Book Club #3: Nudge

This week, we are reviewing ’Nudge: Improving Decisions about Wealth, Health, and Happiness’, by Richard Thaler and Cass Sunstein. The book’s influence has been widespread; following its publication, David Cameron created a Behavioural Insights Unit (appropriately nicknamed the “Nudge Unit”) in order to tap into the potential of behavioural sciences within public policy.

Thaler and Sunstein have penned a very readable and fascinating book in ‘Nudge: Improving Decisions about Wealth, Health, and Happiness ‘. The book uses punchy examples throughout to illustrate how ‘small and apparently insignificant details can have major impacts on people’s behaviour’. This inevitably means that choice architecture – the context within which humans make decisions – can play a pivotal role in steering people ‘the right way’. Choice architects can then harness the power of nudges, for better or worse.

The book relies upon a central doctrine: libertarian paternalism, which advocates the preservation of liberty (i.e. any nudging critically maintains freedom of choice) while maintaining that it is legitimate for choice architects to influence choices that make people “better-off” (in the architect’s opinion). The ethical base of this is that choice architecture is inevitable; in the absence of nudging, there will still always be some context that will influence decisions. It therefore makes sense to modify the architecture and present the same incentives, in order to combat any ill effects.

The book then treads over familiar ground by critiquing the fallible ‘homo economicus‘ assumption. Humans do not always possess full information, nor are they equipped with unlimited cognitive ability to process it. Homo economicus would never be affected by nudges, but homo sapiens will.

Below is a brief explanation of a handful of Thaler and Sunstein’s ideas:

• The power of the default: humans take the “path of least resistance” and usually pick the easy and uncomplicated option, rather than the complex and difficult one. Humans also have a tendency, therefore, to stick with the default (inertia). A good libertarian paternalist can remind humans to make a decision, before setting a default by considering what a thoughtful human would want.
• The three human heuristics (from Kahneman and Tversky): humans regularly use heuristics, which are shortcuts that help us understand the world. These heuristics are prone to biases, which can be exploited.
  • Anchoring: something’s perceived value can be adjusted by introducing a human to a known fact that could well be irrelevant. A study asked two questions: “How happy are you?” and “How often are you dating?”. When asked in this order, there was little correlation between the answers, yet when the order was reversed, the correlation was much higher!
  • Availability: humans are more influenced by events that are more available (that spring to mind easily). This could be an event that was more recent or tragic.
  • Representativeness: humans are too reliant on stereotypes that have arisen from experience.
• Optimism: humans chronically err on the side of optimism, particularly with respect to our ability to achieve things. E.g. 90% of drivers think that they are above average, which is mathematically impossible!
• Framing: the lens with which a fact is viewed dramatically influences decision-making, through the plenary effects of anchors and loss aversion. A drug that causes 10 out of a 100 patients to die sounds far more sinister (initially) than a drug which has a 90% success rate.
• Loss aversion: losing something is far more valuable than gaining it (An infamous example from prospect theory literature is that the pain from losing $1000 is only equivalent to the pleasure of earning $2000.)

Thaler and Sunstein have provided a stunning introduction to the fascinating world of behavioural economics. There are definite constraints to the power of nudging: in a constantly-changing world of different variables, nudges cannot be relied upon for unyielding returns.

Perhaps more importantly, whose right is it to decide what is best for another person? Naturally, the book nudges you to answer: a body whose incentive is directed towards a socially optimal scenario. The applications of behavioural economics within public policy messaging are endless, which is best exemplified by the government’s messaging during the COVID-19 pandemic. Therefore, whether one agrees with ‘libertarian paternalism’ or not, one cannot deny its influence on the policymaking sphere.

Options Explained

Options are key parts of financial markets as they cover a certain aspect of risk that people assume when they open positions in the stock market.

The purchase of an option is purchasing the right to buy/sell a certain underlying object in a specified quantity by a specific date (the exercise date) at a predetermined price (the exercise price or the ‘strike’ price). The ‘underlying’ refers to the specific object that is being considered by the option: these objects range from shares in Tesla to land on the outskirts of London. A potential example would be a petrochemical company wanting to build a petrol station near Ealing. A representative of the company could approach a landowner who has an ideally sized plot for building and ask them if it were possible that he could purchase the ‘option’ to buy the land at a later date. The company might seek to do this as the plans for building have not yet been finalised, but they yet wish to reserve the right to begin building once everything falls in shape. The representative will then offer additional compensation for the landowner’s surrender of choice into the hands of the company for the option. The landowner might ponder his circumstances and accept the offer as in either case the plans to build fall through on the petrochemical company’s side and he gets to keep the compensation, or he accepts the price he would have obtained had he sold on the open market but with the extra bonus. All these added together provide a large, expected utility for the landowner.

There are two kinds of options, call and put. A call option is purchasing the right to buy an underlying whereas a put option is purchasing the right to sell an underlying. The first options were created by Thales of Miletus, one of the seven sages of Greece, who purchased put options for the use of olive oil presses in anticipation of a large harvest. He would leave a sizeable deposit in the hands of the owners of the presses as compensation and would only exercise his right if the harvest were as large as he predicted. Though when he did, he tended to turn a large profit. In the more modern world, however, one can turn to the very many trading apps available on your phone to purchase options.

A secondary example would be the purchase of Tesla call options:

What terminology is necessary?

The term ‘on the money’ as indicated by options in blue are ones whose strike price is less than the actual price of the share, indicating an instant profit. However, if one were to purchase that option now, the compensation you would have to put up would offset the potential profit to be made. The options in white are called ‘out of the money’ as the strike price is greater than the actual price of the share at the current time. It is worth noting that these options also have a limited life by which they must be exercised, or they become worthless. As indicated by the top line, these options expire on the 19^th of February 2021. The ‘last price’ shows what price a person last paid for an option of sorts: looking at the option at the bottom of the list, the last price paid was $14.75 which implies that the market has said that the risk that Tesla shares hit $830+ by the 19^th is worth assuming for that price to a dealer. The ‘bid’ price is the amount a person has offered to purchase a call option with a strike price of $830 which at that time was $14.50. The ‘ask’ is the price to purchase a call option here ‘$15.00’ and open interest refers to how many contracts have not yet been settled.

Tesla put options:

A put option, as referenced earlier, is a contract allowing the option to sell an underlying at a predetermined price. This allows investors who hold risky positions to insure themselves against any serious losses over the short to medium term. For example, if I bought a put option with a strike price of $795 (to insure my single Tesla share I bought earlier at $750) which is currently ‘out of the money’ I would pay the ‘ask’ price, currently $12.65. If I then wait some time and I find that by the 18^th Tesla is trading at $409, my option will become ‘in the money’ and turn blue. I would then immediately exercise my option to protect against my losses. As a result of exercising my option I would still maintain a profit of $795 – $750 – $12.65 = $32.35 instead of a loss of $341. 

The purchase of options is an excellent way to insure against losses or to make money on risky shares that might go either way. It is for this reason it is said that these markets tend to smoothen out a lot of inefficiencies – as efficient markets require all risks to be traded. These markets also minimise exposure of investors who might buy options as a result of being daunted by buying Tesla outright in hopes their value increasing. Thus, it must be said that the market for options is a force for good as they generally encourage the less fervent of investors to give it a go.

Should charities be selective about who they accept donations from? (arguments against)

NB: Though there are many reasons for a charity to reject donations from various organisations, such as conflict of interest, reputation of donors, the proceeds of Crime act, the Bribery act and moral and reputation related contradictions, however this article seeks to outline how it may not be as simple as one might suppose.

Charities should not be selective about who they take money from as restricting donations will impact those on the receiving end. It may be the case that donors assumed wealth through less moral methods, yet the act of background checking will inevitably disincentivise the provision of funds. In addition, the money diverted away from charitable organisations may be used for other less ethically sound purposes: such as digging oil out of the ground or serve no purpose at all, assuming interest and providing no further good for people in need.

A charity is formally defined as ‘an organization set up to provide help and raise money for those in need.’ This definition accentuates a balancing good in the world, in which much is reaped but little is returned. Primarily, decreased ease with which charity can be yielded as a result of greater regulation will cause a rise in inertia, especially in the setting up of new non-profits or charities, since entrepreneurs will be discouraged from taking a risk.

A good example would be where a person might catch on to the problem of a lack of ventilators at the hospital. This person may seek to accommodate that need by seeking charitable donations such that he can coordinate the purchase and donation of a dozen ventilators to the hospital. He finds that an oil company (X) where his brother works would be willing to cover half of the necessary funds and provide substantial publicity by sending out a communication with the donation link to half the company. However, new regulation, affecting who the hospital can take donations from, dictates that sums of money from the oil and gas industry will be rejected if offered. This development may lay detriment to his plans to help cover the hospital’s need for ventilators and he might abandon his plans. A few weeks later a demand shock may occur where there are six more patients who are in critical need of a ventilator than capacity. This will lead to choices having to be made about who is in the greatest need and it may be the case that out of the six left off ventilators, two may die of preventable causes. This would implicate those who enforced selective donations with a role in these people’s death.

On the other hand, if the motivation for blocking certain donations was ‘dirty money,’ and that certain charities might not want to be associated with criminal organisations or ones that pollute the environment, then corporations or groups motivated enough to donate may launder money into charities through reputable individuals or subsidiaries. This avoidance defeats the purpose of a moral obligation to block monies from certain places as it is certain that it will end up in purse of the charity nonetheless. Moreover, the use of donated funds and resources in an attempt to uncover dirty money being given would be a wasteful and would lead to a smaller proportion of the money ending up where it is needed.

Book Club #2: Crisis Economics

This week, we are reviewing the critically-acclaimed ’Crisis Economics’, by Nouriel Roubini

In 2006, Nouriel Roubini, a professor at the Stern School of Business, notably announced to his fellow IMF economists that the United States would face a catastrophic bust in the housing bubble and a crash in mortgage-backed security prices, ultimately resulting in the collapse of several major investment banks and a deep and ensuing recession.

Stephen Mihm, co-author and professor of history at the University of Georgia, jocularly reported that most listeners seemed “skeptical” following Roubini’s speech. After all, many observers still maintain that the financial crash was an unforeseeable “black swan” event, and that policymakers cannot have possibly been aware of it.

Nouriel Roubini, however, would beg to disagree.

Crisis Economics hinges on the argument that economic crises such as these are part and parcel of Western capitalism. Crises start with the emergence of a new technology, before being buffeted by financial deregulation, irrational “this time is different” euphoria, finally leading to the eventual crash. The dot-com bubble of the ’90s is a perfect example of this. In 2008, however, the bubble was fuelled by a financial innovation: the mortgage-backed security, which only resulted in the lining of traders’ pockets. This naturally had adverse consequences.

The book delves into a wide range of problems, from moral hazard to central banks, while aptly using economic history to uncover striking parallels between 2008 and past crises. It argues for a shift away from neoclassical free-market ideologies into a Keynesian era of government-regulated capitalist economies. The limitless wonders of the financial system must be controlled, or we risk another crisis of startling proportions.

A Year in Oil #1

Negative Prices:

The shock of the COVID-19 pandemic vaporised demand for oil dramatically, which led to negative prices for the first time in history on the 20^th of April. The reason for this primarily stemmed from producers of the commodity paying exorbitant fees to store their oil in tankers, as they could not shift their surplus supply. The benchmark price of a barrel of US oil (usually determined by the West Texas Intermediate) tumbled as far down as -$37.63 which was indicative of a market shattered by a ‘mammoth’ demand shock*. Despite the fact prices did crawl back up over the next few days, the sudden fall demonstrates the inherent reliance of oil producers on constant demand and an apparent lack of contingency plans on the instance of a worldwide disaster.

Enormous losses:

More recently however, as of Tuesday the 2^nd of February 2021, many of the largest Oil producers on the globe have published documents detailing their annual losses. From here in the UK with BP to across the pond in the US with ExxonMobil, the virus has wrought destruction on earnings across the Oil sector. BP reported a historic loss of $5.7Bn down from almost $10Bn in profits the year before. With a crumbling international travel sector, ExxonMobil dwarfed BP’s $5.7Bn as it bled to the tune of $20Bn. Such figures stem from unprecedented cuts in capital spending**, large cuts in dividends, many billions borrowed as well as huge job losses as companies shed liabilities to survive. In spite of a recent rally in prices, the following year may bear great fruits or more uncertainty for the oil sector. As the world begins to emerge from the pandemic from the onset of substantial mass vaccination, we may see reductions in travel restrictions and a restored aviation industry which will reinvigorate an industry shattered by an unforeseeable storm.

*A demand shock refers to a sudden increase or decrease (here decrease) in the demand for a good or service.

**Capital spending is the use of funds to obtain or upgrade physical assets (investment in the discovery of oil in this case)

“Shorting” Explained

Particularly poignant with the recent climate in the market is short selling, with $GME up to temporary high of 1500% in the recent year over a reddit-run anti hedge fund coup. But in order to understand what occurred we must peer into the act of short selling. Short selling is the process of selling an asset on the market which you do not own, hoping that its value may fall such that you can close your position (buy back your shares and return them) at a profit.

To take two examples: The first in which I borrow 500 Tesla shares from my broker and sell them at $793.53 each (market price at close on 29/1/2020) which means I now have (793.53 x 500 = $396,765) in my account and a contractual agreement to return them. Say the shares fall in value to $554.55 due to lower quarterly earnings than expected, I can now buy back the shares for (554.55 x 500 = $277,275) and return them, fulfilling my obligation. Hence my profit can be seen as $396,765 – $277,275 = $119,490.

Though in the second case I borrow the same number of shares at the same time and sell at the same price as before, leaving me with $396,765 and an obligation to return them. Although in this case the price of a tesla share rises by a factor of 5, due to a very significant breakthrough in battery technology. Here I repurchase my shares at (3977.65 x 500 = $1,988,825) Therefore upon returning them I now made a loss of (396,765 – 1,988,825 = (-) $1,592,060) which very well might bankrupt me. 

However, issues tend to arise with short selling regarding both the morality behind it and the enormous amount of risk associated with it. This is because assuming a short position may go sour as share prices can (theoretically) rise with no roof such that your losses can be potentially infinite. Referring to the opening line, the second example is very similar to what happened with GameStop and hedge funds opening short positions in the hope it may fall. Though in the case of hedge funds they lost almost $19.04 Billion as of Friday’s close.

Book Club #1: 23 Things They Don’t Tell You About Capitalism

The first article in a brand-new book club column! This week, we are reviewing ’23 Things They Don’t Tell You about Capitalism’, by Ha-Joon Chang

Ha-Joon Chang vocally critiques the prevailing theory of free-market capitalism in his thought-provoking yet delightfully-entertaining book. First published during the aftermath of the 2008 financial crisis, 23 Things They Don’t Tell You About Capitalism is a point-by-point negation of neo-liberal capitalism, seeking to highlight the major flaws in the currently-accepted Chicago school of economic thinking.

In each of his 23 chapters (or ‘things’ as he jocularly names them), Chang first recognises a common conception (or misconception) in the established neo-liberalist version of capitalism, before setting out to critically re-assess these ideas with a flurry of well-procured evidence and thoughtful analysis, casting in doubt many of the economic “truths” that readers and policymakers have been led to accept.

“Chang has masterfully collated a litany of criticisms for neo-liberal capitalism, offering food for thought at a time where the divisions in our society have never been greater.”

ROHAN

After his 23-point rebuttal of the widely-accepted Chicago school of economic thinking, Chang then offers his views on rebuilding the world economy. Amongst other “things”, he argues that there should be more regulations and restrictions in a world shaken by the subprime mortgage crisis, where governments have greater sway over economies. He asserts that there should be a move away from the simplistic and cruel “homo economicus”; self-interest is not the most powerful incentive to work.

23 Things They Don’t Tell You About Capitalism is an equally enlightening and enjoyable read that is riddled with assertions that refute the core principles of the A-Level Economics syllabus today. From bold claims that “the washing machine has changed the world more than the internet has” to more careful and nuanced observations like the “equality of opportunity may not be fair”, the book is well-argued throughout. Chang has masterfully collated a litany of criticisms for neo-liberal capitalism, offering food for thought at a time where the divisions in our society have never been greater. 

Common Crimes in Finance #1 – Tunneling

Tunneling, in its simplest terms, can be described as the expropriation by minority shareholders, board members, and officers of assets for personal gain as if by an underground tunnel.

The practice of tunneling, being a covert crime, is easier to carry out in some countries over others. The ability to tunnel is based upon whether a country follows a civil law or common law system. Common law, as in the United States, is where legislators are able to enact laws alongside the courts, whose judgements may also serve as laws. Civil law, as seen in parts of Europe, is entirely legislative – where a parliament or a congress of sorts makes laws with no consideration of precedent by the courts. This can be applied to tunneling, as judgements made by the courts can become far more tailored to specific situations, such that a more just conclusion can be reached as opposed to rulings which are based purely on general legislation. This is because tunneling tends to be disguised through arduous transactions and long processes to cover trails.

How can this be achieved?

This sort of crime can take the following shapes: Asset sales, contracts to friends, excessive compensation to leading members, loan guarantees, expropriation of corporate opportunities and insider trading. To begin, one could easily sell assets to a friend or family member for below market price (perhaps even as low as 25% of market price) who would then compensate you personally for the favour. This way the shareholders are indirectly having their money taken such that it may be put in your pocket. The next is contracts, where you as a member of the board could massively overpay for a service at 4x market value from a company which is owned by a relation of yours. He may, as a result, return the favour with a particularly generous Christmas gift. The way you can make this ‘slip under the radar’ of the shareholders is by publishing an extremely long contract (2500 pages+) which nobody would be willing to read.

Excessive compensation of leading members would be making your brother CEO and marketing him as a ‘financial wizard’ who is deserving of $200,000,000 a year. Your brother might also pay your mortgage off as an early birthday present with his newfound wealth. Loan guarantees would be guaranteeing a risky loan to another corporation who you know will default. This guaranteed loan might be tunneled out using another method listed above or below. You may also, as head of your corporation, write off his loan such that paying it back would be unnecessary. Expropriation of corporate opportunities would be detailing a brand-new technology which your company has been developing to a friend. This friend may go off and start his own corporation so that they might profit from the untapped market. Finally, insider trading: this is increasing your share of the company before the announcement of good news and reducing your share before the announcement of bad news, allowing you to profit from the insider information.

Will the COVID-19 pandemic be inflationary or disinflationary?

As any adequate A-Level Economics textbook will no doubt inform you, inflation is the general increase in the price of goods and services. This broad price rise devalues wages and savings, ceteris paribus, and erodes the purchasing power of a currency. Of course, modest inflation rates are not to be worried about; indeed, steadily-low inflation rates have been largely baked into the fabric of Western economies since the 1990s. However, one only needs to peer at the chronic hyperinflation of the Weimar Republic in the 1920s, to understand the dire consequences of unchecked inflation.

Topically, the COVID-19 pandemic has wrought havoc in major economies worldwide for the last year; however, it is clear that there is light at the end of the tunnel. The rise of vaccinated economies will induce a boom in consumption (as evidenced by the brief relaxation of lockdown rules last summer). 

This, however, naturally begs the question: since high consumption consequently leads to higher inflation, will the post-pandemic era be shaped by inflationary, or deflationary pressures? This article will be the first of a two-part series that will critically assess the likelihood of a return to the dizzying heights of 1980s inflation, drawing upon past evidence, expert economists, and established (and unconventional) economic theory.

---

Let’s start with the obvious. The COVID-19 pandemic has demonstratively disrupted supply chains, with many firms closed and other firms cautious and not yet at full capacity. Equally, the advent of vaccinated economies will be marked by a short-term spike in demand, which will naturally cause inflation to skyrocket. Supply bottlenecks, where supply has fallen behind demand, have already caused significant price rises: the price of iron ore has risen more than 60% since the start of last year. Simple monetarist principles demonstrate that curtailed output, coupled with fast monetary growth, will cause inflation to rise.

Monetarism asserts that inflation is fundamentally tied to a greater quantity of money. Nearly a fifth of the dollars currently in existence were printed last year alone, following the Fed’s policy of quantitative easing. It concurs, therefore, that there will be inflation.

However, the same logic was applied ten years ago in 2008. Many economists were quick to point out that the rampant quantitative easing back then would provoke the return of inflation. Yet, this did not come to fruition – inflation has still remained low since then.

There is a marked difference between 2008 and today, however. Back then and today, the levels of “base money”— the quantity of physical cash and electronic reserves under central-bank control—have indeed increased. However, “broad money”, which include households’ bank balances, have also markedly increased today; the private sector has been propped up by lending as firms have regularly borrowed cash to upkeep their operations. This is the subtle difference that economists point out: in 2008, QE caused a surge in the quantity of money, but most of this remained within banks as excess reserves, which will not significantly influence inflation. Today, the private sector, flush with cash, will embark on a spending spree, which will lend itself to high inflation.

There is also an argument that governments and central banks may become more tolerant of inflation; in fact, the government may even welcome it, due to the unprecedented levels of national debt caused by the massive fiscal outlay of yesteryear. A sense of complacency may have also set in, following the largely “safe” quantitative easing policies of 2008. Whilst the independence of most central banks is protected by law, there are signs that central banks are willing to allow for greater amounts of inflation to allow for necessary fiscal stimulus. The Fed has allowed the 2% inflation target to be exceeded, which implies their willingness to keep borrowing costs low in a bid to combat the virus. This is necessary, of course, but it may have dangerous inflationary repercussions for the future.