Economist Channel

The purpose of this post (which I am updating from time to time) is to start a discussion online and in the research centre about historical works (say pre-1960) that are most worthwhile to read for people interested in contemporary behavioural science and behavioural economics debates. The remit is probably too broad to be wholly coherent but if it leads to some good suggestions for reading that people had not considered before then it is worth doing. Works from centuries or millenia before often have a way of having a recurring influence on modern fields not least evidenced by the recent renewed interest in Aristotle and Greek concepts of well-being in the modern literature. Would be good to get suggestions from people in the comments, by email, in person.

Aristotle's Nichomachean Ethics is clearly a key reference work from antiquity. Will add more on this at a later stage.

Nico Machiavelli's The Prince contains a wealth of insights into influence in the context of complex governance issues.

Adam Smith's The Theory of Moral Sentiments. See also this article on Adam Smith's pedigree as a behavioural economist. A more general tour of the Scottish Enlightenment's role in the development of disciplines such as Economics would be interesting for a future post and/or walking tour. David Hume's Treatise on Human Nature contains a wealth of ideas that are relevant to modern academic debates on decision making, valuation, causality and so on. See this link for a short blogpost I wrote on the Treatise and modern behavioural economics. Thanks to @cathyby on twitter for repeated reminders on the importance of Francis Hutcheson and also the recommendation to include Bernard De Mandeville. The latter's Fable of The Bees is cited across many areas of Economics.

Pretty much anything from JS Mill in particular On Liberty, The Principles of Political Economy and Utilitarianism. Obviously also Bentham.

Emile Durkheim is a forerunner of many literatures relevant to readers here. A very useful UChicago webpage on his work here.

Simmel's Philosophy of Money is often  cited as a historical reference in modern papers on economic psychology. It deals with a staggering array of questions on the philosophy and implications of using money as the medium of exchange.

Schumpeter's History of Economic Analysis would be one of my desert island books. I once ran an informal book club over several sessions on this work. Contains a wealth of information on the many interesting characters that populated debates on issues such as the correct notion of utility over the centuries.

From Schumpeter, the importance of the German Cameralist movement becomes apparent in particular Johann Justi. Many elements of modern thinking about the state improving the health and welfare of citizens in an economic framework come from this movement. Thanks to Charles Larkin for pointing out to me the importance of Wilhelm Roscher in the development of German historical and institutional thought. The development of Christian social economic thinking through the late 1800s and 1900s is an area that contains a huge degree of historical relevance in terms of debates about the role of state intervention. The theological context is obviously not present in modern BE debates but that does not reduce the significance of these works. The development of various forms of European social economic thinking throughout the 20th century sets a vital historical context for understanding how many European countries established their social democracies and in the works that formed the intellectual backdrop of this there are many debates about the freedom and dignity of the individual set against the wider public welfare and profit and innovation in a capitalist system.

Edgeworth's Mathematical Psychics is a classic work and is eerily relevant to modern debates about decision-making despite being published in 1881. David Colander's excellent JEP article on Edgeworth and Fisher is well worth reading.

Lewin "Economics and Psychology: Lessons for Our Own Day From the Early Twentieth Century" documents the interaction between the development of neo-classical marginalist economics and the development of psychology as a separate discipline. See also Bruni and Sugden's 2007 EJ article argues for the historical importance of Pareto in severing the link between economics and psychology.

This article explores parallels between the debate prompted by Pareto's reformulation of choice theory at the beginning of the twentieth century and current controversies about the status of behavioural economics. Before Pareto's reformulation, neoclassical economics was based on theoretical and experimental psychology, as behavioural economics now is. Current ‘discovered preference’ defences of rational-choice theory echo arguments made by Pareto. Both treat economics as a separate science of rational choice, independent of psychology. Both confront two fundamental problems: to find a defensible definition of the domain of economics, and to justify the assumption that preferences are consistent and stable.

Irving Fisher "Is "Utility" the Most Suitable Term for the Concept It is Used to Denote?" gives a strong sense of the early unease at the notion of utility that emerged from the marginalist period.

Daniel Read's "Experienced Utility from Jeremy Bentham to Daniel Kahneman" provides a detailed account of the attempt to measure utility directly over the centuries. Ulrich Witt also reviews the history of utility distinguishing between sensory utilitarianism that seeks to measure utility directly and the more axiomatic form that dominated in the 20th century. 

William James' The Principles of Psychology is often regarded as the first psychology textbook. Again, time-permitting, a later post on contemporaries of James such as Wundt and Fechner would yield a number of relevant works.

Freud's distrust of empirical analysis puts him at odds with a lot of modern methodological thinking. But his books are surely worth reading for any thinking person and the concepts he grappled with have obvious resonance with behavioural economics models of human behaviour.

Frank H, Knight's classic "Risk, Uncertainty and Profit" provides ideas on the role of uncertainty in economics that continue to be highly relevant.

Keynes' General Theory set out many of the themes in what is now beginning to be called behavioural macro.

Karl Polanyi's "The Great Transformation" is a key work across several interdisciplinary disciplines in Economics. It contains a vast range of insights into the development of market societies and the psychological, cultural, and other aspects of market behaviour.

The work of Maurice Allais was written exclusively in French and not widely translated making it all the more remarkable he was awarded the Nobel Prize in 1988. A study of Allais would require a lot of time, patience and linguistic ability but he is clearly an important figure in the history of economic thought relevant to behavioural economics. Paul Samuelson famously stated that “Had Allais's earliest writings been in English, a generation of economic theory would have taken a different course.”

As much a warning about excess as anything else, Watson (1913) "Psychology as the Behaviorist Views it" is the classic statement of the behaviourist view of psychology.

Frederick et al's 2002 summary of the literature on time discounting provides an exceptionally useful historical background to the development of ideas in this area from the 1800s onwards.

A VAT (value added tax) with no other tax — no income, corporate, estate, etc. etc. etc. — is pretty much the economists’ ideal. But how do you make it progressive? A bright — or perhaps lunatic— idea occurred to me.

A progressive VAT

Everyone pays the maximum VAT rate — 40% say, equal to the maximum marginal federal income tax rate. Then, as you spend money over the year, you turn in your receipts — figuratively, we’re going to do al this electronically in a second. So, for the first (say) $10,000 of purchases in each year, you get a refund of all VAT taxes paid. For the next $20,000 of purchases, you get $30 out of every $40 tax payments back, so you pay a 10% rate. And so on. Finally, after (say) $400,000 you don’t get anything back, so you pay the 40% maximum rate.

As you see, I give people an incentive to declare all their consumption.  That incentive completes one of the main advantages of a VAT over an income or sales tax. In a VAT, each business in the production chain pays the VAT on its inputs, and charges the VAT on its sales. It then deducts the VAT payments on its inputs against the VAT it has to pay on its sales. That gives the business a strong incentive to collect the VAT on sales, and for its business customers to demand proof the VAT was paid so they in turn can deduct VAT payments against their VAT collections. Now people will also demand “receipts,” proof of tax payment.

Clearly this works only if everything is electronic. I would not inflict expense reimbursement drudgery on the American taxpayer. But that largely is the case. We have a sales tax reporting mechanism, so adding or substituting VAT tax reporting is not that hard.


The big change is that each transaction must report the buyer as well as the seller. As a civil libertarian, this initially struck me as a deal killer. We have already lost far to much privacy and anonymity of transactions. But on second thought perhaps it is not that bad. We already report to Leviathan every source of our income, and under e-verify and other immigration controls we have to ask Leviathan for permission to work. Just how much worse is it to report every purchase too? Especially since, once this progressive VAT replaces the income tax, we no longer have to report sources of income. Furthermore, only the amount of the tax payment needs to be reported, not the nature of the purchase, or even who the seller was.

For those of us who already use debit and credit cards for transactions, this would be easy — the card company can simply forward to the IRS that you paid x much VAT. It does not have to report where you paid it or what you bought. It can separately report that the store paid its tax, without saying who to. For those who don’t use electronic transactions, well, it’s high time they did.  If India can set up debit cards and cell phone payments for all its citizens, the US can do so as well. That would make social security, disability, and all other government payments much safer and more secure, and undercut the fees charged by check-cashing businesses in poor neighborhoods. If you pay with cash, swipe your card to record and report the transaction and tax paid. Your incentive to do so is then you get the refund.

I’m sure creative blog readers can do better. Stored value cards or blockchain technology might securely and report taxes paid even better.

It could even be instantaneous. The store pays the VAT electronically, and the Treasury credits your debit-card account with the VAT refund immediately.

Obviously, also, large payments like houses and cars will carry forward over several years, so as not to bump people in to higher expenditure categories.

Of course, reporting individual’s purchases is only required from the desire to make a VAT directly progressive. If you’d be happy with a flat VAT and then achieving redistribution by sending people checks, we don’t have to report anything. Everyone pays (say) 20% VAT, and the government sends checks, on budget, to worthy people.

But I’ll assume that this isn’t enough, and you want to tax the rich more than this allows, so we also have to make the VAT progressive. That goal requires keeping track somehow of how much you consume.

Standard approach

The standard approach to a progressive consumption tax works through the income tax system. Collect information on all income as now, exempt capital income from taxation (dividends and capital gains) then allow people to deduct savings. Roughly, remove all the limits on 401(k) and similar schemes.

This approach is much less clean. People have an incentive to hide income. Furthermore they have an incentive to make what is really taxable labor income look like capital income. Any professional can incorporate and pay him or herself outsize “dividends” on the investment rather than “wages.”

People also have an incentive to make what is really consumption look like business investment. That yacht is really somehow a corporate investment. Well, incorporate yourself, offer just enough paid cruises to keep the IRS happy, and it is. In my world, we pay VAT on investment goods just as we do on consumption goods. And charge VAT on the cruises. If the VAT charged does not cover the VAT paid, it’s consumption and it’s taxed.  And many other gnarly problems.

Similarly, my first idea was to track consumption electronically, as above, and then force high-consumers to pay a higher rate at the end of the year. But then they have an incentive to try to hide consumption, which might be easier than hiding income. By paying taxes and filing for refunds, everyone has an incentive to declare everything.

The European system is even less clean; A flat VAT (20% or so), also a payroll tax (40% or so) and also income and estate taxes on top of that (50% or so). They achieve progressivity with the latter, but suffer all the consequences of an income tax.

It's also important not to let the VAT get screwed up by responding to political pressure for different (lower) rates on different goods, to try to transfer income indirectly or to subsidize pet industries.

Why is a consumption tax so important? 

Fundamentally there is no reason to tax or to redistribute high incomes. If you want redistribution, you want to redistribute consumption. If you have a high income but leave it all invested in a business and live like a pauper, good for you.  The wealth is out there doing good.

Conversely, there is no reason to exempt high consumption that somehow comes from low income. President Trump, according to media reports, managed to get the income tax deductions associated with billions of dollars of his investor’s losses, perfectly legally, and hasn’t paid much tax since. Under a progressive VAT, all those houses and helicopters would be taxed.  

The original sin of the US tax code was to tax income not consumption. Once we tax income, we have to tax corporations, since otherwise individuals incorporate to hide their income. (In case you’re late to the party, The right corporate tax is zero. Every cent of corporate tax comes form higher prices, lower wages, or lower returns to shareholders. Since shareholders can most easily avoid it, my bet is all higher prices. If you understand that you pay higher prices because of sales taxes, then it immediately follows that you pay higher prices because of corporate taxes.)

With a consumption tax in place of an income tax, corporate taxes can disappear; the whole issue of non-profits dissappears — goodby Lois Lerner, goodbye shady “charity” tax dodges — there is no need for the vast confusing array of 401(k), 526(b), IRA, 1031 exchanges (rules delaying capital gains realizations) etc. We don’t need health savings accounts — all savings accounts are tax free!  This vast simplification appeals to me most of all.

There is also the standard economic argument for consumption taxes. If you tax investment returns, people just save less, the capital stock falls, and the rate of return is the same. People can avoid capital gains in particular by just not selling stock.

An income tax made sense in 1914, when it was a small tax aimed only at high incomes, and when incomes were much easier to measure than consumption. But that is no longer the case.

It is possible. Imagine the huge bonfire of hundreds of thousands of pages of the tax code, replaced by one simple VAT -- essentially a sales tax. Now the obstacle of progressivity is gone too.

Starve the beast? 

The main argument I hear against a VAT is that it is too efficient. It can raise so much revenue that government will expand. Starve the beast, these authors say.

I think  this is wrong.

First, it is not a great success.  Government spending seems hardly constrained in the US by lack of revenue, or the specter of a debt crisis.

Second, think just how little faith this reveals in democracy. Shhh, economists, don’t advocate a much more efficient tax system, because a democracy will always operate at the top of the short-run Laffer curve given its tax structure. If democracy is so incapable of self-governance, we might as well hand the keys to western civilization to the Chinese communist party, as we are doomed.

Third, remember that US government overall (federal state and local) spends about 40% of GDP already. If you add in all the hidden spending — tax expenditures, deductions such as mortgage interest, health insurance, charitable, energy deductions, and mandates on business — we’re probably at least a European 50%. I’m proposing a VAT and nothing else, and let’s put all the cross-subsidies and mandates on budget where we can see them. If we make it progressive, the highest rates hit levels that would please Piketty. I’m not sure there is a lot more to squeeze out of this!

So, I am coming to the opposite view. Not: If you want to cut spending, suffer a vastly complex, growth-killing, disincentive-riddled tax system, which produces little revenue at maximal distortion, so as to try to scare the spenders away with a debt crisis. Yes: if you want to cut taxes, cut spending. Once surpluses pile up, they’ll cut taxes.

But let us admit that economists on both sides of this debate are playing amateur (very amateur) political science. We should stick to economics — The VAT is the most efficient tax system, and here is a way to make it progressive too, if you so wish.

Someone must have thought of this already? If so, let me know who! Or there is a fatal flaw I haven't thought of?

Updates: 

Bob Hall reminds me that the Hall Rabushka tax achieves much the same objective, though by a different mechanism.

Kevin Williamson has an excellent essay in National Review explaining some of the many reasons the corporate tax should be abolished.

Nina Olson has a nice WSJ oped on the complexity of the US tax code. The code includes

six “family status” provisions ..filing status, personal and dependency exemptions, the child tax credit, the earned-income tax credit, the child- and dependent-care credit, and the separated spouse rule. …

“at least 12 savings for education incentives—far too many for most parents and students to make an informed choice.”

There are now at least 15..incentives that encourage savings for retirement (IRA, roth, 401k, etc.) 

Of course that’s just the beginning, and even just the beginning of personal income tax complexity, let alone the corporate tax. Oh, and

In 1955, there were 14 civil penalties in the tax code. Today, there are more than 170..

Ms. Olson has been the “national taxpayer advocate” since 2001. But even she has to hedge with “at least” and “more than” — apparently even she doesn't really know just how many there are!

See below for two research posts working with colleagues at UCD:

(i) Vacancy for Research Scientist in UCD; we are seeking a researcher to contribute to an Irish Research Council (Research for Policy & Society) funded project about understanding well-owners perceptions and awareness of flooding, and informing policy to increase preparedness to reduce the risks of infectious disease outbreaks. Masters or PhD with training/experience in qualitative and/or quantitative research methods required. Salary will reflect qualification and experience. Closing date for application May 3rd. Email eoin.oneill@ucd.ie for further information. Check out the postion at http://www.ucd.ie/hr/jobvacancies/ Job Ref : 009243

Luigi Zingales inaugurated a series of essays in Il Sole 24 Ore, an Italian newspaper, on whether Italy should stay in or get out of the Euro, and graciously asked me to contribute. My view, here in English, here in Italian.

To be clear, I kept to Luigi's terms of the debate. This piece is only about whether Italy is better off in the long run, with a common currency. Whether it gets anything out of an exit, a devaluation, a default now is for another day. And this is just about currency, not about leaving the EU, not about debt or austerity, not about whether europe needs a fiscal union, or the rest of it. (Some subsequent correspondence verifies the wisdom, but also the difficulty, of talking about one thing at a time.)

Return to the Lira? A long-run view (Not very good English title)
The euro isn't perfect, but it isn't bad. (Much better Italian title)

Should Italy have her own currency, and run her own monetary policy? For today, let's focus on the long-run question, leaving out for now the transition and any immediate benefits and costs. When contemplating a divorce, it is wise to focus on what life will be like when everything is settled, not just who will have to wash today's stack of dirty dishes.

Remember first that monetary policy cannot substantially improve long-run growth. Long-run growth comes from people and productivity, how much each person can produce per hour of work. In turn, productivity comes from innovation, new companies, new ways doing business, and new products. Like Uber, consumers benefit and existing producers are disrupted. Improvements in long-run growth come only from structural reform, not monetary machination. Money is like oil in a car. Bad monetary policy, like too little oil, can drag an economy down. But after a point more oil will not help you to go faster — you need a bigger engine.


In the short run, monetary policy can also “stimulate” an economy. It's like an afternoon espresso — good when you're feeling a little sluggish, but not wise to drink all the time, and in the end no substitute for diet and exercise. And that is the major advantage offered for an independent currency and monetary policy — the possibility that a wise monetary authority can offset bad shocks with occasional bursts of devaluation and inflation.

But “wise” is a major caution. When the central bank lowers interest rates, inflates, or devalues, that helps exporters, but hurts importers; it helps government finances, but lowers the real amount the government pays its workers, pensioners, and bond-holders; it helps borrowers but hurts those who lent money to the government, homes and businesses.

Once hurt, they wise up. Anticipating the next devaluation and inflation, workers and pensioners demand indexed wages and pensions. Bond investors demand higher interest rates.

So having your own currency really only works for a government whose finances are in sound shape, and whose public institutions are strong enough to resist the constant clamor for one more inflation. Just this once. Again and again.

Staying in the euro thus represents an important pre-commitment. By forswearing the ability to easily devalue and inflate ex-post, Italy benefits from much better credit and investment ex-ante. It is up to her to use this credit wisely, as Greece so notably did not.

Devaluing and inflating is said to work because prices and wages are “sticky,” and do not quickly adapt to inflation. Thus people are fooled into working harder than they would otherwise, or into accepting wage and price declines they would refuse if they could see them directly. But, if used often, they too will wake up and stickiness vanishes.

Furthermore, devaluation and inflation to exploit such stickiness can address an overall level of wages or prices that is too high, but it cannot address an industry or a region that is too high while another is too low. And variation across industries and regions is larger than variation across countries. If stickiness is the problem, it would be much better to remove all the policies that encourage sticky prices and wages in the first place. For Italy in particular, the arguments for one currency are really arguments for two currencies, one for the North and one for the South.

If that sounds unappealing, perhaps one currency is unappealing too.

Italy will face tight limits on what it can accomplish with wise monetary policy. Let us hope that having its own currency means Italy still somehow remains a member of the European Union, or at least its somewhat free-trade and free-investment area, like Denmark, Norway, or pre-Brexit UK. Let us hope that Italians can still buy and sell goods freely across Europe, they can conduct their business in euro or lira, own bank accounts in both currencies, freely buy and sell securities, work in Europe and hire whom they please.

Do not take all of this for granted. The first thing many governments do, faced with weak currencies and government debt problems, or noticing their monetary stimulus efforts have little effect, is to force their citizens to use that weak currency, to ban foreign bank accounts, to limit citizens' rights to buy and sell euros or to borrow or invest abroad. They limit foreign banks, in order to prop up domestic banks who must hold domestic currency and debt. They limit the interest citizens get at banks, and allocate bank credit.

All this passes under bureaucratic bromides like “capital controls.” Economists call it “financial repression,” which gives a better sense of its effect. This is the kind of monetary policy that, like removing oil from a car, really can slow it down. And it is not clear that Italy even can leave the euro without leaving the EU.

If Italy remains open, as she must to grow, monetary policy will always be constrained by the exchange rate and competition from the euro. Too much loosening will cut the exchange rate too much, and vice versa. Wild exchange rate fluctuations are bad for business and investment all around. Italians will just use euros instead, undermining the value of a domestic currency, leading to capital controls. Even Iceland is now thinking it should peg to the euro. Switzerland and to a lesser extent Denmark are fighting hard to keep their currencies from rising.

So will Italy be better off in the long-run, back with her old sweetheart, the Lira? A well-managed currency within an economy open to trade, capital, and people, can have some benefits. The experience of pre-Brexit UK, Denmark, Switzerland, Norway, or Sweden offers small advantages, some challenges, and no particular disasters so far. The experience of pre-euro Italy is less encouraging, that of pre-euro Greece less so, and that of many small countries challenged by debt and growth less so still. Round after round of inflation and devaluation did not produce prosperity, and capital and exchange controls hurt growth substantially.

In the end, no monetary machination can substitute for a dynamic real economy. The Euro, while not perfect, is pretty good, and it offers an important pre-commitment against bad policy. The dangers and temptations of a Lira do not, in my view, compensate for the loss of an occasional afternoon espresso of stimulus.

These are comments I gave on "Inflating away the public debt? An empirical assessment" by Jens Hilscher, Alon Aviv, and Ricardo Reis at the Becker-Friedman Institute Government Debt: Constraints and Choices conference, April 22 2017, along with generic comments on the conference in general. This post contains mathjax equations.

Long Term Debt

Consider the government debt valuation equation, which states that the real value of nominal government debt equals the present value of primary surpluses.

My first equation expresses this idea with one-period debt, discounted either by marginal utility or by the ex-post return on government debt.
$$\frac{B_{t-1}}{P_t} = E_t \sum_{j=0}^\infty \beta^j \frac{u'(c_{t+j})}{u'(c_t)} s_{t+j} = E_t \sum_{j=0}^\infty \frac{1}{R_{t,t+j}} s_{t+j}$$
(\( P \) is the price level, \( B \) is the face value of nominal debt coming due at \( t \) , \( s \) are real primary surpluses, \( R \) is the real ex-post return on government debt.)

This paper's question is, to what extent can inflation on the left reduce the value of the debt, and hence needed fiscal surpluses on the right. The answer is, not much.


The first equation seems to offer some hope. If you change \(P_t\) by, say 30%, then you devalue nominal debt B by 30%, and you can lower the steady state surpluses needed to pay off the debt by 30%.

The trouble is, this only works for an unexpected 30% price level jump. 3% a year for 10 years won't do it. If people expect inflation starting next year the governments gets precisely nothing out of it. Nominal interest rates rise, and short term debt completely avoids devaluation by expected inflation.

Now, this calculation (and those in the paper) makes a crucial assumption here: that nominal interest rates rise one for one with expected inflation. A possible reading of the last 8 years is that the Fed lowered both nominal and real interest rates. If so, then a rise in expected inflation might similarly leave nominal rates behind, and inflation could erode even short-term debts. Debt can run away from inflation, but if it chooses not to, it loses.

Exchange rate jumps are easier to engineer, and as the paper documents a lot of US debt is held abroad. So there is a bit more of a chance that devaluation can work, which would be an interesting extension.
$$\frac{\sum_{j=0}^\infty Q^{(j)}_{t} B^{(j)}_{t-1} }{P_t} = ... = E_t \sum_{j=0}^\infty \frac{1}{R_{t,t+j}} s_{t+j} $$
My second equation expresses the government debt valuation equation with long term debt. (\( Q^{(j)}\) is the nominal bond price of maturity \( j \) zero-coupon debt, and \( B^{(j)}\) is the outstanding quantity.)

Long term debt has several useful properties for government finance. With one-period debt, shocks to the present value of surpluses s are reflected immediately in the price level \( P_t\). With long-term debt, nominal bond prices \( Q \) can decline instead and absorb some or all of the fiscal shock. Declining bond prices reflect future price level rises, so long term debt helps really by spreading the inflationary impact of the fiscal shock across time. Similarly, long-term debt buffers the fiscal impact of interest-rate shocks, as it does for a household choosing a fixed vs floating rate mortgage. Interest rate increases do not affect debt service until the debt rolls over.

Long-term debt helps for this paper's question as well.

The presence of outstanding long-term debt allows the government to devalue debt claims via expected and therefore slow-moving inflation. Higher expected inflation lowers bond prices \( Q \) , resulting in lower future surpluses, even with no change in the current price level \( P_t\).


Figure 1 gives a very simple example. At time 1, debt of four maturities is outstanding. The government will pay off this debt with four surpluses. The surplus required at each date is then the real value of the arriving coupon. If at time 1 the government raises the price level at times 2, 3, 4, then it will have to run lower surpluses at those dates to pay off the debt. (In general the dynamics are more complex as the government will roll over some of this debt, but the point remains true.)

Cumulative distribution of Federal Debt n 2012. Each point plots the total zero-coupon debt coming due after that date. Source: Hilscher, Aviv, and Reis.

Alas, the US does not issue much long-term debt. Figure 2 is a plot of the cumulative distribution of debt -- each point is the amount of debt of that or greater maturity -- using the author's data. About half the debt is less than one year maturity -- the US rolls over half its debt every year. Two thirds of the debt is less than three years maturity. (This figure is the cumulative analogue of the paper's figure 1. I added back currency and reserves. The paper subtracted Fed holdings of Treasuries but did not add back the corresponding liabilities. This change only affects the leftmost point.)

Thus, for example, an announced 30% inflation in year 3 only results in a 10% reduction in the value of the debt. The slower, smaller, and longer-lasting inflations considered in the paper have correspondingly smaller effects.

That's the basic message of the paper. Inflation trundling along with its current variance is quite unlikely to do anything like that. And conceivable deliberate inflation, even if our Fed knew how to achieve it, would have limited effects.

The budget-busters

The paper announces its goal as,

" ... to quantify the likelihood of inflation significantly eroding the real value of U.S. debt."
I want to generalize the quest, and ask "To what extent can greater inflation significantly improve the US fiscal situation?" And I want to ask the converse, "To what extent is the US fiscal situation likely to result in inflation?" Both questions allow me to comment a bit on the larger issues raised in this conference as well.

A government is tempted to default via inflation if debt service requires onerous taxation. At a steady state, surpluses must be r-g times the debt/GDP ratio.
$$b_t = \frac{ B_{t-1} }{P_t} = E_t \sum_{j=0}^\infty \frac{1}{R^j} s_{t+j} $$
$$\frac{b}{Y} = \frac{s/Y}{r-g} \; \; \; \rightarrow \; \; \; \frac{s}{Y} = (r-g)\frac{b}{Y} $$
But r minus g is perilously close to zero! So current debt at current interest rates requires at most something like half to one percent of GDP debt service, or $75-$150 billion dollars a year. Table 1 adds up components of primary surpluses and deficits.

Table 1. Components of primary surpluses.

	% of GDP	2017 $
Debt service		$95b - $190b
CBO deficits	3% (2017) - 5% (2027)	$550b - $950b
Kotlikoff fiscal gap	10.5%	$2,000b

(Throughout I ignore the possibility that r-g is negative, that markets will support arbitrarily large debt/GDP ratios. If so, government debt is a literal money tree, and there is no problem to start with. The eventual end of the Earth when the sun becomes a red giant is enough to put a stop to it. Moreover, I am increasingly convinced by the Chad Jones revision of growth theory that economic growth must eventually be linear, not geometric, so the right value of g is zero in the long run.)

The CBO reports this year's deficit at $550 billion or 3% of GDP, and rapidly rising to $1.4 trillion or 5% of GDP by 2027. That's already a lot bigger than debt service. (CBO forecasts cite appalling debt service amounts, but those are largely debt service on debts still to be incurred as primary deficits spiral. You can't inflate away debts you haven't yet incurred.)

The US' big fiscal challenge is looming primary deficits. And those fundamentally come from social security, medicare, medicaid, pensions, and voluminous explicit or implicit credit guarantees.

One way to think of the long-run entitlements problem is as "debts," that should be included on the left hand side. Larry Kotlikoff computes a "fiscal gap" of $210 trillion, dwarfing the $13 trillion or so of publicly held Federal debt.

(The paper acknowledges but ignores these issues, for the reason that they are hard to measure.

"Unfunded nominal liabilities of the government like Social Security could be included in \( B_t^j \), and the real assets (and real liabilities) of the government could be included in \( K_t^j\). Theoretically, they pose no problem. In practice, measuring any of these precisely, or taking into account their lower liquidity, is a challenge that goes beyond this paper, so we will leave them out."

But the debts are large, so cast a big shadow on any calculation that ignores them.)

These numbers are imponderably huge, and sensitive to interest rate assumptions. I think it's easier to digest them by translating into flows. Kotlikoff's fiscal gap is 10.5% of his present value of GDP. So, to fix it, either Federal taxes must rise by 10.5 percentage points of GDP, from roughly 20% to roughly 30%, or spending must be cut by 10.5 percentage points of GDP. Permanently. Now.

(By the way, if you're feeling superior and taking comfort that Europe will go first off the cliff, Kotlikoff disagrees. Europe's debts are larger, but their social programs are better funded, so their fiscal gaps are much lower than ours. The winner, it turns out, is Italy with a negative fiscal gap. Answering the obvious question, Kotlikoff offers

"What explains Italy's negative fiscal gap? The answer is tight projected control of government- paid health expenditures plus two major pension reforms that have reduced future pension benefits by close to 40 percent."

Don't get sick or old in Italy, but perhaps buying their bonds is not such a bad idea.)

Viewed as flow or present value, it's clear that today's debt or debt service, at current real interest rates, is just not a first-order issue for confronting US fiscal problems. They may be hard to measure, but they are the elephant in the room.

We can, and should, still ask the question whether inflation would help or hurt. To first order, the answer seems to be not much. Social security is explicitly indexed, and health care costs are real. Many union contracts have cost of living clauses. Perhaps the elephant is not so inflation-sensitive.

To second order, inflation may matter. "Inflation is the dean's best friend," a dean once told me. Non-indexed government wages may be slow to adjust. Medicare and medicaid reimbursement rates are sticky, with so little price discovery and competition left in health care, so real government health expenses may lag inflation. Many government pensions remain defined benefit. And inflation remains the friend of the tax code, including taxing inflationary capital gains, devaluing unused depreciation allowances and nominal loss carry-forwards.

Yes, calculating the inflation sensitivity of entitlement "debts" is hard. But I suspect it does matter at least as much as inflating away the current debt, so if the question is worth asking, this answer is worth calculating. I also suspect the answer will still be that you're not going to get $2 trillion of annual surpluses or Kotlikoff's gazillions of present value out of inflation.

(The paper acknowledges the fact,

"Higher inflation may not only lower the real payments on the outstanding nominal debt, but also change primary fiscal surpluses."

but, reasonably given its scope, does not address it. This is is, appropriately, a suggestion for future research. )

Anytime debt and inflation comes up, so does seignorage. One way to think about it is that seignorage too provides a way for higher inflation to help current surpluses, rather than just be devaluing debt. Seignorage, rather than debt devaluation is the main mechanism in Sargent and Wallace's models of hyperinflations.

Currency is now $1.4 trillion. Reserves are trivial when they do not pay market interest. 10% inflation would generate $140 billion of surplus. However, currency demand falls when inflation rises. Currency, now about 7.5% of GDP, was less than 4% of GDP in 1980, and that was before electronic payments. So seignorage is probably capped for the US at something like $50 billion per year, and not really going to make a dent. But on the other hand, seignorage is comparable to the size of the inflationary effects in the paper, so it probably makes sense to include it.

(The paper says, "In companion work (Hilscher, Raviv and Reis, 2014), we measure one of these effects through the seignorage revenues that higher inflation generates.")

How will it work out? Or not? How might inflation happen?

$$b_t = E_t \sum_{j=0}^\infty \frac{1}{R^j} (\tau Y_{t+j} - G_{t+j}) $$
$${b} +PV(G) = \frac{\tau Y}{r-g} $$
So how will our fiscal problems work out? Remember this equation holds, ex ante and ex post. If current projections don't add up, something is going to change in those projections, and those projections do not correspond to expectations driving the market value of debt. So our question is, how does it hold ex ante -- why do agents value government debt so highly -- and how is it going to hold ex post?

Most obviously, there could be fairly massive cuts in entitlement programs, \( G \) relative to current projections. These are not really "debts." Cutting them does not entail formal default. Beneficiaries cannot sue, grab assets, and most of all cannot run or refuse a roll-over. All they can do is vote. I suspect that markets are betting on eventual entitlement reform.

The equation can hold ex-post from massive negative returns, i.e. an eventual default or large inflation, after a large amount of additional debt has been issued. Naturally, that must be unexpected.
More growth is the most sunny possibility. If r-g is 2 minus 1, all it takes is one percentage point more sustained growth g to double the value of tax receipts. In my view, that is not an outlandish hope for what tax and regulatory reform could do, along with the fruits of today's software and biotech. This view may also help to account for the market's high valuation of US debt.

(For growth to solve the fiscal problem, we must assume that the government does not choose to raise health and pension entitlement spending with higher GDP. But that would be a choice -- the entitlements are not GDP indexed.)

What about raising taxes? Absent other cures, we are likely to get much higher taxes eventually, but I think they are much less likely to work. With our current preferences for progressive taxation, and on top of state and local government taxes (and their own problems), ten percentage point higher federal taxes are going to put many current economists' dreams, and Art Laffer's fears, of confiscatory high-income and wealth taxation to the test.
$$\frac{d}{d \log \tau}\left(\frac{ Y}{r-g}\right) = 1+ \frac{d\log Y}{d \log \tau} +\frac{1}{r-g}\frac{d g}{d\log\tau} $$
To think about this issue, I wrote down here the elasticity of the present value of tax revenue with respect to tax rate. The second term is the conventional static Laffer term, which most people think is small. The important point is the third term, which I call the present-value Laffer term. Because r-g is so small, 0.01 or 0.02, it takes only a tiny growth effect effect of taxes to destroy the present value of tax receipts. If Laffer effects take time and affect growth-- if they affect occupational choice, entrepreneurship, long-term R&D investment, business formation and so on -- they can destroy the present value of tax revenue, even though we may never see declines in the level of income. " (Considering labor effort, a higher flat tax rate has equal income and substitution effects, so conventional wisdom assigns a small labor-effort elasticity. One can argue -- more progressive taxes have substitution but not income effects -- and there are many other channels for static Laffer elasticities. But my point is to focus on the third term and dynamic Laffer effects, so I ignore this one here.

As in all my calculations, we do not have to have a "growth effect" vs. "level effect" argument. Growth that lasts 20 years due to a level effect with transition is enough; permanent growth just gives very simple formulas.)

Finally, let's ask how the equation might fall apart -- i.e. result in an unexpected deflation or default. Let's separate out tax receipts and the troublesome spending driven by entitlements,
$$b_t = E_t \sum_{j=0}^\infty \frac{1}{R^j} (\tau Y_{t+j} - G_{t+j}) $$
or in present value terms, with Kotlikoffian "debt" on the left hand side,
$${b} +PV(G) = \frac{\tau Y}{r-g}. $$
As a little more \( g \) would help a lot, a little less \( g \) would hurt a lot. Each point of stagnation makes our governments promises more and more unsustainable.

I think our most immediate danger is a rise in interest rates. If the real rates r charged to our government rise, say, to 5%, then the service on a 100% debt/GDP ratio rises to 5% of GDP, or $1 Trillion dollars. Now, debt service really does matter, and our outstanding stock of debt really does pose a surplus problem.

There are two mechanisms that might raise interest rates. "Not so bad" interest rate rises come as a natural consequence of growth. Higher per capita growth times the intertemporal substitution elasticity equals higher interest rate. If the elasticity is one, the interest rate rise "just" offsets the benefits of higher growth.

Conversely, low real interest rates can buffer the impact of lower growth. \(\gamma\) above one and \( r \) thus falling more than \( g \) may be a reason why our current slow growth comes with rising values of government debt.

"Really bad" interest rate rises come without growth, from a rising credit spread -- the Greek scenario. If markets decide that the entitlements are not going to be reformed, cannot be taxed away or grown out of, they will start to charge higher rates. Higher rates explode debt service, make market more nervous, and so forth until the inevitable inflation or default hits. In present value terms, higher \( r \) can quickly make the present values on the right implode. This sort of roll-over risk, interest rate risk, or run has been the subject of at least half the papers in this conference.

Here, I find the most important implication of this paper's calculations. The paper shows that the US has a very short maturity structure, so higher interest rates turn into higher debt service quickly. The paper shows that a large slow inflation results in a small change in the present value of surpluses. It follows, inexorably, that if a small change in the in the present value of surpluses has to be met by inflationary devaluation, that inflation must be large, and sharp. If \( x \) is small, \(1/ x \) is large.

We live on the edge of a run on sovereign debt. The US has a shorter maturity structure than most other countries, and a greater problem of unresolved entitlements. Despite our "reserve currency" status, we may actually be more vulnerable than the rest of the high-debt, large entitlement western world. That, I think, is the big takeaway from this paper -- and this conference.

The first issue of the new Journal of Behavioural Economics for Policy is available here, See the papers below. Along with the new Behavioral Public Policy journal mentioned in the previous post, this makes a substantial addition to the development of this field.

Behavioral economics: from advising organizations to nudging individuals(90 kB)
Floris Heukelom, Esther-Mirjam Sent | JBEP 1(1) Article

Requiring choice is a form of paternalism (79 kB)
Cass R. Sunstein | JBEP 1(1) Article

An unhealthy attitude? New insight into the modest effects of the NLEA (294 kB)
Mark Patterson, Saurabh Bhargava, George Loewenstein | JBEP 1(1) Article

Experts in policy land - Insights from behavioral economics on improving experts’ advice for policy-makers (84 kB)
Michelle Baddeley | JBEP 1(1) Article

Eliciting real-life social networks: a guided tour (647 kB)
Pablo Brañas-Garza, Natalia Jiménez, Giovanni Ponti | JBEP 1(1) Article

Policy making with behavioral insight (138 kB)
Shabnam Mousavi, Reza Kheirandish | JBEP 1(1) Article

Tax compliance and information provision - A field experiment with small firms(147 kB)
Philipp Doerrenberg, Jan Schmitz | JBEP 1(1) Article

Policy consequences of pay-for-performance and crowding-out (87 kB)
Bruno Frey | JBEP 1(1) Article

To support trust and trustworthiness: punish, communicate, both, neither?(130 kB)
Rattaphon Wuthisatian, Mark Pingle, Mark Nichols | JBEP 1(1) Article

Happiness and economics: insights for policy from the new ‘science’ of well-being (96 kB)
Carol Graham | JBEP 1(1) Article

Behavioral economics and austrian economics: Lessons for policy and the prospects of nudges (94 kB)
Roberta Muramatsu, Fabio Barbieri | JBEP 1(1) Article

Òscar Jordà, Björn Richter, Moritz Schularick, and Alan Taylor wrote a provocative What has bank capital ever done for us? at VoxEu, advertising the underlying paper Bank Capital Redux  (NBER, CEPR link here, google if you can't access either of those)

It starts with a blast:

"Higher capital ratios are unlikely to prevent a financial crisis."

Wow! How do they reach this dramatic conclusion? The post and underlying paper are empirical, collecting a very useful dataset on bank structure across countries and a long period of time. They show, for example, that

bank leverage rose dramatically between 1870 and the second half of the 20th century. In our sample, the average country’s capital ratio decreased from around 30% capital-to-assets to less than 10% in the post-WW2 period (as shown in Figure 1 below) before fluctuating in a range between 5% and 10% in the past decades. 

Here is the very nice Figure 1. (It shows not just how capital has declined, but how reliance on more run-prone wholesale funding has increased.  The fact that capital used to be 30% is one that we need to reiterate over and over again to the crowd that says 30% capital would bring the world to an end.)
With the facts and regressions,

We find that the capital ratio provides virtually no information about the probability of a systemic financial crisis.

Whether used singly or along with credit, higher capital ratios are associated, if anything, with a higher probability of a crisis.

There used to be a lot more capital, and there used to be a lot more financial crises.

Wow. Now, (this is a good quiz question for a class), before you click the "more" button: Do the facts justify the conclusion? And if not why not?

Well, obviously not, or at least not yet.  Ask the standard  questions of any correlation or forecast in economics: 1) Does it reflect reverse causality -- rich guys drive Mercedes, but driving a Mercedes will not make you rich? 2) What causes the movements in the right hand variable (capital)? They are not random experiments, whims of the God of financial regulation. 3) What other causes of crisis are there (the error term)? Why are they not correlated with the right hand variable (capital?).

The opportunities for reverse causality are rich -- and fully acknowledged. Continuing the above quote:

"... higher capital ratios are associated, if anything, with a higher probability of a crisis. This mechanism is consistent with banks raising capital in response to higher-risk lending choices, rather than as a buffer against a potential systemic crisis event in the economy...."

The paper is even clearer:

"...Such a finding is consistent with a reverse causality mechanism: the more risks the banking sector takes, the more markets and regulators are going to demand banks to hold higher buffers."

It is not surprising that more fire extinguishers predicts either nothing, or more houses burning down. People buy fire extinguishers in fire-prone areas. It is not surprising that airplanes in which pilots wear parachutes are more likely to crash than when pilots don't wear parachutes. It would be an obvious mistake to conclude that buying fire extinguishers and wearing parachutes do not increase house or pilot safety.

Similarly, it is not at all surprising that banks, their depositors, their equity holders, and their regulators all would choose more capital when the chances of a crisis are greater. It is not at all surprising that the probability of a crisis in equilibrium is independent of the amount of capital chosen -- the supply of capital just balances the dangers of crisis. All of this is not at all surprising if adding more capital at any point in time would further reduce the probability of a crisis.

Other effects are just as important. The probability of a crisis also depends on deposit insurance, topnotch risk regulators out there spotting impending crises (hmm), bailouts, and so on. We have arguably traded less capital for more of these other responses -- inefficient, in my view, full of moral hazard, but effective in putting out fires -- so no wonder less capital comes with less (before 2008) or no change in frequency of crisis.

Once again, the authors are completely upfront -- eloquent indeed -- about other effects (error terms correlated with the right hand variable)

Increasing sophistication of financial instruments allowed banks to better hedge against uncertain events. As a result, the business model of banks became safer, implying a lower need for capital buffers (Kroszner (1999), Merton (1995)). Furthermore, diversification and consolidation in banking systems may have reduced the equity buffers required to cope with risk (Saunders and Wilson (1999)). 

Probably the most prominent innovation in this respect was the establishment of a public or quasi-public safety net for the financial sector. Central banks progressively took on the role of lender of last resort, allowing banks to manage short-term liquidity disruptions by borrowing from the central bank through the discount window (Calomiris et al. (2016)). The second main innovation in the 20th century regulatory landscape was the introduction of deposit insurance. Deposit insurance mitigates the risks of self-fulfilling panic-based bank runs (Diamond and Dybvig (1983)); but it may, however, also induce moral hazard if the insurance policy is not fairly priced (Merton (1974)). ... 

A last and arguably more recent extension of guarantees for bank creditors relates to systemically important or “too-big-to-fail” banks. While explicit deposit insurance tends to be limited in most countries to retail deposits up to a certain threshold, large banks may enjoy an implicit guarantee by taxpayers. This implicit guarantee could also help account for the observed increase in aggregate financial sector leverage, although the subsidy is difficult to quantify.

What do the authors do about this? Amazingly, nothing. The paper fully acknowledges reverse causality as a plausible, and perhaps the most plausible interpretation, it outlines a host of other effects correlated with the right hand variable -- and then goes on to do nothing about it.

Regression econometrics these days is exquisitely sensitive to these issues. Paper after paper tries to isolate a "natural experiment" -- an increase in capital unrelated to increased probability of crisis -- or adds differences in differences in differences and a plethora of fixed effects and controls to try to measure the correct cause and effect relationship. This isn't always successful, and throwing out 99% of the data variation is sometimes more confusing than revelatory, and sensitive to just which 99% one throws out, but give them credit for trying. This paper doesn't even try.

Now, perhaps I have mischaracterized the "fact," in the above graph, emphasizing the association of declining capital over time with the frequency of crises. In fact the real evidence in the paper comes from a forecasting regression across time and across countries, of crisis at time t+1 on capital and other variables at time t


So, does this capture the correlation of declining capital ratios over time with the chance of crisis? Or does it capture the correlation of different capital ratios across countries with the country's chance of crisis? (Notice here the severity of crisis is left out, that's the later fact.) Well, both since we have both i and t.

Alas, (p. 16)

"To soak up cross-country heterogeneity, we will include a country fixed effect αi for each of the 17 countries...."

That means they throw out the variation, do countries which on average have higher capital standards than others, on average have fewer crises?  Why in the world would one throw that out? Why are cross-country capital ratios more polluted by endogenous responses than over time capital ratios, and cross country crises more contaminated by correlation with other effects -- amount of mortgage market interference, lender of last resort effectiveness, deposit insurance, etc? If the time series variation is important and exogenous, why exclude the major source of variation, the pre vs. post WWII variation?

in sum, commandment #5 of regression running is: Think about the source of variation in your data.  Don't just randomly throw in country or time fixed effects or split the sample in half.

(Yes, "Pooled models are included in the appendix as well."  But that isn't much help. )

The problem is not with the paper, which is otherwise excellent. The problem is with the paper's headline conclusion -- more capital therefore does not help to reduce the chance of a crisis.

The paper does show, and correctly claims it shows, that capital ratios (in equilibrium) are not helpful in forecasting a crisis.

"our first main finding is that, perhaps counterintuitively, the capital ratio is not a good early-warning indicator, or predictor, of systemic financial crises."

For example, a regulator who wants to stop crises might look at banks piling on capital as a danger signal, the way passengers in my glider are sometimes suspicious when I ask them to put on a parachute. The paper verifies that capital is useless as a forecaster. That is a good, solid point. We might have expected the opposite sign -- more capital, more crisis -- as a useful forecast. But we cannot infer that adding more capital would not reduce the chance of a future crisis.

The paper also makes a nice point about capital, which is not just nice because I agree with it but because the data more clearly support it: More capital means the crisis, when it comes, is less severe. The wearing of parachutes may not forecast safer flights, because people tend to put them on when the flight is more dangerous anyway. But when people do wear parachutes, the outcomes of midair collisions are a lot less severe.

"a more highly levered financial sector at the start of a financial-crisis recession is associated with slower subsequent output growth and a significantly weaker cyclical recovery. Depending on whether bank capital is above or below its historical average, the differences in social output costs are economically sizable. Real GDP per capita five years after the start of the recession is about 5 percentage points higher when banks are well capitalised than when they are not. This difference is displayed in Figure 2."

One can complain about reverse causality here too, but the point is not to whine, the point is to see if there is a really plausible channel, and the strength of the counterargument here seems less strong to me.  It does not seem likely that if people knew an unusually bad recession was ahead, or that the economy was unusually sensitive to financial shocks, they would then equilibrate to less capital.

But why did the authors take a very nice paper that shows that equilibrium (including political and economic equilibrium) doesn't forecast a crisis, and plaster on it a completely unsubstantiated conclusion that more capital would not help to reduce the probability of crisis?

At first I suspected it wasn't their fault. Oped editors frequently pick titles without the authors' knowledge. But it's in the first sentence of the paper abstract.

"Higher capital ratios are unlikely to prevent a financial crisis."

The authors say it again at the end of the oped,

the main role for bank capital appears to lie not so much in eliminating the chances of systemic financial crises, but rather in mitigating their social and economic costs – a distinct but arguably more important benefit.

(My emphasis.) And the paper repeats the point,

we find that macroprudential policy, in the form of higher capital ratios, can lower the costs of a financial crisis even if it cannot prevent it.

history does indeed lend support for a precautionary approach to capital regulation. Its main role appears to lie not so much in eliminating the chances of systemic financial crises, but rather in mitigating their social and economic costs... 

 Why am I making such a fuss?

First, in the sad state of current academic-media interactions, this is sure to be picked up and quoted as "A major study shows that" more capital does not help to prevent crises. (Perhaps in a week or two I'll find time to do some google searches to verify this conjecture.) No, studies that claim a result do not always show a result! This is a classic case. Please, ask what evidence the "study" offers, and is it even vaguely logically coherent!

Second, it is a very instructive case study for students to look at -- how to ruin a great paper by trying to make sexy claims that are not supported by the logic of the paper.

Third, in that vein it allows me to reiterate some important lessons about how to run regressions, lessons that we tend to forget too often.

The new journal "Behavioural Public Policy" edited by Adam Oliver, Cass Sunstein, and George Akerlof is a very welcome addition to the intellectual environment in this area. Forthcoming article titles for 2017 are below, including many leading figures in the field.

Sarah Conly: ‘Paternalism, Coercion, and the Unimportance of (Some) Liberties’.

Shaun Hargreaves Heap: ‘Behavioural Public Policy – The Constitutional Approach’.

David Hirshleifer and Siew Hong Teoh: ‘How Psychological Bias Shapes Accounting and Financial Regulation’.

Michael Jones-Lee and Terje Aven: ‘Weighing Private Preferences in Public Sector Safety Decisions: Some Reflections on the Practical Application of the Willingness to Pay Approach’.

Dan Kahan, Ellen Peters, Erica Dawson and Paul Slovic: ‘Motivated Numeracy and Enlightened Self-Government’.

George Loewenstein and Nick Chater: ‘Putting Nudges in Perspective’.

Pete Lunn and Aine Ni Choisdealbha: ‘The Case for Laboratory Experiments in Behavioural Public Policy’.

Sunita Sah: ‘Policy Solutions to Conflicts of Interest: The Power of Professional Norms’.

Barry Schwartz and Nathan Cheek: ‘Choice, Freedom, and Well Being: Considerations for Public Policy’.

Cass Sunstein: ‘Nudges that Fail’.

The Society for the Advancement of Behavioural Economics (SABE) has a new website and twitter page. I will be the country representative for Ireland and we will work with SABE to coordinate the events we are hosting here with the wider global network. SABE is also taking submissions for the recently formed Journal of Behavioural Economics for Policy and the first issue is available here.

Commentators seem to have noticed a lot of the economics  of the United fiasco: Yes, don't stop auctions at $800. (WSJ review and outlook.) Yes, if you need employees at Louisville so badly, call up American and buy a first class ticket. Book a private jet. Or, heck, you're an airline. Bring up another plane. Don't drag people off planes to save a measly $500.

The one economic point that I haven't seen:  the whole issue also comes down to airlines' use of personalized tickets to price discriminate. (And most of the TSA's job is to enforce that price discrimination by making sure you are the name on the ticket.) If you could resell tickets, the problem would go away. Then the airline must sell only as many tickets as there are seats on the plane, as concerts do. If people aren't going to show, they put their tickets on ebay -- or another quick peer to peer ticket trade platform -- and someone else buys them. Including the airline, if it wants to send employees around. Standby disappears -- want to get on the plane? Bid for a ticket. We still get efficiently full planes -- fuller, even -- nobody ever gets bumped, and the auction for the last seat is going on constantly.

Yes, one of the hardest lessons in economics is that price discrimination can be efficient. Business class cross subsidizes leisure and pays for fixed costs. But the airlines could speculate in their own tickets as well, so its' not clear in a data mining race that scalpers would reap the price discrimination profits better than the airlines themselves.

Holman Jenkins adds, in a brilliant column,

While we’re at it, what’s wrong with Chicago airport security? Did not a single officer say, “I’m having no part of this. If United can’t deal with its overbooking mistakes in a civilized, non-cheapskate way, how is it my job to manhandle innocent customers?” This also smacks of our national malaise—police who need an armored personnel carrier before they’ll roll up and serve a warrant, who wait outside Columbine High until they’re sure the shooting has stopped.

And do not the other passengers rebel at seeing such treatment? Well, maybe not the first time, but I suspect the next time they try to drag a customer off an overbooked plane, there will be a riot.

Update: More at the always excellent Marginal Revolution.  One negative reaction, already on display at United -- the crush to get on the plane first will increase.

Getting on United vs. Southwest is a study in bad incentives. Southwest: you get a number. People peacefully line up when called, and quickly get on the plane. Southwest also gives free (bundled in the ticket price) bags, so people aren't hauling trunkolads of junk for the overheads. United: Board by groups, and now everyone with a credit card is in group 1. They charge for bags. Midway through the scramble for overhead space, the bins fill up, then people have to start swimming upstream with their huge bags to gate check. If ever there was a way to make an airplane board slower, having people swimming against traffic with huge bags is it. The result, you line up like it's the New Delhi airport (or Southwest, circa 1995) and 100 million dollars of United plane plus crew sits on the ground.  I do it too (I'm a rational consumer!) Quite a few times I have had someone show up with a boarding pass with my seat number in it, and being there first makes a big difference.   Another fully rational response -- you really want to be a high mileage customer. The love/hate relationship with United will get deeper.

It’s a great pleasure to have Professor Till Grüne-Yanoff from the Royal Institute of Technology (KTH), Stockholm in Stirling on Tuesday April 11. He will give a talk on Tuesday this week (11th April 2017) at 2pm. He will focus on “Boosts” whose objective is to foster people’s competence to make their own choices. The talk will take place in the Stirling University "Court Room" on the fourth floor of the Cottrell Building. All are welcome.

“Nudging and Boosting: Steering or Empowering Good Decisions”.

Abstract:

1. See this link for some details of our new behavioural science and policy group at UCD

2. See this link for information on part-time and/or employer sponsored options for our new MSc in Behavioural Economics

3. We are currently advertising a 2-year postdoctoral position with a closing date of May 31st 2017

4. There are a number of PhD scholarships available at the UCD School of Economics, including in this research area.

5. Details of the MSc in Behavioural Economics are available here.

"In reflecting on any action, which I am to perform a twelve-month hence, I always resolve to prefer the greater good, whether at that time it will be more contiguous or remote; nor does any difference in that particular make a difference in my present intentions and resolutions. My distance from the final determination makes all those minute differences vanish, nor am I affected by any thing, but the general and more discernible qualities of good and evil. But on my nearer approach, those circumstances, which I at first over-looked, begin to appear, and have an influence on my conduct and affections. A new inclination to the present good springs up, and makes it difficult for me to adhere inflexibly to my first purpose and resolution. This natural infirmity I may very much regret, and I may endeavour, by all possible means, to free my self from it. I may have recourse to study and reflection within myself; to the advice of friends; to frequent meditation, and repeated resolution: And having experienced how ineffectual all these are, I may embrace with pleasure any other expedient, by which I may impose a restraint upon myself, and guard against this weakness."

As I noted in the previous post, the Scottish Enlightenment is a historical antecedent to the development of a wide range of modern thought. Ashraf, Camerer and Loewenstein's "Adam Smith, Behavioral Economist" provides an account of the ideas of one of the era's main figures. As well as Smith, over the years I have become increasingly struck by how much of the philosophical essence of the modern behavioural turn in economics is captured in Hume's Treatise of Human Nature.



The Treatise is divided into three books: "Of the Understanding", "Of the Passions", and "Of Morals". The final sentence of the introduction already gives a sense of the grounded empiricism that characterises his approach and has such an affinity with current emerging literatures.

"We must therefore glean up our experiments in this science from a cautious observation of human life, and take them as they appear in the common course of the world, by men's behaviour in company, in affairs, and in their pleasures. Where experiments of this kind are judiciously collected and compared, we may hope to establish on them a science which will not be inferior in certainty, and will be much superior in utility to any other of human comprehension."

Book 1 examines how people make sense of the world and establish causal connections and other relationships. It is one of the founding documents of modern cognitive science and, by implication, the type of behavioural economics work that grew from the cognitive revolution. The difficulty in establishing causal ordering in the world and the necessity for humans to attempt to do this based on their limited experiences is of course at the essence of behavioural accounts of how people make economic decisions. Furthermore, the extent to which decisions are influenced by the interplay of reasoning and emotions is core to the Treatise, with the second book dealing in detail with the role of "passions" in human decision making. As with Smith's "Theory of Moral Sentiments", Hume deals with a variety of human emotions and their effects. The call by Jon Elster to bring emotions back into the heart of the study of human decision making finds a philosophical home in this book.

To some extent the relation of Hume to modern behavioural economics and behavioural science could be seen as coming through the implications he had for the psychological literatures that emerged from philosophy in the 20th century. For example, to the extent that Hume's work is the philosophical antecedent to cognition research, then he obviously affected behavioural work through this. But I think, the third book of the Treatise, from where I found the original quote shown above, has a more direct link. In this book, Hume moves from describing human nature to discussions of what we should do. In particular, he examines the role of government, law and institutions in pushing people toward the common and longer-term good. The style of reasoning is almost directly related to modern behavioural theories of commitment devices and related mechanisms of policy. Section VIII "Of the origin of government" shows this most closely. As well as the quote above that motivated this post, see also below (and apologies for the length). The passage below directly precedes the first quote above. It is a remarkable argument for the limits of individual decision making and the importance of wider deliberative action to promote both common interests and long-term welfare. In total, the interplay in Hume of reason and emotions in influencing decisions, the problems of limited understanding of the world, our tendency toward short-termism, and the role of institutions as co-ordinating mechanisms, as well as his belief in the importance of grounded empiricism, makes his work in my view the most cogent philosophical antecedent to current behavioural economics and behavioural science and policy work. This was my motivation for using "Back to Hume" as the title of a recent lecture.

"Nothing is more certain, than that men are, in a great measure, governed by interest, and that even when they extend their concern beyond themselves, it is not to any great distance; nor is it usual for them, in common life, to look farther than their nearest friends and acquaintance. It is no less certain, that it is impossible for men to consult, their interest in so effectual a manner, as by an universal and inflexible observance of the rules of justice, by which alone they can preserve society, and keep themselves from falling into that wretched and savage condition, which is commonly represented as the state of nature. And as this interest, which all men have in the upholding of society, and the observation of the rules of justice, is great, so is it palpable and evident, even to the most rude and uncultivated of human race; and it is almost impossible for any one, who has had experience of society, to be mistaken in this particular. Since, therefore, men are so sincerely attached to their interest, and their interest is so much concerned in the observance of justice, and this interest is so certain and avowed; it may be asked, how any disorder can ever arise in society, and what principle there is in human nature so powerful as to overcome so strong a passion, or so violent as to obscure so clear a knowledge?
It has been observed, in treating of the passions, that men are mightily governed by the imagination, and proportion their affections more to the light, under which any object appears to them, than to its real and intrinsic value. What strikes upon them with a strong and lively idea commonly prevails above what lies in a more obscure light; and it must be a great superiority of value, that is able to compensate this advantage. Now as every thing, that is contiguous to us, either in space or time, strikes upon us with such an idea, it has a proportional effect on the will and passions, and commonly operates with more force than any object, that lies in a more distant and obscure light. Though we may be fully convinced, that the latter object excels the former, we are not able to regulate our actions by this judgment; but yield to the sollicitations of our passions, which always plead in favour of whatever is near and contiguous.
This is the reason why men so often act in contradiction to their known interest; and in particular why they prefer any trivial advantage, that is present, to the maintenance of order in society, which so much depends on the observance of justice. The consequences of every breach of equity seem to lie very remote, and are not able to counter-ballance any immediate advantage, that may be reaped from it. They are, however, never the less real for being remote; and as all men are, in some degree, subject to the same weakness, it necessarily happens, that the violations of equity must become very frequent in society, and the commerce of men, by that means, be rendered very dangerous and uncertain. You have the same propension, that I have, in favour of what is contiguous above what is remote. You are, therefore, naturally carried to commit acts of injustice as well as me. Your example both pushes me forward in this way by imitation, and also affords me a new reason for any breach of equity, by shewing me, that I should be the cully of my integrity, if I alone should impose on myself a severe restraint amidst the licentiousness of others.
This quality, therefore, of human nature, not only is very dangerous to society, but also seems, on a cursory view, to be incapable of any remedy. The remedy can only come from the consent of men; and if men be incapable of themselves to prefer remote to contiguous, they will never consent to any thing, which would oblige them to such a choice, and contradict, in so sensible a manner, their natural principles and propensities. Whoever chuses the means, chuses also the end; and if it be impossible for us to prefer what is remote, it is equally impossible for us to submit to any necessity, which would oblige us to such a method of acting.
But here it is observable, that this infirmity of human nature becomes a remedy to itself, and that we provide against our negligence about remote objects, merely because we are naturally inclined to that negligence. When we consider any objects at a distance, all their minute distinctions vanish, and we always give the preference to whatever is in itself preferable, without considering its situation and circumstances. This gives rise to what in an improper sense we call reason, which is a principle, that is often contradictory to those propensities that display themselves upon the approach of the object."