How to Avoid Defaultmageddon: Randomize ObamaCare

ObamaCare for some, 

miniature American flags for others

Things in Washington are getting pretty tense. On October 1st, the ObamaCare healthcare exchanges are set to go live. October 1st is also the date on which, unless the Congress can pass a continuing resolution for appropriations, the government will go into shutdown. Also looming on the horizon is another debt ceiling fight.

The confluence of these events has led to a substantial amount of political brinksmanship, with some Republicans demanding that ObamaCare be defunded or delayed in exchange for agreeing to a CR and/or debt ceiling increase. For their part, both Obama and most Congressional Democrats have stated that they will not negotiate over the debt ceiling, and that implementation of ObamaCare should go forward as planned.

The two sides seem irreconcilable. But as it turns out, there is a way for both sides to claim victory. Are you ready? Here it it:

Congress should delay ObamaCare AND allow it to go forward.

More specifically, Republicans and Democrats should agree to randomly split the states into two halves. In the first group, ObamaCare will go forward as planned; for the second, implementation will be delayed indefinitely.

It's important to note here that the two groupings must be truly random. I'm not proposing that ObamaCare go into effect in blue states but not in red states. It's quite possible that ObamaCare would go into effect in Mississippi but not in Minnesota. In fact, you would want a mix of red and blue states in both groups.

Randomizing implementation of ObamaCare would have several key advantages.

First, it would help us learn more about the true effects of the law. Right now, many conservatives are convinced that ObamaCare will make the healthcare system worse, whereas many liberals think it will be beneficial. You might think that, once the law does go into effect, this debate will be settled. But as the continuing debate over the effectiveness of the ARRA shows, this is not necessarily the case. If the implementation of ObamaCare is followed by higher prices, a decline in healthcare quality, or plagues of locust, those on the left can (and probably will) claim that these bad things would have happened anyway, and in fact would have been worse if not for the ACA. If prices fall, quality improves, and research reveals that eating banana splits cures cancer, then those on the right can (and probably will) claim that these good things would have happened anyway, and in fact would have been better if not for the new law.

Turning ObamaCare into the world's largest randomized controlled trial solves this problem. Instead of having to guess counterfactually about what would have happened if ObamaCare either had or hadn't been enacted, we could just compare the changes in healthcare in states with ObamaCare to those without.

Because of this, randomizing ObamaCare ought to be an acceptable compromise to both sides of this particular argument. Granted, supporters of ObamaCare will at first only get to see it enacted in half the states. But if the law turns out to be as beneficial as they claim, then the popular opposition to the law will fade, and the electorate will soon demand that the law be extended to all fifty states. Likewise, if, as conservatives claim, ObamaCare is a disaster waiting to happen, then it won't be long before those suffering under the law look at how much better their non-ObamaCare neighbors are doing, and will demand full repeal. The more certain each side is about the effects of the law, the more willing they should be to go along with this compromise.

UPDATE: In the comments, "Waffles" suggests that denying ObamaCare to half the country would be unethical: 

[I]t's pretty undeniable that the subsidies provided by the law are going to be a huge help to Americans who aren't as well off as yourself. There's a reason that there are pretty high ethical standards for human experimentation in the social and medical sciences, and your suggestion is way, way, way beyond that ethical line.

Of course, RCT's routinely do precisely what Waffles says is way over the line, that is, giving potentially life-saving subsidies to one group while denying them to another. The Rand Health Insurance Experiment, for example, did this, as did the more recent Oregon Medicaid RCT. In fact, one can read entire books recounting the results of this type of experiment (incidentally, my wife's job used to be doing compliance for human experimentation, and she confirmed that Waffles' comments were off base).

But while Waffles' objection is factually wrong, his/her objection to the ethics of RCTs is hardly unique. I'm reminded here of an old anecdote from Dr. E.E. Peacock, which I'll pass along via Marginal Revolution: 

One day when I was a junior medical student, a very important Boston surgeon visited the school and delivered a great treatise on a large number of patients who had undergone successful operations for vascular reconstruction.

At the end of the lecture, a young student at the back of the room timidly asked, “Do you have any controls?” Well, the great surgeon drew himself up to his full height, hit the desk, and said, “Do you mean did I not operate on half the patients?” The hall grew very quiet then. The voice at the back of the room very hesitantly replied, “Yes, that’s what I had in mind.” Then the visitor’s fist really came down as he thundered, “Of course not. That would have doomed half of them to their death.” 

God, it was quiet then, and one could scarcely hear the small voice ask, “Which half?” 

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Based on data collected by Ritchie King, Ben Walsh tries to calculate the opportunity cost of the cronut and iPhone lines. Ben estimates the amount of time spent in the line, converts a $80,326 median/average (huh? go read the original article!) income in the area to $40.16 an hour, and performs some multiplication. He arrives at an opportunity cost of $95.37 for the cronut line and $359.65 for the iPhone 5s line.

The first problem with this calculation is that most people don’t have a marginal wage: they won’t be paid any more if they work an extra hour between 5am and 9am. Or maybe they do—perhaps through the mechanism of facetime with the boss leading to raises in the future—but the marginal cost of taking a very early morning off once a year is not very high even for that group of workers.

Some of the people waiting in the cronut or iPhone 5s lines may be unemployed or underemployed. If cronuts and iPhones existed in the 1990s when there was full employment in the United States, you could perhaps have argued that everyone in line could have worked an extra hour, and that’s the opportunity cost of waiting in line.

Even workers who are paid by the hour do not always have a marginal wage because the work schedule is set by the employer in advance. If you happen to work during cronut line hours and plan in advance, you might be able to get time off during to stand in line, and the lost wages would be an opportunity cost. But I would guess that only a small fraction of cronutters fall into this category.

I decided to use the Current Population Survey (CPS) data to see exactly how this breaks down in the New York area. There are 1,642 employed people (unweighted) in the sample for the New York–Northern New Jersey–Long Island metropolitan area; the unemployment rate in the city is 8.3%.

Of the employed people, 43% are paid by the hour, and 57% are not paid by the hour. For those who are paid by the hour, the average hourly wage is only $10.59, a lot less than the $40.16 Ben assumes. The annual wage income of those paid by the hour is $34,798, while it is $63,007 for those who are not paid by the hour. The overall average is $50,775.

Those who are paid by the hour work an average of 34.4 hours a week, while those who are not paid by the hour work 40.4 hours.

All this means that if you assume everyone in line is actually paid by the hour and the population of line standers reflects the general population of workers in the New York metro area, the opportunity cost is less than Ben has calculated.

I am only counting wages here: some income is investment income, which is typically not “earned” at 5am. Even if you are a hedge fund manager and have a ton of carried interest that should be counted as wage income, taking an hour off before the market opens on a day of your choice probably won’t affect it too much.

Of course the opportunity cost of the cronut line may not be zero, but I think most of the cost is non-economic.

What if I told you that you had to get up at 5am, on a morning of your choice, and stand in line for 3 hours in SoHo. How much would you pay to avoid that? I probably wouldn’t pay more than $20, so that’s my opportunity cost.

Alternatively, we could assume that you have to go to bed 3 hours earlier the night before. If you were forced to do that on an evening of your choice this summer, how much would you pay to avoid that? For me, personally, the standing in line for 3 hours part is much worse than the lack of sleep. If you gave me a chair, or even better, a motorized wheelchair, my opportunity cost would fall a lot.

Whatever that figure is (should we commission a survey?), averaged over all the line standers, forms the bulk of the opportunity cost of the cronut and iPhone lines.

One thing that could mess up my argument, especially as applied to the iPhone line, is if many of the standers are self-employed consultants who are not only paid by the hour, but who could actually be working and earning marginal income at 5am.

Disclosure: I own Apple stock. I do not own any Dominique Ansel Bakery or Ben Walsh stock. Please send cronut donations care of Noah. Also, the underlined word was added a few minutes after I first posted this.

Update: Ben reminds me that he did partially address the concerns about marginal wage. Consider this post an expansion on his.

The Complete Guide to Getting Into an Economics PhD Program (with Miles Kimball)

Below is the full text of my column with Miles Kimball, "The Complete Guide to Getting into an Economics PhD Program", published on 8/16/2013. 

If you want to mirror the content of this post on another site, that is possible for a limited time if you read the legal notice at this link and include both a link to the original Quartz column and the following copyright notice:

© August 16, 2013: Miles Kimball and Noah Smith, as first published on Quartz. Used by permission according to a temporary nonexclusive license expiring June 30, 2014. All rights reserved.

Miles has agreed to give permission on the same terms as I do. 

See also the follow-up posts by Jeff Smith and Bruce Bartlett.

* * *

Back in May, Noah wrote about the amazingly good deal that is the PhD in economics. Why? Because:

1. You get a job.
2. You get autonomy.
3. You get intellectual fulfillment.
4. The risk is low.
5. Unlike an MBA, law, or medical degree, you don’t have to worry about paying the sticker price for an econ PhD:  After the first year, most schools will give you teaching assistant positions that will pay for the next several years of graduate study, and some schools will take care of your tuition and expenses even in the first year. (See what is written at the end of this post, after the column proper, for more about costs of graduate study and how econ PhD’s future earnings makes it worthwhile, even if you can’t get a full ride.)

Of course, such a good deal won’t last long now that the story is out, so you need to act fast! Since he wrote his post, Noah has received a large number of emails asking the obvious follow-up question: “How do I get into an econ PhD program?” And Miles has been asked the same thing many times by undergraduates and other students at the University of Michigan. So here, we present together our guide for how to break into the academic Elysium called Econ PhD Land:

(Note: This guide is mainly directed toward native English speakers, or those from countries whose graduate students are typically fluent in English, such as India and most European countries. Almost all highly-ranked graduate programs teach economics in English, and we find that students learn the subtle non-mathematical skills in economics better if English is second nature. If your nationality will make admissions committees wonder about your English skills, you can either get your bachelor’s degree at a—possibly foreign—college or university where almost all classes are taught in English, or you will have to compensate by being better on other dimensions. On the bright side, if you are a native English speaker, or from a country whose graduate students are typically fluent in English, you are already ahead in your quest to get into an economics PhD.)

Here is the not-very-surprising list of things that will help you get into a good econ PhD program:

• good grades, especially in whatever math and economics classes you take,
• a good score on the math GRE,
• some math classes and a statistics class on your transcript,
• research experience, and definitely at least one letter of recommendation from a researcher,
• a demonstrable interest in the field of economics.

Chances are, if you’re asking for advice, you probably feel unprepared in one of two ways. Either you don’t have a sterling math background, or you have quantitative skills but are new to the field of econ. Fortunately, we have advice for both types of applicant.

If you’re weak in math…

Fortunately, if you’re weak in math, we have good news: Math is something you can learn. That may sound like a crazy claim to most Americans, who are raised to believe that math ability is in the genes. It may even sound like arrogance coming from two people who have never had to struggle with math. But we’ve both taught people math for many years, and we really believe that it’s true. Genes help a bit, but math is like a foreign language or a sport: effort will result in skill.

Here are the math classes you absolutely should take to get into a good econ program:

• Linear algebra
• Multivariable calculus
• Statistics

Here are the classes you should take, but can probably get away with studying on your own:

• Ordinary differential equations
• Real analysis

Linear algebra (matrices, vectors, and all that) is something that you’ll use all the time in econ, especially when doing work on a computer. Multivariable calculus also will be used a lot. And stats of course is absolutely key to almost everything economists do. Differential equations are something you will use once in a while. And real analysis—by far the hardest subject of the five—is something that you will probably never use in real econ research, but which the economics field has decided to use as a sort of general intelligence signaling device.

If you took some math classes but didn’t do very well, don’t worry. Retake the classes. If you are worried about how that will look on your transcript, take the class the first time “off the books” at a different college (many community colleges have calculus classes) or online. Or if you have already gotten a bad grade, take it a second time off the books and then a third time for your transcript. If you work hard, every time you take the class you’ll do better. You will learn the math and be able to prove it by the grade you get. Not only will this help you get into an econ PhD program, once you get in, you’ll breeze through parts of grad school that would otherwise be agony.

Here’s another useful tip: Get a book and study math on your own before taking the corresponding class for a grade. Reading math on your own is something you’re going to have to get used to doing in grad school anyway (especially during your dissertation!), so it’s good to get used to it now. Beyond course-related books, you can either pick up a subject-specific book (Miles learned much of his math from studying books in the Schaum’s outline series), or get a “math for economists” book; regarding the latter, Miles recommends Mathematics for Economists by Simon and Blume, while Noah swears by Mathematical Methods and Models for Economists by de la Fuente. When you study on your own, the most important thing is to work through a bunch of problems. That will give you practice for test-taking, and will be more interesting than just reading through derivations.

This will take some time, of course. That’s OK. That’s what summer is for (right?). If you’re late in your college career, you can always take a fifth year, do a gap year, etc.

When you get to grad school, you will have to take an intensive math course called “math camp” that will take up a good part of your summer. For how to get through math camp itself, see this guide by Jérémie Cohen-Setton.

One more piece of advice for the math-challenged: Be a research assistant on something non-mathy. There are lots of economists doing relatively simple empirical work that requires only some basic statistics knowledge and the ability to use software like Stata. There are more and more experimental economists around, who are always looking for research assistants. Go find a prof and get involved! (If you are still in high school or otherwise haven’t yet chosen a college, you might want to choose one where some of the professors do experiments and so need research assistants—something that is easy to figure out by studying professors’ websites carefully, or by asking about it when you visit the college.)

If you’re new to econ…

If you’re a disillusioned physicist, a bored biostatistician, or a neuroscientist looking to escape that evil  Principal Investigator, don’t worry: An econ background is not necessary. A lot of the best economists started out in other fields, while a lot of undergrad econ majors are headed for MBAs or jobs in banks. Econ PhD programs know this. They will probably not mind if you have never taken an econ class.

That said, you may still want to take an econ class, just to verify that you actually like the subject, to start thinking about econ, and to prepare yourself for the concepts you’ll encounter. If you feel like doing this, you can probably skip Econ 101 and 102, and head straight for an Intermediate Micro or Intermediate Macro class.

Another good thing is to read through an econ textbook. Although economics at the PhD level is mostly about the math and statistics and computer modeling (hopefully getting back to the real world somewhere along the way when you do your own research), you may also want to get the flavor of the less mathy parts of economics from one of the well-written lower-level textbooks (either one by Paul Krugman and Robin Wells, Greg Mankiw, or Tyler Cowen and Alex Tabarrok) and maybe one at a bit higher level as well, such as David Weil’s excellent book on economic growth) or Varian’s Intermediate Microeconomics.

Remember to take a statistics class, if you haven’t already. Some technical fields don’t require statistics, so you may have missed this one. But to econ PhD programs, this will be a gaping hole in your resume. Go take stats!

One more thing you can do is research with an economist. Fortunately, economists are generally extremely welcoming to undergrad RAs from outside econ, who often bring extra skills. You’ll get great experience working with data if you don’t have it already. It’ll help you come up with some research ideas to put in your application essays. And of course you’ll get another all-important letter of recommendation.

And now for…

General tips for everyone

Here is the most important tip for everyone: Don’t just apply to “top” schools. For some degrees—an MBA for example—people question whether it’s worthwhile to go to a non-top school. But for econ departments, there’s no question. Both Miles and Noah have marveled at the number of smart people working at non-top schools. That includes some well-known bloggers, by the way—Tyler Cowen teaches at George Mason University (ranked 64th), Mark Thoma teaches at the University of Oregon (ranked 56th), and Scott Sumner teaches at Bentley, for example. Additionally, a flood of new international students is expanding the supply of quality students. That means that the number of high-quality schools is increasing; tomorrow’s top 20 will be like today’s top 10, and tomorrow’s top 100 will be like today’s top 50.

Apply to schools outside of the top 20—any school in the top 100 is worth considering, especially if it is strong in areas you are interested in. If your classmates aren’t as elite as you would like, that just means that you will get more attention from the professors, who almost all came out of top programs themselves. When Noah said in his earlier post that econ PhD students are virtually guaranteed to get jobs in an econ-related field, that applied to schools far down in the ranking. Everyone participates in the legendary centrally managed econ job market. Very few people ever fall through the cracks.

Next—and this should go without saying—don’t be afraid to retake the GRE. If you want to get into a top 10 school, you probably need a perfect or near-perfect score on the math portion of the GRE. For schools lower down the rankings, a good GRE math score is still important. Fortunately, the GRE math section is relatively simple to study for—there are only a finite number of topics covered, and with a little work you can “overlearn” all of them, so you can do them even under time pressure and when you are nervous. In any case, you can keep retaking the test until you get a good score (especially if the early tries are practice tests from the GRE prep books and prep software), and then you’re OK!

Here’s one thing that may surprise you: Getting an econ master’s degree alone won’t help. Although master’s degrees in economics are common among international students who apply to econ PhD programs, American applicants do just fine without a master’s degree on their record. If you want that extra diploma, realize that once you are in a PhD program, you will get a master’s degree automatically after two years. And if you end up dropping out of the PhD program, that master’s degree will be worth more than a stand-alone master’s would. The one reason to get a master’s degree is if it can help you remedy a big deficiency in your record, say not having taken enough math or stats classes, not having taken any econ classes, or not having been able to get anyone whose name admissions committees would recognize to write you a letter of recommendation.

For getting into grad school, much more valuable than a master’s is a stint as a research assistant in the Federal Reserve System or at a think tank—though these days, such positions can often be as hard to get into as a PhD program!

Finally—and if you’re reading this, chances are you’re already doing this—read some econ blogs. (See Miles’s speculations about the future of the econ blogosphere here.) Econ blogs are no substitute for econ classes, but they’re a great complement. Blogs are good for picking up the lingo of academic economists, and learning to think like an economist. Don’t be afraid to write a blog either, even if no one ever reads it (you don’t have to be writing at the same level as Evan Soltas orYichuan Wang);  you can still put it on your CV, or just practice writing down your thoughts. And when you write your dissertation, and do research later on in your career, you are going to have to think for yourself outside the context of a class. One way to practice thinking critically is by critiquing others’ blog posts, at least in your head.

Anyway, if you want to have intellectual stimulation and good work-life balance, and a near-guarantee of a well-paying job in your field of interest, an econ PhD could be just the thing for you. Don’t be scared of the math and the jargon. We’d love to have you.

***

Miles also added the following comments on his own blog:

In case you are curious, let me say a little about the financial costs and benefits of an economics PhD.  At Michigan and other top places, PhD students are fully funded. Here, that means that the first year’s tuition and costs are covered (including a stipend for your living expenses). In years 2 through 5 (which is enough time to finish your PhD if you work hard to stay on track), as long as you are in good standing in the program, the costs of a PhD are just the work you do as a teaching assistant. So there are no out-of-pocket costs as long as you finish within five years, which is tough but doable if you work hard to stay on track. Tuition is relatively low in year 6 (and 7) if you can’t finish in 5 years. Plus, graduate students in economics who have had that much teaching experience often find they can make about as much money by tutoring struggling undergraduates as they could have by being a teaching assistant. 

When a school can’t manage full funding, the first place it adds a charge is in charging the bottom-half of the applicant pool for the first year, when a student can’t realistically teach because the courses the grad students are taking are too heavy. That might add up to a one-time expense of $40,000 or so in tuition, plus living expenses.

On pay, the market price for a brand-new assistant professor at a top department seems to be at least $115,000 for 9 months, with the opportunity to earn more during the summer months. If you don’t quite make it to that level, University of Michigan PhD’s I have asked seem to get at least $80,000 starting salary, and Louis Johnston tweets that below-top liberal arts colleges pay a starting salary in the $55,000 to $60,000 range. But remember that all of these numbers are for 9-month salaries that allow for the possibility (though not the regularity) of earning more in the summer. Government jobs tend to pay 12-month salaries that are about 12/9 of 9-month academic salaries at a comparable level.

There is definitely the possibility of being paid very well in academic economics, though not as well as the upside potential if you go to Wall Street. For example, with summer pay included, quite a few of the full economics professors at the University of Michigan make more than $250,000 a year. (Because we are at a state university, our salaries are public.)

The bottom line is that the financial returns are good enough that you should have no hesitation begging or borrowing to finance your Economics PhD. (Please don’t steal to finance it.)

     

What about the costs of the extra year it might take to study math the way we recommend? If you have been developing self-discipline like a champion, but are short on money and summers aren’t enough, you could spend a gap year right after high school just studying math, living in your parents’ house at very low cost; most colleges will let you defer admission for a year after they have let you in.    

The Science of Hippie-Punching

Hi, I'm Josiah Neeley. You might remember me from such blog posts as The Libertarian and the Union Organizer Can Be Friends (Maybe) and Corporate Personhood: Why It's Awesome. But today I would like to talk to you about an important issue facing our nation: hippie-punching.*

For those not in the know, "hippie-punching" refers to when someone (usually but not always on the center-left) attacks someone farther to their left as a means of gaining credibility and support with the general populace. The term appears to date from 2007, but the practice itself is far older. Bill Clinton, for example, was an expert hippie-puncher, and the term itself seems to be an oblique reference to the 1968 Democratic convention, when anti-war protesters battled Chicago police under the control of Democratic mayor Richard Daley (the nearest right-wing equivalent to the term "hippie-punching" is "that time when William F. Buckley kicked the Birchers out of the conservative movement").

Hippie-punching is generally used in a derogatory manner, implicitly suggesting that punching hippies is somehow a bad thing. Yet scientific research suggests that hippie-punching may in fact play a positive role in our political process.

For example, last year Chris Mooney looked at the so-called "radical flank effect" whereby the existence of individuals and groups pushing for radical action on an issue makes people more willing to deal with moderates on the issue. For the flanking effect to be positive, however, it is necessary that moderates and radicals not get lumped together in public perceptions. If that happens, the radical flank effect can turn negative, inspiring a backlash and tainting even moderate action on an issue with the actions of the radical fringe:

one of the critical factors in determining whether a radical flank effect will be positive or negative is the way moderates and activists relate to one another. “How clearly are the moderates and radicals differentiating themselves?” asks Carleton College’s Devashree Gupta. This, as Gupta notes, shapes media coverage and the thinking of politicians and policymakers who may be calculating whether helping the moderates will ease the headaches the radicals create for them.

One way for moderates to differentiate themselves from radicals is to engage in a little hippie-punching now and again. And while it may not feel that way to those on the receiving end on such attacks, they are actually providing a valuable service by helping empower moderates to moving policy in their preferred direction:

The sad irony here is that the activists don’t get what they want. In the end, they merely get to help out the moderates. But that’s the nature of the positive radical flank effect.

*All references to violence in this post are purely metaphorical. No hippies were harmed during the production of this blog post. 

Financing the Federal Government with Inflation-Protected Securities

In 1997, the U.S. Treasury made the contentious decision to begin issuing Treasury inflation-protected securities (TIPS). Treasury Secretary Robert Rubin proposed the issuance of these inflation-linked securities as a way to reduce the government's borrowing costs and increase the national saving rate, remarking:

"Helping the economy and raising incomes requires increasing productivity, and the saving rate is central to that objective. The initiative we are announcing today has the potential of raising our national saving rate as well as reducing the cost of capital to the federal government. Today we are announcing our intention to issue securities that will offer investors protection against inflation. Americans' retirement savings in their pension plans or their own IRAs can have inflation protection, which can help ensure their retirement security... 

We believe these bonds will offer savers value-added in the form of protection against inflation, plus a real rate of return backed by the full faith and credit of the United States, and in return for offering that value-added, over time the cost of financing to the federal government will be lower than it otherwise would be...This is a common sense approach to government and an excellent example of government reinvention -- protecting Americans from inflation with an innovative investment method, and saving them money as taxpayers by holding down borrowing costs."

In July 2008, however, advisers to Treasury Secretary Henry Paulson recommended that Paulson should eliminate five-year TIPS and reduce the use of TIPS of other maturities, arguing that the inflation-indexed securities had cost taxpayers billions. This advice was not put into effect. The question remains: Has the Treasury benefited from issuing TIPS? I explore the mixed evidence in this post, the second in my series about inflation-indexed debt. The first post in the series, "Academic Scribblers and the History of Inflation-Protected Securities," describes  the origins and re-origins of inflation-linked government debt, which briefly appeared in 1780 and then disappeared for two centuries.

First, why might we expect TIPS to hold down borrowing costs in theory? Nominal bonds expose investors to inflation risk, so their yields presumably contain an inflation risk premium; by issuing indexed bonds, the Treasury can avoid paying the premium. John Campbell and Robert Shiller pointed out in 1996 that the magnitude--and even the sign--of the inflation risk premium was unknown. How could the inflation risk premium possibly be negative? According to the classic text on asset pricing by John Cochrane,

"All assets have an expected return equal to the risk-free rate, plus a risk adjustment. Assets whose returns covary positively with consumption make consumption more volatile, and so must promise higher expected returns to induce investors to hold them. Conversely, assets that covary negatively with consumption, such as insurance, can offer expected rates of return that are lower than the risk-free rate...You might think that as asset with a volatile payoff is `risky' and thus should have a large risk correction. However, if the payoff is uncorrelated with the discount factor m, the asset receives no risk correction to its price, and pays an expected return equal to the risk-free rate!"

In short, the inflation risk premium does not depend directly on how uncertain or volatile inflation is. What matters for the inflation risk premium is how future inflation covaries with future consumption (alternatively, with the stock market), and that is not obvious. In 1996, Campbell and Shiller estimated the premium by several different methods and came up with an estimate of 50 to 100 basis points for a five-year zero-coupon nominal bond: in short, non-trivial savings for the government. These anticipated savings were part of the reason why the Treasury began issuing TIPS.

Why then, in 2008, did the Treasury Borrowing Advisory Committee recommend that TIPS should play a smaller role in meeting future financing needs? A member of the committee "estimates that the cumulative cost of the TIPs program to the Treasury since inception, when comparing the total expense relative to nominal bonds issued at a similar time, approaches $30 billion with the bulk of that cost a direct result of significantly higher inflation than estimated by the markets 'breakeven' level when issued." They attribute part of the cost to a liquidity cost, since TIPS are less liquid than nominals so investors must be compensated for the lower liquidity. They point out that the first factor--higher realized inflation than breakeven inflation--needn't necessarily continue. I would also point out that TIPS could gain liquidity over time as the TIPS market develops further, but the Committee's recommendation would very likely have reduced TIPS' liquidity.

An academic study in 2010 supports the view of the Treasury Borrowing Advisory Committee. In "Why Does the Treasury Issue Tips? The Tips–Treasury Bond Puzzle,"  Matthias Fleckenstein, Francis Longstaff, and Hanno Lustig estimate that "On average, the U.S. government has to levy $2.92 more in taxes, in present discounted value, to repay $100 of debt issued if the debt is indexed rather than nominal." They add that, in issuing TIPS, the government gives up a valuable fiscal hedging option. Fleckenstein et al. say that "To the best of our knowledge, the relative mispricing of TIPS and Treasury bonds represents the largest arbitrage ever documented in the financial economics literature."

Jens Christensen and James Gillan (2011), in contrast, say that the Treasury has benefited overall from using TIPS. There are two main premiums to consider: the inflation uncertainty premium and the liquidity premium. The former can help the government lower its borrowing costs by using TIPS, and while the latter can raise its borrowing costs. Both premiums can vary over time. Christensen and Gillan attempt to quantify the size of each premium and construct a liquidity-adjusted inflation risk premium. They come up with a range of estimates, and the most conservative is plotted below. The fact that it is, on average, positive (and less conservative estimates more obviously positive) supports Treasury's continued use of TIPS. I find their results fairly convincing, particularly in light of another study

Source: Christensen and Gillan (2011)

Another study, by William C. Dudley, Jennifer Roush, and Michelle Steinberg Ezer (2009) also comes out in support of TIPS as a cost-effective form of government financing. Their estimates of the inflation risk premium by maturity of issue are in the table below. They find that the liquidity compensation was around 200 basis points in 1999 but has since fallen drastically to well below 50 basis points. The positive risk premium and low liquidity compensation in combination imply cost savings for the Treasury.

Source: Dudley, Roush, and Steinberg Ezer (2009)

In my interpretation, the balance of evidence supports the idea that TIPS are mildly cost-effective, or at least not cost-increasing, for the Treasury. The government's borrowing cost is not the only factor to consider when evaluating the net effect of TIPS. Rubin, remember, suggested that TIPS would increase the nation's saving rate and in turn increase productivity. John Campbell and Robert Shiller listed other potential upsides and downsides to TIPS in their 1996 "A Scorecard for Indexed Government Debt." I'll discuss some of these other issues in future posts.

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Part 1 of series: Academic Scribblers and the History of Inflation-Protected Securities

**Disclaimer: This post not intended as investment advice.

Are Humans Rational Utility Maximisers?

Paul Krugman's recent post on Wynne Godley involves a discussion that Yichuan Wang touched on this week — the widely-used assumption that people are rational utility maximisers. Krugman notes that the alternative approach — the sectoral rules of thumb approach embraced by Wynne Godley and many other post-Keynesians — was abandoned by mainstream macroeconomists in favour of other approaches:

So why did hydraulic macro get driven out? Partly because economists like to think of agents as maximizers — it’s at the core of what we’re supposed to know — so that other things equal, an analysis in terms of rational behavior always trumps rules of thumb. But there were also some notable predictive failures of hydraulic macro, failures that it seemed could have been avoided by thinking more in maximizing terms. 

First involved consumption spending. Conventional Keynesian consumption functions suggested that the savings rate would rise as incomes rose — and this wasn’t just the Keynesian interpreters, Keynes himself made the same claim. This, in turn, led to predictions of rising savings rates after World War II, and hence a persistent shortage of demand — hence the secular stagnation theory briefly prominent. (There was even an early Heinlein novel built in part around the secular stagnation theory. As I recall, it was pretty bad.)

In fact, however, savings rates don’t seem to follow the naive consumption function at all; they rise in booms, and are higher for the wealthy, but exhibit no secular trend. And Milton Friedman appeared to explain this paradox by arguing that people are more less rational: they base consumption on “permanent income”, a reasonable estimate of long-run income, and save temporary fluctuations in income.

The second big problem involved inflation. We can argue how many economists really believed in a stable tradeoff between inflation and unemployment, but that’s certainly what got taught to many students. In came Friedman and Phelps to argue that rational price-setters would build expected inflation into their choices, so that sustained low unemployment would produce accelerating inflation. And the stagflation of the 70s seemed to vindicate their argument.

You could argue, and I would, that the rebellion against hydraulic macro went much too far. It’s not at all clear how much good the whole apparatus of maximizing behavior in New Keynesian models really does, and to the extent that such models do seem more or less to work, it’s only by making some ad hoc behavioral assumptions that are grafted on to the rest of the structure. 

Krugman's points regarding the specific approaches of post-Keynesians of the day are reasonable. There emerged empirical observations that their models did not explain, that could be explained by alternative theories. On the other hand, that doesn't necessarily say anything about a rule of thumb or a sectoral approach to macroeconomics. Many approaches can be used to create a model consistent with data, and similar methodological approaches can lead to wildly divergent models with wildly divergent predictions through varying assumptions.

Post-Keynesian ideas — and those of other heterodox schools that made noise about the possibility of the crisis in the early and mid 2000s — have regained a certain amount of public spotlight in recent years, (and in some cases, almost immediately lost the spotlight by making subsequent bad predictions). On the other hand, they do not appear to have gained much academic credibility, perhaps because claims to have "predicted the crisis" are not as convincing to an academic audience as they are to a general one.

The key difference between post-Keynesian sectoral theories, and neoclassical micro-founded ones is in their assumptions. Post-Keynesians using Godley-style models make behavioural assumptions about group behaviours in different sectors; workers, the financial sector, etc. Neoclassical theories make assumptions about individual behaviour — individual utility maximisation, rational preferences and action based on full and relevant information. In both cases, these are all simple heuristics and should probably not really be taken seriously as an attempt to model reality in a literal sense; we should as Milton Friedman famously noted be concerned most by a theory's predictive power. On the other hand, it does not seem desirable to start off with a framework that is obviously wrong. That is, a good theory should have predictive power at both ends — it should start with an accurate (-ish) depiction of reality, and end with successful predictions of reality.

It is arguable that the notion of utility maximisation falls into the category of obvious wrongness. Krugman's conclusion that "It’s not at all clear how much good the whole apparatus of maximizing behavior in New Keynesian models really does" suggests that he may be cautiously leaning in that direction too.  There are two reasons for this — evidence from behavioural economic experiments, and results from neurophysiology. 

One of the most famous tests of Paul Samuelson's definition of utility maximisation (completeness, transitivity, non-satiation, convexity) was undertaken by Reinhard Sippel in 1997. He gave his student test subjects a budget, and a set of eight priced commodities to spend their budget on:

This was repeated ten times, with ten different budget and price combinations. Sippel found that 11 out of 12 of his test subjects’ behaviour failed to meet Samuelson’s criteria for rational utility maximisation. Sippel repeated the experiment later with thirty test subjects, finding that 22 out of 30 did not meet Samuelson’s criteria. Sippel concluded:

We conclude that the evidence for the utility maximisation hypothesis is at best mixed. While there are subjects who appear to be optimising, the majority of them do not.

The evidence emerging in neurophysiology against utility maximisation is more damning. As Daniel McFadden summaried this year in The Atlantic:

Our brains seem to operate like committees, assigning some tasks to the limbic system, others to the frontal system. The “switchboard” does not seem to achieve complete, consistent communication between different parts of the brain. Pleasure and pain are experienced in the limbic system, but not on one fixed “utility” or “self-interest” scale. Pleasure and pain have distinct neural pathways, and these pathways adapt quickly to homeostasis, with sensation coming from changes rather than levels. Overall, presumably as a product of evolution, our brains are organized well enough to keep us alive, fed, reproducing, and responsive to but not overwhelmed by sensation, but they are not hedonometers.

None of this, of course, should be treated as a conclusive blow for any other extant modelling approach or set of assumptions. One reason why neoclassical economics has remained dominant in academia is that other heterodox schools have not yet convincingly envisaged anything conclusively superior Yet, I think, it should be treated as a conclusive blow for the idea that a lot more work is required in coming to a better understanding of the patterns and systems underpinning human economic behaviour. And I think the answers will emerge not from theory but from experimental economics and psychology on the interpersonal level, and from neurology and neurophysiology on the individual level.

This is something that Krugman (and all wannabe Hari Seldons) may eventually be able to get very, very excited about. The only road, I think, to anything approaching psychohistory is mechanically understanding the underlying drives and dynamics of human behaviour, rather than making crude black box assumptions and hoping for the best.