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Change and Information Technology. 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 information.

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Change and Information Technology

  • 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 information


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Comparison with 1970

  • In 1970, there were no organized options markets

  • No financial futures markets

  • No swaps

  • No strips

  • No electronic trading

  • Transactions costs precluded much trading


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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


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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


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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


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Invention Theme

  • Invention is important in institutions for risk management

  • Ideas, once developed, are then copied around the world

  • 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


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Long-Term Risks

  • For most people, labor income dominates

  • Labor income undiversified, unhedged

  • Gradualness of changes, absence of market- revealing prices of present values, obscures risks


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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 contracts.

  • E. g., Fixed income securities in US amount to over $7 trillion

  • Fixed-income pensions still important in US today


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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


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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


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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


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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.


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Language Categories

  • Named concepts receive special attention

  • Recession, bear market, stock price index

  • Units of measurement


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Loss Aversion – Kahneman Tversky

  • People very sensitive to small losses, kink in value function

  • Hence framing a financial product so that potential for loss is not perceived enhances desireability


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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


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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, co-insurance, actuarial tables, public regulation, capital adequacy standards, etc.


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Changes in Patent Law

  • For most of last century, US Patent office rejected patents for business methods

  • Patentable inventions had to have a physical component

  • 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


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19th Century Advances in Information Technology

  • Paper machine, hence cheap paper

  • Carbon paper

  • Typewriter

  • Standardized forms

  • Vertical filing cabinets

  • Bureaucratic management techniques


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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


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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


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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


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Withholding of Income Taxes

  • Important human engineering element of income tax system

  • Endowment effect Thaler

  • Fairness issues

  • Underground economy flourishes where withholding is impossible.


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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


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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 Century,

  • 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.


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Moss’ Theory why Limited Liability Corporations were so Successful

  • 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).


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Inflation Indexed Debt Successful

  • 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 debt


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Barriers to Inflation-Indexed Debt Successful

  • Strong tradition of nominal framing of contracts, so that nominal contracts stand alongside indexed ones

  • 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


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Real Estate Risk Management Devices Successful

  • Value of homes is a major source of risk


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Macro Markets Successful

  • 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 long-term claims on incomes, reframing attentions toward long-term values


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Conclusion Successful

  • Advancing information and other technology will create vast changes in financial markets in next twenty years

  • Many opportunities for innovation


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