Economics #5: Monetary Policy

Ever since the panic of 2008, the federal reserve has been working overtime to patch up holes in the economy. There was QE1, ZIRP, QE2, Operation Twist, QE3, and most recently, an interest rate hike at the end of 2015. In his book The Only Game in Town, Mohamed El-Erian argues that these monetary policy band-aids have reached the limits of their efficacy. El-Erian believes that a pivot to real structural reform is long overdue.

But since the political will to enact real reform is in short supply, it looks like the federal reserve, and the monetary policy that it sets, will continue to be front and center on the world stage. This post will break down how monetary policy works.

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Natural Science #13: The Fermi Paradox

The universe is big. Really, really big. In our Galaxy alone, there are about 400 billion stars – 20 billion of which are similar to our own. Of those sun-like stars, about one-fifth have earth sized planets orbiting a habitable zone – not too far as to freeze, not too close as to burn. If only 0.1% of those planets developed life, there would be 1 million planets with life in our galaxy. And that’s just our galaxy.

This thought process was formalized and made famous by Frank Drake who proposed an equation to estimate the number of active, communicative extraterrestrial civilizations in the galaxy. Drake originally estimated the number of these advanced extraterrestrial civilization between 20 and 50 million.

So where is everyone? This was the question that Enrico Fermi posed in his famous paradox. If the universe is so large and old, and if it only took us 250 thousand years to develop radio communication and space flight, why then is there no evidence of intelligence elsewhere in the universe?

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History #16: The French Revolution

With the American revolution, we broke away from a monarchy and it worked out pretty well. Contrast that with the French revolution, where they weren’t just breaking away from a monarchy – they were overthrowing one. In the process, France experienced violence, bloodshed, war, and the rise of Napoleon. Though this might not have been the best result for France, the ideas of the French Revolution would spread through Europe and end up changing the world.

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Human Nature #17: Mental Accounting

Imagine you are saving up for a vacation and set aside a separate account for that goal. You might put money into that account every month and view it as untouchable until your trip. You might set aside a similar account for your retirement, a down-payment on a house, fun money, Christmas gifts, etc. Each bucket of money would have its own use and wouldn’t be interchangeable for another.

Imagine you just received your paycheck, your tax return, won a small lottery, and found $100 dollars on the floor in the same week. You might apply your paycheck towards your normal bills and savings, but the other windfalls might be treated differently. The value of the money is all the same, but how you use it might not be.

Richard Thaler first described this human tendency in his paper Toward a Positive Theory of Consumer Choice (1980). He described mental accounting as a process in which people code, categorize, and evaluate economic outcomes by grouping their assets into any number of non-interchangeable mental accounts. This can cause problems.

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Numeracy #17: Markov Chains

Suppose we want to predict the chance that it rains tomorrow using the variables available to us today. To make it simple, let’s say there are two variables that we are tracking: raining or sunny. If it is sunny today, the chance of it being sunny tomorrow are higher, and if it is raining today, the chance of it raining tomorrow are higher. This seems like a reasonable, though simplified, way to model reality. When tomorrow comes, we would just repeat the process.

Similarly, suppose we want to predict the next word that will be typed on a cell phone. We could look at every word that has ever been typed on that phone and find the most frequent one, or we could just look at the most recently typed word and see what word usually comes after it.

In both cases, we are using the most recent information available to us to predict the future and ignoring everything that came before. When the future comes, we transition and repeat the process. This way of modeling the world is known as a Markov Chain and it has some powerful applications.

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Economics #4: Economies of Scale

What are some industries are characterized by many small firms in fierce competition (retail, restaurants, etc) while some industries are characterized by a few large firms with market power (telecommunications, railroads, etc)?

What is it about the restaurant industry that allows competitors to open up a shop across the street. What is it about the telecommunications industry that often limits competition to one or two providers in a city.

That answer these questions we will start with the concept of economies of scale and then apply that to industrial organization.

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Human Nature #16: Hyperbolic Discounting

Imagine that we are given the choice between receiving $100 today or $200 tomorrow. The answer seems obvious, we should wait a day and get that extra $100. But now imagine that the choice is between receiving $100 today or $200 in a year. The answer seems less obvious. As the waiting time increases, the importance of that extra $100 decreases.

Statistically, when people are given the second option, they overwhelmingly choose $100 today. When those same people are asked again to choose between $100 in five years or $200 in six years, their preferences flip again, preferring to wait the extra year for the extra $100. They assume that they will be fine waiting in the future even though they aren’t fine waiting today. In reality, when year five rolls around, they will probably want the immediate payoff as much as they want it today.

These conflicting preferences tell us something about the inherent irrationality in how we deal with the future.

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