Biases in Processing Information by Guest Blogger, Buck Klemkosky

The world is awash in data, so much so that a new field has evolved called “big data.” The explosion in data can be attributed to three factors: the increase in computer processing power at lower costs, the start of the World Wide Web in 1990, and the development of cellular technology. The explosion of digital data can only be compared with printed material in the Western world after Gutenberg invented the printing press in 1440.

How much digital data is available? No one knows precisely, but that doesn’t stop people from making estimates. In digital terms, everything starts with bits (short for binary digits, 0 or 1, computers use to store and process data) and bytes (8 bits, which is the basic unit of computing). It escalates from there:

kB kilobyte = 1,000 bytes                               PB petabyte = 1,000 TB

MB megabyte = 1,000 kB                               EB Exabyte = 1,000 PB

GB gigabyte = 1,000 MB                                ZB zetabyte = 1,000 EB

TB terabyte =1,000 GB                                  YB yottabyte = 1,000 ZB

Remember that the first personal computer had 56 kilobytes of memory and todays’ usually have a couple of gigabytes. But the total data in the world is estimated to be several zetabytes with more being produced every day.

As mentioned previously, most of the data in existence is noise and not useful for making decisions. But we try to decipher and glean from all of the data useful information. Our brains are surprisingly powerful processors of data and information, but selecting information to be used in decision making is hampered by several psychological biases.

It is only human nature that we get more pleasure from being right than wrong. So if we have beliefs or have made a decision, we become selective in collecting and using only confirming information. We filter out and reject information that is contrary to our beliefs and decisions. It’s much easier to support

than contradict. Sometimes we even use ambiguous and perhaps wrong information as supportive.

Investors are especially subject to confirmation bias. Once we buy a stock or bond, we are much more receptive to supporting information than contradiction. Some investors have strong opinions about the direction of the market in general, short term and long term. If you are a perma (long-term) bull or a perma bear, eventually you may be right, but it’s those intervening years that hurt.

What makes Warren Buffett such a successful investor is that he actually seeks out nonconfirming information. He has billions of dollars of his wealth, almost all, invested in Berkshire-Hathaway stock. At this year’s annual meeting, for example, he invited one of the most negative investors concerning Berkshire-Hathaway to address the 20,000 shareholders. This investor had taken a large short position in the stock, expecting it to decline in price.

In addition to confirmation bias, investors also have a tendency to use readily available information that can be easily recalled, which is called the availability bias. We also have a recency bias by giving more weight to more recent information and events and less to that more distant in time.

Investors also generalize with insufficient information, which means we use a small statistically insignificant sample or anecdotal evidence as information to make decisions. Most often it represents our own experience or something we are familiar with. The future looks like something we know or are familiar with based upon recent events or frequency of events. This is one of the reasons individual investors have been reluctant to invest in stocks again after the bear markets of 2000-2002 and 2007-2009, even though the market has appreciated 150 percent since the S&P 500 lows in March 2009.

It is easy to have opinions about almost everything. It is much more difficult to have informed opinions. But we never know if we are fully informed or not. Even though we may believe that we have correct information, it has a high probability of being biased. That is why uncertainty always prevails, especially in the financial markets. 

Vanishing Austerity, Lies, and Water Lilies

Cartoon by Jim Gibson

As we approach a new silly season wherein Washington turns its sights once again to fiscal farce, it is good to look at some numbers. The usual actors will despair of the unfairness of austerity and will no doubt quote half-correct and partial figures to explain why renewed fiscal stimulus is urgently needed to save the US economy. And naturally, much will be said about the roles played by government changes in tax revenues and spending. The truth is that the great majority of temporary austerity has come through changes in taxes and it is difficult to find any significant reductions in government spending from here to eternity. The numbers show that there is already plenty of government spending stimulus in works. It is hard to fathom a story of even more.                                           

To see the fiscal policy contributions more clearly we need to use numbers from a special Congressional Budget Office report about Automatic Stabilizers http://www.cbo.gov/publication/43999 

Numbers I quote below are taken from a spreadsheet associated with this report. A special report is necessary since the usual published federal government budget numbers reflect a mix of the impact of both (1) intended policy and (2) the effects of the economy on tax revenues and spending. For example, in 2009 when the economy slumped – unemployed workers automatically paid less tax while government spending increased to pay those newly eligible for unemployment insurance and other social programs. In 2009 without any legislation or government action, these automatic changes in spending and tax revenues amounted to $305 billion. The deficit widened by $305 billion before we took any policy actions into consideration.

The government did enact legislation in 2009 to reduce tax revenues by $165 billion and increase spending by $484 billion. These intended policy changes added another $649 billion to the government deficit in that single year. That $649 billion is the part that we identify as stimulus.  The total change in the government budget of -$954 billion was composed of a cyclical part (-$305 billion) and an intended policy part (-$649 billion).

This coincides with our understanding that intended fiscal policy contributed a very large stimulus at the onset of the recession that began in 2008 and ended mid-2009. The first column of the table below shows that after 2009 the published deficit figures show improvements (the column reports changes in the budget and the positive signs indicate improvements or smaller deficits) in the deficit until 2016 . Except for 2011, each year shows a positive number – meaning an improvement in the government budget deficit. 

In the years between 2011 and 2015, the cyclical or automatic impacts do not amount to much – most of the measured changes are the result of intentional policy. Between 2011 and 2015 the measured deficit is improving largely because of policy changes.

You might think this is because the government cut spending. But the table shows that the intent of government was to increase spending by a total of $380 billion in those five years. So apparently the improvements in the budget did not come through spending reductions. Intended changes in government revenues totalled $1,179 billion over those five years. Tax legislation explains the budget improvements.

My friends tell me that the world will not end in 2015 and it is interesting to see what the CBO envisions for 2016-2019 with regards to the intended impacts of legislation. The improved budget situation reverses itself. In all three years the deficits worsen. While the usual published numbers (in the first column) show a mild reversal – it is mild only because they are assuming a strong economy that will improve the deficit by a total of $350 billion in three years. This sanguine haul of bounty is not enough unfortunately to offset the planned changes to the budget that totals increased deficits of $525 billion. Somehow the horse got out of the barn. While 2016-2019 does show a few extra bucks coming into the treasury via taxes, the overwhelming reasons for the return to larger deficits is a cornucopia of spending – a total of $769 billion of spending added in just those three years.

This fall you will hear all kinds of stories about how we bit the bullet and reined in runaway government spending as we took control over national deficits and debt. These same politicians and economic gurus will tell us that while we need to responsibly manage our national debt in the long-run, our weak economy demands much needed stimulus. A similar sad story comes from Mr. Bernanke at the Fed. Just let us water the flowers a little longer and they will start to bloom!

But it is all a lie. Unless our flowers are water lilies we are in a lot of trouble. We have done nothing to approach our fiscal problems. We had a sort of short-term austerity that came largely from higher taxes. Spending was not cut. In 2015 spending will roar back and threaten our finances once again. A stronger economy will cloud some of these facts because tax revenues will automatically climb. But in the oft chance that the economy grows slower than forecast by the CBO, the publicly recorded numbers will reflect even worse deficits than the tables now show.

All the figures below are changes in the given year . The Rev and Spend columns have cyclical changes removed from the measured changes in government revenues and spending, respectively. These are intended policy changes.

Def	CycDEF	PolicyDEF	Rev	Spend	Year
-954	-305	-649	-165	484	2009
119	-67	186	120	-66	2010
-6	8	-14	142	156	2011
210	23	188	138	-50	2012
244	-36	280	296	16	2013c
229	-22	251	315	64	2014c
186	92	94	288	194	2015c
-46	166	-213	67	280	2016c
-59	142	-201	44	245	2017c
-70	41	-111	132	244	2018c

Free Trade Agreements, Harry Houdini, and Amateur Magicians

 Cartoon by Jim Gibson

Free Trade Agreements are showing up in the news a lot these days. I generally favor anything that smacks of free trade just as I might gleefully accept a glass of Jack with ice cubes. We teach/preach that free trade is good because it removes obstacles to trade, generates more competition, and allows for the benefits of comparative advantage.

So why am I responding so negatively to news articles about the US trying to consummate a free trade agreement with the European Union (EU)? What about recent attempts to agree on US participation in the Trans-Pacific Partnership? How about those 13 proposed bilateral agreements with various and sundry countries (eg. Thailand, New Zealand, Ghana)? I should be really happy that all this free trade activity is going on.

But I am not that impressed and see this like I see the magician’s hand as he waves the magic wand. Magicians use many tricks but none better than sleight of hand. Sleight of hand takes years of practice and involves a very natural movement that attracts the eyes of the audience towards something the magician wants them to see – and more importantly away from the place he or she does not want us to look. For example, a pretty scarf goes out with one hand while the other swiftly and secretly removes a quarter from your pocket.

Our government prefers for us to be reading about all sorts of positive plans rather than focus on the everyday drama of resolving real problems. It is NOT news that government continues to make almost no progress on unemployment, government debt, immigration and more. In this environment advocating free trade seems like a free lunch. Even though it is next to impossible that any free trade agreements will be negotiated and signed by the US government in the near future, the photo ops are spectacular. Our government leaders can toast with important leaders around the world and pontificate about the great benefits of free trade as economic and social problems ferment and threaten to boil over.

I cannot imagine a worse time for free trade agreements. Every country I can think of has high and rising unemployment. Even in the US where the unemployment rate has been falling, we have much pressure for politicians to preserve and protect jobs and companies. This is not the ideal time to be explaining to the American public that the government is reducing long-held protections and allowing greater competition in the most sensitive of industries. It sounds great to say that a new trade agreement will open up opportunities abroad – while the other hand is really picking your pocket – that is, allowing dozens of other countries to compete with your own workers on home soil. And the recent history of globalization underlines how workers in low-income countries can impact the jobs of US workers. If you think the congressional debates about immigration and national debt are loud and ugly now – wait until these free trade pacts show up at Congress.

A second reason to believe that this is all a sham is to make note of the lack of general progress towards multi-lateral (involving more than two countries) trade agreements. The big momma of all such agreements is what is called the Doha Round of the World Trade Organization. This round of negotiation started in 2001. If you had a kid in 2001 he is now almost ready to go to high school and start dating girls with tattoos. That’s a pretty long time. The WTO has had previous rounds and while none of them was easy to conclude, none have taken this long. It is what some people call the problem of the “low hanging fruit.” It was fairly easy to make progress in lowering tariffs when tariff rates exceeded 100%. But the world has changed a lot and the protections that are in line to be removed, are a lot more difficult. For example we want Europeans to gobble biotech foods and they want us to make it easier for European companies to get contracts from the US government. That is not easy stuff. It might be easier to make French American’s third official language!

Sure, we recently concluded free trade agreements with South Korea, Colombia and Panama – but come on – we have pretty special relationships with those three countries. Yet, it took quite a while. Imagine this – once an EU-USA FTA is agreed by EU and US administrations, the agreement would then have to be passed in the capitals of 29 EU countries and the US Congress.  Maybe on some future date when the world recession is a faint memory and all our economies are hitting on all cylinders would such a feat be possible.

So all this trade talk today is simply noise. World leaders have subtle revolutions at least bubbling under the surface. They need to divert our attentions from all their failures to something that looks like Bourbon and Apple Pie (I kid you not – there is a restaurant in the Capital Hill neighborhood of Seattle named Pie Bar that basically sells only pie and whisky. And yes I was there and had a JD and Key Lime Pie!).  These free trade negotiations give the government people something to do. But the reality is that they not only are intended to fool the audience, but they may actually be making things worse because practicing all these tricks is keeping them from putting the food on the table. These guys are clearly amateur magicians and stand to create more harm than amusement. Watch out when they tell you that they are going to saw you in half!

Supply-Side Voodoo

This blog post uses a four-letter word – Supply-side macro policy (SSMP). Many people upon hearing SSMP get that look that often occurs when fingernails accidently screech on a blackboard. Otherwise they shake their heads as if someone just admitted they didn’t pick up their dog’s poopie while doing the circle at Green Lake Park.

Because SSMP has such a checkered reputation (Trojan Horse, Voodoo Economics Trickle Down, Charlie Sheen) most economists make up other names when they advocate a SSMP approach – restructuring, growth policy, tax reform, etc. But even with all this cover provided by taxonomical innovations, there is very little thrust today in the advocacy of SSMP. And let me say in all-caps, that there have been very few times in the USA when we have needed SSMP more that we do today. Okay so I didn’t use all caps. I thought that would be rude and annoying and why diss you now when you are already deep into my second paragraph?

After writing the above this weekend, I saw on Monday, July 8 the article by Princeton’s Alan Blinder on the Opinion Page in the Wall Street Journal, “The Economy Needs More Spending Now.” It is interesting that Blinder admits that “long-run growth is supply determined” and recommends SSMP for the long-run. But this is a Keynesian trick because he strongly advocates only demand-side stimulus now and we all know what Keynesians think about policy for the long-run, ie Keynes’ famous line that we are all dead in the long-run!

The proof that we need SSMP now has several parts. First and foremost is that we have exhausted demand-side macro policy. Whether from the standpoints of monetary or fiscal policy, we have used all of our demand-side policy bullets. There is no more ammunition we can throw at stimulating the economy through the demand side. If anything, the markets are pushing interest rates back up to normal values and there is little more the Fed can do to keep them down. The government knows it has to start addressing deficit and debt problems and simply cannot maintain trillion dollar deficits into the future without severe negative ramifications. 

It is like the field soldier who is out of bullets but he has a couple of grenades next to him. He cries that he is out of bullets and must surrender. His friend says, “but you have a whole bunch of grenades.” He retorts that he heard that sometimes grenades don’t work well and he had better just surrender. Demand-side policies are exhausted now and we have a basket full of SSMPs yet no one is strongly advocating them.

The second and more important reason we should focus on SSMP is that they directly address a myriad of factors or trends that are the root cause of our current problems. Business firms are reluctant to hire workers and produce more output. SSMPs directly aim at improving conditions in labor and output markets. It is commonplace for analysts to list all these supply-side obstacles so I won’t go into much detail. But rising business costs and uncertainty stem from a slew of new regulations relating to coal, energy, capital adequacy, financial leverage, lending to new homeowners, college borrowing, healthcare, Medicaid, immigration, and so on. One SSMP approach would resolve the uncertainty by directly addressing these regulatory issues. Reduce the uncertainty by making the regulations clearer. Of course it is also possible to re-think and change some of these regulations so that they have less negative impacts on employment and output decisions. If we cannot speed or change these regulations, then we are left with them but we can enact SSMPs that offset some of their negative effects.

What are these magical SSMPs? One kind of SSMP goes directly at the labor pool and finds ways to improve the desirability of adding another worker. There are many ways to give firms more incentives to hire. Labor subsidies or reductions in labor taxes might lead to larger government deficits and therefore should be aligned with tax reforms. Broadening the tax base is one way to bring in revenues while you lower tax rates that are more closely aligned with decisions to hire and produce.

Since firms often borrow to expand output or productive capacity, using financial and banking reform to transform all those bank reserves into loans has great supply-side appeal. Foot dragging on such regulations keeps banks in a holding pattern. Rising interest rates might deter some companies from borrowing – but lack of funds makes it virtually impossible to borrow. The same reasoning applies to mortgage markets and school loans.

A third reason to focus on SSP today has to do with the risk of higher inflation. Anything that has the potential to rekindle rising inflation threatens our employment and output goals. When workers begin to expect higher inflation then they are more motivated to ask for pay increases. Suppliers in commodities markets behave the same way. When bankers see more inflation coming, they raise interest rates. The upshot is that expectations of rising inflation become embedded in today’s prices with resulting negative impacts on business costs and profits. In today’s monetary and fiscal environment, any policy moves that lead to larger deficits or looser money will be self-defeating. On the contrary, tighter monetary and fiscal policies can be viewed as SSMPs because of their downward impacts on inflationary expectations and an improved competitive environment.

US unemployment is too high and output is too low.  In a market equilibrium sense, that means both supply and demand for labor and output are too low. The question then is one of causality. Some analysts cling to the idea that demand is the culprit and they advocate more demand stimulus. We gave demand policies more than a fair chance. It is now time to turn to supply. Bring on the Trojan Voodoo Trickle Down!

Immigration Reform, Guitar tabs, and Forecasting

We cannot be too sure where politicians will go next with legislation for immigration reform. There are lots of angles here both political and economic. One discussion in the press lately has to do with CBO forecasts of the impact of immigration reform. The CBO found that when they forecast out 10 or 20 years they get a net positive impact of immigration reform on the US economy. They found that more legal immigration creates jobs and incomes and tax revenues. While there will be social costs of more immigrants, the CBO found that the extra revenues far outweighed the benefits.

We read these forecasts and then choose our favorite spears and throw them at each other. Imagine how many serious as well as drug-induced debates are going on right now about the CBO study. That makes me think about guitar tabs and forecasting. As I understand it a guitar tab is a sort of sheet music to help you learn how to play the guitar. It is along story but I decided that foot tapping to I Wanna Hold Your Hand was not enough for me, so I purchased a guitar and starting taking lessons. Learning a guitar takes a lot of practice. Part of it is exercise to teach you to put your fingers in the right places on the guitar. Anyone who has ever watched a real guitar player knows that they move their hands all over the guitar at high speed and with almost no effort. Anyway, I am spending a lot of time doing mindless practice moving my hands around the guitar strings as if I was caressing a hot steamy bottle of JD.

It is VERY apparent when looking or listening to me “play” that I am about 10,000 hours away from being the next Tiny Tim. But there ain’t no other way but to put in the hours. I must admit that I often drink or watch Fox Business News while I practice so it isn’t real torture or anything like that. So what does this have to do with Immigration legislation and the CBO?

The answer is that practicing with tabs on a guitar is NOT playing songs. And the CBO estimates of the economic impact of immigration reform are NOT the impacts of immigration reform. Just because practicing tabs is not playing real music, that does not mean that practice is not valuable. The CBO estimates are dead wrong – but that does not mean they are not valuable. It also means that one party can say the estimates are just right while the other one says they are backwards.

Before any televised sporting event, there is often a gaggle of experts who tell us who is going to win that game. Analysts never agree but the process of listening to the analysts gives you a pretty good idea of the kinds of things that will determine the outcome. No analyst ever gets all the details and the main outcome right – but some will have been “righter” than the others. That’s the way we can think about the CBO report. It has value not because it will be right, but because the report and the ensuing debate help us focus on the kinds of things that will happen if the legislation is passed.

How can this be helpful to us now as we debate the issue? First, it should make us a little less confident in our own economic projection. If we really listen to those with opposing views, we may learn something. Second, if we start looking seriously at the assumptions made by the CBO about very specific impacts, we realize that this is very much “educated” storytelling. Do those economists at the CBO REALLY know how fast immigrant incomes will rise over the next decade or two?  Do they know how many babies they will have? How many will lose their jobs? Please! Either side of the debate can tweak an assumption about the future and come away with different conclusions about net economic impact. Third, every decade has its surprises. What if Mexico goes to war with Cuba? Or global warming makes Canada the new Caribbean? Stuff happens right?

The upshot is that while the CBO report is totally wrong about the economic impact of Immigration Reform the report does facilitate a debate that will be useful. But keeping in mind how fragile are the numerical conclusions, it is natural to guess that the political debate will be overshadowed by the ethical and ideological issues. One congressman said he would never vote for reform if it meant that criminals – illegal aliens – would be allowed a path toward citizenship. Another one countered that it is simply wrong to evacuate people or families that had been living and paying taxes in the US for extended period of time. While these two opinions might be extremes it is probable that many congressional votes will be more determined by these kinds of issues than by a very fragile set of economic impact numbers. A dysfunctional Congress has yet another chance to resolve difficult issues. We can only guess what the outcome will be.