Lecture 23: Present & Future

Change and Information
• 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
Comparison with 1970
• In 1970, there were no organized options
• No financial futures markets
• No swaps
• No strips
• No electronic trading
• Transactions costs precluded much trading
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
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
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
Invention Theme
• Invention is important in institutions for risk
• Ideas, once developed, are then copied around the
• 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
Long-Term Risks
• For most people, labor income dominates
• Labor income undiversified, unhedged
• Gradualness of changes, absence of marketrevealing prices of present values, obscures
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
• E. g., Fixed income securities in US amount to
over $7 trillion
• Fixed-income pensions still important in US today
Tax and Welfare System’s
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
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
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
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.
Language Categories
• Named concepts receive special attention
• Recession, bear market, stock price index
• Units of measurement
Loss Aversion – Kahneman
• People very sensitive to small losses, kink
in value function
• Hence framing a financial product so that
potential for loss is not perceived enhances
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
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, coinsurance, actuarial tables, public
regulation, capital adequacy standards, etc.
Changes in Patent Law
• For most of last century, US Patent office rejected
patents for business methods
• Patentable inventions had to have a physical
• 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
19th Century Advances in
Information Technology
Paper machine, hence cheap paper
Carbon paper
Standardized forms
Vertical filing cabinets
Bureaucratic management techniques
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
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
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
Withholding of Income Taxes
• Important human engineering element of
income tax system
• Endowment effect Thaler
• Fairness issues
• Underground economy flourishes where
withholding is impossible.
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
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
• 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.
Moss’ Theory why Limited
Liability Corporations were so
• 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).
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
• Shay’s 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
Barriers to Inflation-Indexed
• Strong tradition of nominal framing of contracts,
so that nominal contracts stand alongside indexed
• 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
Real Estate Risk Management
• Value of homes is a major source of risk
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 longterm claims on incomes, reframing
attentions toward long-term values
• Advancing information and other
technology will create vast changes in
financial markets in next twenty years
• Many opportunities for innovation