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The power of recall

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The other day, I heard the Stranglers’ Strange Little Girl for the first time in ages, prompting me to recall having an Indian takeaway in a friend’s Morris Oxford somewhere off the Clarendon Road on a sunny evening in 1982. I wonder: does this help explain why older people are more hostile to the Labour party than younger ones?

My response to that particular song was of course idiosyncratic. But it is nevertheless typical. All of us have Proustian madeleines – cues that prompt us to recall some memories. We all, I suspect, have songs which we associate with specific people and places. This is why “trigger warnings” are sometimes necessary: traumatic memories can indeed be triggered. As Daniel Levitin writes:

The brain is not like a warehouse; rather, memories are encoded in groups of neurons that, when set to proper values and configured in a particular way, will cause a memory to be retrieved and replayed in the theatre of our minds. The barrier to being able to recall everything, we might want to is not that it wasn’t ”stored” in memory, then; rather, the problem is finding the right cue to access the memory (This Is Your Brain on Music, p165)

In a new paper Jessica Wachter shows that this process colours our financial decision-making. Take for example the finding of Erin McGuire and Stefan Nagel and Ulrike Malmendier (pdf), that economic conditions in our formative years influence how much we invest in equities even decades later. From one point of view, this seems absurd: expected returns are the same for all of us. So, how can it happen? Simple. The questions “should I buy shares?” or “What is the economic outlook?” trigger particular memories. For some, these are memories of the bear market of the 70s. For slightly younger people they are memories of the 80s bull market. And these generations invest accordingly.

A similar thing, says Professor Wachter, explains why shares fell so far – in hindsight by too much – when Lehmans collapsed. This triggered memories of (reading about) the Great Depression and hence alarm.  (Luckily, though, it also reminded the Fed of the Great Depression, so it knew what not to do).

I suspect a similar process contributes to older people’s greater opposition to Labour. Remember that it is not inevitable that young people should be predominantly left-wing: in 1987, for example, more of them supported the Tories than Labour. So why are things different today?  

One reason, of course, is that older people own houses and younger ones don’t.

But it could be that different memories are involved. If you are in your mid-50s or older, talk of a left-wing Labour party cues memories of the Soviet Union and of the 1970s – and of the more salient aspects of the 70s such as strikes rather than less salient ones such as the fact that most workers got better real-terms pay rises than they’ve had recently.

Young people, however, have none of these memories. For them, talk of nationalizing the railways trigger not memories of British Rail sandwiches but of pleasant train journeys in Europe.

Of course, the 1970s were the 1970s whether you experienced them or not. But as David Hume said, actual experiences – impressions – are stronger than mere ideas.   

In one sense, all of this might be trivially obvious. In another, though, it’s not. Even though the truth should in theory be the same for all of us – in the way that future share price moves will be – we perceive it differently. This is not (just) because we are stupid or dishonest. It’s because of how memory works.  



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Economy

Cautionary Tales Ep 6 – How Britain Invented, Then Ignored, Blitzkrieg

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Blitzkrieg means “lightning war”, but despite the German name it was not a German invention. Back in 1917 a brilliant English officer developed a revolutionary way to use the latest development in military technology – the tank. The British army squandered the idea but two decades later later Hitler’s tanks thundered across Europe, achieving the kind of rapid victories that had been predicted back in 1917.

This is a common story: Sony invented the digital Walkman, Xerox the personal computer, and Kodak the digital camera. In each case they failed to capitalise on the idea. Why?

Featuring: Toby Stephens, Ed Gaughan and Rufus Wright.

Producers: Ryan Dilley and Marilyn Rust. Sound design/mix/musical composition: Pascal Wyse. Fact checking: Joseph Fridman. Editor: Julia Barton. Recording: Wardour Studios, London. GSI Studios, New York. PR: Christine Ragasa.

Thanks to the team at Pushkin Industries, Heather Fain, Mia Lobel, Carly Migliori, Jacob Weisberg, and of course, the mighty Malcolm Gladwell.

[Apple] [Spotify] [Stitcher]

 

Further reading

Mark Urban’s book The Generals has an excellent chapter on J.F.C. Fuller. Other sources on Fuller include Brian Holden Reid’s J.F.C. Fuller: Military Thinker and Harold Winton’s To Change An Army

Other sources on the development of the tank include Macksey and Batchelor’s TankNorman Dixon’s classic On The Psychology of Military Incompetence and Basil Liddell Hart’s The Tanks.

On modern corporate innovation try Gillian Tett’s excellent The Silo EffectCreation Myth” by Malcolm Gladwell, Clay Christensen’s Innovator’s Dilemma and The Disruption Dilemma by Joshua Gans.

 

The original paper on architectural innovation is:

Henderson, Rebecca M., and Kim B. Clark. “Architectural Innovation: The Reconfiguration of Existing Product Technologies and The Failure of Established Firms.” Administrative Science Quarterly 35, no. 1 (March 1990): 9–30

 

 

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Economy

The Fama Puzzle at 40

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Fama (JME, 1984) was published 35 years ago, but the earlier — perhaps the earliest — appearance of the Fama regression is in Tryon (1979). While the puzzle has largely persisted since then, it has seemingly disappeared since the global financial crisis.

Figure 1: Ex post one year depreciation of euro/dollar up to 2007M08 against one year offshore US-euro interest differential (up to 2006M08). 

Recall the puzzle: If the joint hypothesis of uncovered interest rate parity (UIP) and rational expectations –- sometimes termed the unbiasedness hypothesis — held, then the slope of the regression lines (in red) would be indistinguishable from unity. In fact, they are significantly different from that value. This pattern of coefficient reversal holds up for other dollar-based exchange rates, as well as for other currency pairs (with a couple exceptions). The fact that the coefficient is positive in the post-global financial crisis period is what we term “the New Fama puzzle”.

Interestingly, after 2006, the relationship flips.

Figure 2: Ex post one year depreciation of eur/dollar up to 2019M06 against one year offshore US-euro area interest differential (up to 2018M06). 

In a revision to NBER working paper just released (No. 24342, posted 12/11), coauthored with Matthieu Bussière (Banque de France), Laurent Ferrara (SKEMA Business School), Jonas Heipertz (Paris School of Economics), we re-examine uncovered interest parity – the proposition that anticipated exchange rate changes should offset interest rate differentials, with data up to mid-2019.

This is one of the most central concepts in international finance. At the same time, empirical validation of this concept has proven elusive. In fact, the failure of the joint hypothesis of uncovered interest rate parity (UIP) and rational expectations – sometimes termed the unbiasedness hypothesis – is one of the most robust empirical regularities in the literature, vigorously examined since Fama’s (1984) finding that interest rate differentials point in the wrong direction for subsequent ex-post changes in exchange rates.

The most commonplace explanations – such as the existence of an exchange risk premium, which drives a wedge between forward rates and expected future spot rates – have some empirical verification, albeit fragile.

One key development prompts this revisit. First and foremost, the last decade includes a period in which short rates have effectively hit the zero interest rate bound. This point is clearly illustrated in Figure 1 where we plot one-year interest rates for a set of eight selected economies and the US. This development affords us the opportunity to examine whether the Fama puzzle is a general phenomenon or one that is regime-dependent.

Figure 3: One year yields on Eurocurrency deposits.

As shown in Figure 3, more recently — and since the first version of this paper — short rates in the US have risen above the zero lower bound. This allows us to test to the robustness of our findings.

We obtain the following findings. First, Fama’s result is by and large replicated in regressions for the full sample, ranging from 1999 to June 2018 (for exchange rate changes ending in June 2019). However, the results change if the sample is truncated to apply to only the most recent decade, the period for which interest rates are essentially at zero. For that period, interest differentials correctly signal the right direction of subsequent exchange rate changes, but with a magnitude that is altogether not reconcilable with the arbitrage interpretation of UIP. In other words, we obtain positive coefficients at exactly a time of high risk when it would seem less likely that UIP would hold.

The use of survey based expectations — thereby dropping the rational expectations hypothesis — data provides the following insights. First, interest differentials and anticipated exchange rate changes are positively correlated, consistent with the proposition that investors tend to equalize at least partially expected returns expressed in common currency terms (see also Chinn and Frankel (2019) for results 1986-2017).

Second, the switch in the β coefficient at the one year horizon arises because the correlation of expectations errors (defined as expected minus actual) and interest differentials changes substantially between pre- and post-crisis periods. This is important, as can be seen by examining the probability limit of the β’ coefficient in a Fama regression:

s+1 – s = α’ + β'(i-i*) + error

so:

plim(β’) = 1 – [A] – [B] – [C]

Where

[A] ≡ cov(covered interest diff.,i-i*)/var(i-i*)
[B] ≡ cov(risk premium, i-i*)/var(i-i*)
[C] ≡ cov(forecast error, i-i*)/var(i-i*)

covered interest differential = – [(f – s) – (i-i*)]
risk premium = f – ε(s+1)
forecast error = ε(s+1) – s
f is the forward rate for period +1
s is the current spot exchange rate
ε(s+1) is subjective market expectations of the future spot exchange rate (proxied using Consensus Forecasts survey data).

The decomposition for the euro/dollar β’ is shown in the Figure 4 below, for the 2003M01-2018M06 period (defined by the survey data). The components are shown as theoretical β’ + [-A] + [-B] + [-C], so as to add up to the estimated β’.


Figure 4: Decomposition of euro/dollar β’. [A] is brown, [B] is blue, [C] is green; black square denotes estimated β’, line at 1 denotes theoretical β’ under unbiasedness hypothesis. Source: BCFH (2019).

Exchange risk comovement with the interest differential does not appear to be the primary reason why the Fama coefficient has been so large in recent years (although the altered behavior of exchange risk does play a role). Rather, how expectations errors comove with the interest differential appears of central importance — that is the [C] component. This correlation changes because in the pre-crisis period, the dollar depreciated more than anticipated, while that is no longer true post-crisis. The size of the swing is partly due to the fact that interest differentials are now less variable (the variance has shrunk).

So far the change has proved durable despite the liftoff of short rates — at least in the US, Canada and UK. Whether this will continue to be the case remains to be seen.

Ungated version of the paper, here.



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Economy

Bonus Quotation of the Day…

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… is from page 426 of the late Jan Tumlir’s January 1984 speech at the Cato Institute – a speech titled “Economic Policy for a Stable World Order” – as this speech is reprinted in Dollars, Deficits, & Trade (James A. Dorn and William A. Niskanen, eds., 1989):

Indeed the difficulty for the economist may now lie in explaining why the world economy still functions at all, however dissatisfied we may be with its functioning. The answer is, of course, that there is a lot of ruin in any economy with a modicum of freedom. I am sometimes unsure whether it is actually an advantage of the capitalist system that it can take such an enormous amount of beating. If it were in the habit of collapsing more frequently, we would perhaps govern ourselves more prudently (and more cheaply to boot).

DBx: Indeed.

I’ve long argued that the economist’s standard assertion that government intervenes into the economy first and foremost to correct market failures fails spectacularly as a positive theory of government intervention into the economy. It’s far closer to the truth to say that government intervention into the economy is fueled not by market failures (as understood by economists) but, rather by the market’s astonishing success and robustness.

The market’s success at raising people’s standards of living creates the expectation that wealth creation is easy and normal while poverty is out of the ordinary. But of course historically poverty is the norm – and poverty so deep, unrelenting, and overwhelming that few Americans today can begin to imagine a condition so crushing. Because the market makes wealth so abundant and its production appear to be normal and easy to the point of being practically automatic – and because nearly all of the massive number of details of the intricate processes at work at every moment to create wealth are hidden from view – the market’s ‘failure’ to create heaven on earth is believed by many to be an unanswerable indictment of the market.

On top of this ‘problem’ is the market’s mighty robustness: tax it, saddle it with diktats, poison it with easy money, accuse it of being run by and for demons and devils, and the market keeps motoring along, improving the lives even of those who most hate it and who do the most to harass it. The market works less well than it would absent these intrusions, of course, but it still works surprisingly well. As long as, and insofar as, prices and wages are allowed to adjust according to the forces of supply and demand, the market’s robustness is Herculean. (The market is not, however, indestructible. Harass it too much and it will quit working.)

If the market truly collapsed completely more often, giving people a taste of what life is like without it, the world would have in it not only far fewer communists and socialists, but also far fewer “Progressives” and “conservative nationalists.”

The market’s true failure, in short, lies is its incredible capacity to succeed and to keep on keeping on. The market fails to prevent people from taking it for granted.

The post Bonus Quotation of the Day… appeared first on Cafe Hayek.



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