The Economist who realized how crazy we were

Profile of Richard Thaler from Bloomberg:

...Thaler began to keep a list of things that people did that made a mockery of economic models of rational choice. There was the guy who planned to go to the football game, changed his mind when he saw it was snowing, and then, when he realized he had already bought the ticket, changed his mind again. There was the other guy who refused to pay $10 to have someone mow his lawn but wouldn't accept $20 to mow his neighbor's. There was the woman who drove 10 minutes to a store in order to save $10 on a $45 clock radio but wouldn't drive the same amount of time to save $10 on a $495 television. There were the people Thaler invited over to dinner, to whom he offered, before dinner, a giant bowl of nuts. They ate so many nuts they had no appetite for the far more appealing meal. The next time they came to dinner Thaler didn't offer nuts -- and his guests were happier.

Can incentive pay give us better drugs?

Express Scripts, a PBM (Pharmaceutical Benefits Manager) who negotiates drug prices with pharmaceutical companies (on behalf of consumers) thinks it can

Express Scripts has in recent years been a vocal critic of high drug prices, which the company has used to promote its services to potential customers as it competes against CVS Health Corp. and others to administer drug benefits for health insurers and large employers. Pharmacy-benefit managers also sometimes keep a portion of the rebates and discounts they negotiate from pharmaceutical companies.

Their solution involves incentive pay

Express Scripts this month told clients it is seeking deals with drug makers for differentiated pricing for certain cancer drugs based on how well they work against different types of tumors, Express Scripts Chief Medical Officer Steve Miller said in an interview. Currently, Express Scripts and most insurers pay the same per-unit rate for a cancer drug regardless of the type of cancer it is being used to treat.

The biggest benefit of this kind of reimbursement are the incentives it creates for future drug development.

John Nash, RIP

John Nash and his wife were killed in a car crash as driver of the taxi he was riding in lost control.

Students of our textbook will recognize Nash equilibrium of strategic games from Chapter 15 and his non-strategic characterization of bargaining from Chapter 16.

Up until Nash's work on the theory of games, all we had were models of monopoly (one firm) and "perfect competition" (many small firms).  This was not very useful because most of the interesting problems arise in oligopoly (competition between a few firms), and Professor Nash gave us a way to characterize competition in this setting.  

Insights from his models have been distilled into advice given to generations of MBA students:

Use game theory to figure out where self interest is taking you; and if you don't like where that is, change the rules of the game.  

Likewise his strategic and non strategic (axiomatic) models of bargaining have been distilled into bargaining insights:

The alternatives to agreement determine the terms of agreement.  

John and Alicia Nash, RIP

What happens when the government guarantees over half of all financial sector liabilities?

From the Richmond Fed:

•  A contributing factor to the financial crisis of 2007-08 was the government's long history of emergency loans to distressed institutions and markets deemed "too big to fail." This history has created an expectation that certain parts of the financial sector will be protected from losses.

•  This government safety net effectively subsidizes risk-taking. Investors that feel protected by the government will be less likely to demand higher yields as compensation for risk, and creditors will feel less urgency to monitor firms that are implicitly protected.

•  Excessive risk-taking makes firms more likely to experience distress and require bailouts to remain solvent. Additional bailouts can then further erode market discipline.

•  This self-reinforcing cycle suggests that the safety net will grow ever larger over time. The safety net has increased by one-third since the Richmond Fed's first estimate in 1999. It covered 60 percent of financial sector liabilities as of 2013.

•  Resolution plans, or "living wills," could be an important tool for establishing credibility against bailouts by making the government safety net the less attractive option in a crisis.

Warren Buffett weighs in on the Nashville Mayoral Race

...albeit indirectly:

Warren Buffett thinks a $15 minimum wage will 'reduce employment in a major way, crushing many workers'

The issue was raised in the Nashville Mayoral race by Megan Barry, who supports what she calls "a living wage," one that is set by the government.  The only candidate on the same side of the issue as Buffett is David Fox.

In case you have forgotten Chapter 2, a minimum wage outlaws voluntary wealth creating transactions at prices below the minimum, which reduces welfare.

BLOGGING DISCLOSURE:  I support Fox (previous post here).

Is there anything incentive pay cannot do?

... like motivate women to be better wives and mothers:

Forgive me if I am not exactly sympathetic. 

Fair enough. But look at it another way: the idea of financial incentives to encourage mothers to do the best for their children is a popular public policy idea. 

Bribery, basically? 

Call it what you like but the Progresa (later called Oportunidades ) programme in Mexico, which has been replicated across the world, is among the most lauded anti-poverty ideas of the past 20 years. Randomised controlled trials — the gold standard of research — have shown a strong link between cash payments to mothers and, among other benefits, increased attendance by their children at schools.

Choose Moody's to signal financial health

Moody's just downgraded the Chicago's debt to junk status while S&P has them rated at "investment grade."

The difference is due to the different methodologies:  Moody's uses its own growth projections while S&P defers to the city's growth assumptions.

We have blogged extensively about the systematic underfunding of municipal pensions and the political pressure to under-save:

The city of Nashville uses discounting to decide how much to save for its future pension obligations. For a pension that pays out $100,000 in 20 years, Nashville must save $20,485=$100,000/(1.0825)^20 today, using an 8.25% discount rate.   If the city invests the $20,485, and earns 8.25%, the savings will compound and be worth $100,000 in twenty years.  If however, the investments return less than 8.25% (in fact they have done much worse),then the city will not have saved enough when the future finally gets here.  Of course, a more realistic discount rate, say 6.5%, would mean much higher current savings, 28,380=$100,000/(1.065)^20 to fund the same future pension.  But higher savings means less current spending, and spending is politically popular.

So, for the purposes of illustration, S&P is using a higher discount rate (like the 8% in the example above) and Moody's is using a much lower discount rate, (like 6.5% in the example above).  

OK, now we are in a position of determining which of the agencies is doing a better job?

I trust Moody's for two reasons:

1. City assumptions are typically too high and are almost always backward looking, so after a long period of high returns, the assumptions will be for continued high returns. When in fact, high returns in the past are correlated with lower returns in the future.  

2.  I suspect that S&P gains clients for its consulting services from many of the same cities that it rates.  Its favorable ratings may be an advertisement to financially strapped cities that S&P will come up with a low savings rate which will provide cover to politicians who want to continue their irresponsible behavior.  

If this is correct, financially healthy cities may want to "signal" their financial health by hiring Moody's.

Investment advice, courtesy of Barclay's

The blog post below raises an issue of how one should invest money.  The best advice I can give is

Before you buy a stock, figure out what would cause you to sell.  

The biggest mistake novice traders make is to sell when the stock goes down and buy when it goes up.  This is a strategy guaranteed to lose money.  

A better strategy for investing (its not the only one), is to invest in a “target retirement fund.”  This has the advantage of diversification (stock market will not reward you for bearing diversifiable risk, so it is important to diversify), and rebalancing.  

Rebalancing is a little bit more subtle.  A typical target retirement fund would allocate (100-your age) to stocks  (riskier) and the remainder to bonds (less risky).  So for a 23-year old, the allocation would be 77% stocks, and 23% bonds.  As you age the allocation shifts towards the the less risky asset.  

Periodically, the fund “rebalances.”  This means that if stocks have appreciated relative to bonds, they will rise above 77% of the portfolio, so the fund sells some stocks and buys some bonds, to bring the portfolio back to your 77/23 desired allocation.  Notice that this strategy results in selling assets that have gone up, and buying those that have gone down, exactly the opposite of the strategy followed by Mr. Dumbass in the story below.  

How Barclay's took advantage of its client's stop-loss orders

The FT had a nice article on the efforts to rig foreign currency titled "If you ain't cheating, you ain't trying."  Here is one way the banks tried to make money:

In the FCA settlement, the regulator details an exchange between traders at Barclays and three other firms, refered to as X, Y and Z. Barclays was trying to trigger a client stop-loss order to buy £77m at a rate of 95 against another currency.  

If it could trigger the order, it would result in Barclays selling £77m to its client and the bank would profit it the average rate at which the bank had bought sterling in the market was below the rate at which the client had agreed to buy it.

The key to understanding the strategy is understanding how a stop-loss order works.

Before going to this example, let me give you a simpler example. Mr. Dumbass buys a stock without much conviction at $40 per share. He tells his broker, “I don’t mind if this thing goes down a little, but if it does down to $32.00 or less, sell it at market, regardless of where the market is.” 

This should make the hair on back of your neck stand up because what Mr. Dumbass is saying is that the LOWER the price goes, the MORE HE WANTS TO SELL. In fact, if the price goes down to $32.00 or even less, he wants to sell “at market,” no matter how low the price is. Pretty nuts, but there are people who think this way. That’s why I gave this character the name I gave him. And to be fair, there are LIMITED circumstances in which such an order makes sense (e.g. someone who is highly leveraged and would be bankrupted by a margin call).

In Barclay's case, Mr. Dumbass is short the stock – well, it’s currency here, not a stock -- to begin with. So he’s not worried that the currency will go down and wipe him out. Rather, he’s worried that it will go UP and wipe him out. Remember, he shorted it.

According to the complaint, Barclays is presumably trying to jam the price up so that Mr. Dumbass’s stop loss BUY order kicks in, pushing the price even higher. By “investing” a little in buying, which pushes the price up slightly (or as much as it can manage to push it up…because that is Barclay’s intent, to push up), Barclays hopes to trigger Dumbass's stop-loss buy order and make the price go up yet further still. And at that higher price, Barclays will sell.

In theory people like Mr Dumbass should not exist, because they will have lost all their money.  But I guess it takes time for them to lose money.  

US Central Bank's statement reduces the value of the dollar

Almost everyone had assumed that the US Central Bank would start raising interest rates in June.  The just released notes from their meeting said that this is unlikely.

The dollar then fell agains the Euro

Early afternoon in Europe, the euro was around 0.3% higher on the day at $1.1126, reversing some of the losses it had suffered during the previous two sessions after European Central Bank officials reaffirmed the bank’s resolve to meet its stimulus goals.

Why does this happen?

There are two mechanisms at work:

1. lower US interest rates reduce investment demand for the dollar:  fewer investors want to invest in dollar-denominated investments, which represents a decline in demand for dollars in the market for foreign exchange.  
2. lower US interest rates increase loan demand for the dollar:  more foreign borrowers want to borrow in dollars to invest abroad.  To do this, they go to US banks, borrow in dollars, and then sell dollars to buy the local currency where they want to invest.  This represents an increase in the supply of dollars.  This is called the "carry trade."

Both the increase in supply of dollars and the reduced demand for dollars result in a depreciation of dollars in the market for foreign exchange.

"Wait a minute" asks a student.  "Can this really happen so quickly?"

No, these kinds of moves take time.  However, if speculators know what will happen, then they can "front run" these changes (profit from them) by selling dollars and buying foreign currencies, today, which will make these expected future changes occur immediately.