Sunday, October 30, 2011

Paul Krugman

The more I look at the amazing rise of the U.S. stock market, the more I become convinced that we are looking at a mammoth psychological problem. I don't mean mammoth as in "huge" (though maybe that too), but as in "elephant".
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If each country exports the goods in which it has comparative advantage, then all countries can in principle gain from trade. Once every country specializes in production of goods that has a comparative advantage in, and then trades its excess supply, world production increases. The extra production is the result of better allocation of resources. This extra production can be divided between the trading countries allowing them to achieve higher consumption levels.

4 comments:

  1. Labor Productivity and Comparative Advantage:
    The Ricardian Model

    The Concept of Comparative Advantage using a modern example

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  2. On Valentine’s Day the U.S. demand for roses is about 10 million.

    Growing roses in the U.S. in the winter is difficult: heated greenhouses should be used; the costs for energy, capital, and labor are substantial.

    Suppose that in U.S. 10 million roses can be produced with the same resources as 100 thousand computers. In Mexico 10 million roses can be produced with the same resources as 30 thousand computers. Of course, resources used in making 10 million roses in U.S are not necessarily equal to the resources employed to make that many roses in Mexico. In this example Mexico is relatively less productive in computer production compared to U.S.

    If each country exports the goods in which it has comparative advantage (i.e., lower opportunity costs), then all countries can in principle gain from trade.

    Once every country specializes in production of goods that has a comparative advantage in, and then trades its excess supply, world production increases.

    The extra production is the result of better allocation of resources.

    This extra production can be divided between the trading countries allowing them to achieve higher consumption levels.

    If it takes the same amount of resources to produce 10 million roses in both countries then we say US has absolute advantage in computer production because it can produce more computers with the same resources or it takes less resources to produce computers in US than in Mexico.

    If it takes fewer resources to produce 10 million roses or 30 thousand computers in US then we say US has absolute advantage in both goods.

    However comparative advantage does not depend on absolute advantage. In the example above US has comparative advantage in computer production regardless of the amount of resources it uses for computer production (regardless of whether the resources used to produce 10 million roses in US is larger the same or less than that in Mexico).

    Why relative productivities are different in the two countries? This could be because of technological differences in the two countries or the quality of the resources (or factors of production available) in the two countries (i.e., fertile land and suitable weather in Agriculture, capital and skilled labor).

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  3. THE ICE AGE COMETH

    The more I look at the amazing rise of the U.S. stock market, the more I become convinced that we are looking at a mammoth psychological problem. I don't mean mammoth as in "huge" (though maybe that too), but as in "elephant". Let me explain.


    If you follow trends in psychology, you know that Freud is out and Darwin is in. The basic idea of "evolutionary psych" is that our brains are exquisitely designed to help us cope with our environment - but unfortunately, the environment they are designed for is the one we evolved and lived in for the past two million years, not the alleged civilization we created just a couple of centuries ago. We are, all of us, hunter-gatherers lost in the big city. And therein, say the theorists, lie the roots of many of our bad habits. Our craving for sweets evolved in a world without ice-cream; our interest in gossip evolved in a world without tabloids; our emotional response to music evolved in a world without Celine Dion. And we have investment instincts designed for hunting mammoths, not capital gains.


    Imagine the situation back in what ev-psych types call the Ancestral Adaptive Environment. Suppose that two tribes - the Clan of the Cave Bear and its neighbor, the Clan of the Cave Bull - live in close proximity, but traditionally follow different hunting strategies. The Cave Bears tend to hunt rabbits - a safe strategy, since you can pretty sure of finding a rabbit every day, but one with a limited upside, since a rabbit is only a rabbit. The Cave Bulls, on the other hand, go after mammoths - risky, since you never know when or if you'll find one, but potentially very rewarding, since mammoths are, well, mammoth.


    Now suppose that it turns out that for the past year or two the Cave Bulls have been doing very well - making a killing practically every week. After this has gone on for a while, the natural instinct of the Cave Bears is to feel jealous, and to try to share in the good fortune by starting to act like Cave Bulls themselves. The reason this is a natural instinct, of course, is that in the ancestral environment it was entirely appropriate. The kinds of events that would produce a good run of mammoths - favorable weather producing a good crop of grass, migration patterns bringing large numbers of beasts into the district - tended to be persistent, so it was a good idea to emulate whatever strategy had worked in the recent past.


    But now transplant our tribes into the world of modern finance, and - at least according to finance theory - those instincts aren't appropriate at all. Efficient markets theory tells us that all the available information about a company is supposed to be already built into its current price, so that any future movement is inherently unpredictable - a random walk. In particular, the fact that people have made big capital gains in the past gives you absolutely no reason to think they will in the future. Rational investors, according to the theory, should treat bygones as bygones: if last year your neighbor made a lot of money in stocks while you unfortunately stayed in cash, that's no reason to get into stocks now. But suppose that, for whatever reason, the market goes up month after month; your MBA-honed intellect may say "Gosh, those P/Es look pretty unreasonable", but your prehistoric programming is shrieking "Me want mammoth meat!" - and those instincts are hard to deny.

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  4. And those instincts can be self-reinforcing, at least for a while. After all, whereas an increase in the number of people acting like Cave Bulls tended to mean fewer mammoths per hunter, an increase in the number of modern bulls tends to produce even bigger capital gains - as long as the run lasts. Any broker can tell you that in the last few months the market has been rising, despite mediocre earnings news, because of fresh purchases by ever more people distraught about having missed out on previous gains and desperate to get in on the action. Sooner or later the supply of such people will run out; then what?


    OK, OK, I know that this isn't supposed to happen. Sophisticated investors are supposed to take the long view, and arbitrage away these boom-bust cycles. And maybe, just maybe, the market is where it is because wise and far-seeing people have understood that the New Economy can produce growing profits forever, and that the rise of mutual funds has eliminated the need for old-fashioned risk premia. But my sense is that people who try to take a long view have been driven to the edge of extinction by the sheer scale of recent gains, and that the supposed explanations you now hear of why current prices make sense are rationalizations rather than serious theories.


    The whole situation gives me the chills. It could be that I just don't get it, that I'm a Neanderthal too thick-skulled to understand the new era. But if you ask me, I'd say that there's an Ice Age just over the horizon.

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