Slide 1Change and Information TechnologyComparison with 1970Basic Themes of this lectureRisk ThemeFraming ThemeInvention ThemeLong-Term RisksInflation is an Important Long Term RiskTax and Welfare System’s Importance in Risk ManagementFraming and the History of TaxesFraming and the History of Taxes, ContinuedFrames versus BeliefsLanguage CategoriesLoss Aversion – Kahneman TverskyThe Importance of Invention in Economic HistoryInsurance as an InventionChanges in Patent Law19th Century Advances in Information TechnologyFirst US Income TaxFailure of First US Income TaxBureaucratic Difficulties 1860sWithholding of Income TaxesTracking StocksThe CorporationMoss’ Theory why Limited Liability Corporations were so SuccessfulInflation Indexed DebtBarriers to Inflation-Indexed DebtReal Estate Risk Management DevicesMacro MarketsConclusionChange 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 informationComparison 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 tradingBasic 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 futureRisk 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 systemFraming 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 mattersInvention 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 inventionLong-Term Risks•For most people, labor income dominates• Labor income undiversified, unhedged•Gradualness of changes, absence of market- revealing prices of present values, obscures risksInflation 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 todayTax 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 managementFraming 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 gainsFraming 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, 2000Frames 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.Language Categories•Named concepts receive special attention•Recession, bear market, stock price index•Units of measurementLoss 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 desireabilityThe 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 inventionsInsurance 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.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 patents19th Century Advances in Information Technology•Paper machine, hence cheap paper•Carbon paper•Typewriter•Standardized forms•Vertical filing cabinets•Bureaucratic management techniquesFirst 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 effortFailure of First US Income