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description= 15 posts published by Lars Syll during October 2012;
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1 67 billion if you re not an economist you would probably trust your common sense and decline the offer knowing that a large risk of bankrupting one s economy is not a very rosy perspective for the future since you can t really arrest or reverse the arrow of time you know that once you have lost the 1 billion it s all over the large likelihood that you go bust weights heavier than the 17 chance of you becoming enormously rich by computing the time average imagining one real universe where the six different but dependent outcomes occur consecutively we would soon be aware of our assets disappearing and a fortiori that it would be irrational to accept the gamble from a mathematical point of view you can somewhat non rigorously describe the difference between ensemble averages and time averages as a difference between arithmetic averages and geometric averages tossing a fair coin and gaining 20 on the stake s if winning heads and having to pay 20 on the stake s if loosing tails the arithmetic average of the return on the stake assuming the outcomes of the coin toss being independent would be 0 5 1 2s 0 5 0 8s s s 0 if considering the two outcomes of the toss not being independent the relevant time average would be a geometric average return of squareroot 1 2s 0 8s s 1 2 why is the difference between ensemble and time averages of such importance in economics well basically because when assuming the processes to be ergodic ensemble and time averages are identical assume we have a market with an asset priced at 100 then imagine the price first goes up by 50 and then later falls by 50 the ensemble average for this asset would be 100 because we here envision two parallel universes markets where the assetprice falls in one universe market with 50 to 50 and in another universe market it goes up with 50 to 150 giving an average of 100 150 50 2 the time average for this asset would be 75 because we here envision one universe market where the asset price first rises by 50 to 150 and then falls by 50 to 75 0 5 150 from the ensemble perspective nothing really on average happens from the time perspective lots of things really on average happen assuming ergodicity there would have been no difference at all just in case you think this is just an academic quibble without repercussion to our real lives let me quote from an article by ole peters in the santa fe institute bulletin from 2009 on time and risk that makes it perfectly clear that the flaw in thinking about rational decisions in terms of ensemble averages has had real repercussions on the functioning of the financial system in an investment context the difference between ensemble averages and time averages is often small it becomes important however when risks increase when correlation hinders diversification when leverage pumps up fluctuations when money is made cheap when capital requirements are relaxed if reward structures such as bonuses that reward gains but don t punish losses and also certain commission schemes provide incentives for excessive risk problems arise this is especially true if the only limits to risk taking derive from utility functions that express risk preference instead of the objective argument of time irreversibility in other words using the ensemble average without sufficiently restrictive utility functions will lead to excessive risk taking and eventual collapse sound familiar on a more economic theoretical level the difference between ensemble and time averages also highlights the problems concerning the neoclassical theory of expected utility that i have raised before e g in why expected utility theory is wrong when applied to the neoclassical theory of expected utility one thinks in terms of parallel universe and asks what is the expected return of an investment calculated as an average over the parallel universe in our coin tossing example it is as if one supposes that various i are tossing a coin and that the loss of many of them will be offset by the huge profits one of these i does but this ensemble average does not work for an individual for whom a time average better reflects the experience made in the non parallel universe in which we live time averages gives a more realistic answer where one thinks in terms of the only universe we actually live in and ask what is the expected return of an investment calculated as an average over time since we cannot go back in time entropy and the arrow of time make this impossible and the bankruptcy option is always at hand extreme events and black swans are always possible we have nothing to gain from thinking in terms of ensembles actual events follow a fixed pattern of time where events are often linked in a multiplicative process as e g investment returns with compound interest which is basically non ergodic instead of arbitrarily assuming that people have a certain type of utility function as in the neoclassical theory time average considerations show that we can obtain a less arbitrary and more accurate picture of real people s decisions and actions by basically assuming that time is irreversible when are assets are gone they are gone the fact that in a parallel universe it could conceivably have been refilled are of little comfort to those who live in the one and only possible world that we call the real world our coin toss example can be applied to more traditional economic issues if we think of an investor we can basically describe his situation in terms of our coin toss what fraction of his assets should an investor who is about to make a large number of repeated investments bet on his feeling that he can better evaluate an investment p 0 6 than the market p 0 5 the greater the fraction the greater is the leverage but also the greater is the risk letting p be the probability that his investment valuation is correct and 1 p is the probability that the market s valuation is correct it means that he optimizes the rate of growth on his investments by investing a fraction of his assets that is equal to the difference in the probability that he will win or lose this means that he at each investment opportunity according to the so called kelly criterion is to invest the fraction of 0 6 1 0 6 i e about 20 of his assets and the optimal average growth rate of investment can be shown to be about 2 0 6 log 1 2 0 4 log 0 8 time average considerations show that because we cannot go back in time we should not take excessive risks high leverage increases the risk of bankruptcy this should also be a warning for the financial world where the constant quest for greater and greater leverage and risks creates extensive and recurrent systemic crises a more appropriate level of risk taking is a necessary ingredient in a policy to come to curb excessive risk taking share on facebook opens in new window facebook share on x opens in new window x share on bluesky opens in new window bluesky economists people being paid for telling stories justifying inequality 30 oct 2012 at 20 54 posted in economics 2 comments if economics was an honest profession economists would focus their efforts on documenting the waste associated with protectionist barriers for professionals they devoted endless research studies to estimating the cost to consumers of tariffs on products like shoes and tires it speaks to the incredible corruption of the economics profession that there are not hundreds of studies showing the loss to consumers from the barriers to trade in physicians services if trade could bring down the wages of physicians in the united states just to european levels it would save consumers close to 100 billion a year but economists are not rewarded for studying the economy that is why almost everyone in the profession missed the 8 trillion housing bubble the collapse of which stands to cost the country more than 7 trillion in lost output according to the congressional budget office that comes to around 60 000 per household few if any economists lost their 6 figure paychecks for this disastrous mistake but most economists are not paid for knowing about the economy they are paid for telling stories that justify giving more money to rich people hence we can look forward to many more people telling us that all the money going to the rich was just the natural workings of the economy when it comes to all the government rules and regulations that shifted income upward they just don t know what you re talking about dean baker in case you re in doubt you might better have a look at e g what harvard economist and george bush advisor greg mankiw writes on the rising inequality we have seen for the last 30 years in both the us and elsewhere in western societies even if the income gains are in the top 1 percent why does that imply that the right story is not about education i then realized that paul krugman is making an implicit assumption that the return to education is deterministic if indeed a year of schooling guaranteed you precisely a 10 percent increase in earnings then there is no way increasing education by a few years could move you from the middle class to the top 1 percent but it may be better to think of the return to education as stochastic education not only increases the average income a person will earn but it also changes the entire distribution of possible life outcomes it does not guarantee that a person will end up in the top 1 percent but it increases the likelihood i have not seen any data on this but i am willing to bet that the top 1 percent are more educated than the average american while their education did not ensure their economic success it played a role share on facebook opens in new window facebook share on x opens in new window x share on bluesky opens in new window bluesky why is lm still isn t good enough wonkish 30 oct 2012 at 16 01 posted in economics comments off on why is lm still isn t good enough wonkish matias vernengo has a piece today on naked keynesianism giving us yet another clue to why is lm and its different hybrids still isn t up to the task of helping students to grasp the essentials of modern monetary economies wendy carlin and david soskice have an interesting post at voxeu org on how should macroeconomics be taught to undergraduates in the post crisis era they explicitly follow a new keynesian framework which is an ismp model with price rigidities in their view the monetary authority can move the economy to the equilibrium rate but the equilibrium rate is not controlled by the authorities i would suggest that the central bank actually has control of the key variable which is not natural at all and as keynes suggested is conventional the normal rate of interest and that could be set at a level which will not lead to full employment particularly for distributive reasons in my view the essential feature of a more relevant macro model would be the elimination of the natural rate the idea that the system has a tendency to bounce back to the trend and by the way the model says nothing about how income distribution affects spending yet the main reason behind the crisis has been the fact that workers had to get indebted since income has stagnated so income distribution has to be brought back to macroeconomics not enough kalecki with their new but still neoclassical version of keynesianism that is the problem with carlin and soskice share on facebook opens in new window facebook share on x opens in new window x share on bluesky opens in new window bluesky economic myths that destroy our society and democracy 29 oct 2012 at 17 40 posted in economics politics society 1 comment the romney campaign has defended inequality or brushed it aside to do so it has employed a handful of economic myths here are a few of the most important 1 america is a land of opportunity while rags to riches stories still grip our imagination the fact of the matter is that the life chances of a young american are more dependent on the income and wealth of his parents than in any of the other advanced countries for which there is data there is less upward mobility and less downward mobility from the top even than in europe and we re not just talking about scandinavia 2 trickle down economics works a k a a rising tide lifts all boats this idea suggests that further enriching the wealthy will make us all better off america s recent economic history shows the patent falsehood of this notion the top has done very well but median american incomes are lower than they were a decade and a half ago various groups men and those without a college education have fared even worse median income of a full time male worker for instance is lower than it was four decades ago 3 the rich are the job creators so giving them more money leads to more and better jobs this is really a subset of myth 2 but romney s own private sector history gives it the lie as we all know from the discussion of bain capital and other equity firms many made their money not by creating jobs in america but by restructuring downsizing and moving jobs abroad often using debt to bleed the companies of money needed for investment and using the money to enrich themselves but more generally the rich are not the source of transformative innovations many if not most of the crucial innovations in recent decades from medicine to the internet have been based in large measure on government financed research and development the rich take their money where the returns are highest and right now many see those high returns in emerging markets it s not a surprise that romney s trust fund invested in china but it s hard to see how giving the rich more money through more latitude to escape taxation either through low taxes in the united states or cayman islands hide aways leads to a stronger american economy 4 the cost of reducing inequality is so great that as much as idealists would like to do so we would be killing the goose that lays the golden egg in fact the engine of our economic growth is the middle class inequality weakens aggregate demand because those at the middle and bottom have to spend all or almost all of what that they get while those at the top don t the concentration of wealth in recent decades led to bubbles and instability as the fed tried to offset the effects of weak demand arising from our inequality by low interest rates and lax regulation the irony is that the tax cuts for capital gains and dividends that were supposed to spur investment by the wealthy alleged job creators didn t do so even with record low interest rates private sector job creation under bush was dismal mainstream economic institutions like the international monetary fund now recognize the connection between inequality and a weak economy to argue the contrary is a self serving idea being promoted by the very wealthy 5 markets are self regulating and efficient and any governmental interference with markets is a mistake the 2008 crisis should have cured everyone of this fallacy but anyone wit...
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