Tag: unemployment

Discrete Actions and Inverted Incentives

I remember, about a year or so back, the US weekly non-farm payroll data had shown an uptick in unemployment. Intuitively, a higher unemployment rate indicates lower economic activity, since (among other things) the average purchasing power goes down and fewer things are getting produced (since fewer people are at work). So you would expect the stock market to react to this by going down.

The exact opposite happened. The higher unemployment was greeted with a big rise in the S&P 500. I remember tweeting about it but can’t find it now. But I can find some research someone has done about this:

But here’s the kicker: the S&P500 is inversely related to the unemployment rate, and thus the market actually goes up as a response to a release of a higher than expected unemployment rate. This may seem illogical conceptually, but historical analysis and statistics show that it is true.

In the last 3 years, the unemployment rate in the United States has been surprisingly higher than expected 11 times. The result? The S&P500 went up 80% of those times within a time-frame of 90 minutes (see Fig. 2, click to enlarge the image).

The basic issue (as I see it) is that higher unemployment means lesser likelihood that the US Federal Reserve will raise interest rates. Which means lower rates for the longer foreseeable future, which translates to higher stock prices.

The kicker here is the “discrete action” on part of the Fed. Because their decision (on whether to hike rates or not) is binary, news that decreases their odds of hiking rates, even if it (the news) is bad for the market, leads the market to go up.

You can see this in action elsewhere as well. Let’s say you are the number two at a manufacturing plant, and you are not happy with the way things have been run. However, you know that with the current level of production, the company management will not bother – they only see the numbers and see that the plant is being run well, and they won’t listen to you.

However, if the production drops below a certain level, the management is certain to review the operations, at which point you will be able to make your point to them and be heard, and you will be able to hopefully better influence how the plant is run.

Normally, your incentive is in keeping production as high as possible. But now, with this discrete action (management’s review of your operations) in the picture, your incentives get reversed. It suddenly becomes rational for you to not work so hard to increase production, since lower production means higher chance of a management review.

The problem with a lot of standard economics teaching is that it abstracts away the messiness of real world “step functions” and instead uses a deceptively simple continuously increasing or decreasing demand and supply curves. And so we are conditioned to think that incentives are linear as well.

However, given the step functions inherent in everyday business (which are only made worse (steps become steeper) with discrete actions), the incentives are not linear at all, and there are points in the curve where incentives are actually inverted! And this is everywhere.

I’m writing this on a lazy Sunday morning, having postponed this for over a week, so no enthu da to make pictures and explain my point. However, I guess I’ve explained sufficiently for you to catch my pOint.

Actually – since I have an iPad with a pencil, I did make a simple sketch. Limited by my drawing (and mentally adding curves) skillsBasically normal incentives is like the red line, but the discrete action (modelled here like a negative sigmoid) means that there is a region where the overall payoff is massively downward sloping. Which means your incentives are inverted.

Anxiety and computer viruses

I think, and hope, that I’ve been cured of anxiety, which I was probably suffering from for over six years. It was a case of Murphy’s Law taken to its extreme. If anything can go wrong, it will, states the law, and in those six or seven years, I would subconsciously search for things that could possibly go wrong, and then worry about them. And worry about them so much that I would get paranoid.

Let me give you an example. Back in 2008, after a four-month spell of unemployment, I had signed up with a startup. Two days after I signed, which was three weeks before I was going to start work, I started worrying about the health of the startup founder, and what would happen to my career in case he happened to croak between then and my joining the company! It had been a major effort on my part to try and get back to finance, and that job was extremely important to me from a career signaling standpoint (it played a major role in my joining Goldman Sachs, subsequently, I think). So I started getting worried that if for some reason the founder died before I joined, that signaling wouldn’t happen! I worried about it for three days and broke my head about it, until sanity reigned.

This wasn’t a one-off. I would take ages to reply to emails because I would be paranoid that I had said something inappropriate. When I landed in Venice on vacation last year, my office blackberry didn’t get connected for an hour or so, and I thought that was because they had fired me while I was on vacation. It would be similar when I would look at my blackberry first thing in the morning after I woke up, and found no mails. I needed no real reason to worry about something. It was crazy.

When a virus attacks your computer, one of the ways in which it slows down the computer is by running “background processes”. These processes run in the background, independent of what you intend to do, but nevertheless take up so much of your computing power that it becomes extremely hard to function. Anxiety works pretty much the same way. Because there is always so much going on in your mind (most of it unintended, of course), a lot of your brain’s “computing power” is taken up in processing those unwanted thoughts (the brain, unfortunately, has no way of figuring out that those thoughts are unintended). And that leaves you with so much lesser mindspace to do what you want to do.

So you stop functioning. You stop being able to do as much as you were able to. Initially you don’t recognize this, until you bite of more than you could possibly chew a number of times in succession. And then, having failed to deliver on so many occasions, you lose confidence. And lesser confidence means more worry. Which means more background process. And means diminished mental ability. Things can spiral out of hand way too quickly.

I’ve been on anxiety medication for over seven months now, and the only times when I realize how bad things were are when I happen to miss a dose or two, and there is relapse. And having been through it, trust me, it is quite bad.

On the positive side, the impact a well-guided medication process (administered by an expert psychiatrist) can have on anxiety is also tremendous. For the six years I suffered, I had no clue that I was under a cloud of a clinically treatable condition. I didn’t know that it was only a virus that had attacked my CPU, which could be got rid off with sustained dosage of anti-virus, and I had instead thought my CPU itself was slowing down, maybe rusting (at the ripe old age of late twenties). After I started responding to my medication, I was delirious with happiness, with the realization that I hadn’t become dumb, after all.

It was sometime in March or April, I think, when I realized that my medication had come into effect, thus freeing up so much mind space, and I started feeling smart again. When I met the psychiatrist next, I told her, “I feel exactly the way I felt back in 2005 once again!”.

The fundamental problem with the world economy

… is that wages are sticky.

With increased globalization, it has become significantly cheaper to produce certain goods and services in countries that were hitherto “low income” or “less developed’ or whatever you call it. In the past, in part due to protectionism at various levels and in part due to high transaction costs (transport, communication, etc.) “developed economies” such as the US or Europe had got adjusted to a reasonably high wage structure. In fact, it is possible that in the absence of trade with the rest of the world these countries might still be able to support that structure.

However, with the walls of protectionism and transaction costs falling, these traditionally high wage economies haven’t been able to compete with the up and coming economies where production costs are significantly lower. And because wages are sticky, i.e. it is impossibly hard to cut wages across the board, this has resulted in unemployment. Worse, a lot of other benefits (such as Social Security or Medicare in the US) have been set based on the high wage structure these countries used to enjoy.

And then you have unions, which makes it even tougher for you to cut wages which might make you competitive. It’s a combination of sticky wages and unionism that the various austerity measures in Greece haven’t managed to go through (of course, Greece has another set of problems in terms of law enforcement and tax collection).

And so, in short

1. Wages are sticky. Even though your current wages are not competitive enough, you can’t cut wages

2. That leads to high unemployment

3. That leads to lower economic activity and thus depression

4. The government needs to spend more to “stimulate” the economy, but hasn’t collected enough in good times. And the “level” of the economic cycle itself has gone down now. And the government itself has other obligations linked to the high wage levels

And so it goes. One thing I can think of is “devaluation” (in these times of floating currency rates, that term has lost all meaning), but then now these countries import so much that will again not be a good idea.

Fun!

PS: please note that this post has been filed under “Arbit”