Lecture 23: Present

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Change and Information Technology

• Financial markets have shown rapid change in the
  past
• Information technology is an important factor in
  the change, and portends important changes in the
  future
• Other changes are due to simple invention, and
  slow public acceptance of new information

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Comparison with 1970

• In 1970, there were no organized options markets
• No financial futures markets
• No swaps
• No strips
• No electronic trading
• Transactions costs precluded much trading

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Basic Themes of this lecture

• Long run risks still not managed well
• Invention of new risk management techniques, like
  other invention, proceeds fitfully, then spreads,
  never regresses
• Proper psychological framing important for
  properly human-engineered risk invention
• New information technology opens up many avenues
  for new risk management technology in the future

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Risk Theme

• Biggest risks are long-term nonfinancial risks,
  currently poorly managed by available
  institutions
• There are substantial uncertainties about future
  income distribution
• Risk management broadly interpreted, includes tax
  and welfare system

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Framing Theme

• Variability of economic actions in response to
  framing changes is fundamental lesson from
  psychology for economics
• Framing is determined by language, institutions,
  convenient comparisons
• Standards and units of measurement are frames,
  and incorporation into institutional
  infrastructure matters

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Invention Theme

• Invention is important in institutions for risk
  management
• Ideas, once developed, are then copied around the
  world
• Human engineering is important in invention
• Framing is critical part of risk inventions
• Associated inventions, as with information
  technology, open up new possibilities
• New technology (Internet, Turbo Tax, etc.) create
  new opportunities for risk management invention

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Long-Term Risks

• For most people, labor income dominates
• Labor income undiversified, unhedged
• Gradualness of changes, absence of market-
  revealing prices of present values, obscures
  risks

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Inflation is an Important Long Term Risk

• The difference between 2 per year inflation and
  3 per year inflation, over 30 years, amounts to
  a difference in real value of 30
• Many people are locked into long-term nominal
  contracts.
• E. g., Fixed income securities in US amount to
  over 7 trillion
• Fixed-income pensions still important in US today

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Tax and Welfare Systems Importance in Risk
Management

• Harsanyi-Rawls view of tax and welfare system as
  risk manager
• Because of declining marginal utility of income,
  the impact of any risk management system should
  be measured primarily by how it prevents very low
  incomes
• Therefore, tax and welfare system dominates in
  any discussion of risk management

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Framing and the History of Taxes

• Cognitive biases exploited by lawmakers who see
  need for higher taxes and wish to disguise them
  from public loss aversion, salience
• Highest marginal tax rate most salient
• Lawmakers raise highest rate during wars, when
  salience is lowest, apply only to highest incomes
• Lawmakers exploit the framing, slowly cutting tax
  rates postwar, which people frame as gains

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Framing and the History of Taxes, Continued

• Lowering the income at which higher rates kick in
  is less salient than raising rates
• Disallowance of important deductions, such as
  income averaging, is easy to do after the
  lobbying effort for them has dispersed
• Edward McCaffery, Cognitive Theory and Tax in
  Sunstein, Behavioral Law and Economics, 2000

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Frames versus Beliefs

• Frames are categories of thought, not opinions.
• Frames connected with language and culture. John
  Locke taking words for things
• Coordination problems in changing frames, often
  requires government coordination
• Units of measurement are an extreme case,
  sometimes affecting actions. E. g., lots are
  divided into even fractions of acres.

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Language Categories

• Named concepts receive special attention
• Recession, bear market, stock price index
• Units of measurement

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Loss Aversion Kahneman Tversky

• People very sensitive to small losses, kink in
  value function
• Hence framing a financial product so that
  potential for loss is not perceived enhances
  desireability

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The Importance of Invention in Economic History

• Technological Advance occurs at random places and
  is copied around the world
• Automobiles and airplanes
• Risk management institutions as inventions

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Insurance as an Invention

• Elements of insurance concept are as complex as
  the elements of other inventions, such as engines
  or motors
• Insurance contract, corporate or mutual form for
  insurance company, excluded claims to circumvent
  moral hazard, co-insurance, actuarial tables,
  public regulation, capital adequacy standards,
  etc.

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Changes in Patent Law

• For most of last century, US Patent office
  rejected patents for business methods
• Patentable inventions had to have a physical
  component
• Inventors started claiming computers were that
  physical component. Merrill Lynch CMA Accounts,
  Priceline.com patent
• Starting around 1998, patent law has been
  changed, allowing financial patents, and
  resulting in a flurry of financial patents

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19th Century Advances in Information Technology

• Paper machine, hence cheap paper
• Carbon paper
• Typewriter
• Standardized forms
• Vertical filing cabinets
• Bureaucratic management techniques

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First US Income Tax

• First federal US income tax enacted 1861, took
  effect 1862, 3 on incomes over 800
• 1862 3 on incomes over 600, 5 over 10000,
  deductions for rental housing, repairs, other
  taxes
• Compliance initially was fairly high, attributed
  to wish to support war effort

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Failure of First US Income Tax

• After Civil War, compliance declined, estimated
  that in 1872 only 10 of eligible taxpayers
  actually paid.
• Failure attributed to incapacity of the lower
  officers and dishonesty of the higher ones.
  (Harry Smith, The United States Federal Internal
  Tax History from 1861 to 1871, 1914. 94 282-96.
• Tax rescinded 1872

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Bureaucratic Difficulties 1860s

• Costly to run audits on taxpayers, lacking
  inexpensive and rapid travel, communications
• Costly record copying, inadequate filing systems
• Monitoring for government officer corruption
  difficult for same reasons
• Inadequate civil service professional development

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Withholding of Income Taxes

• Important human engineering element of income tax
  system
• Endowment effect Thaler
• Fairness issues
• Underground economy flourishes where withholding
  is impossible.

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Tracking Stocks

• Tracking stocks are claims on a division of a
  corporation
• Increased use of computers in businesses allows
  greater facility for tracking individual lines of
  businesses
• Tracking stocks are likely to grow in importance,
  and with them a host of related risk-management
  tools

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The Corporation

• David Moss points out that a law requiring that
  all corporations have limited liability was tried
  as an experiment in New York State in early 19th
  Century,
• Moss points out that limited liability was not
  obviously a good idea it created agency problems
  for stockholders, who might pursue risky
  strategies at bondholders expense. Moreover, in
  fact unlimited liability hardly ever caused
  serious problems in practice.
• But, New York experiment was obviously
  successful, and eventually all states copied it.

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Moss Theory why Limited Liability Corporations
were so Successful

• Investor overestimation of miniscule probability
  of loss beyond initial investment discouraged
  investment (weighting function)
• Lottery effect with limited liability, an
  investment in a corporation was a throwaway item,
  like a lottery ticket (prospect theory)
• Allowed for investors to hold a highly
  diversified portfolio (not a concept that framers
  of corporate law were comfortable with then).

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Inflation Indexed Debt

• History shows many examples of nominal debt being
  wiped out in real terms by high inflation
• Indexed debt first attempted in Massachusetts,
  1780, to help finance Revolutionary War
• Shays rebellion 1786, sparked by apparent
  unfairness of other nominal contracts (e. g.,
  soldiers pay) being worthless while indexed debt
  was not
• Indexed bonds did not appear again in the United
  States until 1997. Still today no private indexed
  debt

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Barriers to Inflation-Indexed Debt

• Strong tradition of nominal framing of contracts,
  so that nominal contracts stand alongside indexed
  ones
• Mistrust of indexation formulae
• Need a thoroughgoing indexation, such as that
  afforded by the Unidad de Fomento (UF) of Chile
• New information technology makes indexation more
  of a possibility

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Real Estate Risk Management Devices

• Value of homes is a major source of risk

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Macro Markets

• My book, 1993, urges creation of markets for
  long-term claims on aggregates such as GDP of
  countries, incomes by education level,
  occupational incomes
• Such assets would create prices for long-term
  claims on incomes, reframing attentions toward
  long-term values

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Conclusion

• Advancing information and other technology will
  create vast changes in financial markets in next
  twenty years
• Many opportunities for innovation