Friday, July 24, 2015

Know thyself... or carry a wallet

 
Of all the axioms of utility theory, the completeness axiom is perhaps the most questionable.  
- Robert Aumann, Nobel Prize Winner

One of the reasons you keep a well-stocked wallet in your pocket is because you don't know very much about yourself. Know thyself, as the Greeks say, and you can skimp on the amount of media-of-exchange you keep on hand.

Greater self-awareness leads to a cleaner "mapping out" of an individual's tastes and the preferred timetable for the enjoyment of those tastes. For instance, a moment of self reflection might lead you to conclude that pistachio ice cream at 8:31 PM next Friday is the best possible state of the world. If a complete set of futures markets exists, you can purchase a futures contract that is time stamped to deliver pistachio ice cream at 8:31 PM Friday, guaranteeing ahead of time that your tastes will be satisfied.

The problem is that introspection is difficult. We simply don't have the time, knowledge, or energy to sketch out a full timetable of carefully-delineated tastes and preferences. Even if we are blessed with a full range of futures markets, missing preferences prevent us from making use of these contracts.

Instead of committing ahead of time to satisfying taste A rather than tastes B, C or D at 8:31 PM Friday, an individual may prefer to remain non-committal. They can act on this preference by buying a broad range of option contracts that allow them to satisfy tastes A through D over a fuzzier time period, say Friday evening-ish. At the last minute they'll exercise just one of these many options while allowing the others to expire worthless. This sort of last minute off-the-cuff gauging of preferences allows for direct appeal to the mind's current state. This is surely a far more accurate way to get what one wants than trying to imagine what tastes will be like a week from now and locking that decision in by buying the relevant futures contract.

The problem is that the real world is bedeviled by not only missing preferences but also missing markets. Options on future consumption don't exist. Try buying a range of options exercisable between 6 and 10 PM Friday on twenty different flavours of ice cream.

There's an alternative. People can mimic an option buying strategy by allocating a portion of their portfolio to 'monetary assets,' those assets which are more liquid, stable, and cheaper to store than regular assets. The ability of a monetary asset to act as a good store of value up until the final act of acquiring a consumption good means that its owner needn't worry about lacking sufficient purchasing power to satisfy any of tastes A to D. And the liquidity of these monetary assets means that they needn't worry about being unable to swap for whatever consumption good they feel will satisfy their needs. So by holding a monetary asset, an individual has effectively bought themselves an option to satisfy a whole range of tastes at any point on Friday night. This is hassle-free flexibility.

Options aren't free. In financial markets, for instance, traders must pay a premium to secure an option. Likewise for liquidity. By holding monetary assets, individuals gain more flexibility surrounding the satisfaction of their tastes but give up potential returns. After all, a chequing deposit is more liquid than a term deposit, but a term deposit—which serves no monetary purposes—offers a superior capital gain.

So on the margin, people always measure the cost of becoming a bit more self aware against the drawbacks of holding monetary assets. If there is some low-hanging introspective fruit to be harvested, it may be worthwhile to spend a few minutes in reflection if this allows for a subsequent shift in wealth from liquid low-return assets (like chequing deposits) into illiquid high-return assets (like term deposits). On the other hand, if it is desirable to remain fluid and non-committal about tastes and the timetable for achieving them, cash and liquid securities are a means to buy this flexibility.

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Here's the punchline.

Economists often (though not always) specify that individuals have a complete set of preferences. This means that the cast of characters that populate economic models come outfitted with fully specified sets of tastes and timetables for their enjoyment. There is no room for self-doubt, waffling, or vacillation. Nor do the people in these models need to spend any time or energy on introspection. Self-knowledge is free.

This no doubt makes economic models mathematically tractable. In the world outside of these models, however, our desire to hold liquidity is motivated by the fact that we are not fully self aware. Our tastes and timetables for realizing them are frequently left empty, usually because introspection is costly, inaccurate, and slow. Liquid media of exchange are an ideal way to stay flexible and uninformed about future tastes. By choosing to assume perfect self-knowledge, economists rule out at the outset some very important reasons people have for holding liquid media of exchange. With the 2008 credit crisis having illustrated the importance of liquidity factors, this seems like an unfortunate assumption to make.

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