Matt Nolan

Bounded rationality: A parable

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Often people accuse economists of relying on an imperfect view of human nature – a view that is often disparagingly called “homo-economicus“.  However, our view of the world does not rely on the individuals being able to perfectly calculate the satisfaction they get from things or perceive every opportunity.

Ultimately all we require is that individuals respond to incentives (derived from the relative costs and benefits of things) and as a result try to set themselves up such that the benefits of their actions exceed the costs (include opportunity costs).  Such a situation can occur when individuals are bounded rational.

A good example of bounded rationality comes from the parable of the centipede and its 100 legs.  In the parable there is a centipede walking along.  Now it co-ordinates its 100 legs without thinking and without calculating – it does so just because it has become part of its nature.  Effectively, it is following a rule of thumb which allows it to make the optimal decision.

When asked about how it moves its legs it gets confused and trips – at this level anyone watch the centipede would take this as a failure of rationality, it obviously can’t deal with the complex calculation required to come up with its optimal solution.  However, is this really fair?  Even though the centipede couldn’t consciously decide how to move its legs, over time it had evolved a rule of thumb that had allowed it to achieve the optimal solution.

Economists “believe” (this is our value judgment here) that individuals create rules of thumb that allow them to achieve the optimal outcome – without having to consciously calculate.

Understanding how these rules of thumb evolve and change in a highly complex and changeable world is a big deal (in the parable the rule of thumb does not shift favourably to the introduction of information!), and is something behavioural and neurological economists are currently studying.  However, it is clear from this individuals can still make optimal decisions, even when they aren’t expert calculators with complete information.

Matt Nolan

New Zealand budget 2009

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So, we’ve had the Budget.

The one time that we need a shift in government policy – and nothing happens.

Treasury believes that the size of our economy is fundamentally smaller, that there has been a permanent shock to our income. As a result, spending needs to fall or taxes need to rise – 11 years of operating deficits isn’t good enough. And I’m not sure that S&P will let us get away with it …

I don’t agree with David Farrar when he says:

There’s not much one can argue should be done differently.

As a commitment to cut spending or lift taxes from 2011 would have been the way to go. However, he does give a good summary of what was in the budget.

Update: Miguel noticed that S&P put us back on stable outlook. Story here. Good news and congratulations to the team, but to be honest I have no idea why.  Unless …

Matt Nolan

New Zealand budget 2009: Is there a cost from a downgrade?

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I have noticed only two extreme positions in the media about a downgrade:

  1. It will be terrible – it will cost the govt alone $600m pa
  2. It doesn’t mean much – the credit ratings are “dis-credited”

Let me tell you something – the truth is inbetween.

Treasury’s estimate of the cost of a credit downgrade are based on the downgrade to Ireland.  As we are already facing a fairly high price for the globe underlying belief of our risk, and as it is unlikely we will be knocked down and put on negative watch AGAIN (like Ireland was), the cost will not be this heavy.

However, there is a cost!  It would lead to higher interest rates, restrict access to international credit, and prevent some possible capital investment from overseas.  It doesn’t matter that the credit rating agencies didn’t pick the subprime crisis – investors still stick to their recommendations for what is going on in the little backwater parts of the world (like NZ).

As a result, I wish Labour would shut up about this being a “budget to satisfy S&P rather than to help people”.  If they don’t I wish National would respond by saying that they are trying to stop interest rates going up – which would hurt people, instead of saying that it is “their budget”.

Matt Nolan

New Zealand budget 2009: Is increasing GST the solution?

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In New Zealand we are currently concerned about a downgrade from S&P.  They want us to be running operating surpluses from 2014, and we aren’t quite sure how to do that in the face of a massive global recession.  The suggestion I have is to increase GST rates from 2011.

Now, if we believed that Ricardian equivalence was holding in its entirety any solution with taxes would be silly – as higher taxes would merely lead to higher private borrowing.  As S&P is truly concerned about our national debt position this wouldn’t help.

However, pure Ricardian equivalence does not hold – especially in the face of a highly uncertain and credit constrained economic environment like the one we have now.

If the government can commit to increasing GST rates from 2011 they can both:

  1. State that they are increasing taxes in a way to fill the budget hole – taking us back to operating surpluses in our forecasts and preventing a downgrade (which would have a similar cost except that all the money would be heading offshore),
  2. Reduce the relative price of spending now compared to the future – increasing “aggregate demand” now at the cost of demand in the future.  Given that prices are sticky in the short-term, and the increase in GST rates enters firm and household expectations of future prices, we only really care about movements in “aggregate demand” in the short term – so this seems super.

The main concern would be that a lift in GST would increase long-run taxes.  However, if the economy moves back to potential (output) and the tax take becomes too large we can just can personal income taxes – thereby flattening the tax base and reducing the tax on savings.  Sounds good to me.

Matt Nolan

New Zealand budget 2009: Expectations

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Defective equilibrium points out that there has been little discussion about expectations for the budget around the NZ blogsphere.  As a result, let me lay down some expectations here.

These are the things I strongly suspect will be in there.

  • Future tax cuts to be postponed into the indefinite future,
  • Provisions for future spending to be slashed further IN REAL TERMS (note that provisions should have been cut because of lower inflationary pressures in the first place),
  • An increase in short-term spending on state houses (mainly refitting) beyond that announced,
  • Further shifting forward of infrastructure projects,
  • A REDUCTION in medium term infrastructure spending – implying that any investment now is taking away from future budgeted spending,
  • Increased funding for the establishment of PPP’s,
  • A funding freeze for most departments,
  • A “shifting forward” of welfare entitlements – implying that future real welfare spending will be cut.

These are random possibilities (although fairly unlikely):

  • A lift in GST rates (to 15%) from 2011,
  • A freezing (or cut) on the income level and entitlements for WFF and some benefits,
  • A PPP involving ACC,
  • A complete withdrawal from the Cullen fund to pay for near term spending promises,
  • An expanded program of state house BUILDING.
Matt Nolan

Cartoon: Recessions don’t hurt everyone

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(Source GWS)

Remember, even during the Great Depression there were people that were better off than they would have been.  There are always winners and losers.

When prices are falling, and when relative prices change, there are people who benefit from that – as well as people that lose out.  During such an event we normally only hear one side of the story …