Saturday, January 26, 2013

Economic Rationality

The concept of rational action is a frontier of economic theory. The new field of behavioral economics combines economics and psychology to analyze actions that seem to be irrational. For example, people value health and long life, yet they smoke and eat unhealthy food. A related field, behavioral finance, examines psychological and emotional traits that prevent people from making wise investments. Perverse psychological biases include anchoring to past prices and facts, the bias of weighing recent events too highly relative to the more distant past, being overly confident in one’s abilities, and following the herd to a cliff.

Neoclassical economics often assumes that people are purely self-interested and always seek financial gain, and that therefore altruism is irrational, whereas as Adam Smith and Henry George wrote, human beings have two motivations: self interest and sympathy for others. Since people get satisfaction from serving others, it is incorrect to label altruism or actions based on subjective views of justice as “irrational.”

The Austrian school of economic thought has a different perspective on rationality. The Austrian economist Ludwig von Mises envisioned human action as inherently rational. A person has unlimited desires and scarce resources. Human beings economize, seeking maximum benefits for a given cost, or minimizing costs for a given benefit. At any moment in time, a person ranks his goals, ranging from most to least important. He chooses the resources to achieve the most important goal at some moment, then the second most, and so on, until his gains from trade have become exhausted. This is the inherent rationality of human action.

The process of satisfying one’s ends involves exchange, trades with others as well as trade-offs among one’s own resources. For example, if you goal is to eat delicious food, you trade the money you value less highly for food you value more highly. Economizing man seeks to maximize the utility, i.e. the importance and satisfaction gained, from one’s resources.

Note that economic rationality involves means rather than ends or goals. If a person chooses to drink so much vodka that he gets drunk and then gets sick, there was a reason for doing so, and at that time, he believed that this would maximize his utility. Utility theory does not pass judgment on people’s goals. Utility theory analyzes the means to an end, whatever that end may be.

The man who gets drunk may later regret his action, but rationality has to be based on human action at the moment it occurs. At that moment, his knowledge, emotions, and desires lead him to make a particular choice. At a later moment, he may have different knowledge, emotions, and desires - too bad, because we can’t go back in time. The action was utility maximizing at that time, even if it turns out to be bad in the future.

Rationality in economics is different from rationality in psychology. A psychologist may judge getting drunk as an irrational desire, but an Austrian-school economist recognizes that values are purely subjective, and he takes any particular desire as just data, and economic rationality does not apply to data.

Economic rationality has three criteria:

1. A rational person has a sound functioning mind. He generally observes and understands reality. We all have incomplete knowledge, and many people hold false beliefs, and rational people may have differing interpretations of observations. But people substantially out of touch with reality, such as due to drugs or dementia, are beyond the domain of economic analysis.

2. Rational people economize. Economic theory is based on maximizing benefits and minimizing costs. Economics does not claim that all people necessarily economize, but if they do not do so, they are not rational, and we send them to the Department of Psychology to analyze, since economic theory can only analyze rational action.

3. The preferences of rational persons are consistent. For example, if one prefers an apple to a banana, and a banana to a cantaloupe slice, consistent preference implies that one prefer an apple to a cantaloupe slice. If not, then that person is irrational, and economists send him to abnormal psychology for analysis, since economic theory does not apply to inconsistent preferences.

Given that meaning of economic rationality, what about the perverse psychological biases? Overconfidence is consistent with rationality, since the person is not directly observing what is not there, but interpreting and misjudging his ability as more potent that it turns out to be. A rational person may believe that a black cat brings bad luck, without any evidence, but the rational person does not see himself surrounded by black cats which don’t exist. We call religious belief a “faith” because it is not based on verified evidence, but religious people are nevertheless rational. Merely believing in what is not observed does not imply irrationality.

Behavioral economists sometimes use the term “quasi-rationality” for action that is objectively sub-optimal, but to an economizing man, the future is always uncertain, knowledge is always incomplete, and beliefs cannot all be based on personal evidence, so action is quasi-rational only with hindsight, and not at the moment of choice.

Likewise, with recency bias and anchoring, people weigh some facts and events too much, but again, this is a matter of interpretation rather than direct observation. Suppose somebody buys a financial asset for $50 and the price later falls to $40, and he does not want to sell, because he does not want to experience a loss. In fact, he has already lost $10 per share, and the optimal financial decision has to ignore what he paid, and focus only on expected future risks and yields, but the person anchored to a past price is also weighing in the emotional trauma of acknowledging a loss, so he is still rationally maximizing utility even when keeping a share of stock that is going ever lower.

Likewise the smoker is rational in, at the moment of choice, choosing the immediate pleasure (or avoiding the pain of withdrawing from smoking), over the long-run desire for good health. There are tradeoffs between short-term pleasure and long-term goals, and choosing the short-term pleasure is not irrational, because one’s subjective value at that time is for the pleasure.

Economic psychology has also analyzed the mental process of choice, concluding that much of what we think of as reasoned choice is really induced by subconscious feelings. Much of what we do is based on habit. But even with complete determinism, it is still the case that, at every moment in time, a person thinks and feels that he is weighing costs and benefits to optimize utility, and that state of mind constitutes free will and rational action.

Therefore the claim of behavioral economics and behavioral finance that people do not act rationally is based on a psychological rather than economic meaning of rationality. So long as people can generally observe and believe reality, and they economize to achieve ends, and their preferences are consistent, they are rational, even if they do what they later realize was foolish.

We can well call destructive government policy irrational, but that is a different meaning of rationality than what applies to a choice made by an individual person. The paradox of humanity is that our actions are based on reason, and that human action is rational, yet collectively human beings engage in war, environmental destruction, and economic waste that is inconsistent with the desire of most to live peaceful, prosperous, happy lives.

Wednesday, January 09, 2013

The Disunited Parties of America

Whereas Americans suffered the trauma of moving towards the Fiscal Cliff of 2012, and whereas the divided Congress resolved it only partly and for the short run, and whereas the Republicans and Democrats have vastly differing ideologies and policies for the USA, and since challenger parties have even more radically differing views, one impossible remedy would be to split up the government into the party lines.

If you don’t like political fantasy, then stop reading. Otherwise, here is how the fantasy would work. Americans would choose to belong to one of several political parties, or they could choose, by default, the Nonpartisan Party, which would continue current laws and policies. (We cannot call the Nonpartisan Party the “Independent Party,” because there is already an American Independent Party which is a political party.)

Each party would have its own president and congress, and its own regulations, taxes, spending, and currency. The country would still have a single military, Supreme Court and a federal Constitution amended so that each party would have autonomous control over its own members, recipients of transfer payments, and territory. The joint Congress elected by all the people would still function to authorize spending for foreign affairs and the military.

Consider first the Republican Party. The Republican Congress would enact its own tax structure. The federal debt and unfunded liabilities (promised transfer payments for Social Security and Medicare) would be divided among the party governments by population, so that each party government would be obligated to pay its share of current and promised transfer payments. If it has one third of the population, the Republican government would have responsibility for one third of the national debt.

The territory of the Republican government would consist of the private land owned by its members, plus a population-based proportional share, both assets and liabilities, of federal property. The Republican government would inherit the current laws, but could then change them. They could reduce their income tax rates, but any added debt would be handled with Republican Government bonds. They could cut domestic spending for their members, and they could change Social Security, Medicare, and Medicaid for their new members and the future incomes of their members.

The same authority would apply to the Democratic, Libertarian, Green, one or more socialist parties, a social-conservative party, and others. A new party would be authorized if it had ten thousand members. There could thus be a Geoist party that enacted a Georgist single tax on land values (including a tax on dumping pollution into the people’s land). They would attract millions of members, because only the Geoist party would leave workers and enterprises tax-free. (The Libertarian Congress would most likely keep and enact national sales and excise taxes, as was advocated by their previous presidential candidates.)

As a member of the Geoist Party, I would propose that, in order to get landowners to enrol, landowners with net tax losses would be compensated with geo-bonds. Geo-bonds would be backed by a strong asset: they would have the first claim on the future rents of Geoist land.

The Disunited Parties of America would offer Americans a choice of governance. The division would not be pleasant, but it would at least enable each party congress to deal with fiscal issues without the delays and special-interest concerns that are blocking long-term solutions.

Probably the Libertarian Congress would establish its own currency to replace today’s federal reserve notes. They would implement free-market banking. I imagine the Libertarian Congress would mint half-ounce gold coins with a denomination of $1000, engraved with the picture of the Austrian-school economist Ludwig von Mises. The banks in Libertarian land would issue their own currency convertible into Mises gold dollars. Mises bank notes and accounts would be adopted by people in the other party lands, as it would be sound money not vulnerable to inflation. The Republican and Democratic congresses would surely choose to remain with the federal reserve system.

How well the Geoist party economy prospers depends also on its monetary policy. There would be a big battle within the party on whether the Geoist Congress would directly issue fiat currency, or whether to have a free market in money and banking. If the fiat-money faction won, the outcome would be uncertain, as the debt service of geo-bonds could be high because of uncertainty about any future monetary and price inflation. I would vote for financial free trade, but would probably be outnumbered by the fiat money advocates. I imagine most business and households in geo-land would use the libertarian gold-backed money, and they would prefer to hold libertarian bonds that are denominated in gold-backed money that would be free of any inflation, tax, and uncertainty premium.

The Disunited Parties of America would resolve the tax debates. The Democrats would have high taxes on the wealthy, but all the wealthy persons would join the Geoist and Libertarian parties. The Republicans would have low income taxes and low welfare payments, but enterprises and wealthy people would also abandon the Republicans for the Libertarians and Geoists, and socially liberal people would abandon the party due to its strict social-conservative controls on speech, reproduction and drugs. The socialist parties would have high welfare spending for the poor, but no money to pay for it. The Libertarian Party would have some rich landowners and oil companies, but their 40-percent national sales tax would leave it with few residents in the middle and lower income classes.

The Geoist Party would end up with most of the people and land, but it would pay a high debt service for geo-bonds if buyers feared future fiat monetary inflation. With the Democrats and Socialists bankrupt, middle and lower-income folks would join the Geoist Party, since both their income and spending would be tax-free, and there would be full employment at higher wages than in the other party lands.

None of this will happen, but it shows that one source of the problem is an economic policy that is forced on everybody, in contrast to a pure market economy in which each person, family, and local community can choose its own borrowing and spending. The beauty of the market is that it caters to our individual differences, replacing military and political conflict with a diverse market that satisfied our individual desires.

Tuesday, January 01, 2013

Abandon all Constitutions, Ye who enter Congress

The Constitution of the United States of America authorizes Congress to levy taxes. But now Congress has authorized an agency to obtain revenue without annual Congressional action. That agency is the Consumer Financial Protection Bureau. Created by the “Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010" as a bureau within the Federal Reserve System, the CFPB gets its funding from the Federal Reserve (the “Fed”) rather than from the US Treasury. The Bureau thus escapes Congressional oversight.

The main purpose of economic science is to enable us to understand the implicit reality beneath superficial appearances. The superficial appearance of the CFPB is that it is not a burden on the taxpayers. This is because in appearance, the Fed is not funded by the taxpayer, but rather from the interest income from the Fed’s huge bond holdings. In appearance, the Fed makes a profit, because the interest income of the Fed is greater than its expenses, and the Fed returns the “profit” back to the US Treasury.

Every interest dollar spent by the Fed is a dollar not returned to the Treasury. Thus when the CFPB takes some of that interest money, these are funds that would have gone to the Treasury, but are now shifted to the CFPB. If we want to give the CFPB a nickname, as we do for example for Fannie Mae, we could call CFPB the Crafty Poobah. The CFPB indirectly taxes the public by reducing the funds that would otherwise go to the Treasury, therefore requiring greater taxation to achieve the same level of spending.

Of course the U.S. Treasury also borrows funds, but the economic reality is that every dollar borrowed by the government is in effect a tax on somebody. Borrowing postpones the tax payment, but not the actual tax. When government borrows a dollar, it imposes at that time an implicit tax, to be paid explicitly later, with interest. Either a taxpayer will pay more taxes in the future, or else a bondholder will be taxed by the reduction in the value of his government bond, such as from higher inflation or from a repudiation (cancellation) of the debt.

There are free lunches, but the funding of the Crafty Poobah is not one of them. Not only does the CFPB indeed impose a tax burden, but by bypassing Congress, the CFPB violates the Constitution. The agency can spend money without an appropriation by Congress. The CFPB is authorized to request up to $200 million in discretionary appropriations if the funds authorized by the Dodd-Frank Act are not sufficient for its budget.

The CFPB also imposes costs via regulations on financial firms, on top of the regulations already imposed by the Fed, the FDIC, and other regulatory agencies. The law that set up the CFPB has given the Bureau a broad and vague mandate to “protect” consumers.

The CFPB consolidated consumer-related programs in the Federal Trade Commission, the Federal Deposit Insurance Corporation, and other agencies. so to some extent, it transferred funding from them. But the Bureau also duplicates the programs of other agencies, including the Securities and Exchange Commission, and the state consumer protection departments.

In his article “CFPB Needs a Day in Court” in Human Events 17 November 2012, George Will notes that sixty percent of its employees in 2012 had lavish salaries of more than $100,000 a year, and five percent were making $200,000 or more. He points out that heavy regulation favors the big banks over the small ones, as the big ones already have an army of lawyers and accountants to handle the rules.

Also consumer “protection” can end up hurting consumers and the economy by limiting access to credit. One of the reasons the economic recovery from the Depression of 2008 has been slow is credit constraints, in large part imposed by the federal government. The typical pattern in the “business” cycle is for credit to be too loose during the boom and too tight after the crash.

Congress and the courts have voided the U.S. Constitution in many ways, such as by ignoring the 9th Amendment, by blurring the Constitutional distinction between direct and indirect taxes, by stretching the meaning of commerce among the states, and by pretending that all its spending is under the rubric of the “general welfare” rather than the particular welfares of special interests.

Now Congress has gone a big step further away from Constitutionality by creating a Bureau that gets its funding from the Fed rather than from Congress. The original purpose of the Fed was to control the country’s money, to set the reserve requirements of banks, and to be a lender of last resort for the banks. Now the Fed has a consumer bureau that draws funds from its interest income. What is next? The pride of America has been its Constitution, but it is being replaced by two words, “Anything Goes.”

Consumers do need protection from fraud, but if the federal government is to do it, be honest and create an agency within the Department of Commerce that gets its funds from the Treasury. Good government makes the explicit appearance coincide with the economic reality, and that is the opposite of what Congress has done with the Crafty Poobah.