What Would Stein Do? - Monetary Policy and Financial Regulation

Should monetary policy play a role in financial regulation? Although Federal Reserve Board Governor Jeremy Stein argued in a recent speech that it does, monetary policy wonks such as Scott Sumner have not taken Jeremy's suggestions well. While I am sympathetic to both narratives, I feel that they miss the boat on what monetary policy as financial stability regulation would look like. When reading supporters such as MCK or opponents such as Ryan Avent, Matt Yglesias, and Scott Sumner, I find that the debate is focused on the short term interest rate response to financial risks. However, the focus on only the short term interest rate and its relationship with financial regulation is incredibly narrow and ignores important research on alternative monetary policy tools.

It may be useful to review the positions of the involved parties. According to M.C.K, monetary policy needs to be conducted with an eye to financial stability for two key reasons. First, extended periods of low interest rates encourage excessive lending. This causes bubbles to grow and results in large macroeconomic effects once they pop. Therefore monetary policy should be conducted to pop bubbles before they become major economic threats. Second, monetary policy is more effective than specific microprudential regulations such as inspecting bank balance sheets because financial innovation can allow banks to hide much of their conduct. Because all firms face the same set of interest rates, monetary policy has a better chance of "getting in the cracks" of financial markets and better protecting the system. Thus because monetary policy has wide reaching effects, it should be an important part of any financial regulation toolkit.

On the other side, some more Monetarist authors such as Scott Sumner or Matt Yglesias argue that using the short term interest rate as a regulatory tool is misguided because what matters most are macroeconomic variables such as nominal GDP or employment. Because monetary policy is such a blunt instrument, raising interest rates to pop a financial bubble is akin to fumigating an entire house to get rid of one patch of mold. The instrument is out of proportion with the threat. If the central bank stabilizes nominal GDP  the impact of financial crises on aggregate demand should be minimal. Moreover, it's not even certain if central banks can accurately identify bubbles. Even though the U.S. housing bubble seems obvious now, it's not exactly clear that policy makers could have identified it in real time. Therefore using monetary policy to pop bubbles is unlikely to be very effective and would result in substantial collateral damage.

Were the Fed to use monetary policy as a financial regulatory tool, the dilemma would be that one instrument, the short term interest rate, cannot simultaneously stabilize nominal GDP and the financial sector. One cannot address two problems with one tool. Fortunately, Stein has been working on an alternative policy regime to solve this problem. Once his alternative is considered, we can see how monetary policy and financial regulation can more effectively be integrated.

Stein's core proposal is that the central bank can be both a financial regulator through a combination of strict reserve requirements and paying interest on reserves. In Stein's model, the central bank can guide nominal variables through a kind of Taylor Rule for the short term interest rate while affecting the financial sector by manipulating the spread between interest on reserves and the short term interest rate.

To understand the logic behind Stein's proposal, we need to understand why the financial sector can be so unstable. Stein argues an important cause is an excess of short term debt. In particular, excessive short term debt raises the probability of fire sales, and the risk of a fire sale creates social costs that banks cannot internalize. Because reserves are required for short term debt issuance, a tax on reserves helps to constrain short term debt creation. In this way, a reserve tax helps internalize the costs of certain financial frictions, and therefore is an important tool for macroprudential regulation.

Stein proposes to implement such a reserves tax by first subjecting short term debt to stringent reserve requirements and then by varying the gap between the short term interest rate and the interest rate paid on reserves. To see why the gap between the short term interest rate and the interest on reserves is a tax on short term debt, recall the relationship between reserves and debt issuance. In a world of reserve requirements, the bank must hold a certain amount of reserves in order to issue the new debt.  Had the bank been able to lend those reserves out, they would have earned interest equal to the short term rate. This is the gross tax on reserves. But because the bank is also compensated with interest on reserves, the net reserves tax (heretofore known as the 'reserves tax') is the difference between the short term rate and the interest on reserves.

Under this framework, although both the short term rate and the interest on reserves are nominal variables, the spread between them is a real variable that serves to penalize issuance of short term debt. The pre-crisis policy of not paying interest on reserves meant that the short term rate was the entirety of the reserve tax. Therefore any desired increase in the reserve tax required the Fed to raise short term rates one-to-one. However, if the central bank were to pay interest on reserves, it can hold the short term rate constant while increasing the reserve tax.

In other words, policymakers can regulate debt maturities without deviating from existing interest rate rules. By increasing the gap between the interest paid on reserves and the short term interest rate, the central bank can penalize the issuance of short term debt without having to raise short term rates. In doing so, the central bank can try to stabilize nominal GDP while reducing short term debt fragilities. The central bank can engage in macro-prudential regulation while also staying faithful to its price stability and employment objectives.

No doubt, there are some problems with such an approach. The most obvious one is the case in which the required reserves tax is higher than the interest rate required to maintain price stability. In this case, since the interest rate cannot be lower than the rate on reserves, satisfying one mandate would necessarily ignore the other. To avoid this problem, the central bank could raise reserve requirements on short term debt. The intuition behind this is that for each additional dollar of short term debt, the bank would need more reserves. As a result, the effect of the reserves tax would be magnified, thereby lowering the optimal reserves tax below the necessary short term rate.

Another concern is that raising the reserve requirement could substantially disrupt the functioning of banks. Because banks have become used to certain reserve ratios, they would have a hard time adapting to higher reserve requirements, thereby reducing the money supply and causing more uncertainty. I see three ways central banks could mitigate this. First, they could announce the change in reserve requirements ahead of time and allow banks to more smoothly transition into the new regime. Second, the reserve requirement could be raised when there is a large supply of excess reserves, such as right now. Third, if nominal GDP slows down substantially, the Fed could engage in other "unconventional" actions such as Quantitative Easing to inject assets into the system. Moreover, raising reserve requirements as a part of deploying a new macroprudential framework may make certain Basel III requirements obsolete. In particular, the Basel III proposal of defining a stable funding ratio to limit short term debt issuance may become unnecessary when the Fed can control such a ratio with much more precision through a reserves tax. By making other reserves regulation obsolete, a new policy regime with interest on reserves could actually ease the regulatory burden on banks.

Neil Irwin, in his post on Stein, likened raising interest rates and popping bubbles to fumigating an entire house to get rid of one patch of mold. However, Stein's policy proposal would not be so dramatic. It would be more like a dehumidifier, addressing the risks of mold while still allowing people to live in the house.

Thus the debate over whether the short term rate should be used to moderate credit cycles seems a bit silly in the context of what Stein's papers have been suggesting. It is almost as if in all the arguments over what Stein said, people have forgotten to look at what he has written in the past. The alternative approach with interest on reserves and stricter reserve requirements can coexist with the price-employment mandate. In addition, such a strategy provides monetary authorities more tools to interact with the very large financial sector. In this way, the effective integration of financial regulation and monetary policy should improve macroeconomic stability, not worsen it.

Market Monetarism and Finance

As market monetarism starts to become more mainstream, I have started to take some time to think about what yet has to be done to develop this new brand of monetary theory. One issue that recurs in my thoughts is that market monetarism needs to help develop a richer understanding of financial dynamics.

One of the strongest justifications is that a richer understanding of financial linkages would help untangle the dynamics of monetary policy under different regimes. Scott Sumner argues that monetary policy works not with long and variable lags, but rather long and variable leads. Because agents are forward looking, expectations of future nominal GDP significantly affect current economic activity. The strongest evidence for this comes from the financial markets. For the United States, Marcus Nunes has done quite a bit of work charting the immediate effects of monetary policy hints on inflation expectations:

We also see similar evidence in the international arena, whether Japanese, Swiss, Hong Kong, or American.

However, the chart is incomplete. Past studies do suggest that the effect of interest rate cuts are not felt until several months after the initial policy declaration. While there may be identification issues with those studies, they do open up the possibility that monetary policy does not act as quickly as market monetarists would hope. In this context, a hybrid approach may be more accurate. While monetary policy leads the financial sector, it is likely that monetary policy lags in other "real" sectors, such as manufacturing.

This synthesis of both monetary and financial dynamics is especially important given Lars Christensen's argument that "there is probably no better indicator for the monetary policy stance than market prices." We know from the financial literature that certain phenomena, such as excess volatility, seem to defy the typical market monetarist use of the efficient market and rational expectations hypotheses. This is not to say policy would be better guided by the arbitrary decisions of central bankers, but rather that a move to market based signals needs to be grounded on better a theoretical and empirical understanding of how monetary policy and financial signals lead other parts the real economy.

As an example of this, we can take a look at the relationship between TIPS inflation expectations and PCE inflation. For those who don't know, the TIPS spread is the interest rate differential between the 5 year inflation protected treasury and the regular 5 year treasury, and therefore is a measure of what investors expect inflation to be over a five year time horizon.

Under the rational expectations hypothesis, expected future inflation should be a reasonable estimate of actual future inflation. By the efficient market hypothesis, these expectations should then be expressed in the 5 year TIPS spread. However, for the years during which we actually have data on how the 5 year TIPS compared against the actual inflation rate, performance is quite poor:

This evidence suggests that even market forecasts can be unreliable. While they can sometimes be a good indicator of future performance, in other times they can be unacceptably wrong. In the above example, the relationship between the TIPS forecast and actual inflation was so wrong that it was negative. While such data points may be washed out in the long run, the 5 years of flawed predictive capacity that it would have given should give any policy maker pause.

However, the TIPS spread is actually quite a good predictor of contemporaneous inflation. Below I plotted each month's PCE inflation rate with that month's average TIPS spread, and find that the linear prediction (red points) does a good job of measuring current month inflation:

This suggests that while we may not be able to use market signals to predict with precision, market signals do carry significant information content. Instead of waiting for each month's CPI report with bated breath, we could simply consider the financial data that is always available to us. This resembles my conclusion from looking at forecaster data. Given that we have reasonably accurate forecast, monetary policy should target those forecasts. When bad forecasts come in, central bankers can signal that they are ready to ease monetary conditions if the bad conditions materialize themselves. The trick here is to make sure that the information hiding in market prices can make its way into policy, and a better understanding of the relationship between finance and macro is an important step in that direction.

The Unexpected Implications of Expectations

As Market Monetarists, we always stress that expectations matter. But how can we test this hypothesis? One way we do this is to use financial evidence such as TIPS spreads to show how changes in monetary policy expectations directly affect market conditions. Evan Soltas recently tried to use a different method: surveys. He put together a series of graphs documenting changes in forecaster expectations around the time of the financial crisis, and claims that the graphs suggest that a "sudden collapse of short-to-medium expectations...could be more important than current-quarter NGDP."

But I disagree with Evan on how we should interpret such results. I took a look at the Survey of Professional forecaster data and restrict my analysis to the Great Moderation period since 1990. I also focus in on the 1 year forward NGDP forecast, as the 1 quarter forecasts give qualitatively similar results.

Like Evan, I too observe that current nominal GDP expectations are related to real variables, such as unemployment. However, the overall relationship is quite weak. NGDP expectations can only explain about 5% of the variation in unemployment. Moreover, the slope estimate is likely to be biased downwards as autocorrelation means the true slope is even closer to zero.

However, even if the correlation were stronger, it still would not say anything about the causal effect of future expectations on current conditions. Any observed correlation could simply be rational expectations at work, with causation running from unemployment to NGDP. Because unemployment is high now, it would be rational to assume that future nominal GDP will be slightly lower. Even if the Fed were more powerful, there would still be some imperfection in the implementation of monetary policy that would cause expectations to shift downwards.

To control for this, we need to look not at the change in expectations, but rather changes in surprises. A big theme in nominal GDP disucssions is that nominal prices are sticky. Therefore, when NGDP falls below trend, because past nominal contracts were set under the expectation of the higher trend, markets fail to clear and we have a fall in real growth. Therefore, if this transmission channel were true, when NGDP falls below what was expected, we should expect to see a significant impact on unemployment.

In other words, we should consider whether actual nominal GDP hit forecasts or if it fell short. This way we can construct an error index that measures to what extent forecasters over or underestimated. Positive numbers denote when actual nominal GDP outperformed the forecast, and thus the dramatic fall into negative territory during the financial crisis reflects the unexpected nature of the nominal GDP shock.

While it certainly did fall during the financial crisis, if you use ordinary least squares regression on this index against variables of interest, such as unemployment, you will not find any kind of systematic correlation. However, if you consider only the extreme cases in which the forecast undershot reality by more than 4%, then you do get a significant negative correlation:

Perhaps this evidence suggests that expectations have a nonlinear impact on unemployment, but at that point we are drawing epicycles that the regression evidence does not warrant.

Does this all mean that expectations are useless? On the contrary. When investigating these expectation surveys, I did manage to uncover the following chart comparing forecasts and actual nominal GDP growth. I lagged the actual NGDP by 1 year, so it is easier to compare how the forecast compares with actual growth.

What we can see is that the forecasters, while not perfect, still do a rather good job of identifying times of distress. Given that forecasts do carry information, then this opens up a role for policy to lean against the wind. The Fed, instead of waiting for all the data to come in, could use a joint forecast-contemporary data criterion. If the forecasters are projecting slow future growth, then the Fed could announce that it is aware of a potential problem and prepare the necessary policy machinery, conventional or otherwise, to combat that threat.

Expectations matter, but we need to be clear on why. While they may have a direct impact on growth, expectations also serve as a crucial lens into the future and can carry information content for policy makers. Armed with such tools, monetary policy can turn towards the future, lean against the wind, and in doing so remedy demand shocks before they start to hurt. 

Forward Looking Markets in Japan

Even though Shinzo Abe has not yet cemented in a new era of Japanese monetary policy, markets have already been preparing for such an event. The market response is a good illustration of how markets act in a forward looking manner.

First, we need to identify when the international community started to focus in on Shinzo Abe. For this, we can look at Google's international search intensities:

From here, we can identify the time around December 15th to be the starting point. Now let's take a look at how markets have responded since then.

First, the exchange rate. Easier monetary policy raises aggregate demand, accelerating NGDP growth and depreciates the currency. Even though the statutory monetary policy framework hasn't changed, the yen has already lost around 7% of its value relative to the dollar since December 14th:



Exhibit 2, the Stock Market. In the same time period, the Nikkei 225 index has risen over 9%. To give this some perspective, almost one-third of the gains over the course of the past year have been the result of the past month of advances.



These statistics are quite striking when you think about the policy controversy surrounding Japan's "lost decade" and the hundreds of trillions of yen that went into public works programs.

Also, these statistics are quite interesting for the "long and variable leads" perspective on monetary policy. Historically, the money supply has not had a large effect on real variables such as GDP. In fact, if you really dug into the 5 year rolling correlations, you would find that, most of the time, quarterly money supply growth actually had a negative correlation with quarterly real GDP growth in that period.



Yet just in the past month, a few "open mouth operations" have seemed to dramatically change market perceptions of monetary policy. This suggests that the mechanical money printing is quite powerless without effective expectations management. As such, there should be significant gains to Shinzo Abe's drive to change the Japanese monetary regime.

On a separate non-economic, purely speculatory note, I'm not sure how the nationalism issues brought up by Noah Smith would interact with this drive to make monetary policy more inflationary. On one hand, if monetary policy is seen as a driver to achieve national ambitions, then the nationalist drive may reinforce the increase in aggregate demand. That would be good. But the worrisome possibility, which worries me more than the possibility that Shinzo Abe will give up on monetary policy, would be that the monetary policy stimulus will be too effective and further stoke nationalist ambitions. The last thing we need is some stupid quibble over the Diaoyu islands that leads to a face-losing and economy destroying outcome for everybody.

Update 1/19/13:

Scott Sumner emails me with the following comment:

"Abe actually started pushing for a 2% inflation target during the campaign, in mid-November. The day of his first speech is the exact the the huge stock rally began, and the exact day the yen began falling sharply. I did a post that day, or perhaps the next. 

http://www.themoneyillusion.com/?p=17736 

It's hard to disentangle money printing and expectations. Think of the following thought experiment: The central bank doubles the money supply and is expected to cut it in half 3 days later. Everyone agrees that there is little effect on markets or AD. So in some sense we are always implicitly making assumptions about monetary policy. On the other hand, I can easily envision where big changes in the money supply also contain information about future expected monetary policy, even if not made explicit. So I can envision QE "working" at least to some extent, even w/o an explicit promise regarding future policy."

Looking back at the data, I should have been more careful with the timing issue. Although the November 15th spike looks minimal, it is only because the December spike was much larger. Focusing in on that one month of the Google data yields the following graph:




On the relationship between money printing and expectations management, I agree with Scott that money "printing" policies, such as QE, can have significant effects even without explicit open mouth operations. The Fed doesn't need to announce a NGDP target for those policies to have effect. But the point with Japan is that effective communications policy can enhance monetary policy. Given that money supply expansion hasn't been sufficient in the past, perhaps a more powerful target will do the trick.

Very Quick Thoughts on (Chinese) Healthcare

The problems consumers face in the Chinese health care system may suggest that the information asymmetries and uncertainties in the provision of health care are much more difficult that we think.

In China, a significant issue that I hear complaints about is that there never is enough capacity. Hospitals are crowded, and it's hard to get adequate care. Instead, doctors spend minimal time with the patient, medicate them to the maximal extent, and then send the patient on his way.

Even when you do get medicines, there's no guarantee that they are the best value for the patient. Many Chinese doctors get commission from companies based on the prescriptions they push forward to their patients, and are thus incentivized to recommend the more expensive imported medicines.

Why does this persist? I suspect it is a combination of both government failure and market failures.

Let us start with the market failures. First, it seems clear that the market is not competitive. Otherwise, perhaps more hospitals could be built to help mitigate the overcapacity. But the most obvious solution -- encouraging more entry by lowering regulatory barriers -- may not be the most effective. In such a world, there would be two tiers of health care, the first being the traditional system that we have now, the second being the new deregulated system.

In the second system, I fear that it may become dominated with fraudulent medicines and unscrupulous doctors. In China, it's already a common frustration that goods that you buy never seem to be real, and whenever there is a profit opportunity, fake goods appear. At best, this wastes money. At worst, this wastes lives. As a result, I have a hard time imagining that deregulation would go off without a hitch.

I also doubt word of mouth would do much to solve these information problems in the second tier. It's hard to tell the differences between charlatans, and as such it would be much easier for consumers (who are predominantly old) to group the entire second tier collectively as ineffective. The difficulty consumers face in evaluating the quality of care also makes it harder for the market to converge on a fraud-free equilibrium. Moreover, if consumers need relatively limited amounts of healthcare, then it's hard for them to learn from experience.

As such, while deregulating the provision of health care in this way could improve health care by giving much more choice to consumers, it does not seem sufficient. The lack of competition seems to be the result of these information asymmetries, and to address the lack of competition you have to first address the problems in getting information.

Yet this story of market failures may instead be a story of government failures. In the case of overmedication, the government does have laws on the book in order to mitigate it. Their solution is to control the prices of individual drugs as well as limit the total monetary value of drugs that a doctor can prescribe in a single visit. However, doctors then respond to this by reducing the length of prescriptions, and then having patients come to the hospital more often. This contributes to the capacity issue because patients are forced to come to the hospital more often.

Also, because prices are controlled, patients have to "walk the back door" (走后门) and pay additional bribes to doctors to get care. This exacerbates the imported drug problem, because if doctors cannot earn as much money through conventional means, it is natural that they find ways to work around the system to make the money.

Price controls are also problematic because they make investing in new medicines very risky. Even if a given company can create a drug, it's always uncertain how the government will regulate it.

Based on these competing narratives, I draw two broad conclusions.

First, crude price regulation is rarely an answer. In such a world, it's too easy for people to work outside the system (in the case of bribes) or for doctors to subtly change their work inside the system (in the case of overmedication). Instead, if regulation is to work, it needs to address reasons, like asymmetric information, why health care provision hasn't been working like in a regular market.

Second, consumer choice is insufficient. As healthcare consumption becomes dominated more and more by the elderly, it strikes me as very odd that the most feeble in society are now tasked with identifying the best form of healthcare in an environment that is growing increasingly complex. There is just too much uncertainty, both ex-ante and ex-post, about the quality of care, for the standard word of mouth and experienced buyer mechanisms to work.

Voter and Consumer Irrationality: An Extension

Questioning rational choice is not a sufficient basis for arguing for government intervention. But my past few posts questioning standard market propositions in the case of health care are not meant to promote every single government regulation. Rather, I wonder if we can try to further the study of economics and public policy by reversing the typical way public choice economics is applied.

When I think of public choice economics, I think of papers about how the marginal costs and benefits of lobbying lead to poor government policies or how decentralizing the functions of governments leads to a competitive equilibrium with better governmental policies. At its core, I interpret this line of analysis as using the success of markets to explain why governments fail. Markets succeed because marginal costs line up with marginal benefits, and thus governments fail because these costs and benefits are distorted. Markets succeed because there is competition between firms, and thus governments fail because there is no competition. What I want to propose is that we change the direction of this line of thought, and start from the vast literature on why governments fail, and see if that can teach us about why certain markets fail. 

This is why I think behavioral economics is so important. By reducing biases down to core psychological first principles, it highlights the connection between government and market failure. But we should also make sure to avoid thinking that policy makers themselves are perfectly rational. As John Papula pithily points out:

Why in the world do behavioral economists who study our flaws and irrational quirks advocate centralized power in the hands of a small group of flawed overlords? If people are irrational, so are government regulators, only they have corrupting monopoly power.

As such, I agree that it is important that behavioral economists grasp the concept of public choice, but also for public choice to grasp the concept of behavioral economics. There exist reasons for why the market often overcomes behavioral biases, but then there also exist markets in which those mechanisms don't function well. And most likely, we can trace these mechanism failures to arguments past public choice economists have made about the failure of government. That is my conjecture, and I hope to be able to pursue further analysis of health care under this framework.

Voter and Consumer Irrationality: Two Sides of the Same Coin

One strong argument against the government provision of services is that democracy is a very imperfect substitute for markets. As noted by Bryan Caplan, voters have a hard time rationally evaluating policy options, and thus the public choice economy may be a very bad one. The natural conclusion of this argument is that, to the greatest extent possible, the provision of goods should be pulled away from government and the responsibility should instead be allocated to the market. Yet this line of logic contains its own contradiction: if voters cannot rationally choose the right public policy, how can they be expected to make the right private choice?

Now, I don't mean to say markets never work. I am very happy with the way capitalism has treated me, both in terms of the large historic liberalizations that brought me to this country as well as in the small conveniences that improve my everyday life. I don't mean to reject this. But what I want to suggest is that the acceptance of the irrational voter hypothesis suggests that we should take a closer look at our acceptance of the perfect market equilibrium in many different sectors, in particular health care.

Bryan Caplan, in his work on voter irrationality, outlines four main biases: the anti-market bias, anti-foreign bias, make-work bias, and pessimistic bias. 

Anti-market bias refers to the public's systematic bias towards policies that interfere with prices and profits, such as farm subsidies or rent control. I like to think of it as the public's bias against simple supply and demand explanations of the market. 

Anti-foreign bias refers to the way the public tends to see people from other countries as fundamentally different from itself, and thus the bias causes people to under-estimate the benefit of free trade and immigration. People focus on the auto jobs outsourced by free trade and the native fast food restaurant replaced by immigrants, while paying little attention to the new opportunities and technologies granted by interaction with foreigners.

Make-work bias refers to the way the public confuses productivity with having a job. As Caplan cleverly states, "For an individual to prosper, he only needs to have a job. But society can prosper only if individuals  do a job, if they create goods and services that someone else wants." People tend to make the classic luddite fallacy, that new technology destroys more jobs than it creates, and that, as a result, technological growth actually worsens the standard of living.

The fourth and final bias, pessimistic bias, refers to the way the public tends to overemphasize the things the get worse over time, and forget the ways that life improves. Recession is confused for regression, and the massive technological advances of the markets, such as improvements in information technology and energy infrastructure, are forgotten.

Yet when I think about these biases, I would argue that they all are manifestations of a more fundamental psychological bias: a bias towards salience.

Salience refers to the way certain effects or phenomenon are more apparent and more obvious. We should be familiar with this idea of salience in our everyday lives. It's easy for me to enjoy the concentrated fun of watching old episodes of scrubs, it takes more effort to remind myself of the dispersed benefits of working hard on math homework. It's easy for me to catch up on the extra hour of sleep, it takes more effort to remind myself of the long-term benefits of exercising in the morning. As Katherine Baicker, Sendhil Mullainathan, and Joshua Schwartzstein like to joke, "Our research has definitively determined that running is unpleasant and donuts are tasty," and as such, people tend to choose the salient joy of tasty donuts and the immediate avoidance of hard running instead of the long term benefits of consistent exercise. Or as Thaler and Sunstein put it in their book Nudge, very rarely do people ever make new years resolutions to smoke more cigarettes or drink more alcohol.

I would argue that salience forms the basis of Caplan's irrational voter biases. Salience means that people tend to see the direct negative impacts of market liberalization, and neglect the role of the fallacy of composition in hiding the harms that arise from government intervention. In the case of the anti-market bias, the benefit from paying farmers is salient, whereas the cost of higher food prices are dispersed and not as apparent. In the case of the anti-foreign bias, the closed steel mills down the street are immediately visible, whereas the newly created jobs in the software industry and management consulting are not as visible. In the case of the make-work bias, people directly observe the seamstresses fired and don't see the new women, who on count of greater general prosperity, are then given the chance to go to college for a better life. And finally, in the context of the pessimistic bias, people tend to worry about the bad changes more than the good. People complain more about the rising price of gas and food, which they buy everyday, and not the fall in computer prices, which they rarely have the chance to purchase.

Re-framing the issue in terms of fundamental psychological first principles adds to the way we should interpret the irrational voter hypothesis. Rather than seeing the phenomenon of the irrational voter as an isolated problem that makes government policy ineffectual, we should see the irrational voter as a more general irrational person. As such, there may be certain (not all) markets, such as health care, that do not liberalize in the way other markets do. In the case of health care, because certain differences between doctors, such as bedside manner, are more salient than others, such as improved recovery times, a simple market liberalization may not always promote the best health outcomes. We need to think again, again, about why we need reform. Promoting price disclosure makes the costs consumers pay more salient. Moving away from an employer provided health care system towards individual insurance with an individual mandate makes the costs of choosing bad insurance more salient. But just kicking back and "letting the market (not) work", and treating healthcare just like "consumer electronics, telecommunications, computers" or cars is not a sufficient answer. And if we can move away from fiery rhetoric about socialism and capitalism and towards a grounded and pragmatic analysis of psychology and behavioral economics, only then can a meaningful dialogue on healthcare can occur.

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Update 11/18: I extended some of my thoughts on public choice and health care here.