Thursday, April 22, 2010

Temporal Arbitrage

My first reaction to reading this article was, "This guy is an idiot.  I have no sympathy for him.  Anyone who buys a Jacuzzi should be cut off from all taxpayer-funded charity, forever."

He had lost his $75,000-a-year job as a mortgage consultant, his three-bedroom house with a Jacuzzi, his Lexus sedan. He could no longer pay even the rent on his cramped studio apartment — not on his $10-an-hour part-time job as a fry cook at a fast food restaurant.

Faced with eviction, he was staring last month at the imminent prospect of joining the teeming ranks of the homeless. His last hope was a new $1.5 billion federal program aimed at preventing that fate.

Days after Mr. Moore applied, a check for $775 was on its way to his landlord, enabling him to stay — at least for now.

But the fact that he is a fool does not change the fact that he is human, and he is in trouble.  He also has two kids, and $775 is a very small price to pay for preventing two children from growing up with a homeless dad.  Then there is the fact that he has paid far more than $775 in taxes over the course of his life.  He might as well get some return for that.

There is no evidence that this guy would have saved any more of his money if he was taxed less.  He probably would have wasted it on an even bigger house or an even more expensive car.  A government that took about $50,000 in taxes away from him when he was earning a lot of money and gives him less than a thousand dollars when he is broke has improved his life.  This is the 'temporal arbitrage' of the title.  By moving money from one time period of his life to another, the government has helped this man.

Of course, any bank or insurance company would have given him a much, much better return on his money.  Even if he put it in the stock market and it lost half its value, he would have been better off.  He would have $25,000 instead of $775.  If the government cut taxes, made a credible commitment to end this kind of welfare, and convinced people of the need to save more in the marketplace, then everyone would be better off.

But they cannot make that kind of commitment when people have grown to expect that the government will bail them out.  We, as a society, have basically promised to protect people and give them aid, even when their predicament is the result of their own foolishness.  This man acted exactly like the big investment banks.  He spent all of his money, did nothing to prepare for a catastrophe, and then gets a government handout when things go bad.  And now that the government has demonstrated a pattern of bailing out people, there is a much smaller incentive to take care of yourself.  You might as well spend your money and enjoy the good times.  

This is because, with handouts and without a strong sense of honor, the marginal value of saving approaches zero.   If this guy had saved money, and was forced to take care of himself, he would probably still have to move into a small apartment when he lost his job.  His life would be just as messed up, and the government would give him nothing.

Saving money and properly planning for the future is costly, and it is not just a money cost.  Information is expensive.  Computation is expensive.  Planning for various contingencies requires both.  It would be very difficult and costly for an average person to attain my level of financial skill, or to hire a trustworthy person who is as good at managing money as I am.

So, given low benefits, high costs, and a low probability of it ever becoming relevant, a rational actor will put almost zero thought and money into planning for the future, and trust that the government will do it for him.

The problem is that this dynamic constantly makes people more likely to need government, which means more taxes and a bigger government.  This leads to a weaker economy, causing a vicious spiral.

The fundamental cause of the financial crisis was individuals and institutions failing to do contingency planning.  They extrapolated recent trends into the infinite future.  This guy thought a few years of high mortgage commissions would last forever.  Banks basically thought the exact same thing.  People spent all of their money and more, and when the income dried up they had no reserve.  If people continue to act like this, then more crises are inevitable.  Any system without spare capacity is very fragile.

The only way to end these crises is to develop a culture of caution and thrift.  Economists do not think about culture much, but it can be seen as information.  It may take a lot of trial and error and thinking to figure out how much to save and how to do it, but once one person figures it out it is easy to follow that example.  Cultural norms often contain a lot of wisdom.  And while people are very bad at calculating things, they have an instinct to obey cultural norms.  If everyone is expected to save a lot of money, then this guy would have.

I have enough money in savings to support my lifestyle for at least six years, even if my earnings were zero for that entire time.  I would guess that my parents, who both have very safe and steady jobs, could say the same thing.  More people, and institutions, need to act like this.

But it probably will not happen.  The cultural norms of industry, frugality, and thrift only evolved because those who lacked these traits died off or failed to reproduce.  Such selection pressure will, hopefully, never be repeated.  We are destined for a future of codependency with a state that always grows more powerful and intrusive.


NotanEster said...

given that people in the early part of the century did seem to cultivate a culture of thrift (at least in the working classes), why do you think that failed to transmit to the next generations? Incidence of nuclear family over extended family living? Rise of nursing homes? Generational hubris?

NotanEster said...

the 20th century, I mean.

Alleged Wisdom said...

People seem to show a general tendency to revert to primitive behaviors in the absence of strong pressure to do anything else. One of these behaviors is short-term thinking. Another one is copying the behavior of whoever appears more successful right now. People who spent all their money on conspicuous consumption looked better off and gained social status, while those who saved money did not. By the time the benefits of saving were revealed, the bad habits were set.