, or parents, inundated with too many pointless warnings will start ignoring them, and some will also ignore real hazards.