Wednesday, December 15, 2010

Excessive whining about uncertainty

This article is one of many that complains about the inhibiting effect of uncertainty on business investment and other good things. Business people are supposed to be used to the idea of taking risks. The biggest risk they take is the decision to start a business at all, given the number that fail. For small risks, like variations in tax rates, it would seem that expected-utility theory is the way to go. You judge the probabilities, multiply them by the outcomes of various options, and pick the option with the highest weighted sum. They used to teach this in business schools. It is simple enough to teach in high school. A business that thought this way would, statistically, come out ahead of its competitors.

But a second problem is that people (i.e., those in business, overreact to salient risks and ignore the huge risks that are off screen. Compared to those huge risks, uncertainty about taxes is almost trivial. I'm reminded of a story about someone who presented a precise economic prediction of the price of oil over the next few years. One of the listeners asked, "Er. What about war in the middle east?"

A final comment. Some of this is not about risk so much as ambiguity, the psychological state of feeling that you are lacking crucial information. This is, as I have argued, something of an illusion, as we are always lacking crucial information whenever we cannot predict an outcome with certainty. We over-react when certain missing information, like what Congress will do with taxes, is called to our attention.

Monday, December 13, 2010

Action, omission, and the health-care law

Judge Henry E. Hudson has just said that the insurance mandate of the new health-care law is unconstitutional. The center of the opinion, as I understand it, is that the constitutional power to regulate interstate commerce extends to economic "activities" but not to omissions of economic actions, such as not purchasing health insurance. It seems that Hudson's reasoning on this is empirical, namely, that prior court decisions on the scope of the commerce power have all concerned actions. Because no case has concerned an omission, then it must be that the power does not extend to omissions. Apparently - and I stand to be corrected if wrong - no prior court decision has explicitly said that omissions don't count. (Apparently the most relevant part is around pp. 20-21 of the opinion, which is available in the NY Times web page.)

A simple alternative explanation of the empirical facts is that most economically significant activities are actions, so an omission has never come up before. The judge here seems to be making his own distinction out of what seems to me to be thin air. (Again, I stand to be corrected if wrong.)

The decision seems to attest to the psychological salience of the act/omission distinction. As the lawyer for the health-care bill pointed out, the application of that distinction is in any case unclear, especially in this case. (Jonathan Bennett, in "The act itself", might be seen as saying that is unclear more generally.)

Tuesday, December 7, 2010

Hindsight bias and Obama's "capitulation"

Paul Krugman and many other Democrats are saying that President Obama and the Democrats made a mistake by putting off until now the question of what to do about the Bush tax cuts. Clearly - as David Leohhardt, Nate Silver, and others have argued - the Democrats are not in a strong bargaining position now that the Republicans have threatened utter chaos (hold up all the other legislation, kill all extensions of all tax cuts, etc.) unless the Democrats extend the unproductive and unfair tax cuts for the rich.

But the wisdom of hindsight is wonderful. Where were the pundits saying "Now is the time to bring up the extension of the tax cuts"? And, looking back over the last two very difficult years, even now, can someone point to a specific time when the Democrats could have done this? My hunch is that there were always more important things.

So long as one of the two major parties is willing to sacrifice the well-being of the nation and the world for its misguided ideology, we have a problem that is not easy to solve. In this respect, the U.S. is much like Israel, where the equivalents of the Republicans are in control.

Added later: Seems I'm wrong. Here is what should have been done, in hindsight. But the congress had to do it, not the president.