Behavioral Economics, Episode #27

This week on Crash Course Economics was not so much…economics.  In this economist’s view, behavioral economics is more akin to psychology or sociology, despite having the “economics” in the name.  Nonetheless, we are going to talk about some of the points that Crash Course did make on economics in this weeks episode.

The Big Picture: Predicting Behavior

11

When economists make their models, they generally assume that people are rational and predictable.  But when we look at actual human beings, it turns out that people are impulsive, shortsighted, and, a lot of times, just plain irrational.

People often point to the existence of human irrational behavior to argue against economic truths that they might not like.  For example, if you are arguing through economic logic that price controls make an economy worse off, a position that economists from all sides of the spectrum agree with, you might hear a response like “well, that assumes that people are acting rationally in their own self-interest, or with perfect information, but that isn’t always the case.”

While this might be true (there isn’t always perfect information, and people aren’t always rational) it doesn’t disprove any economic theories.  What it does support, however, is that economics is very difficult to predict empirically.  Let’s look at an example from this week’s episode:

126

Some grocery stores in the Washington DC tried to decrease the use of disposable plastic bags by offering five cent bonuses if customers brought reusable bags.  The policy didn’t do that much. Later they tried a five-cent tax on plastic bags, and, this time, people used fewer disposable bags.

While empirical economists would be wrong in their predictions of the effects of the bag bonuses, those economists who shy away from empirical predictions (namely from the Austrian School) would only predict that there would be fewer plastic bags used than before, which is likely true.

In short, Crash Course’s big picture look at behavioral economics shows us how all those brilliant economists working for different government agencies and universities manage to get things wrong.  The problem is not the theory, but the empiricism.

Lack of Information

Capture

Classical economics assumes that consumers have perfect information when making choices. That is, they know or at least can quickly access information about prices and quality, but, in reality, they often don’t.  Sure, the consumer could ask around or call their friends to see if they’ve tried that type of ice cream but they’re probably not gonna do that. In this situation, consumers may act on the limited information they have, a suspiciously low price, which means either the ice cream is a great deal or it tastes like mayonnaise.

The way markets work is that the supply, demand, and price work out over time.  Consumers might be cautious to any product at first, but as more people try the product and share the information about it (whether it’s on cnet, yelp, or amazon), the market tends to work itself out, even when it’s a little rocky at first.  As Crash Course points out correctly, perfect information doesn’t happen all at once, but the market does move toward perfection as time goes on.  As for the ice cream example, if the ice cream had a suspiciously low price but tasted like high quality ice cream, over time demand would meet the market’s expectations, although it might not happen at first.  Ever heard of two buck chuck?

Nudging

Crash Course talked about a fantastic and recent theory in behavioral economics called Nudge Theory.  Best explained in the book Nudge: Improving Decisions about Health, Wealth, and Happiness, Nudge Theory recommends an opt-out system of public policymaking, where the preferred choice is made easier or more visible to to the consumer, while still allowing the consumer to choose the less desired choice:

22222

[Behavioral Economists] wanted to see if they could get children to eat healthier by rearranging school cafeterias.  They put healthier food like fruits and vegetables on eye-level shelves and less healthy foods, like desserts, in less convenient places. Classical economic theory suggests that this idea wouldn’t work since rational people would pick the brownie.  But it turns out, students choose the healthier foods. Nudge theory works and it’s changing how we implement public policy.

What Crash Course failed to mention, however, is that policymakers choose to impelement Nudge theory because it is particularly libertarian.  If schools really wanted kids to stop eating unhealthy foods, they could just ban them entirely.  Instead, Nudge Theory retain’s the consumers’ freedom to choose, while still encouraging them to make the healthy choice.

Bubbles are Caused by Animal Spirits?

 

housing-bubble

Many economists used to believe that assets, like stocks and real estate, would stay at or near their real value because cold, calculating investors would buy undervalued assets and sell overvalued assets. But that doesn’t explain bubbles: In real life, investors aren’t always cold and calculating. They can get worked up and irrational sometimes.  

This helps explain bubbles. From the Dutch Tulip Mania of the 17th century, to the 2008 financial crisis.  Investors became irrationally exuberant, and were driven not by logic, but by what economist John Maynard Keynes once called, “Animal Spirits.”

This is very strange, since back in episode 7 on bubbles and episode 12 on the 2008 financial crisis, Crash Course explained bubbles quite differently.  Back then, bubbles were created by complex financial products and lack of regulation, but maybe those were only the environments to create the bubble, and it was actually the animal spirits that created the bubble all along.

barbrady

If you, as an economist, are going to stop your analysis of bubbles at “animal spirits,” you might be doing your audience an injustice.  People blame a lot of different things for creating the 2008 bubble (legal incentives to encourage bad lending, poor credit-rating by agencies, monetary policy), but you can’t just dust off your hands and say “it just happens”  Bubbles of 2008’s magnitude don’t happen with animal spirits alone.  The spirits might do the popping, but bubbles are created by other factors.

Thanks for reading, and you can look forward to a new episode reviewed every Thursday! And don’t forget to join our newsletter and our facebook group, and comment below!

Episode #12 – The 2008 Financial Crisis

Personal Note: It’s been a while since I’ve made a post, and my apologies for that.  I currently have a lot on my plate in my non-CCC life (believe it or not, this is not my day job), but I’ve recently received some thoughtful emails concerned with if I have given up or not.  In the blogging world (or any project in digital media for that matter) it can be tough to stick with it, but the encouraging messages like the few I’ve received do make a difference, and for that, this project is revitalized and will be as great as ever.  And away we go…

This episode is a mammoth.  The 2008 financial crisis is one of the most significant moments in US economic history.  600-page books and hours-long debates have dedicated themselves to this topic, and Crash Course bravely tries to sum it all up in about 10 minutes.  That’s a tough task for anyone to do.

For the most part, the facts in the Crash Course video are 100% objectively correct.  The subjective element, however, comes in with the particular ways the hosts describe the events to imply that something is good or bad.  My other main objection to the video comes with what it chooses not to include, despite it being very, very important to what happened.

Mortgages and Lending Practices

It’s very difficult to simply explain what caused the financial crisis without sounding partisan, but I usually explain it this way: banks gave home loans to people who couldn’t pay them back in the future.

This is a good starting point.  Now, whether you want to argue that these loans were made because of capitalist greed or government-created incentives is where the partisan stuff starts coming in.  But let’s look at how Crash Course explains it:

Screen Shot 2015-11-21 at 4.18.36 PM

Investors were pretty desperate to buy more and more and more of these [mortgage-backed] securities so lenders did their best to help create more of them, but to create more of them, they needed more mortgages, so lenders loosened their standards and made loans to people with low income and poor credit.  You’ll hear these called subprime mortgages.

Eventually, some institutions even used what are called predatory lending practices to generate mortgages.  They made loans without verifying income and offered absurd adjustible-rate mortgages with payments people could afford at first, but it quickly ballooned beyond their means.

If you, as an intelligent Crash Course fan, thought critically about the implications of making bad loans, you would ask youself: Why weren’t lenders worried about not being paid back?  Would you, intelligent Crash Course fan, make a loan of $20 to a random person who approached you on the street if he said he would pay you back $40 in a week?  You probably wouldn’t, because he probably wouldn’t pay you back and you don’t want to lose $20.  So why would enourmous financial institutions in the business of giving mortgages make loans to untrustworthy borrowers?  Why would anyone willingly agree to something that will lose them money?  We’ll return to this in a bit.

Financial Products from Morgages

Financial Services Markets_124560

After our Crash Course hosts briefly talk about the root of the problem (bad mortgages), they spend several minutes on different new financial products derived from mortgages.  These Mortgage-backed Securities include CDOs and Credit Default Swaps.  Crash Course’s explanations of these financial instruments are pretty accurate (from my knowledge), so I don’t think many people, regardless of their political persuasion or economic school of thought, would take issue to how they explained these.

Another accurate point by Crash Course is how leveraged these financial institutions were.  A lot of these firms were holding a large number of these bad financial products as safe assets, especially since the credit-rating agencies rated them the highest rating (AAA).

Credit Rating Agencies

Crash Course mentioned at the beginning of the video the role that the credit-rating agencies played:

Screen Shot 2015-11-21 at 4.46.53 PM

They gave a lot of these mortgage-backed securities AAA ratings–The best of the best.  And back when mortgages were only for borrowers with good credit, mortgage debt was a good investment.

So all these new financial products came onto the scene, and the credit-rating agencies were still rating them AAA, giving a guarantee of the high probability of them being paid back.  They were, of course, completely wrong on this.

Screen Shot 2015-11-21 at 4.47.06 PM

No one knew how bad the balance sheets at some of these financial instutions really were –these complicated, unregulated assets made it hard to tell.

With these two words, Crash Course has diagnosed the problem (assets are too complicated), and has already prescribed the solution (regulation).

The word “unregulated” here is a bit of a misnomer.  Since the financial sector is the most regulated industry in the country, and there exists an enormous agency just for securities (the SEC), calling any financial product unregulated would be a stretch.  However, there were not any specific regulations on these particular financial products, which seems to be what the issue really is.  But since mortgages were heavily regulated and regulators couldn’t stop bad mortgage loans from happening, I doubt any regulation specific to these financial products made before the crash would have done any good.

Crash Course is completely right on their point about how complicated these new securities were.  They were very complicated.  But who is in charge of verifying the quality of complicated assets?  The credit-rating agencies.

Crash Course seems to be giving the credit-rating agencies some slack here, forgiving them for giving good ratings to bad securities because the securities were complicated.

What’s Missing

whats-missing-in-your-marketing-strategy-blog-image-resized-resized-600

Crash Course then goes on to talk about the government response to the crisis: bailouts, stimulus, and Dodd-Frank.  Other than the similar partisan phrasing as I mentioned previously, most of their telling of history is spot on.

Mr. Clifford then talked about certain principles (Perverse Incentives, Moral Hazard) that created the crisis, and Adriene summed up the Financial Crisis Inquiry Commision’s report, which blamed the regulators (for not doing enough) and too much faith in free markets.

It seems like Crash Course leaves it at that: either it’s the fault of the financial instutitions, regulators not doing enough, or the free markets.  Pick who to blame among these three.

It’s astonishing to see no mention of any government action (as opposed to inaction) that is to blame for the crash.

Fannie Mae and Freddie Mac were two Government Sponsored Enterprises (SPE) that purchased many subprime mortgages, as they were directed to hold a large number of assets related to affordable housing.  These SPEs contributed significantly to the high demand of subprime mortages and banks issuing these mortgages, since they could be quickly sold to the SPEs for a profit.

The Federal Housing Administration was also missing from the video.  The FHA encouraged banks to issue subprime mortgages by guaranteeing their repayment through their FHA insurance policy.  If a third party takes away all the risk of giving a loan, then why wouldn’t a bank want to give more loans, even if they are to untrustworthy lenders?

These government actors could have been included under Mr. Clifford’s “Moral Hazard” explanation, but it was nowhere to be found.

 

Crash Course is correct when they say that the financial crisis is incredibly complicated and caused by many different things; however, a little critical thinking would have you leaving this video with more questions than answers.  This post is a brief alternative explanation from Crash Course’s video, but the official Crash Course video left a lot to be explained and the subject deserves multiple explanations.

For a more thorough explanation of the crisis from a free-market perspective, I strongly recommend Tom Woods’ Meltdown.

 

Thanks for sticking with me, fans of CCC.  I’m still 3 episodes behind, but I’ll try to catch back up ASAP.

-Gary

Crash Course Episode #8, Fiscal Policy and Stimulus, Part 2

And we’re back for part two!  In this post we’re going to talk about the finer points in episode #8, namely what economists think of “Austerity” and “The Multiplier Effect”

Austerity

Crash Course explains Europe’s response to the 2008 financial crisis as such:

Screen shot 2015-09-26 at 2.14.36 PM

[European countries] were pursuing a policy called Austerity: raising taxes and cutting government spending to reduce debt.

While in the US, Keynesian recessionary policy called for increasing spending and increasing their deficit (and debt), countries in Europe were focusing on reducing their deficits (and debt).

Important distinction: A country’s deficit is the difference between what a government spends and the amount of revenue it takes in.  A deficit means that the country has spent more than it has a collected, resulting in more debt at the end of the fiscal year.  In other words, a deficit is the yearly rate of increasing debt.

Side note: When people talk about Austerity, they are usually referring more to the reduction in government spending and less about increasing taxes, while both are technically austere.

Crash Course does not stray from the common opinion that Austerity is bad for an economy:

Screen shot 2015-09-27 at 1.06.02 PM

Since 2011, when the US and European policies really started to diverge, the US economy has grown at an average rate of 2.5%, while the Eurozone GDP actually shrank by %1.  US unemployment fell to 5.5%, while Eurozone unemployment rose to 12%.

Just the facts here, all of which are true.  From here, Crash Course moves on to talk about another subject, which leaves the viewer thinking “well, with these numbers, austerity clearly doesn’t work and Keynesianism does.”

What needs to be mentioned is what European Austerity really entailed.  How much did governments reduce their spending, and how much debt did they reduce?  Below is a chart of European countries and their deficits (not debt) as a percentage of GDP:

Screen shot 2015-09-26 at 2.24.24 PM

European countries continued to spend more than they took in, resulting in more debt (also known as taxes on future economies) each year.  While many countries decreased their deficits, they still continued to increase their debt.  Is this really Austerity?

If you compare the resulting budgets (spending and revenue) of the US and Europe following the financial crisis, they don’t look like opposites.  Europe is Keynesianism Light, while the US is like Keynesianism Extra.

As I mentioned in the last post, increasing government spending, financed through debt, will benefit the economy in the short-term at the sacrifice of future economies.  And free market economists would argue that since you are taking from the private sector and spending in the public sector, that action will necessarily make the economy worse off.

Since both Europe and the United States are spending now what they will need to tax later, it makes sense that the present economy of the bigger spender (the US) would be doing better in the short-term.  But to take selected facts and declare “increased government spending = prosperity” would not be showing the full picture.

Multiplier Effect

The multiplier effect theory is often attributed to Keynes (among others), and Crash Course explains how the theory goes:

Screen shot 2015-09-27 at 1.08.08 PM

The idea here is that if the government spends $100, then the highway construction worker who got the money will save $50 and spend $50 on a concert or something.  The musician who got that money will save $25 and spend the other $25 and so on.  So because of this ripple effect, the initial increase in government spending of $100 might turn out to $175 worth of actual spending in the economy…

Spending on welfare and unemployment seem to give us the most bang for our buck, since people with low incomes spend virtually all of their additional income.

Basically, spending money on the poorest individuals results in a better economy because poor people are more likely to spend that money than save.  Spending is good for the economy, and saving is bad.

I mentioned this before, but money that you put in the bank doesn’t just sit there.  Banks lend out that money to the people who want it and are willing to pay interest on their loan.  Crash Course rests a lot of their economic arguments on the assumption that saving doesn’t improve the economy.  In reality, saving, instead of spending, merely shifts money toward capital goods instead of consumer goods.  The money gets used either way.

The multiplier effect also rests on another principle:

Screen shot 2015-09-27 at 1.09.42 PM

General cuts to payroll and income taxes seem to have a multiplier of about 1; if the government cuts $100 in taxes, the economy is going to grow by about $100 […] Tax cuts  puts money into people’s hands quickly, but that money might get saved rather than spent.

I don’t know if this is true or not, and Crash Course did not explain why someone’s tax savings (or more like, many people’s marginal tax savings) is not likely to be spent, while money toward a salary would be.

Regardless of whether this is true or not, the money would be used whether government takes it from people, or someone puts in the bank and it’s lent out.

Crash Course’s Greatest Moment Yet

Crash Course concludes this episode with a fantastic point:

Screen shot 2015-09-27 at 12.55.55 PM

When people are miserable and unemployed, they want to feel like help is on the way.  Doing nothing doesn’t create the kind of confidence that will get consumers and businesses spending again.  And it doesn’t get politicians reelected.  So it looks like Keynesian policies are here to stay.

For now, I’m going to ignore the claim that recessions are corrected by consumers and businesses “having confidence in spending more.”

The most refreshing part is the reluctant acceptance that, whether or not Keynesian economic policy is correct or not, it is going to be implemented because it gets politicians reelected, and it makes people feel like help is on the way.  Nevermind what is effective economic policy, what’s important is that it you believe it’s effective.  And why wouldn’t you?  Policians (and to some extent, Crash Course) tell you it’s effective!

 

Like what I wrote? Hate it?  Drop some feedback in the comments.  Also sign up for the Newsletter (first one is coming soon).

The Business Cycle, Crash Course Episode #5

Economies grow and recede.  Recently, people have related economic recessions to bursting bubbles.  In 2001, the United States saw the Dot Com bubble burst, and in 2008, there we saw the housing bubble burst.  The ebbs and flows have been a part of every economy since people started keeping track of economic data.  But why does this happen?

Depending on which economic school of thought you prefer, you can have many different answers.  Communists might argue that recessions are caused by capitalists acting in their own self-interest and taking advantage of the working class.  For example, in 2008, banks were giving loans to people who could not afford to pay them back.  When people stopped paying the loans back, money that was relied on was not there, and the economy suffered.

3f34920ffe731226fd6a501d24344355

While this explanation of recessions (which can be summed up in one word: greed), is a catch-all for an incredibly complex economic dynamic that occurred over several years, it is not adequate.  A real look into the business cycle would explain not just how the past recession occurred, but why recessions will continue in the future.

Crash Course and Keynesianism

We mentioned before how Crash Course, while admitting that there are different theories for economic phenomena, favors one in particular for macroeconomics: Keynesianism.

To be fair, the Keynesian explanation of the business cycle is also what is taught in your average economic textbook, so we shouldn’t be too surprised.  It is explained in the video using the common analogy of a car:

Screen shot 2015-08-30 at 4.51.54 PM

If we imagine the economy as a car, then GDP, employment, and inflation are gauges.  A car can cruise along at 65 miles per hour without overheating.  Safe cruising speed is like full employment; unemployment is low, prices are stable, and people are happy.

But if we drive that car too fast for too long, it’ll overheat.  In an economy significant spending increases GDP, causing an expansion.  Unemployment falls and factories start producing at full capacity to keep up with demand.

Screen shot 2015-08-30 at 4.55.26 PM

Since the amount of products that can be produced is limited, people start to outbid each other, resulting in inflation.  Eventually, production costs increase as workers demand higher wages and the economy starts to slow down.  Businesses lay off a few workers.  Those workers spend less, causing the businesses that produce the goods that they would otherwise buying to lay off more workers.  

This is a contraction.  The economy is going too slow.  Eventually things stabilize, production costs fall as resources are sitting idle, and the economy starts to expand again.  This process of booms and busts is called the business cycle.

A lot of this explanation is fluff, but the essential explanation of the business cycle can be cut down to the following:

People start to outbid each other [for resources], resulting in inflation.  Eventually, production costs increase as workers demand higher wages and the economy starts to slow down.

Essentially, the price of raw materials increases, and workers demand higher wages.  The combination of the two hurts business, which starts the downturn.  Let’s take a look at these two separately:

Screen shot 2015-08-30 at 4.52.24 PM

1. Increase in the Price of Raw Materials

Resources are scarce, and businesses have to compete for these resources.  When businesses are doing well and demand more of these scarce resources, the price must increase, since the supply cannot increase.  The increased price weakens the businesses.

But businesses can also forecast the price