New Directions for IPE: Drawing from Behavioral Economics

1. New Directions for IPE: Drawing from Behavioral Economics Deborah Elms IPES Conference November 2006

2. Equity Premium Puzzle • Why do people simultaneously hold stocks and bonds? • Puzzle: given low yield on bonds and standard risk calculations, no one should hold both • Unable to explain 6% difference in return • Puzzle holds from 1802-1990 • Even concerns over stock market crash insufficient to account for pattern

3. Solution: Myopic Loss Aversion • Two key elements for Thaler et. al. • Mental accounting • Loss aversion • Under mental accounting • Evaluate stocks and bonds separately • Viewed at various time intervals (esp. one year) • Loss aversion • Short-term losses in stocks felt keenly • Reinforced the more often reevaluation takes place

4. Reevaluate Ken Scheve’s IO Article • Do macroeconomic priorities of citizens differ across countries? • Answer—yes, especially with focus on inflation and unemployment • National-level variables account for most of difference • Inflation aversion and “acceptable” unemployment levels not stable across countries • No convergence on “ideal” policy

5. But Add in Myopic Loss Aversion • Should prefer greater unemployment and less inflation under high inflation • If myopic loss aversion happening, key issue is not “what is current level of inflation?” but “is level of inflation rapidly rising or falling?” • If inflation is high but unchanged, less public demand for broad policy changes • The more often public gets information about levels, more volatile reactions become • Election season critical

6. Historical Experience Matters • History important in setting baseline expectations of public over inflation/unemployment • More information leads to more reevaluation of status quo and changes from status quo • Under loss, accept more risk • Optimal policy response impossible to achieve across multiple states • Design of monetary institutions will vary across states

7. Review of Paper • Why has IPE not incorporated insights of behavioral economics? • Normative role of baseline expectations, methodological concerns, and lack of knowledge • Role of losses • Why do regulators opt for harmonization? • Twin shocks drive perception of losses • Fairness • What drives state behavior in GATT/WTO negotiations? • Law, power and fairness considerations