Archive for July 8th, 2009

Choice Architecture and How To Mitigate Predictable Irrationality

July 8, 2009

I received an email from Jack Fuller of Per Capita. Per Capita is a Australia based thinktank.

He informs me of his new paper on how we can use choice architecture to mitigate predictably irrationality:

Two themes run throughout this paper. Firstly, that choice architecture offers a range of tools to solve problems and save resources, without resorting to either mandates or laissez-faire approaches. Secondly, that there is a progressive rationale for designing choice contexts, to improve patterns of choice in relation to social outcomes and individual lives. Choice architecture employs five tools to design the contexts in which people make choices:

1. Setting the default option in a set of choices
2. Offering ‘self-contracting’ to support commitment
3. Presenting and organising information
4. Designing physical spaces to guide behaviour
5. Supporting the development of social norms

The applications of choice architecture are immediate. Rebuilding a resilient economy will require behaviourally-informed regulation, and improving health and sustainability outcomes will require policies informed by realistic human decision-making. Its applications are also long term. Policies based on a real account of human decision-making will enable communities, organisations, and government to improve social outcomes. By focusing on how physical and social environments shape choice patterns, and how choices are framed, we can put markets to the service of a better society.

I haven’t read the paper. But it looks good.

NY Fed Chief on Monetary Policy and Asset Prices

July 8, 2009

William C. Dudley, President of NY Fed in his recent speech reviews the lessons learnt form the crisis. He says there are 5 main themes of this crisis which in turn offers lessons :

  • Interconnectedness of the financial system
  • System dynamics—How does the system respond to shocks?
  • Incentives—Can we improve outcomes by changing incentives?
  • Transparency
  • How should central banks respond to asset bubbles?
  • On Central Banks responding to asset bubbles he says:

    In my opinion, this crisis should lead to a critical reevaluation of the view that central banks cannot identify or prevent asset bubbles, they can only clean up after asset bubbles burst.


    As I wrote in 2006, this orthodoxy can be summarized by three propositions:


    1.   Asset bubbles are hard to identify.

    2.   Monetary policy is not well-suited to respond to bubbles.

    3.   Thus, the cost/benefit tradeoff of “leaning against the wind” against asset bubbles is unfavorable.


    From these propositions, the two important policy implications directly follow:


    1.   The central bank should only take asset bubbles into consideration in the conduct of monetary policy to the extent that these asset bubbles affect the growth/inflation outlook.

    2.   The monetary authorities should be there to “clean-up” after bubbles burst, both to prevent systemic problems and undesired downward pressure on economic activity and/or inflation.


    Relative to this, I would argue that:


    1.   Asset bubbles may not be that hard to identify—especially large ones. For example, the housing bubble in the United States had been identified by many by 2005, and the compressed nature of risk spreads and the increased leverage in the financial system was very well known going into 2007. 

    2.   If one means by monetary policy the instrument of short-term interest rates, then I agree that monetary policy is not well-suited to deal with asset bubbles. But this suggests that it might be better for central bankers to examine the efficacy of other instruments in their toolbox, rather than simply ignoring the development of asset bubbles. 

    3.   If existing tools are judged inadequate, then central banks should work on developing additional policy instruments. 


    Let’s take the housing bubble as an example. Housing prices rose far faster than income. As a result, underwriting standards deteriorated. If regulators had forced mortgage originators to tighten up their standards or had forced the originators and securities issuers to keep “skin in the game”, I think the housing bubble might not have been so big.


    I think that this crisis has demonstrated that the cost of waiting to clean up asset bubbles after they burst can be very high. That suggests we should explore how to respond earlier.

    This is quite a change in thinking from NY Fed chief which he acknowledges as well . He says three important things:

    1. Central banks cannot ignore large asset bubbles anymore
    2. Some large asset bubbles can be identified beforehand
    3. Short term interest rate may not be adequate to dampen bubbles, so new tools to be developed.

    Most Central Bankers still don’t agree to this very important aspect of central banking- should central banks look at asset prices. They might agree on 1 but still don’t agree to 2 and 3. Let’s see whether some developments can be made on this very important topic.

    Economic History of Budget deficits

    July 8, 2009

    Martin Feldstein presented LK Jha lecture in 2004, a lecture series conducted by RBI. The lecture is here and is an excellent read on growing budget deficits and debt levels.

    The most interesting aspect of his speech is the historical thinking on budget deficits. The debates amidst econs over whether budget deficits are good or bad is quite engrossing:


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