Inattention and bank overdrafts

It happens to everyone: you are not careful and despite having sufficient funds, your checking account is drying up at the wrong moment and you incur an overdraft fee from the bank. Oh well, you say, the penalty is somewhat stiff, but bad planning has consequences. But for those who have genuine liquidity problems or those that are really bad at planning, those fees can add up quickly and become substantial. Even on an aggregate level, it is important. Apparently, US banks earn $35 billion a year from overdraft fees, or a staggering $100 per capita.

Victor Stango and Jonathan Zinman study what can make that people avoid those fees. A lot has of course to do with education and self-discipline, thus reminders become an important tool. Indeed, they notice that people who were exposed to information about overdraft fees in surveys are less likely to incur such fees in the next month, by 12%, and this effect builds up over multiple exposures. This works best with those who need it the most: low education and low financial literacy. And as people avoid overdrafts by making fewer transactions, not increasing balances, it indicates they lower their expenses as a reaction to realizing that they may not afford that much spending. In other words, financial and economic literacy are important and should be favored.

The high welfare cost of small information failures

Are stock markets efficient in the sense that stock prices reflect all available information? This question has preoccupied finance lately as many have started to doubt the efficient market hypothesis during the latest crisis. One critical aspect of this is whether current tests of the hypothesis actually give an accurate picture, and if not whether this matters in a significant way.

Tarek Hassan and Thomas Mertens
claim that it is possible for stock markets to aggregate information properly, that small errors at the household level can accumulate and amplify if these errors are correlated, and that the welfare consequences can be substantial even if the initial errors were small. This cost emerges for a portfolio misallocation due to the higher volatility of stock prices. To get to such a result, they take a standard real business cycle model, add to it that households get a noisy private signal about future total factor productivity. They then look at the stock market for additional information to form expectations. If you allow households to be on average more optimistic than rationality in some state, and more pessimistic in others, you get the above results. Interestingly, Hassan and Mertens show that households face little incentives to correct individually for these small common errors (0.01% of average consumption), but collectively the consequences are large (2.4%). Talk about an amplification.

Bubbles with collateral and infinite credit

Rational bubbles occur when people believe that prices will increase into the infinite future, which makes that they invest in more assets and prices really increase. But equilibrium models have difficulties replicating such phenomena because this increased wealth also induces, at some point, people to consume more, and then the budget constraint bites and halts the bubble. So how could one still get a rational bubble? By relaxing the budget constraint.

This is what Christopher Reicher does in a way that is reminiscent of the US before the crisis: through the provision of unlimited credit, which is possible if real estate is used as collateral. This sounds rather intuitive, as long as lenders are willing to go along. What is more interesting is that the model shows that there are monetary and fiscal policies that can prevent bubbles from happening. One is to apply the fiscal theory of the price level to credit markets, that is, to make sure the price level instantaneously responds to land prices to deflate the debt. If this is difficult to implement, and it would, another way to deflate a bubble is the make sure the returns of assets are lower by increasing interest rates of bonds, which makes them more interesting than real estate. Of course, one could also tax away the bubble. And one has first to recognize that there is a bubble.

You are more trustworthy if you are drunk

One advice I give to job market candidates is to make sure they do not drink to much at dinner, or they may say stupid things. It turns out I may be wrong on that one.

Jan Heufer makes the point that being drunk or under the influence of a drug is a very good commitment device if you are trying to show truth telling. He finds that this is a possibly good argument for the legalization of some drug that is not addictive if consumed in moderate quantitites. There is a loss of efficiency because people are sometimes under the influence, but there is a gain because better contracts are written.

How simultaneously borrowing and saving can be rational

Why would one have simultaneously debt and savings? We covered previously why people have simultaneously a savings acocunt and credit card debt, in which case it is perfectly rational. Can there another case be made for rationality?

Karna Basu claim that if you know you are time-inconsistent and want to do something about it, you can set up a scheme whereby you save your wealth and then borrow when investment opportunities arise. How would this make sense? The goal is to prevent over-consumption. To do this, you need some commitment device, and in this case it is unsafe lending. People save, but because of the uncertainty about losing their holdings, their are penalized when they fail to invest. This disciplines future selves. Indeed, one could simply indulge on current consumption using the loan. However, because this is borrowed, and savings may be lost, it is too risky to be caught bankrupt next period, and one limits one's consumption. Without the risk on the savings, nothing would prevent one from over-consuming. Thus, the risk on savings is beneficial. A subtle and counterintuitive conclusion.

Economists are less generous, but not by indoctrination

From many experiments, it is known that economists are more selfish than others. the interesting question is whether selfish people select themselves into Economics, or whether Economics students get indoctrinated by the material they are covering in classes.

Yoram Bauman and Elaina Rose use data from students at the University of Washington to elucidate this. There, students can donate to social programs each quarter. This is tracked along with their taking Economics classes. While Economics majors are indeed less generous, this does not appear to evolve over time. One can thus conclude this is a section effect. However, non-majors become more selfish once exposed to Economics. In other words, economists are quite convincing.

The Bible and the price volatility

There has been a lot of talk about irrational exuberance in the housing market, of irrational fears in the current recession, and animal spirits in general. Given this, it seems natural to study whether religiosity would have had any impact on these developments. Concentration on evangelical protestants, Christopher Crowe finds that they are much more level-headed than the general population: wherever they population share is higher, house price volatility is lower.

The reasoning here is that their behavior is countercyclical. Evangelical protestants believe that we live in the end times, so any bad news is good news to them, and vice-versa. But the argument needs to be more subtle than that. Imagine that the current bad economic news is some sign of the end of the world. Then asset price should be going further down, as the horizon on which future expected returns are cumulated is shortened. This would lead to more volatility. Crowe argues instead that evangelical protestants are taught to live normally through the end times, and that they are more "joyful" when bad news, such as 9/11, occur. And this would make them spend more, including on housing.

I find this argument rather hard to swallow. But clearly, the empirics seem to be consistent with that. Also, interesting to see that the IMF is interested in this type of topic.

Momentum traders and the housing market bubble

Bubbles are very difficult to recognize, by definition: you need prices to depart from fundamentals, and in the case of housing, expectations of fundamentals play the most important role. Determining whether expectations are overblown is thus quite subjective. But I think we have now a wide consensus that there has been a bubble in the housing market for several countries. The question is obviously how this could happen.

Monika Piazzesi and Martin Schneider argue that very little is required to get a bubble. A small number of so-called momentum-traders is sufficient. Using the Michigan Survey of Consumer, they find that there are always households who think is to a good idea to buy because price will rise further, but there number doubled during the bubble. They then proceed to write down a simple search model where they demonstrate that these momentum traders, even if outnumbered, have a strong impact on prices.

This is not unlike the rise of chartists on stock and currency markets who believe that future asset prices can be determined by past trends. Eventually markets started behaving in the way they were predicting once a sufficient, but not large, number of investors where following these rules. But once these self-fulfilling propecies start deviating too far from fundamentals, the markets correct themselves and get back to fundamentals. We have seen this again and again, but some people are always going to follow Mickey Mouse financial strategies, and unfortunately they seem to influence markets.

What households are financially sophisticated?

In the current crisis, some blame has been put on households who took rather strange financial decisions, especially with respect to house purchases and mortgage products. Essentially, they were lacking financial sophistication (or even common sense). This begs the question, what are the characteristics of financially sophisticated and unsophisticated households?

Laurent E. Calvet, John Y. Campbell and Paolo Sodini answer this question using household finance panel data from Sweden. They distinguish three types of mistakes: under-diversification, inertia in risk taking and disposition effect (the unwillingness to realize losses and too high willingness to realize gains). It would not surprise you to learn that richer households are more sophisticated in financial matters, after all this is probably the reason they got rich. But, interestingly, other factors are more important. Household size matters a lot: the more children, the more sophisticated the finances. Education and financial experience matter less. Of course, exception abound, like the California octuplets mom proves. But is shows that people are much more careful when financial decisions matter: you have children, you have some wealth, you have perspectives of future wealth (being educated). If the worst that can happen to you is foreclosure and you have little to start with, foolish financial decisions will not matter much.

People overvalue their own homes

A lot of blame in the current financial crisis has been put on mortgage providers, who have been myopic and thought, erroneously, that house prices would always increase. Rationality would dictate that homeowners should have a better idea about the value of their own home and their capacity to service the mortgage (unless they were counting on foreclosure). So it is a natural question to ask whether home owners are rational: do they properly value their home? They can make errors, but they should not be systematic, as in the rational expectation hypothesis.

Hugo Benítez-Silva, Selcuk Eren, Frank Heiland and Sergi Jiménez-Martín answer this question by stating that homeowners overvalue by 5-10%. Interestingly, they also find that the homes tend to be undervalued when bought in hard times. Thus, by their own recognition, homeowners evaluate home prices with excess volatility. Why mortgage professionals were so myopic becomes an even bigger mystery.

Why you lost the office pool

Are you getting frustrated because you never win in the office sports pool despite being an expert? The problem is that office sport experts typically have some allegiance to a team or a country, and the subjective winning probabilities are higher for your idols than the objective probabilities. The receptionist, however, looks at rankings or seeds and objectively makes the best guesses.

Now think in more aggregate terms. Imagine the qualification for Euro 2008, the football tournament where countries need to play several games to reach the finals. People bet on those games and the market determines equilibrium odds. Are the markets odds the same everywhere? Sebastian Braun and Michael Kvasnicka claim that there are not, and typically the odds of the local country are too high. Thus there are clear arbitrage opportunities available, but not for long now that this is known.

We are impatient because our brains are schizophrenic

There is ample evidence that humans are impatient. The traditional assumption in Economics has been to assume that we have preferences that exogenously feature a discount factor. Isabelle Brocas and Juan Castillo claim to explain endogenously impatience by thinking about how the brain functions.

Essentially, the brain is composed of competing entities. Say that there is a principal maximizing undiscounted intertemporal utility on a finite horizon. Then, there are distinct agents in each periods, all myopic in the sense that only contemporaneous utility matters. The principal can impose choices on agents, but the latter have private information on marginal utilities. The problem is closed with an intertemporal budget constraint with a strictly positive interest rate.

Impatience emerges as a result of this asymmetric information. Each agent has independent valuation, so there is no information to be gained from one agent that would be useful on the others. However, the principal can elicit some valuation revelation by granting more immediate utility to the agent. Thus, impatience is the result of asymmetric information between the principal and the independent agents.

In the particular implementation of this problem, the only intertemporal binding is the interest rate. This is the reason why the principal wants some savings. In the model, this positive interest rate is exogenously imposed. If it is zero, there is no impatience. Then, why would the interest rate be positive in the first place? Isn't it to reward patience among impatients? Aren't we going in circles here?

Why are retirees not buying annuities?

Retirees face a major uncertainty when they have to decide how much to spend from their assets: how long they are going to live. You do not want to spend too much in case you end up centenarian, but it would also be a waste to live thriftily when one ends up dying early. Luckily, the market provides a solution and has done so for centuries: annuities, which provide a constant stream of income as long as one is alive. This represents substantial welfare gains. Yet, very few people take advantage of this.

The literature has been puzzling over this for a while, see Jeffrey Brown. For one, public pension plans already provide some constant income. But this still leaves a lot of gain from annuities. Inflation risk is not a problem as annuity products are offered that are indexed, even even some that provide long-term care benefits. Bequest motives have been ruled out as well, as is risk-sharing within families.

Note also that in a lot of the life-cycle modeling with uncertain lifetimes, researchers use annuities to represent the dynamics of assets during retirement and death, because it is simple to model and because it is plain rational to buy annuities. The fact that this is not borne by facts is worrisome for some results coming out of this research.

In a recent NBER paper, Brown, Kling, Mullainathan and Wrobel may have found a solution to the annuity puzzle: it is all about how annuities are sold. If it is clearly labeled as a consumption insurance, then people are willing to buy it, as consumption risk is minimal. If it is sold as an investment, people realize it is very risky (as an investment): one may lose a lot if one dies early. This does not look like a rational reasoning, but the authors have conducted experiments that confirm that how annuities are framed matters crucially.

Then why would companies selling annuities frame it as an investment product? The authors conjecture that this is simply what they are used to. Maybe this research will show them how to change their marketing.

Neuroeconomics: the nanofoundations of economics

Over the past couple of decades, microfoundations have been all the rage in Economics, and in particular in Macroeconomics. The latter relied traditionally on reduced forms, which lead to the Lucas Critique: reduced form elasticities fail to account for elasticity changes that policy shifts can induce. It is now accepted in all fields of Economics that you need to build theory from the ground up, in particular by looking at preferences and constraints.

Of course, the next question is then where those preferences come from and under what circumstances they can change. Too often, the unexplained part in economic behavior is attributed to preference shocks, in part because we do not understand preference formation. Neuroeconomics is about understanding where preferences, and behaviors, come from, and possibly rewrite decision theory from the ground up.

As its name implies, this new field combines Economics and Neurology. It conducts economic experiments, where subjects need to take some decisions while their brain is scanned. Some researchers try to formulate the neurological phenomena during decision taking into formulas, and inferring decision theory from there, or invalidating it.

For general surveys on Neuroeconomics, see Colin Camerer in the Economic Journal, Camerer, Loewenstein and Prelec in the Journal of Economic Literature, and Douglas Bernheim. There are also dedicated research centers at Claremont, Stanford and George Mason. And even a Society for Neuroeconomics. The time of economists with lab coats has come.