Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Wednesday, March 25, 2009

Larry Summers on Fear and Greed

I used to think that Larry Summers was a reasonable sort of fellow. By here is some evidence proving that spending too much time in administration and politics can rot even the best mind; see White House: Greed Will Help. Here are some quotes:

"In the past few years, we’ve seen too much greed and too little fear; too much spending and not enough saving; too much borrowing and not enough worrying," Summers said Friday in a speech to the Brookings Institution. "Today, however, our problem is exactly the opposite."

Borrowing, you see, is evidently linked to greed; especially if one borrows too much. I am reminded of university students who mindlessly accumulate too much student debt. The greedy bastards. Or of poor people mindlessly borrowing to finance a home purchase. The greedy SOBs. There is too much borrowing; too much spending; there is too much greed.

Saving, on the other hand, is evidently linked to fear. Fear is a virture (as in the fear of God). As when all those virtuous savers bid up the NASDAQ to 5000. Whoops; this doesn't sound right. Perhaps he means saving in virtuous assets, like government treasuries (backed by virtuous/coercive taxation; rather than the prospect of future cash flow from a successful enterprise). Yes, fear is a virture...unless there is too much fear. Then fear is bad.

To summarize then: greed is vice; fear is a virtue. Unless there is too much fear, which is not a virtue. Not enough greed is a virtue; but not a good virtue...which is to say it is a vice. I am getting confused. Let me consult the article again.
"While greed is no virtue, entrepreneurship and the search for opportunity is what we need today."

OK, this clears things up. Make no mistake: greed is no virtue. But we do need more of it at a time like this. So to sum up, greed (borrowing) is bad and fear (saving) is bad (unless there is not enough of either). In the world economy (a closed system), we know that borrowing = saving. And this proves that greed is always balanced by fear. Wait a second, I am confused again. Perhaps what we need is a "new generation" IS-PC-TR like model to help policymakers confront the difficult economic choices they face in balancing fear and greed.

Assume that the policymaker has a quadratic loss function in deviations of actual fear and greed around some socially optimal level of fear and greed (we will let Woodford provide the microfoundations for this social welfare function). Accordingly, let us write this loss function as,

L(t) = 0.5(f(t) - f)^(1/2) + 0.5(g(t) - g)^(1/2)

Here, (f,g) are the socially optimal levels of fear and greed. f(t) and g(t) are the prevailing levels of fear and greed at date t. The policymaker wishes to minimize the fluctuations in fear and greed around their socially optimal levels.

We need more restrictions. Let's see. It seems natural to suppose that fear is influenced in some manner by endogenous variables and an exogenous shock; let's say

f(t) = a*f(t-1) - b*y(t) + e(t)

where y(t) is the output gap; and e(t) is the shock (like a "fear" markup shock in New Keynesian models).

Greed, on the other hand, is influenced by the interest rate and exogenous factors; e.g.,

g(t) = c*g(t-1) - d*r(t) + u(t)

where r(t) is the interest rate, set by monetary policy. Lowering r(t), the way Greenspan did, results in an increase in greed. Seems right.

Now, the policymaker wishes to choose an interest rate rule that miminizes the loss function, given the stochastic processes (estimated as the residuals from a mindless OLS or VAR) governing the fear and greed shocks.

Yes, I can see how the New Keynesian model, so widely used by central banks to justify the policies they follow, will no doubt be replaced by my formalization of Summer's hypothesis. The implications for policy design are likely to prove equally enlightening. Anyone care to coauthor this paper with me? Fame (or notoriety) is virtually guaranteed!

9 comments:

  1. Maybe the government could put something in the water to stimulate us all into having optimal moods conducive to a better economy?

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  2. .. on the other hand, what do you think about the role of emotions in decision-making?

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  3. Pani Pani:

    I think that emotions can certainly be the byproduct of changes in the environment. And I believe that emotions can influence decision-making. But exactly how this works, I am not sure (that is, I have no way of formalizing the link between emotions and their influence on decision-making).

    Perhaps one way to model this is to imagine that an uncontrolled emotion temporarily suspends the ability to make a calculated decision. Or perhaps, one is still able to make a calculated decision, but on the basis of a temporarily smaller information set (i.e., the emotion blinds one to the larger information set, leading one to focus on less information).

    I once read a book entitled "Passion within Reason" that explained emotions as an evolutionary stable strategy. An uncontrollable urge to become angry and act foolishly may seem irrational at the individual level, but if the trait is developed in a population, the population can be made better off (e.g., no one wants to pick a fight with a drunk little Irishman).

    What did you have in mind?

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  4. Not only is what Summers says sensible, it is perfectly consistent with the evidence from academic finance over the past 30 years, which finds that the main driver in asset prices is fluctuations in the "risk premium." He's just using layman's terms to try to give an interpretation of what the REAL experts (using much more sophisticated models than the one above) already know.

    I don't think that coming up with an intuitive layman's interpretation of the cutting edge of academic finance qualifies as "brain rot."

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  5. Chris, I appreciate your post, but...

    [1] Re-read what Summers says; it is logically incoherent;

    [2] Risk premia may fluctuate for many different reasons, not the least of which has to do with the way people assess risk. New information can change this assessment. What is the evidence supporting the notion that "fear" or "greed" influences risk premia? (indeed, how does one even measure these objects?)

    [3] By "real" experts, are you referring to those whose opinions are alligned with your own preconceived notions? Who are these "real" experts; please provide references.

    [4] If you believe that there are "real" experts who "already know" the truth, you are sadly misguided. All we have are theories; all theories are tentative hypotheses.

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  6. Keeping in mind that this is wild-ass conjecture coming from a layperson, my feeling (haha) is that emotions can be "rational" in the utility sense if it helps one to decide among alternatives. Like for example if I assess the likelihood of various opportunities and its outcome, my assessment can be based on emotion to derive a probability let's say.

    That is, emotion is information and can provide signals like prices do, particularly if we seek out how others feel about certain things in order to make decisions. So in that sense information is compressed as emotional signals though the informational content may be noisy. But the tradeoff of emotions with non-emotion based information might be less costly for individuals with constraints such as time or information processing costs like learning specialized terminology. I think that might be consistent with what you're saying about information sets. Or am I missing something?

    So in that sense Larry Summers may be providing noisy information. Perhaps it is because I am not an economist that at least viscerally, upon seeing his statements it "feels like it makes sense" and gives me the feeling he understands the crisis. Perhaps that's the intention. But as you make clear in your post, it's clearly contradictory.

    Anyways I'm going to see if I can find the book you mention.

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  7. Pani Pani:

    We have many examples from history that show how willing some people appear to be to listen to the arguments put forth by self-proclaimed messiahs; frequently, to their ultimate doom. There appears to be a large demand for "religion" and "religious leaders." People who are confident that they KNOW THE TRUTH. People like Summers who KNOW that "fear" and "greed" explains everything. They are so much more attractive to listen to than (say) a Socrates; whose wisdom resides in the recognition that his knowledge is limited.

    In any case, I thought that the idea you were developing sounds interesting (you would have made a good economist). The book in question is called "Passions Within Reason" by Robert H. Frank. Let me know what you think of it (I read it long ago).

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