Friday, December 19, 2008

The insidious perversion of extreme wealth

It’s becoming increasingly clear that not only did the actions of many of the big hitters in finance hurt all of us, but that they really hurt their own firms too: witness the long list of big names who’ve been burnt in the Madoff affair, and don’t even appeared to have wanted to ask basic questions before handing over 100s of millions of dollars of their investors money.

But the observation that there exist greedy people who will do anything for a buck is not exactly earth-shattering. A more interesting question is this: why weren't people in government and even academia not as critical as they might have been about these things, and why are they still so muted in their response?

I think it's because of the psychology of wealth and its almost seductive lure. How often do you see a seemingly sensible person happen to meet someone Very Rich and come away gushing "He's such a smart guy, I hadn't realized what amazing insight he has" etc. People - especially otherwise rather impoverished academics and MPs - love to be around real money, and over time, invites to attend parties and speak at events start to affect their thinking. It's not usually corruption in the sense of brown paper bags or money wired to Swiss bank accounts, but a more subtle corruption of thought.

Economists who work in finance and related areas have a lot of clout via newspaper op-eds and being consulted by both private firms and the government. However, if you toe the line (or make a few interesting comments, enough to seem independent but not enough to case doubt on the whole enterprise) you get invited to cool rich parties and paid very well to speak at business lunches and so on. If you're more open, you will never enjoy any of that.

Equally, if you're in government, if you're too trenchant in your critique, you will be cut out of these activities. And you may be a long time retired from whatever cabinet post you currently hold. Think of how well former chancellors are received on the business circuit and among wealthy society: and how much they'd be hated if during their term they'd said things like this.

This is what I would call implicit corruption: it's not money in brown paper bags and conspiracies hatched in dark halls, but the insidious perversion of reason by the lure of wealth.

For me, this aspect of how extreme wealth distorts information gathering and regulatory activities in society (and tehreby makes the economy less efficient) is one of the strongest arguments in favour of limiting extreme wealth. I am convinced that Page and Brin would have started Google for expected future earnings in the millions (provided no one else was making more: people are very competitive). But if no one has vastly more than that, it's harder to bring about intellectual and political corruption on the grand scale we're now seeing.

Political economy of the housing bubble

I’ve argued below that the housing bubble was like an economy-wide Ponzi scheme. But how did it start and why was it allowed to keep inflating? I think the reasons are mostly political.

For the bubble to even start, you had to have major changes to mortgage regulation, which allowed people to get huge loans, leading to an "arms race" effect which had a key role in bringing about the bubble. This happened mostly in the UK, US and a handful of countries heavily influenced by these two (Ireland, Australia, Spain). These changes were in turn an important part of the conservative shift in these countries. Reagan, Thatcher, Aznar, Howard all made a big deal out of the notion of an "ownership society”. Politically this had the effect of making people on quite modest incomes feel some kinship with the rich: after all, if you own your home and maybe even some stock, aren't you one of “them”? (Among other things, this led to counter-intuitive effects such as poor people seeming to support policies that hurt them, like the repeal of inheritance tax, and reductions in capital gains.) I agree it's hard to make a causal argument here, but the political and economic changes were clearly coupled at some level.

But let’s be nice and assume that the origins of the housing bubble were random and unplanned. I would still argue that the decision to keep it inflated was largely political.

The crucial thing was the collapse of earnings growth for middle-income people. Remarkably, in recent years, in the US in particular, real median income didn’t grow at all even as productivity grew, mainly because the top were taking such a huge slice (as beautifully documented by Piketty and Saez). Harvard's Elizabeth Warren has shown very carefully what this meant at the household level: budgets became much, much tighter, with disposable income (after basics) going down: money tight in (what should have been) a time of plenty.

If you're in government the right thing to do would have been to start to address the reasons for stagnant incomes (i.e. look at executive compensation, the City, tax loopholes etc.). But if, for ideological reasons, you've already decided you don't want to talk about those things, that route is closed to you. Yet if people are really struggling, on a day to day basis, you’ll lose the elections. So when people start using their homes as ATMs and so on, you encourage it. This allows you to achieve something extraordinary: to engage in a massive transfer of national wealth to the rich and win popular elections at the same time*.

*Unfortunately, the downside is net destruction of national wealth, but by then you're out of office, or you pretend the whole thing is an exogenous shock, like a hurricane.

Wednesday, December 17, 2008

Is it a lie if you believe it?

The anti-hero George in the TV show Seinfeld once says something to the effect that it ain't a lie if you believe it. Do financiers understand that at the best of times their industry contributes far less to society than the rewards they have claimed would suggest and that their actions are now directly responsible for destruction of wealth on a massive scale, which simply put means worse lives for everyone - more preventable deaths, lower living standards, higher unemployment - than need have been the case?

The FT's John Kay has had a ringside seat in London, and offers his view in today's paper:
It would be consoling to believe that these individuals know in their hearts they are at fault, but are advised not to admit it. If you are in a road accident, every decent human instinct is to say “sorry” but the small print of your insurance policy dictates otherwise. However, mostly these titans of finance do not experience regret because they do not feel it. They truly believe they were victims not villains, that if the world does not allow them to make large profits the fault lies with the world, and that government agencies should protect them from the consequences of their own actions. They prattle about free markets and the evils of government but deny personal responsibility.

I think that's a no.

Tuesday, December 16, 2008

Brown, Greenspan = Madoff ?

Madoff was operating a "Ponzi scheme" in which there was no real growth, but payouts were made from the money that came in because the fund appeared to be doing so well. Why is this morally and legally wrong? Because it's unsustainable, and the operator knows it.

But how different is a housing bubble, if it's patently obvious to the government, central bank and other key players that it is indeed a bubble? Like a Ponzi scheme, a housing bubble gives illusory returns, not based on any real increase of value but rather through the attraction seemingly high returns have for new entrants to the game. This is surely morally equivalent to a Ponzi scheme?

If so, aren't Gordon Brown and Alan Greenspan guilty of perpetrating (for political rather than pecuniary gains) Ponzi schemes at the level of the entire economy, whose effects are vastly worse than even Madoff's historic scam?

(Agreed, these key players may not have been 100% certain it was a bubble, but it was pretty clear some time ago. But look at it this way: suppose Madoff was, well, mad, and genuinely believed his investors would get those sorts of returns if they stayed with him long enough. Would that make his fraud better? It might affect personal responsibility, but the policy imperative would remain the same. So at some level, what matters if whether it was possible to know it was a bubble: I would claim it was. Of course, when you add to this the story of how a relatively small write-down in the value of some real estate led to this mayhem, you only get more evidence against Greenspan, Brown and the legions of bankers they served.)

Sunday, December 14, 2008

German housing

Some thoughts on the German housing market:

* They didn't experience a bubble (certainly nothing comparable to the UK/US craziness).This was largely a consequence of "old-fashioned" mortgage practices.

* Yet, despite these more restrictive mortgage practices, the fact of the matter is that Germans, at essentially all levels of society, live in better houses than Brits. That is: rich Germans have nicer houses than rich Brits; ditto the middle-class and poor. Comparisons with the US are harder, because the countries are so very different in their use of space and living habits. But I don't think anyone would disagree that German homes are better built.

* This may come as a surprise if you read enough of the business press in the Anglo world, but the purpose of housing markets is to give people somewhere to live.

* So let's get this straight, leaving out any economic jargon: Germans live in better homes, while paying less, and experiencing less volatility in house prices. How is this possible? Simple: good mortgage rules, regulations regarding build quality and schemes to make sure there are enough professionally trained builders. This is not rocket science.

* Do we in the UK and US perhaps have something to learn from them in this instance?

Can we please finally get back to basics?

The unemployment situation in the US is truly scary, the nerds at the US Bureau of Labor Statistics publish a more inclusive unemployment figure (called "U6") than the one reported as headline unemployment which is arguably closer in spirit to European notions of unemployment. It now stands at 12.5%. There are some observations I think are worth making about both what is likely to happen and what it says about what has already taken place:

* Unemployment is a so-called "lagging indicator" in that there tends to be a delay before economic problems translate into unemployment (because of inertia in employment contracts, hiring etc.). So unemployment will probably go up a lot in the next year or so, upto 15% or more in U6 terms.

* For ten years, the UK and US have kept employment up basically on the back of what we now can clearly see was a massive - and often fraudulent - bubble/Ponzi scheme. This has hid a truly terrifying hollowing out of real productive capacity in these two countries. This kept employment in these countries in some sense artificially high. Artificial in the sense of not based in fundamentals and therefore not sustainable. (One thing that's striking is that even during the bubble, unemployment, properly measured was actually not that low, which underlines just how poorly managed these economies have been by those useful idiots Gordon Brown and Alan Greenspan.)

* Now that the bubble's burst, it's panic stations. Many of the major employers who make real stuff in these countries - as opposed to the bogus finance industry - have not been competitive for years. It's all very well to say labour will be re-deployed doing "other stuff", but do we here in the UK any longer have the large scale management and engineering know how to restructure fast enough? Equally, much of US management is disgraceful compared with northern Europe or Japan, and as fantastic as the US research sector is, it's simply not a big enough sector to keep millions of families going.

* Meanwhile, if you take the example of Germany (who've for years been derided by the Anglos for being "old-fashioned" for making useful stuff not keeping pace with all those wonderful financial innovations) their continuing productive capacity is astonishing. They are in trouble too, but their biggest problem is lack of consumer demand in the US (and consequently industrial demand in China), which means no customers for them. This is a huge problem for their economy, but it's important to realize that it's a second-order problem, driven by the collapse here and in the US. They make stuff people want to buy: we no longer have the capacity to buy anything, which hurts everyone. This is different from pursuing policies that lead to primary collapse.

* I hope the lesson has been learned, but has it? There is nothing to be gained by paying management tens of millions. GM's CEO makes vastly more than Toyota's (really!): but who's going under? Super-high pay creates perverse incentives. Put it this way: do you really want someone in charge of a firm who doesn't have enough passion to want to run the company for $1m a year, but would do it for $50m? To me, such a person is surely a bit pathological.

* It's simpler: you have to treat people well; train them; make good products; pursue engineering excellence; invest long term in schooling and public health and so on.

* These are simple social democratic ideas which have their worth in the US heyday between 1950 and 1970 and in northern Europe since the 70s. There has been a war against these common sense ideas by a handful of financial robber-barons and wannabe robber-barons. Can intelligent people now stop listening to these economic fairy tales and come back to reality?

Wednesday, December 10, 2008


Are the Greek riots at least partly a reaction to economic issues? I have no idea, but they might plausibly be. In a number of countries around the world - certainly the US and UK, but in the last five years or so, even in solidly social-democratic countries in Europe - there has been a massive transfer of wealth from the lower and middle strata of society to the top. This has led to the rather remarkable spectacle of median wages remaining stagnant (or even falling) while productivity increased. Meanwhile, in China, one way of looking at what's happened is that only some of gains from their huge leap in productivity have found their way to workers, the rest having being used to prop up the US and help pay for ridiculous financial shenanigans in the West.

To be clear: I'm not saying there was a coherent global conspriacy, only that there was a prevailing economic ideology, unfounded in theory or empirical evidence, which favoured some people, who therefore both believed in it, and sought to spread its influence.

In any case, the net result of all this is that the amazing gains brought about by (i) advancing technology (often underpinned by publicly funded research and carried out by poorly paid scientists) and (ii) hard work on the part of ordinary people all over the world flowed disproportionately to a handful of businesspeople (perhaps we should call them rent-seekers, or even parasites), who contributed little to (i) or (ii).

For a whole host of reasons people didn't see the extent to which they were being ripped off. However, now that the years of looting are taking a more obvious toll, people are not happy.

I would therefore not be surprised (very sad, but not surprised) if in the next few months and years we see more unrest, in even less obvious places than Greece, perhaps in the UK, Germany or even China.

Will things change? I think probably not very much. What I've called The Looting simply isn't understood widely enough to be a political issue. The crisis has already been carefully spun to sound like an act of Nature, and people are bracing themselves for hard times. The parasites remain very close to government on both sides of the Atlantic, and it is by no means clear that the crisis has taught them anything, dampened their hubris or reduced their political clout.

Wednesday, November 12, 2008

The Looting Continues

I'm astonished by the subdued public response to the extraordinary events of recent times: we have been, and are being, looted on a scale hitherto unheard of in peacetime.

Two excellent posts from econ blogs do a brilliant job of explaining what's gong on.

First, this is a great post on the AIG situation by Yves Smith. Smith is ex-Goldman, ex-McKinsey and was head of M&A at Sumitomo, so is no pinko:

Next, Steve Waldmann looks at the implications of the bailout more generally:

His discussion of what government investment means is superb: the bailout is a disaster for all of us even if it turns a slight profit. And the distributional consequences - bad as they already are - may get a lot worse.

I don't really have anything to add except a question: why aren't people enraged by all this? It's not hard to get a sense of roughly what's going on, is it?

Tuesday, November 11, 2008

Financial innovation

Behavioural economists Richard Thaler and Cass Sunstein hav a piece in today's FT:

On financial innovation:
Not so long ago, most mortgages were of the 30-year fixed-rate variety. Shopping was simple: find the lowest monthly payment. Now they come in countless forms. Even experts have trouble comparing them ...

Which begs two questions (i) what purpose did the added complexity serve and (ii) what to do going forward? Their response:
A potential response to complexity would be to require simplicity – for example, by allowing only the standard 30-year fixed-rate mortgages. This would be a big mistake. Eliminating complexity would stifle innovation. A TiVo is a more complicated product than a VCR, but it is also better.

This analogy seems to me just a little inadequate as an explanation of the value to society of the very changes in the financial system which have been at the heart of a meltdown whose costs (direct, opportunity and otherwise) are as huge as is now becoming clear.

System complexity and highly attractive incentive and tax regimes come at a cost. The former can lead to unpredictable outcomes, the latter to perverse behaviour, in the worst case undamped by either social norms or tax structure, and the two together to the massive economic damage we are now witnessing.

So you have to justify these things. Why do we need complcated mortgage deals? Why must we allow banks to trade obscure derivative products? Clearly there are huge costs in terms of failures of this kind? Can we quantify the benefits? Are they really large enough to be worth it?

Ditto incentive and tax structures. Clearly you want outstanding people to be incentivized to do things that make us all better off. But if you're going to argue in favour of a system in which bonuses alone far exceed the entire amount spent on all scientific research and positively dwarf what we spend on alternative energy, you have to justify it: what do we get from the activities of these people and these organizations that is so superior to simpler and less lucrative alternatives?

Thursday, October 16, 2008

Baker has to go

How can this guy be a column writer for the Times?

So we are about to witness something extraordinary. America ... is about to have the most left-wing government in what used to be called the industrialised world. ... In Europe, Conservatives rule in Germany France and Italy, and despite the miraculous recent apparitions of the Dark Lord Mandelson of the Manipulative Genius and Saint Gordon of Perpetual Financial Succour, the Tories still look likely to take over within the next two years. Meanwhile, across the Atlantic, a fully Democratic Government will take office with a domestic agenda that would make European hearts pine nostalgically: huge expansion of healthcare; a vast programme of public investment in modern energy technologies; a liberalising social agenda to be pursued, as is now customary, through stacking the courts with politically activist judges.

Anyone who's spent any time in any of these countries, or even just reads the newspapers would know that nothwithstanding the fact that the Democrats are to the left of the Republicans, there's no way an Obama government would be more left wing than the Merkel government in Germany or even a Tory government here. This is just stupid.

Horse race reporting from the BBC

On a BBC TV news programme a couple of nights ago something to the effect that the Obama and McCain economic plans aren't that different but that "Obama does empathy better".

Three hundred BILLION in tax cuts for the wealthy vs. tax cuts for the majority; a promise to end a three TRILLION dollar war asap vs. at some point one day maybe in a "hundred years"; a real national healthcare systems vs. continuing with the most expensive and least fair system in the developed world.

How different do their policies have to be before news coverage moves away from "he said, she said" and "on the other hand" nonsense to saying something substantive?

We rightly call out leaders from non-western countries when they're being crazy, why are we so afraid to say that today's Republicans are simply not fit for government?

An emerging narrative

Nicholas Nassim Taleb doesn't seem to be a big fan of the financial sector, but in one way the notion of the "Black Swan" he has popularized is helping to weave a narrative which provides cover for the looting carried out by the sector. It goes like this: the crisis was fundamentally unpredictable, a real Black swan event, so who could have known? Shrug. Call in the government. Wait a couple of years. Start looting again.

This is a huge distortion of what has really happened. While the full extent of the crisis has been a surprise I think to most people, the underlying issues - a house price bubble, crazy short-term incentives and a mass capture of national wealth by the finance sector - have long been recognized by a number of commentators. Of course, the ruling elites have never wanted to hear these views, so for some years they've filled the opinion pages of WSJ, FT, London Times, Telegraph etc. with hand-picked cheerleaders for the looting. Now that the sleight of hand has become plain to see, the story has switched to this one of complete unpredictability.

The problems with the finance sector were no Black Swan. The sector's been sucking the nation dry for some years, and with a compliant government buying into it's story has driven (i) a crazy house price bubble, (ii) a huge misallocation of human capital (read smart young people) away from other tasks (health, energy, research, training, transport) into an increasingly zero-sum, if not negative-sum financial game, (iii) a capture of wealth (something like 40% os all UK corporate profits, and that's after paying out those huge salaries; finance adds some value, but that much relative to everything else?) leading to the remarkable phenomenon of stagnant real wags at a time of increasing productivity and (iv) a broader corruption of the public sphere in which taxes are seen as nothing more than a drag on the economy, leading to under-provision of public goods at a time when they're needed more than ever.

Beware the emerging narrative. The underlying causes of this mess have been evident for years, and need to be addressed as soon as possible.

Wednesday, October 15, 2008

Housing madness continues

UK house prices are way out of line. It's a bubble, it's distorting the economy and is one of the underlying elements in the financial crisis. Banks whose assets include IOUs on houses are not going to get all their money back. For that reason their assets are worth less than was thought by optimists during the bubble. It's going to get worse before it gets better: people are going to default, banks are going to have to face up to reality, sellers are going to have to face the fact that people are not going to pay five times their salary for a place to live and so on.

Yet the government seems determined to keep the bubble inflated. It appears to be insisting that the two newest branches of the government, HBOS and RBS, keep lending at 2007 levels, i.e. too much. I can understand that you'd want to "smooth" the house price crash, and I hope this is what they have in mind, but it looks awfully like a desperate attempt to keep the bubble going.

Newsnight had a couple of house price cheerleaders on last night: an estate agent and some guy who wrote a book called "How to make a million in housing" or something like that. And these guys of course are gung ho about the housing business being the backbone of the economy and so forth. The presenter asks a perfectly reasonable question: why not follow other countries which have long imposed fairly hard rules on how much you can borrow (effectively as a damper on bubble formation)? Guests just ignored the question and keep shaking their pom poms. What a joke. This is like asking thieves about preventing robberies. Meanwhile Yvette Cooper refused to even say that there's something wrong with 125% mortgages.

House prices will drop. It's only a questio of how long psychology and government intervention keeps them artificially high and how much broader economic damage is caused in the meantime.

Monday, October 13, 2008

An oldie

From this blog in August 2007:
The labour market distortions induced by extremely high wages in the finance sector are worrying. Put simply: is it really efficient to have legions of bright young physicists and engineers (usually trained at great public expense) slugging it out in the City in the hope of a becoming lucky young millionaires instead of doing research on, say, sustainable energy, or designing genuinely innovative new products?

Arm twisting

A question is being asked about the consumers who over-stretched to take on huge mortgages which goes like this: no one was twisting their arms to take on these loans, isn't there an element of personal responsibility? Sure there's some element of personal responsibility but let's not pretend that decisions to take on huge loans are made in isolation. If everyone else is taking out huge mortgages, house prices go up, and for an individual family the choice is to follow suit or live in a bad neighbourhood (say). Mortgage decisions are in this sense coupled: the prices of homes depend on how much others are willing to borrow, so the prudent have to pay a very high price, in terms of quality of life, possibly for a long period, before a house price bubble deflates and their prudence pays off. This simple fact limits the negative feedback we can expect to see cautious borrowers exert.

Worse, in the UK, the house buying mania is so deep seated that it's actually very difficult to raise a family in rented accomodation. The rental market for familiy houses is thin and the tenancy regulations not great for people in that position.

If even prudent individuals feel compelled, for quite rational reasons, to buy at inflated prices, you know you've got huge systemic problems!

I suggest:

(1) Act to make the rental market bigger and better. There needs to be a range of rental options at every level. The option to rent has a key role to play in controlling house prices inflation during bubble formation, by drawing the prudent out of the market.

(2) Impose limits on how much people can borrow. Mortgage borrowing is akin to an arms race: you need to control how much people can bid, or in small, locally rational steps, they'll bid prices up so high it hurts most of us.

(3) Simplify the mortgage business. How does the huge layer of brokers and other intemediaries add value? If there isn't a clear answer, get rid of them, and move to a simpler, stripped down mortgage service, using new regulation if needs be.

Bursting the bubble

Gordon Brown is being widely praised for leading Britain's relatively well thought out bank bailout. However, it's worth remembering that Brown was Chancellor the whole time the huge house price bubble was inflating. Basic indices (house prices relative to rents, incomes etc.) have been hugely over trend for some time, and the lines of Roubini, Shiller and Krugman have been sounding warnings about the bubble for years.

Against that background, you have to criticize Brown for not taking action earlier to control rampant house price inflation. Quite apart from the fundamental role this has played in the crisis, excessively high house prices have also caused huge distortions in the economy, resulting in vast transfers of wealth and misallocation of resources.

Among other things, this means that we now need to begin taking steps to deflate the bubble. Clearly, you don't want to do this too fast - that would be too much of a shock and would probably push us into a terrible recession - but we do need to get house prices back to the right level (i.e. close to trend). As of now, we're not hering anything about this from the government, but I hope we will once things have settled down a bit.

Saturday, October 11, 2008


This crisis has awakened me form my blogging slumber. What's going on is outrageous.

Our banks are no longer viable entities. They have now been promised vast sums of our money, through a variety of schemes. Yet the bankers who created the whole mess are not really losing very much, and are, at this very moment, continuing to receive large salaries. There has been no guarantee of a moratorium on bonuses, only vague words. Am I wrong to think that at the very least, these rescue schemes should work as follows. Firms should be free to sign up or not, but if they do want to take huge chunks of public money to recapitalize, they should see salaries capped, across the firm, at the top civil service rate, say. Furthermore, they should open up their books to a comprehensive investigation by a new investigative unit (if we're spending this kind of money, we can afford something like this - think of it as a Keynesian stimulus), with a remit to prosecute actions that were either truly fraudulent or simply cases of gross irresponsibility, criminal charges in the first case and civil in the second. Firms that do not wish to be exposed in this manner, or who do not wish to cap their wages, would be free to take their chances in the open market (I understand it's important that a critical mass of banks get back on their feet, but putting the scheme this way frames the issue correctly: while it's necessary, it's also the government doing the sector a favour.)

Yet this is not what is happening, certainly not in the US, and not even here in the UK. Two nights ago a senior banker on Newsnight explained, with a straight face, that all this talk of doing away with "$2m bonuses" and so forth would come to nothing because that is how "it works" in the City.

These people beggar belief. They are not only the biggest theives seen in the history of business, but have so convinced a generation of political leaders with their pseudo-economics (unfounded, as far as I can tell, in either theory or empirical evidence) that it seems that even after what has happened the moral response has been muted.

Wednesday, January 23, 2008

Back to school

A perennial debate in the UK concerns private, fee-paying versus public, government-funded schools. The former are often academically strong (but of course don't have to deal with the full range of students to which government schools must cater) but find themselves blamed for a number of social ills related to equality of opportunity, social mobility and so on.

Here's an attempt to at least describe the trade-offs involved in the schools issue. I'll start off by saying I don't know what the answer is, but am for now simply trying to pose the question.

It seems to me there are two issues here: (i) (academic) selectivity (selective or non-selective) and (ii) fees status (fee-paying or free). These dimensions are often discussed together, but I think it's useful to consider them one at a time. All four combinations are possible: German gymnasia and the old English grammar schools are examples of free, selective schools; equally, one can imagine fee-paying schools which accept any student who can bear the cost, regardless of academic ability (the other two combinations are the conventional ones: free, non-selective, and fee-paying, selective).

What I want to do first is consider the possible costs and benefits of selectivity and fees, with some first thoughts on how important those effects might be in practice. I'll then sum up with some (tentative) conclusions.

First, what are the costs of selectivity? One is an "external cost" to the remaining, non-selective schools. If we assume some fixed number of academically able students, simply by bringing together such students in one place, selective schools must reduce their proportion elsewhere. To the extent that the presence of such students benefits the class as a whole, there must be some cost associated with selectivity. On the opposite side of the ledger there is an external benefit: bringing together academically inclined kids may help them achieve their best, and protect them from some of the schoolyard problems such students sometimes face.

How important are these effects? My feeling is that the number of academically inclined kids is sufficiently small that the effect of spreading them out in a non-selective system must surely be small. How much difference can it possibly make to have one or two academic kids in a typical classroom? On the other hand, the positives of having at least some environments in which these kids can excel are considerable. We should all want smart kids to achieve their full potential: even someone who hates studying would surely want the person operating on their heart, or designing their car, or in charge of their country's energy policy to be as capable as possible. I would tentatively conclude then that selectivity is overall probably a benefit.

But what are the costs of selective schools being explicitly fee-paying? Suppose you hold academic ability constant and look at the effect of parental income. Under a fee-paying system, does having richer parents confer a better chance of attending a fee-paying selective school? If yes, then there is a serious issue to be addressed. We surely don't want to place yet another hurdle in the path of bright, poor kids, and equally we should want to find the most able students in the country, no matter what their parents financial status. How big is this effect? While most fee-paying schools have some scholarships for poorer students, I don't think anyone would argue that the chances of attending such schools is neutral to parental income in the sense I've described above.

So what we need is some way of making it easy for bright kids to attend selective schools regardless of parental income. One approach would be for the government to directly pay privately-run schools the fees for students who are good enough to get in but can't pay. The downside of this approach would be the usual difficulties of enforcement and means-testing: such things are clunky and lend themselves to being "gamed". Alternatively, selective schools might be government funded and free to attend. (A possible downside might be a loss of competition: fee-paying schools presumably have to work hard to keep parents happy. Some would say a government-run school might have a captive audience and not really care about how well it's run. But equally, there are plausible market-failure type arguments against fee-paying schools).

On to tentative conclusions. I think it's fees, and not selectivity per se, that is the key issue. Two possibilities are (i) government grants for poor kids to attend privately-run schools and (ii) selective schools which are free to attend. I would be in favour of having both approaches and seeing what works: it's hard to know in advance just how difficult grants would be to administer, or how effective government-run schools would be compared with their private counterparts.

Thus, I think an at-least reasonable solution is to have selective, government-run schools which are free to attend (but which students are free to choose between), and privately-run selective schools with full grants available for poorer students.