Why do we love to gamble?

It seems like every-time I turn on the TV today, I see the latest craze of bingo adverts, ‘bet-in play’ gambling and of course the persistent national lottery. ‘It could be you’ is accompanied by seeing the flash sports car that could be won at the casino, the giant teddy you’d love to win your other half at the fairground, the £100 grand prize on the fruit machine.

In 2010/11, the licensed UK gambling industry took in proceeds of £5.5bn, and that is only a small proportion of what Brits spend gross, as the figure doesn’t account for payouts¹. Why is gambling, where house odds imply negative expected value, so compelling?

The type of gambling concerned shares the trait of a small, almost certain loss in return for a very remote, very large gain.

The National Lottery is most readily observable example of this, viz; the probability of winning the jackpot on The National Lottery, that is by drawing 6 number, is a staggering 14million to 1². In theory that implies if you were to go to your local shop to do a line per week, on average you’d wait 270000 years before you complete the set(4)! Note also that the process is totally random and beyond the players control, unlike perhaps sports events or trading (if you call that gambling) where sleight of hand is able to beat house odds consistently³, meaning a player is bound by this as a rule. Yet every week, millions of players across the country line up in fruitful anticipation that it could be them.

The massive jackpots of the Euro-millions draw many to play; here the odds are an astonishing 116million-1

Why we are compelled by the small certain loss-large unlikely gain gambles

Debunking rational economic man: There are various propositions as to why someone would gamble despite, how house odds are arranged, the expected value financially is negative.

Prospect Theory and Pascal’s Wager

As opposed to taking on the risk of a large loss for a small, certain unlikely payment, the gambling industry has equilibrated the vice versa, with more people willing to play the latter than the former. This results even in the example of when house odds are arranged more favourably in the ‘insurance’ game. The prominent behavioural psychologists Kahneman and Tversky provide an explanation of loss aversion; in their research they discovered that if someone were to lose £10000, the emotional intensity of hurt is twice that of pleasure if that person were to gain £10000. This when translated into the chance of a large loss on the cards, is a risk too much for most to stomach.

This can work in conjunction with Pascal’s wager, which implies that the consequences of a decision are the defining factor when the probabilities are unknown(5). The consequence of failure when its a small, almost certain loss is relatively easy to handle when going after a large prize. The consequence of failure on the flip-side is scary.

Gamblers Fallacy 

Once someone has began, they may continue to lay down their bets in the wake of a series of losses in the belief their ‘luck will balance out’ and the likelihood of winning rises to erase out past ‘bad luck’. They play along with the gamblers fallacy, believing that Karma is in operation and the ‘universe balances out, where in reality the odds remain fixed. But if I were to flip a coin and it landed tails seven consecutive times, it would now appear certain that a head must finally come up as it is overdue. Really, it is still 50/50 as it always was. This explains the allure of the Martingale Strategy, that a win is guaranteed if one doubles up on their previous losses.

Implications of Prospect Theory

Illusion of Control

Experiments conducted by the Harvard psychologist Ellen Langer have confirmed the hypothesis that people are wired to feel that they have control over events which are completely defined by chance alone(6): For example, if a person was presented with a completely random sequence of numbers, they would nevertheless have a tendency to identify a pattern and attempt to predict the next sequence. This is known as the ‘illusion of control’ which is applied to lotteries and casino games such as roulette.

Contemplate this experiment: Two groups, one in positions of ‘high power’ and ordinary individuals were asked to predict the outcome of rolling two dice. When presented with the option of rolling the dice themselves or having someone else roll for them, 100% of the ‘high powered’ group elected to roll themselves, as compared to roughly 70% of the ordinary group(7).

Hubris

The opposite outcome of what may prompt Gamblers Fallacy is a series of wins which may prompt Hubris in the participant, encouraging more gambling. This is where the person overestimates their abilities as a result in games which are purely by chance (related to above) or some skill element involved:

Consider for instance in 1999, when the stock-market had climbed like a monkey on speed there was a remarkable increase in the number of people who had quit their jobs to become day-traders, especially in the US. With such confidence, some believed they had a special talent for stock picking due to their previous gains on internet companies, whereas the truth is if you had selected a monkey to pick stocks he wouldn’t have done any worse, as the conditions at the time meant it would be hard not to ‘perform’ well. Overestimation in their capabilities was a causal factor of greater gambles.

Peak End Experiences and Fading

A key final point; people remember peak experiences, such as a large win very vividly but forget experiences which are smaller in significance or negative in perception (the latter is called the Fading Effect). It is commonplace to have older people talk about these vivid peak wins in great esteem: For example how the legend of Red-Rum won them hundreds of pounds at the Grand National or how they were one of the few to predict Douglas beating Tyson. In contrast to pumped up endorphins on a large win, the small regular losses which chip away at ones account are often faded out of the memory. It is easy to see how someone arrives at the bookies with irrational optimism.

Why they keep us playing

Overall it is confirmed that cognitive biases are a driving force of the gambling  industry, we are wired to lotteries, casinos and bingo; games where a small likely loss is exchanged for an improbable large gain. Peak end experiences, fading bias and prospect theory are how the house sets the game so you want to keep on playing: Few experiences are too harmful to leave emotional wounds with the punter despite the magnification of loss as compared to gain, because they are consistent and small. Wins are peak end experiences which the punter remembers for years thereafter. If one keeps losing on a game, gamblers fallacy can keep him playing. If one wins, hubris and overconfidence can keep him playing. The illusion of control and prevailing superstitions persist regardless.

So say goodbye to rational economic man, as if the world were populated by such actors the gambling industry would cease to exist. Oh yeah, and it can be fun too. Many love a day at the races, and remember with affection their childhood trips to the arcades!

1. http://www.gamblingcommission.gov.uk/pdf/Industry%20statistics%20-%20April%202008%20to%20March%202011.pdf
2.  http://lottery.merseyworld.com/Info/Chances.html
3.  Unless one believes in the Efficient market Hypothesis
4.  By then, the National Lottery might not be around but surely something would have taken its place
5.  Assuming the average lottery player is unaware of the 14million-1 jackpot odds, in my view realistic
6.  Ellen J Langer, The Illusion of Control http://psycnet.apa.org/journals/psp/32/2/311/
7. http://www.sciencedaily.com/releases/2009/03/090303171451.htm

The Growing Opposition to Foreign Aid

Aid is universally measured as ‘Official Development Assistance’; the quantity of financial assistance, loans, grants and relief¹.

The paradigm of the 20^th century was foreign aid being the most efficient action available to the G20; international intervention serving as the enabler of development, free from external dependence (although this the more disputed). This thought has been a kingpin in every plan and most policies on this issue, notably The Millennium Development Goals and the various charities. With approximately $120billion per year¹ transferred from developed to the less developed, and aid representing a stratospheric 70% of total government receipts across Africa² (!), the ‘beggar thy neighbour’ is massive. It is a very important issue of debate, and thus deserves a high degree of attention; surely all this is benevolent?

Aid, like First World Plans are a source of debate. The MDG’s cite to 2015 as the deadline, but are behind schedule. Critics point to the non-responsibility of such idealism as a flaw.

The benefits of aid, be it through loan or grant appear logically correct. When giving the recipient is able to build schools; develop infrastructure; buy mosquito nets and the like to set the country in motion. In fact, it is instinctive of the more developed to play the ‘knight in shining armour’ and encourage donation, a moral duty which is illustrated in the attitudes of many.

A Growing Opposition

Opinions on aid are polarized, gaining momentum the opposing arguments to aid, possibly the most poignant being that of Dambisa Moyo and Bill Easterly. Following from the shockingly high % of government revenues being assistance, Moyo stresses in ‘Dead Aid’ that governments neglect developing their own economy if they are receiving ‘free money’ from the first world, being more concerned with their relations with donors² then their own citizens wellbeing. With empiricism, we can certainly look at the corruption of Eritrea and Sierra Leone, economies with aid accounting just shy of 30% GDP³!

A more sinister argument and sadly, reality, is the retention of aid by the government for their own pleasures, a stomach wrenching crime for which Mobutu or Zaire among others was capable². The quantity of aid is measurable, but what about the accountability? The question is whether aid is necessary, even when no regard to the above conditions is given; the phenomenal 9% average growth of Botswana from 1966-99 accompanied falling aid per capita, loans for industrialisation actually created a ‘lost decade’ for Latin America in the 1980’s.

A proponent of aid, Jeffrey Sachs, uses the counteragurment of the Global Fund to Fight Aids  to advocate a private sector, investment driven approach to aid where results are more accountable⁴. This shall possibly precede an approach to charity of a competitive pitch to investors, results driven, instead of government bilateral aid which has been the target of the opposition.

Aid as beneficial is culturally instilled, and we feel good about ourselves when we ring up Children in Need to donate a tenner or so. It is interesting to observe a growing opposition to this given assumption.

1. Composition:http://www.un.org/millenniumgoals/pdf/MDG%20Report%202010%20En%20r15%20-low%20res%2020100615%20-.pdf#page=69
2. Dambisa Moyo Wall St Journal: http://online.wsj.com/article/SB123758895999200083.html
3. Statistics: http://www.nationmaster.com/graph/eco_aid_as_of_gdp-economy-aid-as-of-gdp
4. Jeffrey Sachs: http://www.ft.com/cms/s/0/4c510f34-c4fb-11df-9134-00144feab49a.html#axzz1iL6IRod9

The Solow Residual

The Solow Residual is the somewhat mystical factor which explains why some economies, with rougly equal endowments of capital and labour, are able to produce more than others. It is named after the Nobel Prize winning economist Robert M Solow.

It can be defined as the constant ‘A’, in the often proverbial Cobb-Douglas:

Output = AK½L½

With K being the capital stock and L the quantity of labour employed.

But what could be the defining factors of this intangible residual?

Immediately springing to mind are the usual education of labour, and technology levels of capital, but I think there is an intangible lying deeper then that. As all of the economic output, spending and allocation of resources and capital depends on the acts of human beings, I believe it is necessary to think on a more human level, moreover human potential.

For people, from a multitude of socioeconomic backgrounds to reach a higher plane of achievement, some conditions act as a catalyst:

1. A moderate level of income inequality
2. Ethics and values instilled
3. Secure family structure

When income inequality is too high, many individuals may become demoralised, for example feeling their labour is being unrewarded, whether it be for the (often wealthy) shareholders or studying a potential employer only to find family connections have filled the internships. A state of learned helplessness sets in, certainly lowering productivity among the masses, and casuing other ugly manifestations, as seen in the English riots this year. The moderate level of inequality is a driving factor in the prosperity of Sweden, Norway and Denmark, each with a Gini Coefficient in the 20′s¹.

The Kuznets Curve theorises a limiting factor of high inequality

The nations philosophy approach to work plays a major role in the skills, and longevity of the labour force: Work with high versus low intensity; just to pay the bills or do what you enjoy. What children are taught by their parents and at schools imbeds itself for the remainder of their life, and that attitude defines the output and creativity.

Work Ethic

For instance, Western philosophies have viewed ‘hard work’ as positive, even if mainly futile, and frowned upon laziness, even if necessary for recuperation. This Puritan work ethic possibly accounts for the high output but arguable standards of living and stresses in these economies. This brilliant piece may change your entire thinking on ‘work’~ http://www.anxietyculture.com/puritan.htm

Reminding the reader about the human potential approach, underlying this piece, it is statistically proven that family breakups have a damaging effect on youth academic and career prospects² although this is obvious a priori: The route is often family breakups leading to insecurities, drink, then drugs. Although in some cases it may drive one to greater achievement, unfortunately the former is more common.

Human beings shape the economy, with capital being merely a manifestation of human action. Human potential is thus what defines the Solow Residual, how much of it is realised and if not, what is holding it back.

Sources

• 1: Most recent figures https://www.cia.gov/library/publications/the-world-factbook/fields/2172.html
• 2: See the academic prospects and unemployment http://apps.olin.wustl.edu/macarthur/working%20papers/wp-mclanahan2.htm

Government as a charity banker-Can voluntary contributions replace taxes?

In light of the worldwide problem of excess government spending and budget deficits an idea came to me, one I am surprised is not discussed more often:

Will there be, in the future, a system where the government collects revenues not by forced taxes but by voluntary contributions?

The way it can work is the government can act somewhat like an investment banker. Each part of government spending that is believed to be needed can be pitched to the public and companies and households can decide how much of their income to give to each cause.

For instance, the reasons why defence finance is needed this year and how much needs to be raised.

Let’s see the reasons how this system could work-and for the better

Money for a Cause

The money goes exactly where the people who are giving it want it to go. People will feel they are giving their money for a cause and purpose, rather than having little to no say individually.

People, not feeling obliged to pay, feel good when they do, like for charity or tips at a restaurant. When they are forced there is greater reluctance.

It could instead be government in need. They could have one of those ‘we have raised so far’ computerised blips outside Westminster. Can we make our target? Come on people! Get donating! More fun, right?

To ensure people will donate 

Companies can be made to include what causes and how much they have given in their annual reports. With households this would be more difficult but the idea is to name and shame those who have not given and reward those who do.

If the public thinks it’s a disgrace that, for example, healthcare is inadequately funded, they can do it themselves, and buy only from companies who do so.

To ensure the government are estimating costs correctly and efficient

About how much it will cost to fund a part of their spending and it’s effects, independent thinktanks can have regular contact with the public about their investigations to their policies.

E.g. Does it cost as much as they’re saying? Are the costs and benefits of an infrastructure project correct as to people are reading?

Such pressures and the need for government to pitch their projects just as a company would pitch for investment puts a private sector efficiency in the ways they are using the money.

When not enough money is raised

An urgent plea can be made, saying that, for instance, we will not be able to fund policing in your local area if you do not donate.

In a recession: If they cannot get enough donations due to a recession due to automatic stabilisers they can, like a company, issue equity in nationalised businesses or project finance or debt. This will make government collections part of a person’s savings instead of an outflow.

Countering a ‘Plutocracy’ A.K.A. Government run by the rich

One issue which springs mind is that if government spending policy is decided by how much donation is given towards it, the wealthy will have a disproportionate say due to their financial clout.

You could argue though that as many of the extremely wealthy are known for their philanthropy, money going to the ‘right’ areas shouldn’t be a problem.

Also, the wealthy find ingenious ways to avoid paying taxes when a tax system is in place anyway. We should be better off if those do start paying to this system, even if that now houses a lot of power in their corner.

Greater economic activity

Taxes discourage economic activity. The issues of ‘brain drains’ to Switzerland^^, tax avoidance, Bermuda based companies etc can be avoided and activity bolstered by this system….

In conclusion:

We know politicians are good at pitching, so they should have no problems selling government spending ideas to the public. They will perform more like a private charity, pressured by think tanks, lobbiers  and possibly a financial watchdog just as companies are when they are pitching for investment…

An issue is just getting the average Joe to be able to be bothered in analysing the costs and benefits of each funding area or a source of news which can accurately translate likely complicated pitching documents to the layperson, missing nothing meaningful but hidden….

Administration could be costly too, especially if it gets very specific e.g. for your local area. The free rider problem will be be a big issue to overcome also.

We could see a system like this brought into play, it has definite advantages, but also disadvantages that cannot be ignored.

 

Interesting reading, even though it disagrees: See bottom of http://mises.org/daily/2510

Hysteresis in Depressions

It is known that a fall in aggregate demand which is sustained will eventually erode away at aggregate supply and the productive capacity of an economy through a process known as hysteresis.

This happens during economic depressions i.e. long periods of depressed economic activity and means that reflationary policies become less and less effective.

The worst so far have been the Long Depression of 1873-79 and Great Depression of the 1930′s.

But we may be entering into one now….

We’re Seeing the Process

A trait of hysteresis is the rise in the natural rate of unemployment due to deskilling of the labour force through:

1. Inactivity of the once employed
2. Emerging generation lacking skills due to youth unemployment

And that is if they are back in work again, some get demoralised and become economically inactive, putting strain on the state..

1 in 5 16-24 year olds are unemployed in the UK, Spain has a terrifying 45%

Reduction in human potential is the most significant, but not the only cause of hysteresis.

Physical Capital Depreciation

With less production than productive capacity, more of an economies physical assets, plants, shops and such sit idle.

While doing so they depreciate, becoming less and less useful when put back into use.Despite the UK being a service and retail based economy (accounting for 77% of GDP) we will still feel this effect through our shops, warehouses offices and malls.

Riots

As we have been seeing, property can be damaged by riots: Depressed economic activity and high unemployment makes rioting more likely ceteris paribus due to social unrest and in other cases, trade union protests.

It’s not only demand that needs to be restored. A nation must be rebuilt and rejuvinated, as well as being able to buy more stuff.

Chimerica-How is China being affected by what’s happening in the US?

The term Chimerica, describing the relationship between the now 2 largest world economies was made popular by the economist Niall Ferguson, with a chapter in his 2008 book The Ascent of Money

 With the current debt uncertainty in the US and devaluation of the dollar, the economic growth of China may not be such a dead cert.

Here are the two main ways China is exposed to the falling $

Foreign Exchange Reserves

It starts with the Chinese government, which has had for a long time a policy of keeping the currency, the Yuan undervalued in an attempt to boost exports.

It has done this by directly pegging it’s currency to the dollar and due to a ‘managed floating’ regime it has bought up masses of US dollars in the foreign exchange markets.

That is just over $3 trillion, yes with a ‘t’, half of China’s economy!

 

Of course, these holdings are not just cash, which makes up a minimal holding (there is nothing like $3trn in cash even circulating, let alone what 1 country can get it’s hands on) but a variety of US assets…

Mainly Treasuries

The main characteristic of the Chimerica relation is simply, China lends the US money and the US buys it’s goods. This has made China the joint highest holder of US government securities with the Fed.

It is a very large holder in US equities, corporate and agency bonds

Though put in the Wealth of Nations that sovereign wealth funds is a main source of funding public works, this was much more common in the 18th century under Mercantalist colonies. Today it is unique in China..

The Export Market

China is a lead exporter in manufactures, particularly gadgets and communications equipment as well as textiles and non precious metals. Who is the main buyer?

As said before, the US, buying over $280bn of China’s stuff in 2010

Now a drop in the $ makes Chinese products less affordable, causing it to lose this export income unless:

1. The price elasticity of demand of China-US exports is inelastic: Unlikely (but not impossible).
2. China devalues the Yuan to move it with the $: Exposing it to bigger losses on $ denominated assets.

China’s high rates of growth in the last 10 years have been largely due to their exports, and it would hurt them to see a fall in demand from their biggest customer which is almost certain given the exceptions above.

US Dollar Index has plunged against a basket of currencies. Taken from Bloomberg

You can compare the US and China to a company which lends it’s customers money to buy it’s goods, as it is in simplicity the same model. When it’s going good, it’s a fine strategy, but when something unexpected happens, the company is hurt twofold; by write downs of its debt assets and falling sales.

The stories of such companies reveal the risks of this approach. Notably MFI and Lucent Technologies

The Savings equals Investment condition: What can this tell us about organic growth?

It is known by macroeconomists through the circular flow of income that, given a balanced budget and current account of goods and services, aggregate savings by households is equivalent to aggregate investment by businesses.

It took me a while to understand how this works, but having done some reading and thinking, I have been interested in looking at this in more detail.

Definitions and Assumptions of S=I

By investment here we mean the purchasing of plant, property and equipment or the development of intangible assets. We can see investment resembling the addition to fixed assets of firms over a period of time.

By savings we mean any income that is not personal consumption. To build up wealth not including one’s own house, car and such.

Given the assumption that savings has tended to equal investment over a stretch of time it must be true that aggregate savings of households equals total fixed assets or capital of firms. For if the current account is balanced so is the capital account, thus any savings directed for investment overseas is offset by FDI.

Given this, we are in the same position if we assume, for simplicity that there is no flow of capital across borders.

Balanced budgets over time mean, on the whole, no outstanding government bonds which could be a haven for savings.

What Can This Tell Us?

Through S=I, we may be able to learn a few things….

Firstly we must know that Investment by businesses is done by 2 methods.

1. Businesses money: Retained earnings
2. Other people’s money: Stock or debt issues

Household savings only fills in #2, through the banking system, funds of various sorts and personal interests in ventures in the macro economy. When stock and debt is owned by another business, it can be seen as ownership by owners of the holding company. Household savings do not go to organic investment.

So this leads us to the idea that #1, the buying of capital by retained earnings is equal, given our assumptions, to household savings not held in stock or business debt over any period of time.

This would be investments in household and mortgage debt. Consumer, not producer debt.

Government securities are another use of savings but are excluded with the assumption of a balanced fiscal policy over time….

Conclusion

Without going into great detail, but using the savings=investment condition and the assumptions and defintions given. We can come to the idea that:

Investment through retained earnings is roughly equal to total outstanding household and mortgage debt (consumer debt), and this influences organic growth…..

Sure, there are a few things that haven’t been considered, such as depreciation and why stock and debt issues are reasonably assumed to be for the purpose of investment etc but on the surface what I have come up with appears to be true. It is a bare bones and there may be something I have missed out!

Thoughts please.