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New Research Highlights: January 2023
Is popular financial advice supported by economics? Are we less creative? And how exactly does relaxing gun laws increase violence?
Popular Personal Financial Advice versus the Professors by James J. Choi
There is a lot of publicly available financial advice covering all aspects of personal finance – savings, how to spend money, investing, and taking out debt/mortgages. The most popular authors and media personalities who give out this advice do not come from technical economic backgrounds. The advice they give is followed and does alter people’s behaviors. Chopra (2021) found that “exposure to Dave Ramsey’s radio show, which promotes high saving rates, reduces household retail spending tracked by the Nielsen Homescan panel by at least 5.4 percent.” With this in mind, James J. Choi wanted to find out how popular financial advice compares to what economic models consider to be optimal behavior. To do this, he went through the 47 most popular books on financial advice, summarized their advice and compared it to theoretical advice stemming from economics (this is presented in the table below). Some of the popular advice does coincide with economic theory (such as investing in passive funds), while other advice goes entirely against economic theory.
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One of the more interesting findings is the approach to mortgages. Popular advice generally suggests two things: 1) using a fixed interest rate mortgage; and 2) putting a relatively high down payment on the house (or more precisely, not putting down a low dollar amount). Both of these ideas are challenged by economists. Fixed rate mortgage payments are impacted by inflation, while adjustable rates are not. This is because nominal interest rates, which dictate adjustable-rate mortgages, respond one for one with inflation, while fixed rates do not move. In instances when inflation begins to fall, and thus nominal interest rates fall, the only way to lower your fixed mortgage rate would be via refinancing. However, besides introducing additional refinance costs, refinancing itself might not be possible. Low inflation and low nominal interest rates usually occur during recessionary periods. At this time, your house value may drop to such a level that no one would want to refinance your mortgage, because the loan-to-home value ratio may be too high. Therefore, economic models generally suggest using adjustable-rate mortgages (unless interest rates are already very low). Regarding down payments, most popular financial advice is agnostic about it and rarely, if ever, recommends low down payments. On the other hand, economists recommend taking into account what you expect regarding the future price of the house. If you are pessimistic and believe your house will not appreciate in value much, you should have a lower down payment. Basically, a down payment is no different from an investment and thus the return on this down payment should matter when making decisions about it.
Another discrepancy between popular financial advice and economics advice is how to allocate between saving and consumption (spending). Popular advice, nearly universally, advises to save a percentage of your income regardless of how much you make or how old you are. By using popular advice, a person's consumption pattern will correlate with the income they have in a given year – if you earn a lot one year, you’ll spend a lot, while if you’re unemployed the next, you will reduce spending significantly. Since people have been shown to have concave preferences, that is each additional dollar of spend generates less utility or happiness1, economic models show that we should optimally maintain the same level of consumption every year of our lives. This means that when someone is young and just started work, they should not only save very little, but even possibly go into debt. Since in the future, their incomes will be higher, they know they’ll make more money in the future, allowing them to save or repay the debts they took out.
The conclusion from this exercise is best summarized by James J. Choi:
“Popular financial advice can deviate from normative economic theory because of fallacies. But popular financial advice has two strengths relative to economic theory. First, the recommended action is often easily computable by ordinary individuals; there is no need to solve a complex dynamic programming problem. Second, the advice takes into account difficulties individuals have in executing a financial plan due to, say, limited motivation or emotional reactions to circumstances. Therefore, popular advice may be more practically useful to the ordinary individual. Developing normative economic models with these features, rather than ceding this territory to non-economists, may be a fruitful direction for future research.”
Are we less creative? The Creativity Decline: Evidence from US Patents by Aakash Kalyani
In recent decades, the growth in our overall economic productivity of output (called “Total Factor Productivity” or TFP in economics) has slowed down, while the number of patents being filed has significantly increased (see figure below). TFP is a measure of efficiency – it states how efficiently we can transform inputs, such as labor and capital, into final goods. For simplicity, it can be thought of as our level of technology. Theoretically, more patents would imply that we have more technologies and discoveries that should benefit the TFP. Aakash Kalyani, in his paper, argues that this divergence in results is driven by the fact that the patents today are less creative than they were in the past.
One question that immediately comes to mind is how can we determine the ‘creativity’ of patents, especially in a systematic way? Kalyani proposes the following novel way: using an algorithm, he goes through the text of all filed patents and decomposes the text into two word combinations (for example “wireless network”), which he calls bigrams. He then filters out commonly used phrases in the English language, and also gets rid of conjunctions (words such as “and”, “of”, etc.). He then looks at these bigrams in a specific patent and sees how often they were used in other patent filings in the prior 5 years – the less the bigram was used, the more ‘creative’ the patent is. As he knows which inventor or firm filed the patent, he can test his classification method by looking at how these companies and industries respond financially to the patents. He finds that company stock prices respond positively to creative patents and do not respond at all to derivative patents. An additional creative patent, on average, increases the stock price by 3%. The benefits of creative patents are not only limited to the company or inventor – the industry in which the patent was created, actually sees larger productivity gains than the firm that invented it. This suggests that his ‘measurement’ of creativity is valid.
Regarding the overall trend, Kalyani finds that, on average, patents in 2018 are half as creative as they were in 1981. Moreover, even though we are filing more patents, the total number of creative patents is dropping by about 4-5% per year since 2000. The boom in the number of patents today is primarily driven by derivative patents. One explanation of this decline proposed by Kalyani is the change in demographics. In analyzing which inventors are more creative, he found that first-time inventors are far more creative than people who have patented before. Since our population is aging and younger people, who are more likely to be first-time inventors, represent less of the society, we have fewer creative patents. Kalyani finds that falling population growth explains 42% of the observed decline in patent creativity.
Gun Laws – More Guns, More Unintended Consequences: The Effects of Right-to-Carry on Criminal Behavior and Policing in US Cities by John J. Donohue, Samuel V. Cai, Matthew V. Bondy & Philip J. Cook
The US has undergone a significant shift in gun policy in the last 40 years. In the 1980s, the vast majority of US states banned concealed carry of firearms or had an arduous permit process. Today, 42 states have Right-to-Carry (RTC) laws that require states to issue permits to any individual that requests one, with a narrow set of exceptions. This was a significant policy change, relaxing gun restrictions and making individual access much easier. Using the different timing of implementation of the RTC laws in states, the authors were able to determine that the rate of firearm violent crime goes up by 29%, while overall violent crime goes up by 13% due to RTC. This result, on its own, is not unique, as it has been confirmed by numerous papers. Therefore, the authors of this paper focus on what are the plausible mechanisms as to why firearm and violent crime increase after RTC laws are enacted. They find that two thirds of the increase in crime can be explained by two factors: 1) an increase in gun thefts, and 2) a reduction in police effectiveness. After the implementation of RTC, gun thefts go up by 35%. This makes committing crimes easier, as the costs of acquiring a gun for criminals goes down. Not only are criminals able to steal a gun if need be, but also because there are more guns available for sale in the illegal market, their price goes down, making gun acquisition cheaper. Regarding police effectiveness, resolving violent crimes falls by 13%. The reason for this is that police not only have to deal with more violent crime, but also have to address other issues caused by RTC – resolving gun thefts, processing gun permits, dealing with accidental gun discharges and shootings. All these additional procedures take time and also impact police budgets (interestingly, such costs are rarely if ever estimated when discussing policy proposals). Furthermore, police may be more hesitant to engage with someone that is more likely to be armed.
To illustrate with an example, we value an additional slice of pizza differently depending on how many slices we’ve already had – if you had none, you’re really excited for the first slice, but if you already ate a whole pie, you will probably not give any value to another slice.