Consumption Behavior

How do people decide how much of their income to spend and how much to save?

This is a pretty fundamental question in Economics, and has been the subject of a lot of theoretical and empirical literature over the past several decades. The starting point for much of modern theory is Milton Friedman's permanent income hypothesis, which concludes that people should consume at their "permanent income," adjusting consumption only in the face of unanticipated shocks to lifetime income, and smoothing over predictable changes. In other words, people should save money when they are earning above their long-run "permanent income", and borrow when they are earning less.

However, the empirical evidence does not back this up. While people do smooth over some anticipated changes in consumption, they do not do so to the extent implied by theory, and in many cases fail to smooth at all.

Economists have basically taken two approaches to resolving this problem. The first is to attempt to model human irrationality. This is a difficult task because irrationality is such a broad term. "Rational" behavior is pretty easy to define since it represents a definable subset of behavior-space. "Irrational", on the other hand, is very broad, since it's defined as all the rest. I'd put models of bounded rationality in this category, along with models with loss aversion, models with habit-formation, and so forth.

The second approach is to posit failures in the economic system that prevents people from smoothing consumption as much as they would like. This includes liquidity constraints and differential rates of borrowing and lending.

Somehow I don't find myself very comfortable with any of these approaches. Somehow, this looks an awful lot like adding epicycles to epicycles. I feel like there should be an elegant model of consumption that can readily describe observed behavior without needing to append all sorts of additions and special cases. Maybe our failure to cleanly match the data suggest a more fundamental flaw in our theory of economic behavior.

Or maybe I'm just falling for a reductionist bias towards elegant mathematical models. Maybe economic behavior in complex society is, well, complex. That's also possible.

Elinor Ostrom and Oliver Williamson have won the Nobel prize in Economics. They're responsible for pioneering New Institutional Economics. Paul Krugman has a good summary of the significance of their work.

The papers cited by the Nobel committee in their decision were published between 1971 and 1990. This is typical of the Nobel prize in economics, which is typically awarded for work done many years before. This is done because the ultimate significance of a body of work is not always readily apparent. Often promising and much-cited papers (or application essays) end up not being as meaningful in retrospect.

Apparently, the Nobel peace price is awarded according to a much different standard. In explaining the decision to give the award to President Obama, Thorbjorn Jagland, the Nobel committee chairman, said:

"The question we have to ask is who has done the most in the previous year to enhance peace in the world... And who has done more than Barack Obama?"

If this is indeed the criterion by which the Nobel peace prize is awarded, it is very different from the other prizes. Personally, I disagree with this philosophy. I would prefer that the peace prize be awarded to people for work done many years before.

This would serve two purposes. First, it would prevent current politicians from receiving the award for work on current issues. Granting the award to present politicians gives appearance that the Nobel committee is using its power to make statements about controversial political issues. Secondly, it would avoid the embarrassment of granting the award to politicians for work that ends up being short-lived, or who go on to make a travesty of the award in later years.

I believe that the way the peace prize is awarded at present gives a strong impression that the Nobel committee is using the prestige of the award to make political statements. Further, the spotty history of the award shows that the second concern is not idle speculation. Altogether, I have to conclude that the peace prize cheapens the institution, which is unfortunate because I think having it is a great idea.

Sleep Schedules

Noon is the middle of the day, and midnight is the middle of the night. One would expect diurnal animals to keep symmetric hours. If we assume that 8 hours of sleep each night is optimal, that would mean going to bed at 8pm, and getting up at 4am.

Yet this sleep pattern is very unusual. Most people would probably consider anything before 7am "early." Yet if one rises at 7am, one has already missed an hour of sunlight at the equinox.

So why do we keep such an unnatural sleep schedule? And does it have any adverse effects on our health?

John Taylor on the Minimum Wage and Unemployment

John Taylor points to an editorial in tomorrow's WSJ concerning the recent minimum wage hike and high teen unemployment. He also points to a discussion of empirical research on the minimum wage from his introductory economics textbook. He mentions that the research generally shows a significant impact:

But as is so often the case in economics, not all economists agree, so the box also describes some contrary findings by David Card and Alan Krueger. I side with Neumark and Wascher in this debate, but you can read the editorial, look at the diagram, read the box, and draw your own conclusions.

John Taylor is the originator of the so-called Taylor Rule, that closely predicts actual Fed policy. Papers by Neumark and Wascher are here and here.

Why Do Lawyers Run the World?

The governments of the world are run by politicians. In the first world, most politicians are lawyers by training.

Why is this so? Why aren't countries run by experts in policy or public administration? It's because our politicians are elected by popular vote. The ideal training for a democratic system is in persuasion of the median voter.

In public policy schools, they teach you how to make good policy. In economics departments, they teach you how the economy works. In schools on public health or public administration, you learn how various parts of the system functions. These degrees teach you to choose correct policies, and to think in such a way as to persuade experts in those fields. This is all very useful if you're running a country, but it doesn't make you particularly good at persuading the average voter that you would be good at running a country.

Lawyers are taught to argue cases, and they're taught to argue cases to non-technical audiences. It's true that not all lawyers are trial lawyers, but the field is still predicated on making a case, not finding the right case to make. Those are the skills they teach you in law school, and those are among the skills most useful to being a politician. They are not particularly helpful to being a lawmaker.

What are the consequences of this state of affairs? At one time I agreed with Winston Churchill's assessment that democracy is the worst possible system of government except for all the others, but now I'm a lot less sure. There probably is a viable alternative that would be a significant improvement, we just haven't thought of it yet.

Isn't It an Amazing Coincidence...

...that those who believe the benefits of a policy are high, tend to believe that its costs are low?

A few examples prompted this thought, but similar coincidences are quite common among social commentators, along with the converse coincidence that policies with limited benefits (invariably advocated by the "other side") have high costs.

I sometimes feel quite lonely considering questions without a clear winner.