Allison's Ode to the Second Moment


I’ve missed you, Pension Geeks! Welcome back to the 45th edition of Allison’s Ode to the Second Moment, a newsletter that takes the unpopular view that people can understand risk.

Well, Maybe Not People on Twitter

I’ve often heard people justify overstating certainty about certain issues, take aspects of global warming, because what’s at stake is too important, the risks are too great, and people just don’t understand the risk.

I don’t agree. Humans have a capacity to understand risk and make sensible decisions—it just comes down to how the risk is presented to them. But the pundit class is not helping the case for risk thinking.

I noticed some taking a victory lap a few weeks ago about monetary policy. During the second and third rounds of QE, some people argued that additional monetary stimulus would not boost the economy or reduce structural unemployment (there is evidence that’s true). Because we were reaching the limits of monetary policy, there was a risk the stimulus could be inflationary with few economic benefits. I heard it argued that because inflation did not happen we should call out those inflation crazies, so we know not to listen to them in the future.

I am not a fan of keeping score when it comes to predictions. Predictions are futile. Everyone is right some of the time and wrong at other times. Being right is pretty random. Keeping score suggests more certainty than really exists.

Here’s the ugly truth with economic policy: the outcomes are never certain. There are always unintended consequences. A healthy debate over policy acknowledges this. And every time we discuss a policy move, it is correct to say "This is the range of things that might happen, here are the downside risks, and here are the potential benefits."

And then we should ask if it is worth the risk. Often it is, and sometimes it is not.

Shaming people, who raised the possibility of a downside risk that did not happen, does not serve good economic policy or risk literacy.

And Even If People Are Irrational about Risk, So What?

If you are an economist, every day of your life someone tells you, “Guess what? People are irrational, and all you economists are wrong.” To which you politely reply, “Thank you for telling me that. You are very clever.”

Economists are people too. We also make decisions that are inconsistent or irrational. This is indeed at odds with many economic models. But it may not be a big deal. Every economic model makes unrealistic or simplified assumptions—that’s what makes them models. The question is which simplifying assumptions are worse than others. Economists can allow for more complex human behavior in economic models, but it may not change a model’s predictions, it only makes the model harder to use.

The hot debate in economics is not whether people rational or not. It's: Is rationality a bad assumption? Deirdre McCloskey says, “No, it is a fine assumption. Irrational behavior is not so important to economic outcomes, but people still use it as an excuse to justify government intervention.

I agree rationality is a harmless assumption some of the time. Other times, depending on the model or economic relationship you are trying to model, it may be a bad assumption. That is why interpreting economic models takes skill.

Well, Okay, Maybe Pension Beneficiaries Don’t Understand Risk

In The Economist, Buttonwood explains the costs of DB pensions. Guaranteeing all that risk is expensive, but beneficiaries don’t appreciate its value. No wonder employers find it more cost effective to stick employees with that risk instead. Why offer an expensive benefit if no one appreciates it?

Take the uproar over stagnant teacher pay in America. A big part of teachers’ compensation is their risk-free pension. Risk-free assets have become more expensive in the past 20 years, and this means it is more expensive to finance pensions. If you include pension value in teachers’ pay, their compensation has increased. Compensation may not have increased enough, but that’s another issue. The fact is their pay did go up.

Workers don’t appreciate pensions until they are taken away from them (how’s that for behavioral economics?!). Academics in the UK have been striking for weeks over changes to their pension scheme. Cash-strapped universities want to switch to a defined contribution scheme. This does not impact past, accrued benefits, but such subtitles are lost on the mob.

Sex Workers Understand Risk, While Lawmakers and Celebrities Do Not

The Senate just passed legislation to police sex trafficking. That sounds great, no wonder lots of celebrities supported the bill. The legislation has law enforcement go after websites that knowingly host ads for sexual services. In the past 20 years, most sex workers came to advertise and screen their clients using these websites. After the legislation passed, the most popular sites shut down.

This will put lots of sex workers in danger. Trafficking is a small share of the sex industry. The web freed most sex workers from relying on agencies and pimps. Evidence has shown, the ability to screen clients in advance made them much better off by reducing their risk of violence.

Besides, there is little evidence this bill will reduce sex trafficking. I’ve been told the sites had an unofficial agreement with law enforcement. They’d report trafficking and minors to authorities in exchange for law enforcement ignoring willing adults on the websites. This law will only push trafficking further into the shadows.

For some reason, The New York Times has pegged this as a story that pits Silicon Valley against lawmakers. I suppose that is one way to describe it, but I think the welfare of vulnerable sex workers is a bigger deal.

Other News

General McMaster, a great risk scholar, is out. I am not surprised he never meshed well with President Trump. He has the makings of a great National Security Advisor, just not for this administration.

And there’s an increased risk of a trade war, though our enormous trade deficit may be an illusion resulting from bad measurement.

Until next time, Pension Geeks!