Sadly, Soup will no longer be provided

Recently the UBS compliance department took a look at my blog and made a judgment on whether or not, as a Strategist, I could continue writing on this thing. Sadly, the answer was no, unless I changed the subject to gardening or “showing my vacation pictures”. I was hoping that a disclaimer that “the views shared here in no way reflect those of XYZ” would solve any potential issues, but quite frankly I am not surprised. It’s a big bummer because I had a lot of fun with this blog, and there were a lot of subjects I looked forward to writing about in the future, especially labor mobility, the concept of human beings living and working where they please.

Maybe I’ll pick this up again in the future, or maybe I’ll find someone to take it over for me. Until then, I am contemplating starting a blog on another of my passions, which is religion, theology, and my experience as a Baha’i. Stay tuned for that, if it’s something that interests you.

Thanks to everyone who read this blog and posted their comments.

-Eamon

Like I mentioned in my last post, recently I attended the 10th anniversary of the founding of the Harvard Kennedy School’s MPA/ID program. This was an awesome spectacle in the middle of Harvard Square, with 10 classes worth of alumni from the development field (and others), some big-name guest speakers, and plenty of partying. Mostly, it was just great to see all my old classmates (even though we graduated only about a year ago). But it was also just nice to get back into the “classroom”, so to speak, and think about development again.

One of the most interesting parts of the weekend was a short presentation by Sendhil Mullainathan, the Harvard economist, as part of a panel discussion on “innovative finance”. Mullainathan summarized some of his and others’ research into why certain financial products and interventions fail in the developing world. The answer in some cases, he argued, was that people simply can not costlessly process the complex sets of information necessary to make certain financial decisions. This is especially true of the poor, and he gave the example of a particular fruit vendor. How can we assume that a woman who sells fruit for off of a cart for a living, and who doesn’t know what her income is going to be when she wakes up each morning, is going to properly calculate her expected annual income and decide optimally on a myriad possible consumption and saving choices?

In a summary of this line of behavioral research, Mullainathan writes:

In the standard economic model people are unbounded in their ability to think through problems. Regardless of complexity, they can costlessly figure out the optimal choice. They are unbounded in their self-control. They implement and follow through on whatever plans they set out for themselves. Whether they want to save a certain amount of money each year or finish a paper on time, they face no internal barriers in accomplishing these goals. They are unbounded in their attention. They think through every problem that comes their way and make a deliberate decision about each one. In this and many other ways, the economic model of human behavior ignores the bounds on choices (Mullainathan and Thaler 2001). Every decision is thoroughly contemplated, perfectly calculated, and easily executed.

As I’ve written on this blog before, it’s not the model that is faulty, it’s those of us who over-interpret the assumptions of the model –  assumptions that are intended to achieve a mathematically useful result, not serve as a view of human nature — who are causing harm. Mullainathan argues that the standard model is limited if we are going to properly understand how the developing country poor interact with finance, and properly design policies and make rules.

I’ll take it one step further and argue that in the developed world, this is also a major issue, and that people who insist on the hyper-rationality of all human beings need to come down from their clouds and embrace reality. What Mullainathan and his colleagues have illustrated is at the very heart of why Americans, for instance, would benefit greatly from a Consumer Financial Protection Agency that protects individuals from intentionally confusing or misleading behavior on the part of financial institutions.

Here’s one example from my own life to illustrate the point. When I was in my last year of grad school, I took a few minutes to go through a bagful of mail that had piled up for weeks. Most of the envelopes, as usual, were junkmail. But toward the end of the pile I got to what looked to be a check for ten dollars, though it wasn’t clear from whom. In my haste I looked over the check to figure out the payer, but after I couldn’t figure it out in a few seconds, I just kind of assumed that I had overpaid for something, and the money had just been paid out by some processing center somewhere. Here’s what the check looked like on the front:

As I focused on getting through the pile of mail, and as I probably pondered the other dozen things I had to do that night, I was about to put the check into my wallet to deposit the next time I went to the bank. Right before then, however, I decided to look more closely at the back of the check and caught this message, written vertically in small type on the back of the cover of the check envelope.

So the question is: If the Budget company can nearly get a graduate student who is actually literate in management and economics to pay $64.99 enroll in a program when he doesn’t actually intend to, simply because he’s distracted and not thinking clearly, what else is going on out there? Somehow, the assumption that all individuals are ready to costlessly and effortlessly sort through information (including intentionally deceptive information) looks more and more naive.

Motorola and Google are promoting the Droid as raw horsepower-in-a-handheld. Their catchy slogan, which calls the Droid a “bare-knuckled bucket of does”, along with the TV ads featuring automated robot hands presenting in a rugged black backdrop, seems like the very opposite of Apple’s marketing strategy for the iPhone (or pretty much any of their products).

My first reaction to the ad campaign was to view it as just another example of tech companies failing to understand the customer and how that customer uses technology. The “user experience” which Apple understands so well and so masterfully weaves into its product design and marketing is where other PC and electronic good manufacturers have so famously fumbled. In the 1990s we saw a race, famously won by Dell via its revolutionary supply chain, to provide the PC with the greatest specifications at the lowest price. Unfortunately that game proved barely profitable, and even the winners like Dell ended up losing on the bottom line.

I didn’t fully get how bad Apple was abusing its competition in the user experience game until I interned there as an MBA student in the summer of 2007, the same summer the iPhone was launched. Almost weekly, the interns gathered to listen to a top executive speak, and by far the most interesting lecture was delivered by Johnny Ive, Apple’s user experience guru. One of his most entertaining stories was about developing the look and feel of the original iMac, which famously had a handle on the top. The handle, he explained, wasn’t to carry the computer around easily. It was to invite people to reach out and touch the computer and become phy7sically acquainted with it, after research had revealed a major psychological comfort barrier between the user and the machine.

It was amazing how most of us back at Sloan failed to get this. When we came back from our winter break the same year, we discussed the recently-unveiled iPhone in our first Strategy class. The idea got totally blasted. Margins in the mobile device sector are razor thin. They’ll cannabilize the iPod. And Apple just doesn’t do phones. I heard something similar about a year later, while waiting for an interviewer in a hotel lobby with some other Sloan students. One of them was chatting loudly with his friends about Apple computers. “They get killed in pretty much all the specifications!” he said confidently, apparently referring to hard drive size, RAM, processor speed, etc. He must have forgotten about the specification about whether or not people actually understand and enjoy using their computers.

Have the Droid people totally missed this? It seems like they have, although it’s hard to believe they could actually miss something so obvious, especially when Google is involved. When your marketing strategy is to present the product with black robot hands, who do you envision buying the product? And how well does this message resonate with the the dozens of millions of people who are forecasted to use smartphones for the first time in the next few years?

I don’t get it. But of course, it’s entirely possible that I’m missing something, and the Droid marketers are smarter than I think. Or maybe they’ve recognized that Apple does easy-and-approachable so well that the only people left to market to effectively are the tech geeks, and the guys drinking vodka with sexy robots.

Within the past two years the dollar’s value has taken us for a particularly curious ride. Through much of 2008 it actually appreciated, as global investors fled to the safety of the dollar amid financial crisis (one of the few times in history, I imagine, that a country went through a financial crisis and demand for its currency actually increased). Then dating back to about 12 months ago it started a steep decline, and that’s when the exchange rate panickers came out again in full force.

When it comes to public perceptions, exchange rates constitute one of the worst-understood topics in economics. Many bright people fall into the trap of thinking “strong dollar: good; weak dollar: bad”. The simple truth is that weak can be as good or better than strong, depending on what you want or what you need . If you want to buy lots of foreign goods, then strong dollar: good. If you want to sell more of your goods and services to foreigners, then it’s actually weak dollar: good. In reality, a free market does a great job of getting you to a not-too-strong, not-too-weak equilibrium of the value of a country’s currency. (Of course, if you’re a small developing country with an inflation problem, then there are other factors at play.)

Despite the decline in the value of the dollar against most currencies over the past ten years or so, I personally believe there is still no way to go but down from here for the next ten. The rest of this blog is about explaining a) why I feel that way, and b) why this is actually a good thing.

There are a handful of interconnected reasons why the dollar must weaken in the coming years. The first and most important of these is the US current account deficit, the other mega-gigantic global imbalance that has been overshadowed by the 2008 financial crisis and the worst recession in 70 years, not to mention the deterioration in public balance sheets for pretty much all of the OECD countries. Part of the reason people don’t take this as seriously as they used to, I think, is the fact that the current account deficit has effectively been cut in half in the past few years. (Back in Q3 2006 it was about 6.4% of GDP, while in Q4 2009 it was 3.2%.)

But the decline in the size of the current account deficit shouldn’t be interpreted as a sign that we’ve escaped disaster. The reality is that much of the closing of the deficit had to do with a dampening in the country’s voracious appetite for imports, not regained export strength. After exports collapsed at a faster rate than imports starting in late 2008, the last two quarters have seen imports recover faster than exports, a discouraging sign to those focused on the current account. The reality is that, barring a surge in global demand for American exports, over the next few years the current account deficit isn’t going anywhere. Does this necessarily mean we’re destined for a hard landing? No, but it doesn’t matter. Whether the gap closes quickly or slowly, the reality is that at some point foreigners will be unable or unwilling to finance the American trade deficit.

So how do you increase exports to close the gap? There are microeconomic levers, for sure. National governments can provide tax breaks and other incentives to exporters (within the rules of the WTO), for instance. Monetary policy plays a role too, though it’s tough to argue that the Fed’s stance can or should be more accommodating than it is at present. The real mechanism, of course, the big hammer in the toolbox, is the exchange rate. Just take a look at the relationship of the strength of the dollar and the current account deficit over the past decade. It’s not surprising that the two are very closely (negatively) correlated.

The problem is, of course, that the US doesn’t fix the value of the dollar, so you can’t quickly intervene and devalue as if you were on a fixed exchange rate regime. But there are things you can do. One is being pushed somewhat aggressively these days (as it has been at various points in the past), which is putting pressure on China to revalue. This is obviously sticky territory; push too hard, and the issue will be even more linked to national sovereignty and pride than it is already, and Chinese leaders will be even less inclined to accept a cut in the value of their dollar reserves. But the world in general wants this to happen, not just the US. Given the slow pace of global recovery from a horribly deep recession, a great untapped source of global demand is the Chinese consumer, whose consumption most would say is being artificially restrained by the cheap yuan. My feeling is, given the mesh of issues on the table between China and the West – most notably Iran and climate change, but also other issues like Sudan – the chance for a compromise in the next few months, featuring a modest appreciation of the yuan, is possible.

But China is small potatoes compared to a much more significant factor, which is the dollar’s role as a global reserve currency. Check out another chart, showing a very clear connection between dollar strength and its share in global reserves. Part of this relationship of course occurs because the fluctuation in the dollar’s value directly affects its collective share of the value of total reserves. But another component of the issue is how the demand for dollars as a reserve currency artificially props up its value. If you’re like my roommate, a brilliant private equity brain who understands global markets as well as anyone I know, you’d nonetheless defend the dollar’s role as the world’s premier reserve for this very purpose. You can’t let the value of individuals’ assets plummet! he likes to argue. But this is exactly the point. The dollar should be gradually taken off the pedestal as the world’s reserve of choice, such that a collapse from foreigners’ dumping dollars all at once is a less likely doomsday scenario. While the idea of a world reserve currency, recently promoted by some heavyweight political and economic personalities, is tough at present from an implementation point of view, it is less crazy than it sounds, and it may be the only thing to calmly bring the dollar from off the ledge.

But what about higher prices? Wouldn’t a depreciation trigger a cycle of inflation? I’m quite surprised how much attention inflation gets these days. I don’t mean to say that inflation is never going to be an issue in the United States. I’m young enough practically to never witness real inflation. When I was born in 1980 the inflation rate was 13.5 percent. The following year it was 10.4 percent, and after that it was 6.2 percent. Since then, over a 26-year period, the highest it has been is just 5.4 percent (in 1990), and in the past twenty years it’s averaged (arithmetically) 2.6 percent. That’s just incredibly low for any country for any stretch of time.

So some would say that people of my generation are naïve about the dangers of inflation. Perhaps. But I also know that the IMF forecasts inflation to be 2.3 percent or below for the next five years. That sounds entirely reasonable to me, with unemployment still hovering around ten percent, and nearly every macroeconomist anticipating a sluggish, perhaps decade-long return to employment normalcy. Given these facts, do you really prefer to guard against inflation via a strong dollar, at the expense of regaining international competitiveness?

The big trump card here is government debt. To this point I’ve paid pretty much no attention to countries’ governance and fiscal situations, a major topic in recent months given the enormous stress that the financial crisis and recession have put on public balance sheets. It is tempting to look at the Greek fiscal crisis, the threat of contagion to other vulnerable Euro members, and the shaky European response as evidence of poor governance, and take a short position on the Euro in response (the recent EU-IMF deal, of course, cooled some of the anxiety). But the problem is, does the American governance situation really make you more comfortable? Never mind the share of debt to GDP; had this been the only factor in this conversation, Japan would have been underwater a decade ago. What I see in the US – and I admit that I have only a limited basis to compare to other countries or other American generations – is partisan and corporate strangulation of federal policymaking. When you have the worst financial crisis in eight decades and basically nothing has changed from a regulatory perspective more than a year later, this makes me somewhat skeptical that the two parties will successfully work together to avert the coming fiscal reckoning.

So if not the dollar nor the Euro, what’s left? I know there has been some talk lately about the Scandinavian currencies as a safe haven. But it also might be a golden opportunity for smart investors to reconsider a basket of emerging market and developing country currencies in the medium term. Particularly intriguing are the “pre-EM” countries, as I would call them, the ones at the lower stages of economic and financial development, some of which are exhibiting responsible policies, stability, and healthy flows of FDI (though there are some logistical problems here). Smartly diversified, these currencies could prove a smart choice if investors make a move for the next frontier of value.

The proposed financial reforms announced by President Obama — including new rules  to limit the size of “too big to fail” banks that create moral hazard — has been casually referred to by commentators in TV and print as “populist”. The most common argument is that now that the Democrats lost the special senate election in Massachusetts, they’ve got to pander to the American public by demonizing the easy-target banks. But now there are a handful of people challenging this, arguing that just because something is popular, that doesn’t make it populist.

One of those people is Simon Johnson, former chief economist at the International Monetary Fund who’s now at MIT Sloan (where else). He wrote in Baseline Scenario recently:

“The fact that dramatic banking reforms would be popular does not make them populist.  It merely means that a broad cross-section of our population has woken up to part of our appalling reality.  Sure, they are angry – but with good reason, and the remedies they seek are entirely appropriate.” (Full entry here.)

I don’t want to make this blog a political forum, but I have to unequivocally side with Simon Johnson 100% on this one. He’s been right on this issue for months. The president is now experiencing a policy that has that rare combination of overwhelming popular support  and actual policy integrity. People are angry at the near-fatal financial collapse and the enormous bail-out and stimulus funds needed to avoid an economic cataclysm. Now we have nearly every famous economist making the case that without serious financial reform, we’re bound to face a “doom loop” of collapse and bailout until the problem is fixed.

So don’t call this particular popular policy “populist”. There are plenty of policy ideas floating around — even in this country — that deserve that tag.

The only question is: If financial reform is both politically and economically smart, why isn’t it a sure thing? To understand this one, consider that by some estimates the biggest four American banks now hold about half of the nation’s deposits and two-thirds of credit card balances. Then read my last entry.

Why does the recent ruling by the US Supreme Court on corporations and political influence strike us as so potentially dangerous? The answer lies not in the legal side of the issue, but rather the economics of how individuals consolidate to influence decisionmaking.

Source: bendib.com

It’s clear to me that from a legal perspective, both arguments on this issue have validity. The point argued by a slight majority (five of nine justices) — that corporations are entitled to First Amendment protections and thus can not be differently restricted in their political contributions — is hard to refute, if one focuses on the language of the Constitution itself. Nonetheless, one could easily respond that this was never the intention of the authors of the Constitution, and that the ruling would have destructive effects on democratic institutions. The complexity of the issue is summed up by the words of Justice John Paul Stevens, who sided against the court’s decision. Stevens conceded that “we have long since held that corporations are protected by the First Amendment”, but ultimately concluded that “the court’s ruling threatens to undermine the integrity of elected institutions around the nation”.

But regardless of the legal correctness of the ruling, there is the issue of ruling’s actual effects, and this is where many of us feel a chill down our spines. We imagine a world where corporate interests have even more sway in legislation than they have now, and the voices of individuals are drowned in a sea of lobbies and interest groups. But is this really what will happen? Wouldn’t a free market for information produce the best possible political decisions, just as it does in goods markets? The argument is that if the market for information and political influence are free, then the elements with the most to gain will push and spend the hardest to get their policy choices to the front in Washington. Just like people vote with ballots, the free market allows the nation to vote with dollars. At least that’s how the narrative reads.

Most people with sense, however, take a look at American politics and realize that this narrative doesn’t quite play out in real life. There seems to be something getting in the way of this neat and just market scenario, and skewing the distribution of influence towards the big players. But most of us can’t really put our finger on what that something is.

That missing something in the narrative above is a well-known phenomenon in economics called coordination failures. The premise is simple: there are costs to coordinating efforts and information, and because these costs can be particularly large for some groups (especially if those groups have lots of people), these groups will tend to have more trouble coordinating than others.

The textbook example of this is international trade, where a large number of individuals within a country each receives a very small benefit from liberalizing trade, and a relatively small group of individuals stands to lose in a big way. Even though the total benefit from liberalizing dramatically outweighs the costs of not liberalizing (because the winners are so many), liberalizing trade is hard. Why? Because there is a small group of individuals who stand to lose very acutely from liberalization, and they can organize themselves relatively costlessly and channel their resources into influencing policy. On the other hand, the larger group, with loads of people who each stand to gain only modestly from liberalization, are extremely unlikely to get organized.

What you see in American politics — as in other democratic environments — is exactly this story playing out in a multitude of contexts. Whether it’s the health insurance industry, Wall Street, or labor unions, small pockets of the population who stand to win or lose in a big way from policy decisions will have a disproportionately loud voice in government. And unfortunately, the story of a perfect market for political influence ends up being just a fairy tale.

Economists understand this perfectly, and yet I rarely hear them weigh in on the problem of corporate influence. Why not? It’s one thing to adhere to the Constitution, but it’s another to ignore a problem altogether.

If consumers aren’t really rational, I argued, then producers could find ways to exploit that lack of rationality with clever tricks and gimmicks. As I discussed earlier, if you don’t believe this is possible, just one piece of evidence is Bertrand et al’s experiment in South Africa, where men were shown to be significantly more likely to accept a loan offer when a woman’s face appeared on the promotional material. Behavior on the part of firms that targets consumers’ irrationality is so common, I argue, that we barely bat an eyelash at the bikini babes used to sell beer on TV, or asterisks on big “50% off!” signs with fine print at the bottom.

An ad from uvacreditunion.com. Few people, it seems, know the difference between APR and APY interest rates.

This type of behavior would be fine if the influence it has was distributed evenly across types of goods, but that is unfortunately not true. There are some industries or products for which such messages are enormously powerful, and others where they are not used at all. So you end up with a world where the consumption of things that can be effectively advertised with persuasion is too much, and the consumption of things that can’t is too little.

One industry that is great at this is credit cards. I don’t think credit card companies necessarily utilize the emotional cues that I talked about in my earlier post any more than any other industry. But they have mastered the art of confusing consumers and overwhelming them with seemingly impossible-to-understand information. One of the silver linings of the financial crisis (especially relating to subprime mortgages), I think, is that it raised awareness of the need to protect the consumer when it comes to personal finance.

Let’s look at one of the simplest and seemingly most innocuous examples of this: the clever use of APR and APY interest rate quoting standards. If you don’t know already, the principle difference between APR (annual percentage rate) and APY (annual percentage yield) is that the first one doesn’t count compounding in the number, while the second one does.

For an illustration, imagine a loan of $100 that has an APY interest rate of 12%. This means that at the end of a year, the balance of the loan is $112. Pretty simple. Now imagine a loan of $100 that has an APR interest rate of 12% (with interest compounding monthly). What APR of 12% means in this case is that you pay 1% per month. At the end of the first month, your balance is $101. But in the second month, that 1% is taken on $101, not $100. So your balance at the end of the second month is not $102, but slightly more, and so on and so on until at the end of the year, your balance is not $112 but $112.68.

Here’s a real-life example. Recently I bought a suit from Express, the clothing retail store (they make surprisingly good, reasonably priced men’s suits), and opened up a store credit card to save some money off the initial purchase. The first piece of mail I got for the credit card cited two numbers: an APR interest rate of 22.8%, and a “daily periodic rate” of 0.06246%.

I of course understand what these numbers mean. The daily rate, when multiplied by 365, equals the APR rate. But the real annual interest paid on the credit card, of course, is not the APR percentage. It’s the daily rate compounded on top of itself 365 days in a row, which ends up being around 25.6%, or about three percent more. This means that a person carrying a $100 balance (and believing that APR is actually what he or she pays) would expect to owe $123 in about a year. In reality, it grows to about $126.

Is this a big deal? Three bucks, after all, really isn’t that much money. But on the other hand, you have to consider the cumulative effect of not only the APR/APY thing, but all the similar types of marketing tools, collectively.

But before this, you have to ask whether or not people actually understand the interest rates they are paying. I was curious enough in this question that I actually did a survey about it. The survey population wasn’t of course a representative sample of the city, the state, or the country; I relied on an electronic survey among my friends (education and good looks heavily biased upwards), and a paper survey I handed out near my home in Brookline, MA (yes, I actually stood out on a street corner and handed out surveys). But even though the sample wasn’t representative, I still think the results I gathered were eye-opening.

Here’s what I asked, in addition to some background info:

Interest rates are sometimes quoted in APR, and other times quoted in APY. Do you know the difference between APR and APY? If so, explain the difference in the box below. If you don’t know the difference, just write “don’t know” in the box.

The proportion of people who could actually answer this question was remarkably low. Of the 34 people I found in Coolidge Corner, zero knew the difference between APR and APY, and less than a third had any idea whatsoever. Keep in mind that this is in the middle or Brookline, one of the most affluent, cultured, and well-educated neighborhoods of greater Boston; among the 34 respondents, 31 were college graduates, and 20 had gone to graduate school.

Among my non-MBA friends, the numbers were slightly better, but still ugly. About one-in-five (22%) answered the question correctly, with a slightly higher percentage (32%) mentioned compounding in their answers. More than half (59%) offered no guess. This is a group for which 87% had gone to grad school.

Predictably, the business school students were better, but still not great. Sloanies got the right answer just 30% of the time, and a big chunk (45%) said they didn’t know the difference.

You may not be that shocked by these results. I was a bit surprised that the numbers were so low, but then again, the very reason I did this exercise was to show that even highly educated people would have trouble with this question.

For two major reasons, the lack of understanding on how interest rates actually work is alarming. The first one is moral in nature. No matter how common or accepted it is, to me it just does not seem right that your credit card quotes your interest rate in APR to look small, when your bank quotes your savings account interest rate in APY to look big. (The same can be said, by the way, of accounting standards and the various ways that publicly-traded companies can value assets, depending on which method makes their balance sheets look better.)

But the second reason has to with pure economic value. Though the APR-quoted interest rate looks very close to the real compounded (APY) rate, and this difference may make little difference to a single consumer, I wonder about what the aggregate effects are for the 300 million or so living in this country, collectively. You’ve got a situation where Americans are constantly exposed to an immense amount of clever marketing and advertising methods, coupled with their apparent irrationality (not a uniquely American phenomenon of course), and then on top of this the not-really-honest-but-still-legal tools such as APR and APY interest rate quoting. Is it such a mystery, then, that Americans save so little and spend so much as compared to nearly every other wealthy country? To assume our nation’s savings rate is determined only by purely economic phenomena is, I think, a fantasy.

Let me end this by saying, as I’ve said before, that I am not in the “get the bankers” angry mob that thinks that the profit motive is the root of our current financial crisis. Nor is consumer credit a bad thing by any stretch; I recently read an article in Atlantic Magazine about Dave Ramsey, the evangelical finance guy who tells everyone to cut up their credit cards and eschew all debt. Ramsey is of course way over the top. In a recession especially, consumers need access to credit, and should not be hindered from getting liquidity, as long as they are making decisions that they are comfortable with, and they know what they are doing. The question is, do they always know what they are doing? Unfortunately the answer is no.

Instituting more requirements on credit cards and other financial products, like mandating clearer information or creating new standards on how that information is conveyed, may seem like a crippling shackle to these industries. But the point is not to maximize value to any industry, but maximize value in general. You can’t do that when consumer choices are purposefully distorted. And further, given the incredible level of distrust that the financial crisis has stirred up against these industries, doing away with the APR/APY dichotomy may be an important step towards dissolving some of the bitter uncertainty and skepticism among consumers, maybe even benefiting these industries in the long run (like a car dealer willingly disclosing a vehicle’s accident history, to earn a potential buyer’s trust).  Given the tenuous state of the economy as it stands, any ounce of added trust would be helpful to all of us.

Adam and I have a usual ironic pattern to our arguments. It usually involves him (Muslim, at least by family) arguing how terrible Islam is while I (not Muslim but very respectful of Islam) defend it. Usually the arguments are about some aspect of Islamic history or doctrine (for instance, where Adam will raise the example of some hadith where the Prophet Muhammad said such-and-such ridiculous thing, and she sheer ridiculousness allegedly proves Islam’s falsehood).

To Adam, though, Islam is not just a false religion, but it represents a movement and belief system that is actually harmful to his country’s progress. Recently, we argued over email from 8,000 miles apart about this, when Adam pointed out how poor female labor force participation is in many Muslim countries. This isn’t an opinion, but a fact; in reality, Muslim countries perform very poorly on a wide range of social indicators. Below is a scatter plot, just to provide a visual example, with World Bank Voice & Accountability scores on the y-axis, and the proportion of countries’ populations being Muslim on the x-axis. The downward sloping relationship is pretty visible here.

However, making the jump to the conclusion that Islam somehow causes these poor social outcomes (or anything else) is something that no sensible person, including Adam, would do. Adam’s argument was based both on the data and on anecdotal evidence from his own life. On the contrary, rather, it is possible (likely) that the prevalence of Islam happens to be correlated with some other factor that is driving these outcomes.

Is it poverty? In other words, do Muslim countries seem to be different simply because they happen to be poor (prevalence of Islam is definitely correlated with poverty)? I was curious about this, so I decided to run some regressions, with the dependent variables being a series of social indicators, and the explanatory variables being 1) the percentage of the country’s populace being Muslim, and 2) per capita income. If there’s a connection between Islam and the social indicators other than through the correlation with lower income, then the coefficient of the “percent Muslim” variable should be statistically significant.

The results were pretty remarkable. The prevalence of Islam, controlling for income, is associated with poorer scores on all six World Bank governance indicators; lower levels of education; higher fertility rates; less frequent use of contraception; less use of the internet; lower ratios of female-to-male school enrollment; a higher ratio of female-to-male unemployment; fewer women in parliament; and a lower ratio of female-to-male income. The one bright spot was that it was also associated with less inequality. (See here for a table of results.)

It occurred to me that oil might be playing a part in the results. The reason is as follows: a) poor results on the social indicators mentioned above are strongly correlated with lower incomes; b) the prevalence of Islam in a country is correlated both with lower incomes and with having oil; and c) having oil can be seen as a “short cut” in some cases to higher incomes, where the link that the same endogenous process of rising incomes and improving social factors doesn’t take exist. Is it possible that a handful of wealthy, oil-rich Gulf countries which happen to be predominantly Muslim were skewing the results?

I ran a second regression, this time adding another control variable, the number of barrels of oil a country produces per thousand people. If the link between Islam and poor social outcomes is explained by oil, then adding this control variable should render the Islam coefficient statistically insignificant.

It turned out there is some evidence for the oil hypothesis above. The coefficients for most of the factors examined get smaller, meaning the effects of the “percent Muslim” variable is weaker when you introduce the oil variable. For instance, the first regression on contraceptive prevalence predicts that in an all-Muslim society, 17 percent fewer women would use contraception than in a no-Muslim society; in the second regression, this difference is just 12 percent. There are also some social factors for which the statistical significance of the “percent Muslim” variable decreases. For regressions on rule of law and internet use, the coefficient no longer passes a 5% test (as it before adding the oil control), and four other factors see the coefficient no longer pass a 1% test. Of course, you have to take this with a grain of salt, because the additional multicollinearity when you introduce the oil variable should drive up standard errors, so this might just be a purely statistical phenomenon, not anything meaningful. (See here for a table of results for the second batch of regressions.)

Nonetheless, you can’t deny the obvious here, which is “how Muslim” a society is does have a statistically significant link to different social outcomes, even after controlling for income and oil. The next question, and one I think is much harder to explain, is why.

It is naive to look at a group of people who embrace a particular set of beliefs, identify their characteristics, and conclude that the beliefs are the cause of those characteristics. This blind leap from correlation to causality is as naive as the first-semester statistics student who, upon learning that people who eat caviar tend to live longer than those who don’t, concludes that the consumption of slimy fish eggs is the key to long life. It takes common sense, and a will to resist one’s intellectual pride, to wonder about what the real reasons might be, even if we have eliminated the possibilities of income and oil.

What my own common sense tells me is that, though many of Islam’s social teachings (having emerged in the 7th century) seem antiquated, this is not unique to Islam. In every other religion that precedes Islam, we can find teachings that are seemingly barbaric by today’s standards. And yet, I have never read a news story about some Israeli adulterer getting stoned to death, even though the Torah says so. Neither have I read such a story coming from Turkey either, by the way.

So what’s really going on here? Add your comments below.

Why is this interesting? Well, if you look at the last few months’ worth of employment change data, it’s tough to figure out just what the next few months have in store. Job losses seamed to peak (or trough, whatever) back in January, when the US economy lost about 741,000 jobs on a seasonally adjusted basis. In the next four months we saw this number steadily decline to just 303,000 in May, and everyone got excited. Then the next month it jumped back up to 463,000 in job losses, still a devastating number and pretty disappointing for those that hoped we’d reemerge into positive territory soon.

Now I feel that analysts don’t really know what to expect from the next few months. Will we continue to shed employment at a lower level for much of 2010? Will the numbers reach into slightly positive territory or hover around zero for a while, at a pace of growth slower than that of the labor force? Or will employment rebound strongly in the next few months, enough to bring down the unemployment rate? (Unfortunately, not many people seem to believe in this last scenario.)

What does a quick forecast say? Well, using just the “household” items, you can get a good historical approximation of quarterly employment changes, two quarters down the line. These “household” items are:

• Second-order change in employment (basically change in change, from Bureau of Labor Statistics)
• Inflation (BLS)
• GDP growth (rates from the most recent three quarters, from the Bureau of Economic Analysis)
• Growth in durable goods consumption (BEA)
• Export growth (BEA)
• Business output per hour (indexed, from BLS)
• Business output per person (indexed, from BLS)
• Business average weekly hours (indexed, from BLS)
• Change in business unit profits (BLS)
• Interest rate spread (10-year T-bill minus Federal Funds rate, from the Fed)
• Percent change in M1 (Fed)
• Percent change in S&P 500 prices (lots of places on the web)
• Consumer sentiment index (from the University of Michigan… basically because I’m too cheap to pay for consumer confidence data)

The results of this exercise were surprisingly good. Regressing all of these things on employment change two quarters into the future yielded an R-squared value of about .90. And an eyeball test proved pretty satisfying. Take a look:

Using data up to Q2 2009, the model predicts a drop in employment of roughly -673,000 in Q3. Like a lot of other forecasts (by people who are actually paid to do this), this turned out to be much smaller than the actual loss (-1,042,000) reported by the BLS for that quarter.

Unfortunately, the model doesn’t exactly anticipate a robust turnaround in Q4 (shocking), with a predicted employment loss of -613,000 over those three months. So, basically don’t quit your job at the dry cleaners just yet.

Making matters worse is the situation with what is probably my favorite leading indicator of employment: temporary help services. As companies start dipping their toes into the water in terms of once again increasing headcounts, they often start with low-risk temporary employees that are easy to shed. Unfortunately, after completely falling off a cliff the past year-and-a-half, recent data on temporary employment gives us very little to be excited about.

What’s your prediction for the next few months? How positive or negative are you? What’s the big missing factor from the model? Let me know your thoughts.