Wednesday, February 2, 2011

A Savings Account for Risk Lovers

If you've ever purchased a lottery ticket, enjoyed a trip to the casino, or taken part in a cash-prize March Madness pool, chances are that (like me) you are secretly a risk-lover. OK sure, you probably take great care in managing your investment portfolio, making sure not to take on too much risk for your age and income level, or perhaps you have hired someone who you trust will do this for you. Deep down though, you love risk - maybe not all risk, but at least risk that involves a relatively small upfront cost and a small, but positive, probability of a relatively large payout.

An Economist named Maurice Allais documented this phenomenon when he mailed out a survey to his economist collegues asking them to choose between two lotteries under two different circumstances.

First, you must tell me (without thinking, or trying to figure out the "right" answer) which of the following lotteries you would prefer.

A: I will give you (straight up) 1 million dollars.
B: I will give you
$1 million with a probability of 89%
$0 with a probability of 1%
$5 million with a probability of 10%

Have you made your choice?

Good. Now I have another, somewhat less generous proposition for you. Which of the following lotteries would you prefer?

A: You get zip, zero, nada with a probability of 89%
I will give you $1 million with a probability of 11%
B: You get nothing with a probability of 90%
I will give you $5 million with a probability of 10%

Got it?

OK. Now if you picked the same letter of lottery both times (A and A) or (B and B), you are what economists refer to as a "rational" person. You have preferences that are consistent. Economists (except for those funny Behavioral ones) always assume that all people are "rational". It is a basic principle of economics that I teach my students on the first day of Econ 1. For those of you who preferred lotteries with different letters (usually first A and then B), you just proved all of those economists wrong.

See theoretically, these two sets of lotteries are identical. In both sets of lotteries the same outcome happens 89% of the time. Really you are supposed to be choosing between differences in what happens the remaining 11% of the time. In both sets of lotteries you are given the same choice.

A: Take $1 million with a probability of 11%
B: Take $0 with a probability of 1%
Get $5 million with a probability of 10%

Theoretically, the baseline 89% doesn't matter because you have the same outcome in both options. Now, those of you A/B people are probably saying "Wait! of course the baseline matters! In one situation you're giving me $1 million dollars, and that's awesome. I don't want to risk losing that for a small probability of getting $5 million. In the second situation I've got nothing, and the chance to get $5 million 10% of the time seems much better than getting $1 million 11% of the time." Until now there were no financial instruments designed to suite the "irrational" preferences of us A/B people. Now there is one.

In order to encourage savings among the poor, many of whom spend large sums on lottery tickets each year, the "save to win" concept was born. First implemented in South Africa, and now all the rage in Michigan, "save to win" accounts do not pay you interest, but instead distribute interest in random, lump-sum payments each month. If you have $1,000 in the bank, you won't get your 0.15% (generous these days), or $1.50 per year, but you will have a small probability of getting everyone's interest payment, a much larger amount, each month. Sounds good right? - Especially considering that the average american family spends $500 on lottery tickets every year. Why not get the same thrill by putting that money in the bank?

The only downside is that these accounts are illegal in every state except Michigan. State governments make big bucks by exploiting our preferences, profiting on state lotto players and the fees they charge to casinos. This is widely recognized as one of the most regressive ways to raise revenue, but nearly every state does it, and they don't want to give up their monopoly on lottery play. Perhaps its more politically feasible than raising taxes, but does that mean that we should continue to encourage the poor to pay for our roads and schools instead of saving for a rainy day?

Come on fellow Americans, let's man up, pay slightly higher taxes, and stop exploiting people with gambling addictions, or maybe a need to have some hope that their financial situation could change overnight. "Save and win" accounts may not fix all of our problems, but it would encourage a higher savings rate, and give the people who need it a chance at a more secure future - at least in the short-term.

If you are interested in learning more about the history of the "save to win" idea, check out the Freakonomics podcast called "Is America Ready for a No-Lose Lottery?" - available free on iTunes.

Friday, January 28, 2011

Political Lessons from an Emerging Nation

Sudanese Secession: Political Lessons from an Emerging Nation
By Erin Kaplan, January 28, 2011

The week long vote on a historic referendum for Southern Sudanese independence ended January 15th. Although the final results won’t be announced until February 14, the outcome is no longer in doubt: All indications are that the electorate turned out in force all across East Africa, with some estimates putting turnout above 95%, and voted overwhelmingly, again likely higher than 90%, in favor of independence. Though the international community had been making preparations for the vote since 2009, the election, which lasted a full week, went more smoothly than anyone could have predicted.

There are undoubtedly many tough decisions ahead on both sides of the new border, but thus far leaders of the soon-to-be separate countries have shown remarkable goodwill toward their counterparts. In comments during a church service on January 16, the Southern Sudanese president, Salva Kiir, called for forgiveness for the some two million casualties of the North-South conflict. The more infamous Sudanese president, Omar al-Bashir, who has been indicted for genocide by the International Criminal Court, appears to be looking forward as well.  Multiple Sudanese papers are reporting that al - Bashir is focused on restructuring the government in the North: reducing the number of government ministries and privatizing some of the currently state-owned industries.

The success of the referendum on Southern Sudanese independence raises the question, could other ethnically divided, conflict‐ridden countries benefit from a similar process? There is no disputing the fact that much of the conflict in developing world is symptomatic of poorly drawn colonial‐era borders. So why have political leaders continued to embrace arbitrary boundaries that were drawn half a world away? Until now the answer has been, for the sake of stability.

The primary goal of most African nations in the post‐colonial period has been to foster stability. Since 1980 more than half of the 54 African nations have experienced civil war. It is thus not surprising that powerful, though many times cruel and self‐interested, dictatorships were often welcomed with open arms to replace decades of civil unrest, uncertainty, and violent conflict. Even Botswana and South Africa, two countries often touted as representing the triumph of democracy on the African continent, have only managed to support one viable ruling party.

With the primary goal of stability accomplished in all but a handful of countries, African nations must now turn their attention toward the pitfalls of permanence in political regimes, whether they legitimately elected or not. Even die‐hard democracy proponents recognize the potential, in such cases, for "tyranny of the majority" – where the political party, or ethnic group, in power favors its own interests, neglecting the wants and needs of the minority.

There are different methods of dealing with this potential pitfall, including proportional representation in the legislature, the protection of individual rights in the constitution, and a strong judicial system to judge the fairness of policy and prosecute corrupt officials. Though optional secession is often overlooked as a method of balancing the power between ethnic or political groups, in Africa where countries were slapped together somewhat haphazardly in the first place, it may prove to be a reasonable mechanism to facilitate transfers of power or natural resource wealth.

Theoretically, the option to secede enhances political equality in a democracy even if it is never exercised. Suppose that within a country there exists a majority group which controls the ruling political party and some disgruntled minority group that would pursue independence if given the opportunity. Allowing the minority group the option to secede will force the majority group to respond either by accommodating the needs of the minority, or recognizing their right to independence. If the majority values the unity of the country (in other words, if the whole is more than the sum of its parts) the ruling party will have an incentive to give equal treatment to the political desires of the minority in order to preserve the union. If, however, the majority is not willing to make large enough concessions to appease the minority, the socially optimal outcome is for the two groups to part ways. In this case, the inevitable split of the two incompatible states will be less costly to all if it is pursued at the ballot box rather than the battle field.

Some people will argue that larger countries or regions of economic integration will prosper more than small segregated economies. Although both theoretically and empirically true, this is less of an argument against secession and more of one in favor of international economic integration. Much as Europe has fostered a strong region of unregulated trade, the African Union works to undo protectionist policies as well as promote international trade and economic unity between African nations. Trade liberalization within the African continent is clearly in the economic interest of all involved, but will not necessarily be a casualty of introducing secession rights.

Policy makers ought not to fear the possibility of democratic secession in cases where other methods have failed to bring political equality to a struggling democracy. On the contrary, the rational approach to the possibility of the disintegration of African nation states that is now playing out in The Sudan may, in fact, be a rare beacon of hope for democracy and development on the continent.