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My recommendation: 7/10

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Summary of notes and ideas

When people are confident they go out and buy; when they are unconfident they withdraw, and they sell. Economic history is full of such cycles of confidence followed by withdrawal.

In the plain vanilla version of this game: If everyone acts cooperatively the returns for the whole group are the greatest. But at the same time there is an incentive to act selfishly: I achieve the best outcome for myself if everyone else puts his money into the pot—to be augmented and shared—but I act selfishly.

There is a standard wisdom about the outcomes of such games: experimental subjects initially play such games with some degree of cooperation, but if the games are repeated they first learn that some other players are defectors and then they themselves increasingly defect. The behavior pattern is very basic: it has been documented in monkeys as well as in humans.⁸

The sociologists say that, when transactions are not fair, the person on the short end of the transaction will be angry. The impulses released by that anger force exchanges to be fair

Blau observed the pattern of these consultations and explained it in terms of equity theory. He noticed that the agents had different levels of expertise. It rarely happened, as one might suppose, that low-expertise agents sought advice from those with high expertise. Instead the low-expertise agents gave and received advice from their peers, who also had low expertise. And similarly, high-expertise agents gave and received advice from others with high expertise

These examples illustrate that the business cycle is connected to fluctuations in personal commitment to principles of good behavior and to fluctuations in predatory activity, which in turn is related to changes in opportunities for such activity.

The money illusion is another missing ingredient in modern macroeconomics. Money illusion occurs when decisions are influenced by nominal dollar amounts. Economists believe that if people were “rational” their decisions would be influenced only by what they could buy or sell in the marketplace with those nominal dollars. In the absence of money illusion, pricing and wage decisions are influenced only by relative costs or relative prices, not by the nominal values of those costs or prices.

The term overheated economy, as we shall use it, refers to a situation in which confidence has gone beyond normal bounds, in which an increasing fraction of people have lost their normal skepticism about the economic outlook and are ready to believe stories about a new economic boom. It is a time when careless spending by consumers is the norm and when bad real investments are made, with the initiators of those investments merely hoping that others will buy them out, not feeling independently confident that the underlying real investment is sound.

Study by Erica Groshen: In that way she could discover how much of the wage could be ascribed to individual workers and how much could be ascribed to the luck of where they happened to work. She found that 50% of the variation in wages was explained not by the individual workers with their different skill levels but instead by their work establishment. Workers at the same skill level do receive very different wages.

Similarly a study by Alan Krueger and Lawrence Summers shows that when workers move from industries with high pay to industries with low pay, they tend to take a wage cut; when they go in the opposite direction they tend to get a raise.⁹ They also showed that workers seem to prefer working in the high-paying industries. They are less likely to leave such jobs voluntarily. Thus the quit rates from low-pay industries are higher than those from high-pay industries. This suggests that the wage differentials in the high-paying industries are more than what is just needed to attract workers to the jobs

That might suggest that their financial assets will be much lower relative to their income, since richer Americans save higher fractions of their income. But that is not what we see. On the contrary: non-cardholders have considerably higher financial assets relative to income. Those who are resisting the American dream by not holding a credit card also seem to be affirming their rebellion in another way—by saving more.

The price changes appear instead to be correlated with social changes of various kinds. Andrei Shleifer and Sendhil Mullainathan have observed the changes in Merrill Lynch advertisements. Prior to the stock market bubble, in the early 1990s, Merrill Lynch was running advertisements showing a grandfather fishing with his grandson: “Maybe you should plan to grow rich slowly.” By the time the market had peaked around 2000, when investors were obviously very pleased with recent results, Merrill’s ads had changed dramatically. There was a picture of a computer chip shaped like a bull. “Be Wired . . . Be Bullish.”

One way or another, asset price movements feed into public confidence and into the economy. There is thus a price-to-earnings-to-price feedback. When stock prices are on the upswing, that feedback boosts confidence. It encourages people to buy more. So corporate profits go up. That in turn encourages stock prices to go up. These positive feedbacks can occur, mutually reinforcing one another, but only for a while. On the downswing the feedback—and the economy—both go in the opposite direction

If there is a rise in rents during a home-price boom (there was a slight rise in real rents in the U.S. housing boom of the early 2000s), they will think that the rental increases are a justification for home-price increases. They will not think of the possibility that the rent increases are just a temporary manifestation of the home-price rise

Jack Welch’s phrase “straight from the gut” sums it up: decisions that matter for investment are intuitive rather than analytical. That intuition is a social process that follows the laws of psychology—and in particular, since group decisions are being made, social psychology

Although the data do not speak with any certainty here, they seem to say that when loss of confidence causes stock markets to fall, there will be a fall in investment. But if the stock market is falling because of inflation, while the economy remains otherwise strong, then most likely investment will also remain strong

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