The Compulsive Theorist

Is my pessimism justified?

2009-09-30T19:09:00.010+01:00

I'm increasingly pessimistic about prospects for meaningful reform in the wake of the financial crisis, and feel that a repeat, quite possibly on an even larger scale, is not unlikely. Martin Wolf in the FT seems to agree. His tone is of course more sober and measured: here are some excerpts, but do read the whole thing:

What entered the crisis was, we now know, an ill-managed, irresponsible, highly concentrated and undercapitalised financial sector, riddled with conflicts of interest and benefiting from implicit state guarantees. What is emerging is a slightly better capitalised financial sector, but one even more concentrated and benefiting from explicit state guarantees. This is not progress: it has to mean still more and bigger crises in the years ahead. ... Today, the core financial institutions are, beyond doubt, a part of the state. ... The most important point is that where we are now is intolerable. Today’s concentrations of state-insured private wealth and power must surely go.

And this from Michael Pomerleano in Wolf's FT Forum (HT Mark Thoma):

In 2008, salaries of the top 10 banks reached $75 billion (up from $31 billion in 1999), while cash dividends to shareholders were only $17.5 billion. Management took 4.3 times more than shareholders at a time when shareholders were injecting capital and government was guaranteeing deposits. He pointed to the critical principal-agent fiduciary problem. Essentially, financial sector losses will be paid for by future taxation (large fiscal debt) or inflation.

The bottom line here is that we are already collectively paying (through the nose) to support the financial sector and will continue to do so. This is a scale of state subsidy that is surely unparalleled in the West. And the ultimate irony of course is that the beneficiaries of our largesse continue to kid themselves that they are "innovating" and "creating wealth", embodying the free market spirit!

What next for Britain?

2009-09-24T04:50:00.002+01:00

Right-wingers are now arguing that because of the crisis, we have to reduce public spending and reduce income taxes. For these people, whatever the data, the remedy is the same - during the boom/bubble they said essentially the same thing, i.e. cut income taxes, free up "innovation".

I share the Right's disdain for Labour, although perhaps for different reasons. They are a disgrace, and certainly not a social democratic party: in all their years in charge they have done little to move Britain towards the kind of high-human-capital society I would like to see, and instead were cheer leaders, if not prime movers, in the banking fiasco.

Equally, while I have sympathy, even a natural liking for, the notion that technology and good management can raise productivity in public services, my feeling is that the gains that can be realized are hugely exaggerated. Britain still lacks a lot of basic, fairly physical stuff: accessible training, facilities for quality education (especially at the lower end), public sporting facilities, public spaces; on-the-ground comparison with our neighbours in Northern Europe really bears this out. Does anyone really think it is possible to see more of such things with a reduction in spending? Equally, in Britain's (many) deprived areas, by all accounts in most cases a small number of social workers/doctors/nurses are overwhelmed by the troubles of a poorly educated, often dysfunctional populace. Where are these huge numbers of public servants who can be let go without impact? I'm sure there are a few, maybe even quite a few, but enough to make a serious difference?

Britain needs a fundamental re-think of it's spending priorities. First, we need massive investment in public physical infrastructure and facilities, especially in deprived areas, and especially when this impacts human development (i.e. learning skills and abilities, early childhood experiences and so on) and in particular those many young people who are neither in training or employment. Second, a real move towards quality vocational training: we have a dire lack of people who can really do things well, from bakers to cooks to builders. This is where there is a real opportunity to both improve productivity and reduce expenses that arise in managing the fallout from having a vast number of untrained, often unemployable people. Third, a reduction in the size and importance of the financial services sector. It is not clear that the sector is at all profitable at the margin, absent implicit and explicit government support. However, it is clear that the distortions induced by this support enjoyed by the sector damage the wider British economy: what might all the smart young scientists and engineers have done if they hadn't gone into the City? Been brilliant teachers? Genuine entrepreneurs? Worked in R&D? Fourth, we need an infusion of technical expertise into management. In Britain most senior management, even at engineering firms, appear to know very little about the business they run. Thus, a CEO is almost always a lawyer/PPE/MBA or the like, rather than a PhD engineer or scientist. This is emphatically not the case in Germany, for instance, certainly not as often, and I think this is a major reason why Britain's scientific excellence does not translate in successful businesses.

But doing these things requires taking on the City and it's increasingly deadly grip on the national psyche. And that is where none of our political parties will go.

When, not if.

2009-09-22T18:46:00.003+01:00

I wanted to apologize to readers for my silence and offer some explanation of why I have not been continuing with my post-crisis blogging. First of all I've been even busier than usual at my day job, doing science.

But second, I now feel that there is little real point in continuing (I will continue to blog, but less often on the crisis itself). This really is preaching to the converted. Most people in the econ blogosphere now agree - at least broadly - about the kinds of things that need to be done. Yet it has to be said that the vast eruption of post-crisis blogging, while intellectually stimulating, has politically been a failure. Most of our politicians seem unable to discern either the scale or nature of our problems, and many are, I think, simply intellectually corrupt. People are already suffering, but treat the crisis and its aftermath as a random event, akin to a weather calamity, rather than the consequence of repairable systemic flaws coupled with criminal behaviour on the part of an avaricious minority.

What is the end game here? My prediction is that we will (continue to) suffer considerable short-term economic fallout and (truly huge) longer-term social costs and missed opportunities. The systemic flaws will not be substantively addressed, and the actors involved not held responsible in any serious way. Moral hazard will grow, as it's now abundantly clear that not only is it permitted (if not encouraged) to be too big and/or interconnected too fail, but that even when you do fail there are essentially no consequences. There will be a second crisis, probably larger, whose timing will depend on precisely how little action is taken in the present.

But what is clear is that it's now a question of when, not if.

A tale of two press conferences

2009-04-01T21:59:00.006+01:00

The tale of two pre-G20 press conferences (Obama/Brown and Merkel/Sarkozy) is being played in the UK press as a Anglo-Saxon versus (old) Europe story, with headlines like "France and Germany throw down the gauntlet" and "Franco-German demands upset G20 unity". This press reaction is surely greatly exaggerated, and the politicians themselves are no doubt doing a lot of posturing for their home audiences, but it is interesting to consider the political and economic background that gives these stories traction.

The crisis really does have a great deal to do with the political economy of the US and UK in particular: these two countries were its economic, political and intellectual epicentre. European countries which have been most directly affected - Ireland, Spain and Iceland among them - were precisely those which were most influenced by the business culture of the US and UK. Indeed, until recently these countries were often hailed by the Anglophone business press as economic poster children, and examples for "sclerotic" Europe to follow.

While Germany and France have been hit hard by the crisis, it is important to distinguish between first-order effects due to asset price bubbles and opaque financial products, and second-order effects due to the reduction in demand brought about by first-order problems elsewhere. While the banking sectors in "second order" countries face very real problems, it is important to note two things. First, the asset write-downs and financial (mis)innovation at the root of these problems took place mostly in the Anglo sphere of influence (in many cases even when the firms in question were European). Second, it was a very Anglo influence that drove what now appear to have been deleterious changes in the banking culture in these countries in the first place. (Indeed, in the last decade it became commonplace to see starry-eyed European students at business and finance schools in the UK and US, eagerly imbibing the wisdom on offer. This influence likely had a major role to play in reshaping financial institutions in Europe.) It is fortunate that Germany, for example, did not heed advice to loosen mortgage restrictions: there was no real house price bubble there, but if there had been we might now have been facing an even worse crisis.

With recessions looming or underway almost everywhere, isn't this first-order/second-order distinction just splitting hairs? I don't think it is. The fact that Germany is suffering due to a sudden drop in US demand for its cars is simply a different type of problem from the primary economic problems in the US. I would argue that these second-order problems are less fundamental and will prove easier to adapt around. Think of it this way: Germany has fewer major fundamental changes that it will needs to make in its business culture. Certainly like everyone else it will have to undertake major banking reform, but mostly this will be a matter of shaking off a recent, foreign influence on that sector, rather than the much deeper rethinking that will be needed here and in the US. This is surely part of the reason why the German government seems inclined to wait until the crisis is resolved elsewhere and in the meantime simply keep their manufacturing sector in one piece, ready to pick up again once global demand is restored.

This background is important in reading quotes like this:

Action to regulate bankers' pay in order to discourage excessive risk-taking could not be taken by a few countries alone as they would be penalised in the competitive global marketplace, [Sarkozy] said, adding: "This has to be a worldwide decision to inject new ethics into trader remuneration."

Mr Sarkozy said: "These are our red lines. We are totally prepared to discuss other things so long as these issues are clearly dealt with and solved."

( I don't know how serious Sarkozy is about this, but for what it's worth I agree with the sentiments he expresses about ethics and remuneration.)

Is the seeming optimism of Obama and Brown matched by a real desire to undertake serious reform? Certainly these two leaders appear to remain much more wedded to a finance-centric worldview than their counterparts elsewhere. Gordon Brown was Chancellor during the long run up to the present crisis, and played a role in fostering the political and economic climate that made the crisis possible. Meanwhile, Obama's economic team has, to put it mildly, some conflicts of interest with respect to fundamental reform of the financial sector. Perhaps European cynicism is unwarranted, and Obama and Brown will indeed recognize the role played by the Anglo business culture in bringing about the crisis and try to rectify it. But if not, we are likely to see more real political disagreement in the months to come.

Norms follow-up

2009-03-28T10:58:00.004Z

Just a quick follow-up to my previous post on norms in the financial sector. To summarize and clarify that long post:

Norms matter: strong regulation is no substitute for good norms, both because of enforcement costs and the likelihood of regulatory capture and gaming.
I am not saying that all - or even most - employees in financial services have no interest in the social value of their work: my claim is only that there appears to be a critical mass with a more cynical viewpoint who have effectively set the cultural tone.
The issue not really a lack of altruism, but something less lofty: caring about the work itself as opposed to earnings alone.
Financial services have, of course, considerable social value and I do not doubt that many entrants into the sector are motivated in this way. But I think that such people quickly find themselves in a culture where their views are not much heeded. Consider the position of a (hypothetical) young recruit into AIG's Financial Products division who may have been concerned about what was going on.
I used a contrast between bankers and doctors to bring out some differences in norms. This contrast is probably much more extreme in the UK than the US: doctors here earn far less than their counterparts in the US*. In the UK at least, it is pretty clear to me that doctors care far more about the social impact of their work than bankers. There are of course many exceptions to any such statement about averages.

Willem Buiter's latest blog post makes many of the same points, but perhaps less politely. Some excerpts (but the whole post is worth reading, even if you find yourself in disagreement with him):

"I am, however, as more detailed evidence accumulates about the genesis of the financial collapse, becoming more and more impressed with the importance of misfeasance and malfeasance - of negligent, unethical and outright criminal behaviour, ranging from high crimes to misdemeanours."

"...to enrich themselves by robbing their shareholders blind. ... Where are the class actions suits by disgruntled shareholders? Where are the board members in handcuffs?"

"What we have seen and continue to see in much of the border-crossing financial sector, however, is a rather more literal form of moral hazard: a lack of morals in some key participants in the financial system dance causing major hazards to the financial well-being of millions of powerless victims. Corrupted morality putting at risk genuine, wealth-creating financial intermediation, innovation and risk-taking."

*A side note: US doctors are very well paid by international standards, and there is considerable evidence and mounting concern about the many conflicts of interest in the US medical establishment, see for example the book by Marcia Angell, or many recent examples, including the recent Harvard Medical School controversy or the JAMA case. To the extent that these issues are especially prominent in the US, this would support the general thesis that extremely high earnings can have a deleterious effect on norms.

Why the culture of the financial sector has to change

2009-03-26T15:35:00.004Z

I want to say a little about business and cultural norms in the financial sector, how they affect tangible outcomes we all care about, and why they need to change. Norms are inherently less tangible than items on balance sheets, so it can be hard to see the role they play. I want to focus on norms in the financial sector, but to bring them out of the background I’ll start with a comparison to another field.

Doctors and bankers are alike in that they can inflict enormous damage by doing a bad job, doctors with a flick of the scalpel, bankers with a click of the mouse. Both are therefore subject to regulation which tries to trade-off costs of enforcement against risk of damage. But there’s a huge difference in the way doctors and bankers view their work.

Doctors, for the most part, care very deeply about the social impact of their work. Their ethos is one of wanting to do a good job for its own sake. Some make a lot of money, others do well but are not super-rich (this is the typical case in Europe), but from day one at medical school, the ethos is pretty evident. In contrast, bankers tend not to care - or sometimes even think about - the social impact of their work. It is very clearly a fundamentally different ethos. I do not want to idealize doctors - there are clearly some real exceptions - but only to put bankers alongside them to bring out some of the differences in culture.

You can see this difference in culture play out on the supply side of the labour market. Doctors are usually smart, hard-working people who could do well in other areas, but in most countries they have to go through a very long and genuinely tough training phase before they earn really good money (and in many countries the money isn’t even that great). Yet this doesn’t seem to deter applicants: medical schools can almost everywhere afford to be highly selective. This is because medical school applicants are, for the most part, people who actually want to make ill people better: that is, they have a sense of mission. In some sense, the “delayed gratification” acts as a filter: if you don’t care about the mission, you’ll find it hard to make it through to the latter, more lucrative stage of the medical career.

It’s not just medicine where there is a sense of mission, an ethos in which substantive social impact means something. Think of engineers, teachers, technology innovators. People who start tech firms want to get rich, sure (who doesn’t?) but a big part of their motivation is a desire to develop products that are widely used and make things better for people. (In open source you have the extreme case of people – often highly skilled – who care mostly about impact, not earnings.) Analogous to the delayed gratification in medicine is the high risk and opportunity cost of getting involved in a start up. If you’re finishing CS grad school, and have a bright idea, at that point in time it’s by no means clear that pursuing it will make you a millionaire. Yet to chase the dream you may have to pass up on other opportunities (e.g. a steady job). It’s a high risk, high reward choice. Note also that in technology (as in music or sports) a long-running passion for the job is almost a pre-requisite for doing well; in this sense the opportunity costs kick in as early as high school, or even primary school.

In fact, if you look across the economy, it’s hard to find another line of work that offers high rewards as quickly and with as little risk as finance. If delayed rewards in medicine and high risk in technology act as a filter, selecting the passionate over the merely greedy, the quick riches and relatively low risk of finance perhaps act in the opposite manner, selecting for people who simply want to become wealthy as quickly as possible. This view certainly accords with anecdotal evidence. Entrants into finance are often very smart and ambitious, but I would argue that many do not really care very much about anything other than making money and certain positional concerns (i.e. doing well relative to their peers). This is a stark contrast with most other “elite” fields, where money and rank matter, but so does mission.

We can extend this analysis in time and across people by looking at how norms evolve in groups. When groups of like-minded people get together, they tend to reinforce their initial views. So if you like science at high school, four years with like-minded peers at Caltech may take your passion to another level. This effect of reinforcement by clustering can work for good or evil: it helps us all to put wannabe tech innovators together in CS departments and places like Silicon Valley, because they spur each other on in mostly a good way. But it can work against us too: think of criminal gangs, or extremist political groups.

My feeling is that at present because finance offers high rewards with low risk but does not emphasize social value, it attracts a disproportionate number of people who are smart and competitive but who lack a real mission. Note that I am not saying financial activity does not or cannot have social value, only that at present this is not something that is very much emphasized or thought about in the sector.

Norms are intangible, but they have very tangible economic consequences. Enforcement alone is a costly and crude tool: if you had to police everyone all the time, many activities would no longer be wealth creating, net of enforcement costs. In this sense, productivity is a function of both norms and enforcement: if you have good norms, you can get away with less enforcement, but if you have bad norms, you’re better off with strong enforcement (but will do less well overall). The upshot of this is that improved norms can have enormous benefits in terms of concrete wealth creation.

Even a year ago, I think many outside the financial sector (and not a few inside it) would have recognized at least a kernel of truth in this analysis of its norms and ethos. But norms being as intangible as they are, any concerns would not have made it as far as impacting policy. But the events of the last few months have shown us that we ignore bad norms at our peril.

We are in a situation where bad norms in one systemically important sector have brought us almost to the brink. A short-term analysis of the crisis has to take bad norms as given, and construct tough regulation and enforcement regimes which keep the system stable despite its poor ethos. But such stability comes at a price. First, the level of enforcement required for stability will be difficult to achieve and sustain. Second, if the mindset of the sector does not change it will only be a matter of time before enforcement is undermined, by regulatory capture, lobbying, corruption etc. Only a change of norms can reduce this tension, by re-aligning the motives of agents in the financial sector and the society that they supposedly serve. Changing norms is hard, but not impossible. Now is the time to start.

All roads lead to reform

2009-03-26T00:19:00.006Z

These are remarkable times. There has been the build-up of a historic asset bubble followed by a global financial collapse, unparalleled since the Great Depression. As many have noted, a key characteristic of the crisis has been the fact that it was caused largely by the financial system itself (rather than an exogenous shock), through the actions of individual agents coupled with failures of regulation, corporate governance, policy and politics. The breadth and inter-connectedness of these failures has made it increasingly clear that we will need wholesale reform: not just recapitalization of those institutions in the worst trouble, but changes to major parts of the financial system, including firms and their governance, the regulatory framework, as well as the broader culture and norms of the financial sector (the latter being perhaps the most challenging).

If this sounds exaggerated, consider where we are, how quickly we've got here, and how ridiculous it would have seemed, even a year ago, that any of this would come to pass. Indeed, both Obama and Gordon Brown (in the UK) pay at least lip service to the need for this sort of wider reform. Their substantive actions to date have not matched the rhetoric, either because they are hoping it will all "blow over", or (optimistically) perhaps because they intend to really proceed on these issues once things have stabilized a little.

I want to make the case that despite the politicians' evident reluctance, major reform will almost certainly be needed. The only real question is whether we get round to it sooner or later. Given the rapidity with which crisis can spread and deepen (making "contagion" a very apt metaphor), I think it is very much better if we act sooner. This would not be pre-emptive by any means: it would be in response to what is already a crisis of historic proportions (rather than waiting for something even more extreme.)

To get some sense of what might happen next, it is helpful to think of a tree of possibilities. For simplicity, let's restrict this to two possibilities at each stage. First, the Geithner plan (or some minor modification of it) can either succeed or fail: either the injection of government funds (essentially via non-recourse loans) is sufficient to restore the system to some semblance of normality, or not. If the plan is successful (as it might be, in this narrow sense, even if you object to its unfairness and lack of transparency) there are two further possibilities. Either the administration presses on with systemic reform (this is the optimistic view) or it decides that the worst is over and that minor, even cosmetic, changes will be enough. In the latter case, I would expect to see a replay of the crisis, perhaps during the following Presidential term (in this scenario, the bailouts did indeed work, so it would perhaps be a second term for Obama). Even if this sequel was not as bad as the cataclysm I fear, coming on the heels of this crisis, it would, I think, make reform unavoidable for even the most reluctant administration. And if the current bailout doesn't work? If it's a clear failure? This is not a pleasant scenario. Things will be even uglier than at present (unemployment is already touching double figures with U-6 at around 15%) and the calls for fundamental reform almost impossible to dismiss. This covers all the leaves of the tree: it therefore seems very likely that however things play out with the administration's short-term plans, the need for reform will at some point become too obvious to ignore.

System-wide reform cannot be avoided for the same reason bubbles have to burst: reality can be wilfully ignored for some time, but not forever. Clearly the political obstacles in the way of wholesale reform are formidable, and in that sense some reluctance on the part of the administration would be understandable. So the question for Obama and his team is this: do you start on reform now, or wait for even stronger evidence of its necessity? And when the weaker evidence is the present state of the economy and the associated human costs, do you really want to wait for more?

Why a second best bailout may not be good enough

2009-03-24T17:54:00.007Z

It’s not often I find myself disagreeing with Mark Thoma, but on the issue of the Geithner bailout plan I think I do. Thoma is a careful and reasoned writer, so what comes below I say cautiously, but nonetheless with some conviction.

Thoma writes:

So I am not wedded to a particular plan, I think they all have good and bad points, and that (with the proper tweaks) each could work. Sure, some seem better than others, but none — to me — is so off the mark that I am filled with despair because we are following a particular course of action.

Let me start by nailing my colours to the mast: I am not convinced the Geithner plan is a good one, and would greatly prefer to see a much more thorough reform of the financial sector, including a bankruptcy-like reorganization of insolvent firms. I understand that this sort of “solution” is much easier to consider in the abstract than implement in the real world and that such a plan would encounter formidable political obstacles at a time when the policy response needs to be rapid. So my argument below against Geithner-type plans is made neither lightly, nor simply to play devil’s advocate to optimists.

My opposition to the Geithner plan stems not primarily from outrage, concerns about equity, or even book losses borne by taxpayers, but from major concerns about future economic output and stability. The other issues are important and certainly things I care about, but my feeling is that even these are of secondary concern next to the signal issue of how today’s bailout will affect tomorrow’s broader economy.

For the moment, let’s categorize bailout plans into those which seek to recapitalize the banks while maintaining the current system in roughly its present form and those which go the route of bankruptcy-type proceedings and (given the breadth of the current crisis) would involve a much more thorough overhaul of the financial system. The Geithner and Paulson plans are of the first kind, and the “Swedish” plan (and its many variants) of the second kind. I’ll call these “bailout” and “restructuring” plans respectively. Clearly this nomenclature hides a lot of detail, but I think captures a key axis of difference between the various plans.

Two things about the aetiology of the crisis stand out. First, perverse incentives for agents within the financial sector played a central role in bringing about the crisis. Second, there were (and remain) issues of poor system design in the financial sector: even perverse incentives might have had limited consequences in a robust system. The problem with the Geithner plan is that even it works in terms of stabilizing the economy in the short-term, it does relatively little (the uncharitable would say almost nothing) to correct either incentives or system design. But the business and cultural norms and system-wide conflicts of interest which form the backdrop to the crisis run deep, and will not change without substantial impetus. It is precisely these deeper issues that we must address if we are to reduce the risk of a re-run of the crisis, probably on a larger scale, in a few years time.

I sympathize with the point of view which says that the political window of opportunity is narrow and the need for action urgent, so let’s accept the bailout plan for now, and deal with these wider issues later on. But the very fact that political momentum is limited means that if these wider changes are to be brought about, the process has to begin in earnest at once. Does anyone seriously believe that in a years time, if following massive government support the banks are stable - or can be made to appear stable – there will be any political will to break up very large institutions, or any real change to underlying norms in the financial sector?

However, absent these deeper changes, it is entirely possible that we will see a replay of the crisis - but on a larger scale - in a few years time. Naturally, one cannot say with certainty that such a cataclysm (and if it were much larger than the current crisis, it really would be a cataclysm) will occur. But if it does, the resulting costs will be huge. Martin Wolf has written persuasively about the costs of major economic dislocation. Net of unemployment, political instability and even wars, the human costs of a sequel could dwarf even the current crisis. Then, the choice in the present between the “bailout” and “restructuring” plans hinges on whether expected cost (in the broadest sense), conditioned on the “bailout” strategy is higher than expected cost conditioned on “restructuring”. One could formalize this argument as a decision problem, but it comes down to a judgement call on the relative probability of such a cataclysm under the two strategies and the magnitude of the dislocation. My feeling, admittedly subjective, is that the gloomy cataclysm scenario is substantially more likely under the “bailout” than “restructuring”, and that the costs would be immense.

This case can be put very simply: if we do not use current political momentum to fundamentally reform a system which has shown itself to be unstable and even dangerous, a second opportunity may come at a very high price. And this is not a gamble I wish to see our leaders make.

On toxic cars

2009-03-23T10:52:00.009Z

Mark Thoma comes up with a terrific analogy for the issues around "toxic" assets held by financial institutions. Among other things, he gives a particularly clear explanation of the Paulson, Geithner and "Swedish" plans for dealing with these assets.

Thoma concludes with the important point that even if a government intervention loses the taxpayer money on the toxic assets themselves, it may still in a broader sense be a good strategy, once we account in our risk function for the high probability of very severe economic disruption absent any intervention.

Suppose we agree, on these grounds, that some intervention is better than no intervention, even if it loses the taxpayer money in the narrow sense of a book loss on the toxic assets. The question then shifts to which of the plans on offer is best (or least bad)?

In terms of the short-term book loss to the taxpayer, I doubt there will be a huge difference between the plans. As a Deutsche Bank economist memorably put it: "Ultimately, the taxpayer will pay one way or another". This is surely true. I don't want to trivialize such differences as there may be - this may still add up to a huge amount, which could literally have been spent saving lives - but only to emphasize that this is unlikely to be large relative to the costs of inaction for the broader economy.

Why then should we care about precisely how taxpayers end up picking up the tab? To my mind it is crucial here to recognize two things about the present crisis. First, the very fact that so many of the assets held by banks are toxic in the first place has much to do with the behaviour of agents within the financial sector and the regulatory environment and business and cultural norms within which they operate. Second, the entire game is iterated: whatever we do now will provide the backdrop for further rounds of play.

Going back to the beginning of the Thoma analogy:

Imagine a car lot that has 100 cars on it. However, some of these cars have problems. Half of them will have engine troubles that total the cars - the engines blow up and the cars are then worthless - and this will happen just after purchase. The other half are perfectly fine.

Now imagine something further (and I realize I'm stretching the analogy a little): what if the engine troubles that some of the cars will experience were caused by employees in the dealership swapping out good engine parts for bad ones? Or if all the while they had been currying favour with the local authorities and pushing for a relaxation of the town's laws prohibiting such activities? Or even that they were using op-ed pieces in the local newspaper to argue that this new way of selling cars was fundamentally better, and that the old-fashioned car dealer in the next town who suggested otherwise was an old fogey? And that the local dealer whose firm is now in such trouble that it is threatening the very social and economic fabric of the town continues to live in the biggest mansion and drive the fanciest car in town (and opines in the local paper that everything's fine)?

If this were the broader context within which the townspeople had to decide on a rescue plan for the dealership, I suspect many would lean towards some version of the "Saab" plan (i.e. Swedish plan or variant thereof) so as to mitigate the chance of another batch of exploding cars appearing on the streets of the town in the near future.

The key point I want to emphasize is this. Once we recognize the role of incentives and regulatory capture in the crisis, and the fact that once the immediate problems are dealt with the game will start again, this gives us another element to include in the objective function through which we evaluate competing policy proposals. What do such proposals do to incentives going forward? What do they say to players preparing to take part in the next round of the game? The magnitude of the economic fallout from inaction would almost certainly dwarf book losses taxpayers suffer on toxic assets. So it's vital we take action. But the magnitude of future losses from the wrong action, might dwarf even the current crisis. So it's also important we get intervention right.

In denial

2009-03-21T11:58:00.005Z

Over in the parallel universe that is the financial sector, people are not happy about the "clawbacks":

http://www.ft.com/cms/s/0/4ff2f77e-1584-11de-b9a9-0000779fd2ac.html

There are some terrific quotes in the piece. Here are a few:

“Finance is one of America’s great industries, and they’re destroying it,”said one banker at a firm that has accepted public money.

“The work we have all done to try to stabilise the financial system and to get this economy moving again would be significantly set back if we lose our talented people because Congress imposes a special tax on financial services employees,” [Vikram Pandit, Citigroup CEO] wrote.

“There are three big industries where the US has global leadership: financial services, media and technology. Introducing this 90 per cent tax is like taking one of those industries out the back and shooting it,”

Leaving aside people who were knowingly fraudulent, or borderline fraudulent, my feeling is that the majority of people in the sector did not have bad intentions, but were simply greedily responding to wage signals. If you could make several times as much working the City or on the Street as you might in an alternative career, why not go for it? If you were the thinking type it might have occurred to you that something was a bit odd about the sheer size of your pay packet relative to equally or better qualified friends who were working long hours doing seemingly useful things like medicine, teaching or technology. But you figured, hey this is what the market's saying, it must be right. Plus there would have been persuasive voices (not least in the FT, WSJ and Economist) explaining that your sector was indeed magically creating wealth on a scale large enough to justify your pay packet.

But now that reality has made a belated appearance, where do these people go psychologically? Do they accept that much of the justification for their earnings was false? That perhaps some of the people they admired for their drive and ambition were in fact frauds? This is a lot to take on board, so these people are now in denial.

If we allow things to drift, they will stay in denial, and there will be none of the broad changes in sectoral culture and norms which are needed. And in a few years we will have a replay of the crisis, but on an even bigger scale. Yes, you can change regulation - and we should - but one-off legal and regulatory changes alone are never enough, you have to somehow change the culture and norms as well. Else, once public and political attention is elsewhere, regulatory capture will rear it's ugly head again and the seeds of a new crisis will be sown.

This is why it's so important to get the policy response right, not just in terms of the immediate economic impact of the bailout, but in terms of psychology, in terms of the message it sends to actors in the financial sector.

Biting the hand that feeds

2009-03-20T19:37:00.005Z

AIG is suing the US government to get back tax payments it made, but figures it can argue its way out of using the usual array of barely legal tax avoidance tricks:

http://www.nytimes.com/2009/03/20/business/20aig.html

Oh, and they're probably using Federal funds to pay for the law suit! You couldn't make it up.

Of course, in a certain sense all this is a perfectly rational response to the regulatory and legal framework*. Which just underlines how much work is needed to overhaul the entire framework to rehabilitate the financial sector as a normal corporate citizen, rather than the renegade it appears to have become. I realize all firms engage in some of these sorts of activities, but at least they mostly create wealth. Plus, I somehow don't think a Google, Microsoft or Apple offers clients services as dubious as "regulatory arbitrage"...

(*Although net of negative publicity and related downtream effects perhaps not so rational.)

Crisis Quote of the Day

2009-03-19T22:40:00.002Z

Britain's Chancellor (= Finance Minister) Alastair Darling doesn't want to restrict bankers' salaries*:

“It is good that excesses in the banking sector are brought to an end but it does mean our revenues [via taxation] suffer as a result.”

This makes about as much sense as saying, for any person X (X=Compulsive Theorist, for instance): "We should double X's salary, this will put him into the high tax bracket and increase revenues.". Which is to say it doesn't make any sense at all.

A more serious post tomorrow on wages and incentives.

(*To be fair to Darling, I don't know the full context of his remarks, and he may have meant something more sensible.)

Financial extortion?

2009-03-17T07:24:00.011Z

Andrew Sorkin makes a case in favour of the AIG bonuses in today's New York Times. The article - I think unwittingly - provides a remarkable snapshot of all that is wrong with the financial industry today, and why, for the sake of efficiency if nothing else, it has to be radically reformed. I think it's worth reading in its entirety, but here are some excerpts with comments:

...more sobering thought: A.I.G. built this bomb, and it may be the only outfit that really knows how to defuse it. ... A.I.G. employees concocted complex derivatives that then wormed their way through the global financial system. If they leave — the buzz on Wall Street is that some have, and more are ready to — they might simply turn around and trade against A.I.G.’s book. Why not? They know how bad it is. They built it.

[CT here] First, isn't that illegal? If it isn't, shouldn't it be? Second, isn't this nothing less than extortion (not even by analogy, but literally)? It's the most explicit example of rent-seeking you could hope to find. The crucial thing here is this: it is now clear that these particular actors have never created any wealth (only destroyed it) but because they can do still more damage, we have to pay them whatever they want. If you think about it, this is even worse than the looting that takes place when financial systems are in chaos: it's the financial equivalent of a gun to the head (and really not so different from a demand from terrorists or kidnappers).

“We cannot attract and retain the best and brightest talent to lead and staff” the company “if employees believe that their compensation is subject to continued and arbitrary adjustment by the U.S. Treasury,” [Edward Liddy, AIG CEO] said.

[CT here] How about "arbitrary adjustment" by the market? Isn't that how markets work? These people are not schoolteachers, adding value far away from any explicit revenue stream, and therefore needing protection from market failure in the provision of their wages. Far from it: they're benficiaries of a market failure in the reverse direction - they've been overpaid for too long. At best, they're meant to be at the mercy of market forces, or at least that was the story they gave us in (what seemed like) good times, to justify their earnings.

Would you want to work at A.I.G.? Sure, maybe for $3 million. But not if you could go somewhere else for even more — or even much less.

[CT again] Sadly, this is probably true. Yet, you may ask, how can there possibly be a bidding war (and at wage levels that make the President look like an underpaid janitor) for "talent" between bankrupt firms? The answer is of course that on account of the "too big to fail" situation, these firms are now neither private firms nor publicly-operated utilities, but (and I'm being polite) but "zombies" (to continue the analogy you might say they are feasting on our national wealth).

Moreover, for the financial sector as a whole, the relationship between wages and marginal product has completely broken down. We're not talking about subtle issues, minor failures in labour markets, but a near complete breakdown of the link between what these people are paid and what they contribute to society.

This is glaringly obvious in the AIG case, but I would argue has been true for some years, for the financial sector as a whole. I'm not saying no net wealth creation took place, averaging across the entire sector and say a ten-year time window (although this may still turn out to be the case). What I am saying is that it is increasingly clear that the huge rewards flowing to this one sector (in recent years in the US and UK, ~30-40% of all corporate profits, net of a massive wage bill) bore little relation to the true value of the sector, under any reasonable definition.

What's going on right now is simply looting and in at least one case extortion. What happened until recently was legal, but a massive market failure of sorts which led to an extreme misallocation of wages.

One last quote form the Sorkin piece:

“The jobs are terrible,” said Robert M. Sedgwick, an executive compensation lawyer at Morrison Cohen who represents a number of employees of banks that have taken government money. “You have to read about yourself in the paper every day. These people are leaving as soon as they can.”

No comment.

Obama on AIG

2009-03-16T21:06:00.005Z

Barack Obama ponders the AIG situation:

The President said the bonus situation underscored the need for overall financial regulator reform and said the government needed “some form of resolution mechanism in dealing with troubled financial institutions, so we have greater authority to protect the American taxpayer and our financial system in cases such as this".

Is he joking around? The Federal government needs "greater authority"? It has a huge controlling stake in an otherwise bankrupt firm. That is authority. You just have to want to exercise it.

There's crime, then there's...

2009-03-16T18:59:00.008Z

To get some perspective on what's going on, I looked up the total direct losses from property crimes in the US. This totalled $17.6 billion in 2006. Meanwhile, the cost to US taxpayers, for one firm alone (AIG) are around $170 billion (and quite possibly going to increase further). That's almost 10 times more than all property crimes.

These property crimes were committed by many thousands of people. Those who were caught are now languishing in prison in the US (often under truly horrific conditions). Amazingly, just a few hundred people at a single AIG division in London were responsible for much of the insurer's woes, and thereby played a key role in getting the world economy to where it is. These people, having been rewarded very handsomely all these years, are now getting another half a billion dollars in "retention bonuses". These people and their managers don't seem to care one bit about the economic chaos and mass hardship their actions have helped cause, so it's not entirely surprising that they don't seem to be taking much notice of Obama's disgust or Geithner's harsh words either.

If there are just two things about the financial crisis I think are worth stressing they are this. First, the crisis was not an outside shock (like a hurricane or asteroid collision) but a consequence of things people in the system did, acting "rationally" under perverse incentives (which still largely remain in place). Second, however you tally up the numbers, the scale of the hit to your wealth absolutely dwarfs things like "normal" crime and benefit cheats.

Why we need to nationalize. Now.

2009-03-15T22:44:00.002Z

Nothing better illustrates the urgent need for nationalization of bankrupt financial firms than the latest news from AIG:

http://www.nytimes.com/2009/03/15/business/15AIG.html?em

AIG are in any meaningful sense, insovent. The firm survives only because of government support. The government owns nearly 80% of the firm. Yet execs are enjoying further bonuses, essentially direct from taxpayers money.

Robert Reich puts it very clearly:

...illustrates better than anything to date why the government should take over any institution that's "too big to fail" and which has cost taxpayers dearly. Such institutions are no longer within the capitalist system because they are no longer accountable to the market. To whom should they be accountable? As long as taxpayers effectively own a large portion of them, they should be accountable to the government.

But if our very own Secretary of the Treasury doesn't even learn of the bonuses until months after AIG has decided to pay them, and cannot make stick his decision that they should not be paid, AIG is not even accountable to the government. That means AIG's executives -- using $170 billion of our money, so far -- are accountable to no one.

The execs in question hide behind the letter of the law. But the natural, legal course of events (i.e. bankruptcy) was set aside when AIG received its first huge injection from the Federal government - in that sense, the spirit of the law was violated some months ago.

Opportunity costs

2009-03-15T12:49:00.001Z

People respond to incentives and over time their very view of the world is moulded by them. I teach at a British university. Most of the undergraduates I encounter (in math-heavy subjects) want to go into finance. I talked recently to a final year student who was worried about the job market (in finance). I put it to him that it'll probably be pretty bad for a while. His response? To apply for an Masters in financial mathematics and see if it's better next year.

The bloated compensation in finance isn't just unfair in some social-democratic sense. It's also inefficient. An entire generation of mathematically gifted kids can scarcely imagine doing anything else, even though we need solutions to all sorts of problems which require efforts from people like them. This is one of the opportunity costs of what's happened: we have missed out on all the cool stuff that would have got done if these bright people had been doing something other than devising elaborate scams in the City and on Wall Street.

Will this scarce human capital now get allocated more efficiently? The answer to this depends on what our governments now do.

British press RIP

2009-03-15T01:13:00.008Z

Another flat-earth piece in a major British newspaper:

http://www.telegraph.co.uk/comment/columnists/christopherbooker/4990704/Nobody-listens-to-the-real-climate-change-experts.html

This "real" climate change conference he attended was organized by the Heartland Institute, yet another one of the odious think tanks funded in part by - you guessed it - the Olin Foundation and the always unbiased Exxon-Mobil.

For a take from someone who can actually read, check out this piece by Google research director (and AI pioneer) Peter Norvig. An excerpt:

...an amazing amount of research went in to building up this consensus on global warming, but I hadn't heard much about the specifics. Reporters think (with some good reason) that the public is not interested in hearing about Analysis of some direct and indirect methods for estimating root biomass and production of forests at an ecosystem level and so they never cover such things. But by failing to talk about the years of research and the building on the works of others that go into producing a paper like that, reporters give all ideas equal footing: a half-baked whim with no evidence gets equal footing with a proven theory with hundreds of confirming studies, because it is too complicated to talk about the confirming studies.

Just to be clear: I'm not saying it's not ok to question the climate change consensus, of course it is (although I would argue that the media makes it sound as though there is much more disagreement between experts than is the case). What's not ok is to misrepresent what is in every sense a fringe view as the voice of the "real experts".

It's a weird time when...

2009-03-11T23:45:00.004Z

... a major US newspaper talks about mainstream financiers as looters:

http://www.nytimes.com/2009/03/11/business/economy/11leonhardt.html

Some excerpts:

In effect, the bankers had siphoned off this bailout money in advance, years before the government had spent it.

Either way, the bottom line is the same: given an incentive to loot, Wall Street did so.

If we don’t get rid of the incentive to loot, the only question is what form the next round of looting will take.

Blame Game II

2009-03-11T23:37:00.004Z

Harvard's Dani Rodrik seems to agree in spirit with my gentle critique of the economics profession and the role it played in the political economy of the crisis:

http://www.guatemala-times.com/opinion/syndicated/roads-to-prosperity/887-blame-the-economists-not-economics.html

I like - and agree with - the distinction he makes between economics and economists. Even for an outsider such as myself, it is apparent that there is a great deal more to economics than the "free markets rule, down with regulation!" caricature. What's sad is that many economists have been happy to promote that caricature and provide intellectual support for what the regulatory errors that got us to where we are.

Parallel universe

2009-02-25T22:45:00.004Z

Some people are still living in the parallel universe of Big Finance. This comment piece by Anatole Kaletsky has to be read in its entirety for full effect, but I will whet your appetite with one choice passage:

If, on the other hand, public opinion rejects this message and forces American and British politicians to drive their banks into insolvency and full-scale nationalisation, then this week will mark the end of 200 years of market-based capitalism throughout the world.

Moral Hazard 2.0

2009-02-16T15:01:00.002Z

If you'd asked bankers a year or two ago whether, if they'd just bankrupted their own institutions and brought financial calamity upon the world, they would get bailed out by the taxpayer on the scale they have with as few strings attached, I suspect all but the most optimistic would have hesitated to say "yes". And now? Surely most would nod their heads in agreement and confide that even in their most optimistic moments they hadn't realized just how far you oculd take this game.

If the bailouts continue in the manner they have (as opposed to some mix of full nationalization, bankruptcy, new "good banks", prosecution) what does this portend for the future? In a few years, the immediate feeling of crisis may have abated, but the memory of what happens when it all goes wrong (you keep your beach house, everyone else gets fleeced) will stay with the financial industry. The implication is this: moral hazard will become an even bigger issue after the dust has settled on these bailouts than it already is. The next generation of bankers will really believe that they can get away with almost anything. We have to get the bailouts right, now.

(I'm using the term "moral hazard" pretty loosely here to mean the propensity of agents within financial firms to engage in risky activities because of their insulation from the consequences of those activities. There's a huge principal-agent problem here too, with the principals being firms and shareholders and the agents being employees.)

A plot I'd love to see

2009-02-15T20:50:00.002Z

Income level (on the horizontal axis) with the proportion of people in that income bracket who are in finance, real estate or closely related to either (e.g. mortgage broker, lawyer working primarily for financial clients) on the vertical axis. I would guess it shoots up to close to 100% for very high income levels.

To put this another way: I would guess that when you see someone driving a really expensive car, most of the time they will be people who benefitted from the upside of the bubble. And are now leaving you (and your kids) to deal with the downside.

Too pessimistic? Maybe, but I'd love to see the data.

Black swan takedown

2009-02-15T18:36:00.003Z

Via Andrew Gelman's wonderful blog, a link to an excellent review of Taleb's Black Swan by legendary Bayesian statistician Dennis Lindley (you don't have to be a mathematician to follow this):

http://www3.interscience.wiley.com/cgi-bin/fulltext/119424936/PDFSTART?CRETRY=1&SRETRY=0

My feeling from reading Taleb and seeing him speak is that although he thinks he has found some huge flaw in probability (his hubris really is breathtaking), his real beef is not with probability or statistics but with finance. His critique is really one of conflicts of interest, perverse incentives and so on: he is talking about political economy, not mathematics.

And from that perspective, he's quite right. Building bogus models and making nonsense predictions pays pretty well (and continues to do so), so it's really just another case for that Upton Sinclair quote I use too much: "It is difficult to get a man to understand something when his job depends on not understanding it.

What De Long might call the London Times Death Spiral Watch

2009-02-15T06:39:00.004Z

From a piece in today's London Times on bonuses:

It would be surprising if Brown did not meddle in this politically charged vote winner, but I suspect he’ll bungle it. These are migrant international workers and if Brown were to block pay-outs they would take their skills to other financial centres — if not now, then when the next upturn comes. ... Excessive interference would damage London’s status as a financial centre and stop financial innovation.

What planet does this guy live on? Note the language - "meddle" for the possibility of government acting for it's citizens against an oligarchy that has brought the entire nation to its knees. London's status as a financial centre is gone, my friend. And that "financial innovation" is leading us into what is now certainly the worst downturn since the Great Depression.

This is why the UK may be affected even more than the US: here the rot has set even deeper, an entire generation has internalized the nonsense spouted by the banking sector.

The compensation these people have received in the last few years was (i) out of all proportion to their contribution and (ii) a direct cause of behaviour that led to the crisis. The crisis will get even worse before it gets better, and if at the end of the day we end up with a utility-like financial system (see Canada), and a better balanced economy, so much the better. If at that point - after many trillions of dollars of losses worldwide and enormous distress - some people still want compensation of the kind that was available during the bubble and some country is enough of a financiers' oligarchy to offer such compensation, then it surely would be a good thing if these rapacious characters left our shores.

Bankers playing us for chumps

2009-02-15T00:54:00.002Z

Watch this interview with Simon Johnson. Now.

http://www.pbs.org/moyers/journal/02132009/watch.html

Johnson was formerly Chief Economist at the IMF and is currently a Professor at MIT's Sloan School of Management, so he's not exactly a leftie. Which it makes it all the more worrying that he chooses to phrase his case this way: "The bankers think we're chumps."

Should economists be apologizing too?

2009-02-11T22:38:00.008Z

As a natural scientist, my perception is that a lot of my peers feel less than entirely happy with economics, and its role in the current crisis, especially in the English-speaking world. Here are some initial thoughts:

It's not simply the case that the crisis was caused by rapacious bankers. This is true, of course, at one level, but it was important that the game they were playing appeared to have some sort of intellectual foundation. This was tacitly (and sometimes quite explicitly) provided by economics.

I realize that it's not as though there was ever a theorem which said that what was happening (e.g. wages, impacts on the wider labour market) was in some sense optimal, at least under real-world conditions, but the impression was often given that there was.Countless WSJ and FT comment pieces from the boom years have this tone, sometimes pretty explicitly. This was an intellectual deception, which I think played a key role in getting us to where we are today.

I realise that economists, if asked about this point blank, would always be equivocal, but my impression is that during those years the bulk of the profession was happy to go along with the story. Why? Well, it didn't hurt the profession as a whole to be so closely associated with an industry sector raking in 30-40% of all corporate profits. I'm not talking about direct benefits like endowments and speaking fees, but more the intellectual glow of feeling that your work provides the theoretical edifice on which what seemed a hugely profitable sector was based.

Again, there were dissenting voices, but my impression is that these people (for example Dean Baker and Steve Keen; quite often Krugman and Stiglitz) were viewed as academically minor-league (DB, SK) or politically motivated (PK, JS) and therefore not entirely in tune with the academic mainstream in the profession, at least on these issues.

To take one example: most people outside economics always thought that salaries in finance were somehow wrong. This was a widely shared perception. Yet economists mostly seemed to support the notion that these wages reflected value added (perhaps this is the wrong term, but you know what I mean), or least didn't appear to question what were huge changes in the labour market. It is now clear that lay people were broadly correct.

It's perfectly alright to be wrong about something, especially when the subject of study is something as complicated as the economy. I do not pretend natural science has the answers, and I hugely respect economics for taking on the challenge of at least trying to understand these things. But when the profession as a whole was wrong, or at least seen to be supportive of positions that were wrong, I think it's time to explicitly refute some of the intellectual claims of the bubble era.

Surfing the econ blogs, I see a lot of technical discussion about the crisis but little by way of apology, contrition or even just a "hey we were really wrong about this".

Peanuts

2009-02-09T23:18:00.002Z

Scientific research is feeling the pinch too. From a piece in Nature Biotechnology:

...even before the economic slowdown, the UK Engineering and Physical Sciences Research Council had planned to reduce its grants portfolio for physics from £137 million ($206 million) for 2006–2007 to £97 million for 2008–2009, according to council reports.

I'm struck by the numbers here: the amount spent on physics research in the UK is tiny in absolute terms (and just got smaller). Less than 100 million UKP is the national budget for the the only research which will give us long term solutions to our energy woes (and much, much more)? The long-term ROI on this spend must be huge: economists, what's going on, why is this stuff so woefully under-funded?

Do I need new glasses?

2009-02-08T21:59:00.003Z

Am I reading this graph (from WSJ) right?

The insidious perversion of extreme wealth

2008-12-19T11:52:00.005Z

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

2008-12-19T11:51:00.001Z

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.

Is it a lie if you believe it?

2008-12-17T10:06:00.002Z

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.

Brown, Greenspan = Madoff ?

2008-12-16T17:56:00.002Z

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.)

German housing

2008-12-14T12:43:00.004Z

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?

2008-12-14T00:09:00.003Z

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?

Riots

2008-12-10T23:11:00.003Z

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.

The Looting Continues

2008-11-12T00:23:00.002Z

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:

http://www.nakedcapitalism.com/2008/11/aig-looting-continues.html

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

http://interfluidity.powerblogs.com/posts/1226367450.shtml

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?

Financial innovation

2008-11-11T23:54:00.002Z

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

http://www.ft.com/cms/s/0/ac2839ac-b015-11dd-a795-0000779fd18c.html

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?

Baker has to go

2008-10-16T23:04:00.003+01:00

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

http://www.timesonline.co.uk/tol/comment/columnists/gerard_baker/article4958311.ece

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

2008-10-16T22:46:00.003+01:00

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

2008-10-16T00:11:00.003+01:00

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.

Housing madness continues

2008-10-15T23:41:00.002+01:00

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.

An oldie

2008-10-13T23:49:00.001+01:00

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?

http://compulsivetheorist.blogspot.com/2007/08/masters-of-universe-ii.html

Arm twisting

2008-10-13T23:34:00.003+01:00

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

2008-10-13T22:14:00.002+01:00

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.

Outrage

2008-10-11T00:30:00.002+01:00

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.

Back to school

2008-01-23T19:49:00.000Z

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.

What women want

2007-12-21T22:41:00.000Z

Via the Freakonomics blog:

Richard Gray at the U.K. Telegraph reports that Sir David King, a University of Cambridge chemist, staunch global warming activist, and one of Britain’s top government scientists, gave the following advice to a woman who asked him what she could do to curb global warming:
“Stop admiring young men in Ferraris.”

A general point here is that I don't think women fully realise the massive collective influence they have on (heterosexual) men via their sexual decisions. Men are very powerfully motivated by the desire to impress women, I think even more than they generally, half-jokingly admit. David King touches on one male behaviour pattern he'd like to see changed, I'm sure you can think of many more. Advantaged men playing fast and loose with the rules, dodging taxes, ripping people off? Disadvantaged young men showing no interest in learning things and instead wreaking havoc on the streets? Men being generally violent, whether outside the pub or with their own families? How different would the motivations to engage in these kinds of behaviours be if within the relevant social groups women treated such men with complete sexual indifference? That is, in each case, if the behaviour led to the man being treated as though he were short, fat and profoundly ugly. Note that in all three cases, if the anti-social behaviour were pointed out, many women would disapprove, but what matters is what they do - revealed preference in econ jargon - and in all three cases I'd argue that it's not the case that such men are shunned. You could even make a case that (perversely) some aspects of these kinds of behaviours are rewarded by women.

Of course, even if it were true that women could exert some influence in this fashion, it would not follow that they ought to. It is the men in these cases who are at fault. But it's an interesting thought that women collectively have a powerful policy lever available.

DRiving Me nuts

2007-12-18T18:12:00.000Z

Itunes' Digital Rights Management (DRM) is driving me nuts. For various reasons I'm sick of the Ipod, but if I switch to a different player, I won't be able to listen to the many songs I bought on Itunes. This is ridiculous: it would be like buying a CD in a Virgin store and only ever being able to play it on a Virgin-branded CD-player. I know there're ways around this, but that's not the point. The point is that DRM as currently implemented on ITunes is immensely clunky.

I'm a guy who loves music and is very happy to pay for it. I want a seamless, easy experience, but that is not what I'm getting. The result? I buy far less music than I might otherwise, because the whole business now just has this association with aggravation in my mind. I can't be the only one: and as bad as I am, I'm surely not the least tech savvy user out there. What all this means is that the music companies are losing out on good business: they're throwing the baby out with the bathwater.

This rant's been bubbling nuder for a while, so I was delighted to find that computer security expert Bruce Schneier (speaking of course from a much better informed position) broadly agrees with me:
http://www.schneier.com/essay-157.html

So what's going on? Schneier says "I don't see the market righting this wrong", and I have to agree. The prize at stake is near-monopoly control of a sector for at least a while. Apple have it right now with digital music; Microsoft want it with movies. For consumers the problem is this: every company, no matter how innovative, wants to push out it's competitors any way they can: what is most profitable for an individual firm may not be the best route for the industry as a whole or for consumers generally. So paradoxically, today's innovators can turn into tomorrow's monopolists.

In my view, this is what's happening to Apple. Given the technology available today, it's a crying shame that digital music is such a pain. At the very least there ought to be multiple online music vendors with industry-wide catalogues, and open standards giving the ability to play purchased songs on any piece of hardware. This would in turn trigger off intense competition on the part of (i) the online stores, who would have to strain every creative sinew to provide a fantastic music browsing experience, and (ii) the manufacturers of players, who'd be competing on hardware alone.

Maybe the only solution is from outside the market: regulation to make it mandatory to allow purchased digital music to be played in standard formats. Then, let the market work its magic.

Counterintuitive data: strikes edition

2007-12-08T18:56:00.000Z

Check out this graph from the Economist:

I find these data pretty surprising:
* Three countries - Germany, Netherlands and Sweden - with strong labour protections lose fewer days to strikes than the US or UK
* Germany and Japan seem to lose something like an order of magnitude fewer days to strikes than the US (!)
* France is just a touch above the OECD average, losing a little bit more than the US, but fewer days than either Australia or Ireland

Is it just me or are these numbers just a little counter-intuitive? I would have expected countries with strong labour protections to lose more days to strikes, and for France in particular to be an outlier. I would have expected the US, and to a lesser extent the UK, Australia and Ireland, all thought of as places where it's easy to hire and fire workers, to lose far fewer days to strikes.

But that's not what we see in the graph. Are these numbers right? Or is this one of these things like unemployment where off-the-shelf numbers need careful interpretation?

(The right would expect easy hiring and firing, weaker worker protections etc. to mean less unproductive striking, with the market taking care of who should get how much etc. The left would expect more strikes in countries with the "worker friendly" policies they like, but they'd view those strikes positively as a mechanism by which workers collectively express preferences. Surely both camps would find these data a little surprising?)

Relative and absolute poverty

2007-12-03T20:41:00.000Z

I've never understood the notion of absolute poverty, as opposed to relative poverty. The absolute poverty rate is defined by Wikipedia as quantifying "... the number of people below a poverty threshold, and this poverty threshold is independent of time and place. For the measure to be absolute, the line must be the same in different countries."

But what is it that is absolute about absolute poverty? As I understand it, absolute poverty is calculted using a basket of goods type of argument: if you can't afford to buy enough to feed yourself (say) you're absolutely poor. But the amount and quality of food which counts as "feeding yourself" changes with time and place. How much is enough? Raw calories? Enough protein? Fresh fruit and vegetables? The first two were a luxury until recently, the fact that they're now regarded as things everyone should be able to afford is an inherently relative concept. Most people can afford to obtain them, so you are poor if you cannot.

What of education for your child? I suppose being unable to buy books or send your child to school would count as absolute poverty (if education was private, and formed part of the basket of goods and services). But again, these are things which were a luxury not too long ago and still are in many places. So why do we draw the line where it is, and not at say access to violin lessons or playing fields or small class sizes?

My point is that the notion of poverty is inherently relative. The absolute poverty line is determined by social convention, implcitly relative to what others in society can afford. How large a gap is tolerated between those at the poverty line and the median, or some higher rank position, is convention and nothing else. Surely all poverty is relative, or am I missing something?

Tucked away in the FT...

2007-12-01T01:26:00.000Z

Tucked away in the Financial Times:

EUROPE: YOUTH AT WORK
By Simon Briscoe, Financial Times
Published: Mar 18, 2006

The proportion of French youths without work is more in line with other countries than suggested by official figures that put French youth unemployment at more than 22 per cent, compared with 11, 12 and 13 per cent in the UK, US and Germany, writes Simon Briscoe, Statistics Editor.

FT research suggests that 7.8 per cent of under-25s are out of work in France. This is only slightly above 7.4 per cent in the UK and 6.5 per cent in Germany.

The discrepancy reflects the fact that France has a much smaller youth labour force than other countries because a greater proportion go on to higher education after the age of 16, delaying their entry to the labour market.

Now, think of how often you've heard the factoid that 1 in 4 French youths is unemployed or whatever, and how rarely you've heard the point made above. I repeat, for emphasis "7.8 per cent of under-25s are out of work in France. This is only slightly above 7.4 per cent in the UK and 6.5 per cent in Germany" (the corresponding number in the US is around 7.4%, as far as I know).

Why is one particular and highly misleading spin on the numbers so widely disseminated? Your guess is as good as mine, but it's weird.

Why does banking pay so well?

2007-11-28T19:30:00.001Z

Superb article from Martin Wolf in the FT:

http://www.ft.com/cms/s/0/3da550e8-9d0e-11dc-af03-0000779fd2ac.html

He starts with the question: "Why does banking generate such turmoil, with the crisis over securitised lending the latest example? Why is the industry so profitable? Why are the people it employs so well paid?" and goes on to suggest the answer is "banking takes high risks. But the public sector subsidises this risk-taking. It does so because banks provide a utility. What the banks give in return, however, is gung-ho speculation.".

The key point is that (Wolf again; I can't put it any better): "banks benefit from sundry explicit and implicit guarantees: lender-of-last-resort facilities from central banks; formal deposit insurance; informal deposit insurance (of the kind just extracted from the UK Treasury by the crisis at Northern Rock); and, frequently, informal insurance of all debt liabilities and even of shareholders’ funds in institutions deemed too big or too politically sensitive to fail... if things go well, shareholders earn exceptional returns. If they go badly, the downside cannot exceed their equity. Beyond that point, creditors and government share the losses."

This goes a long way towards explaining why bankers are paid so well: during times of profit, banks can pay out crazy wages and bonuses. However, the government guarantees Wolf alludes to above in effect put a lower bound of zero on remuneration: bankers don't ever have to pay back earnings (i.e. receive negative wages), no matter how thinly capitalized their industry or how bad their decisions turn out be. Wolf again: "...a run of profitable years in which shareholders receive high returns and employees are handsomely rewarded. Then comes the year of the locusts ...since they do not receive negative pay, they are able to keep their earlier gains."

An unexpected ally...

2007-11-19T17:43:00.000Z

It seems as though Bill Gates' dad - of all people! - is on my side about inheritance tax:

http://www.responsiblewealth.org/commonwealth/index.html

Apparently Gates senior's view is:

"...individual wealth is a product not only of hard work and smart choices but of the society that provides the fertile soil for success. They don't subscribe to the "Great Man" theory of wealth creation but contend that society's investments, such as economic development, education, health care, and property rights protection, all contribute to any individual's good fortune..."

Exactly!

Where are the doctors?

2007-11-06T08:23:00.000Z

Here's a curious fact. The UK and US are both countries where doctors get paid very well: UK is (anecdotally) #1 in Europe on this count (or close), and US doctors are certainly far better paid than their European counterparts. Yet the UK and US - and here's curious bit - are not the countries with the most doctors per capita. Germany - to take one example, there are others - has more docs than either the UK or US. The difference is actually quite striking: Germany has 3.4 practicing doctors/1000 people, the UK and US each have 2.4 (numbers from OECD). This is a huge difference of 42%. Absent any fundamental scarcity, a high wage for a given profession should increase the supply of labour and thereby reduce wages. If this is what's happened in Germany, why doesn't it happen in the UK and US? Given the rewards on offer, why don't more people become doctors in these countries?

Vacation

2007-08-31T16:55:00.000+01:00

I'm always ranting about vacation time. Well, here's where the theory gets put into practice: I'm away for 12 days starting tomorrow (ok, it's not three weeks, but it's a start!), and no, I'm not taking a laptop...

Market failure: the airport edition

2007-08-31T16:46:00.001+01:00

A post from Maria at Crooked Timber makes me wonder whether there isn't perhaps some sort of massive market failure going on at airports. Here's Maria:

Here are the things most people would happily pay for at an international transit airport: – a shower – clean underwear (for those of us who habitually forget to pack it) – daylight – an exercise facility to help with the jetlag and minimise DVT – nutritious but not too heavy food – a nap, lying flat, somewhere quiet.

And here’s what is generally available: – Gucci – Chanel – l’Occitane – Bodyshop – Lacoste – Nike – a few plastic seats – McDonalds, dougnuts, and the local variety of fried, sugary dross to add a sugar hangover to your jetlag.

I suppose the obvious point is that as a consumer of travel, your decision about where to travel is not about the airport but the place. If you want to go to London, you have to put up with Heathrow. So the airport company have a captive customer base, attracted by, and in a sense paid for, by the business environment and tourist attractions of the city. It's hard to see a market solution to the problem, except perhaps in very large cities, where you could conceivably have multiple airports in genuine competition.

So is there a solution? Are there any good publicly funded airports? Or are they just as bad? Is this dream airport something we're just never going to get?

Bail us out!

2007-08-28T20:45:00.000+01:00

Watch this remarkable rant from "Mad Money" host Jim Cramer on CNBC. Isn't it funny how quickly free-market types turn to the government when things go wrong?

Slate's Daniel Gross puts it best when he writes about these characters having a special bye-law which says "The government should never intervene in the economy, unless it is to bail out hedge funds and investment banks". (For the record, I certainly don't hold the position that government intervention should be ruled out because it might help reckless financiers.)

Only economists...

2007-08-16T12:00:00.001+01:00

Here's the start of a piece in the Economist about working hours:

Most people greet the weekend with gratitude. But some economists view it with puzzlement. Why, they wonder, does the bulk of the population rest on the same two days each week? Why does everyone's week end at “the” weekend? From an economic point of view, it would surely be more efficient to stagger days of rest throughout the week. That way, expensive pieces of equipment would not lie idle for two days in seven, and infrastructure would be less congested the other five.

Surely only economists could possibly be puzzled by why people like to have the same days off! More seriously, isn't it a somewhat sobering thought that something as important as the fact that people like to enjoy leisure time with other people might be missing from models used to make decisions about our lives?

Five weeks off

2007-08-16T11:44:00.000+01:00

US blogger Ezra Klein writes about vacation time, and says he'd love to be able to take more time off. Here's a fairly typical response from an irate reader:

So here's my problem with Ezra's post:

...I'm not willing to give up a lot for five weeks of vacation a year, right now. I like the Bay Area, and the cost of living is high, here. I'd like to get a house. I'd like to be able to live here AND still have enough money to go on vacation to Japan this year or next. And some of that's going to have to go by the wayside if I lose 8% of my paycheck.
Now, maybe in a few years, that personal equation will change for me, and I'll start thinking of ways that I could shift my work-life balance more towards "life." But I like to think that, if those few years later Ezra's got a kid and a mortgage and needs to hold onto every penny that's coming his way...“

Does anyone spot the flaw in this argument? The problem is a classic Prisoner's Dilemma: if the respondent alone works less, he's in trouble, because houses will still cost the same, but he alone will have less money. If, on the other hand, everyone works a bit less, house prices will have to fall, and so long as his rank position in the earnings table remains unchanged, he's going to be able to buy the same house as before, except that now he'll also have been able to spend three weeks on a canoeing trip. Thus, with respect to "competitive" goods like housing, it is possible to enjoy more leisure without any real sacrifice: but only if it's a collective decision. On the other hand, a Japan vacation or flat-screen TV will not get much cheaper even if everyone in the Bay Area does work less, so those kinds of things are examples of genuine leisure-consumption trade-offs.

So, yes, working less mean earning less, but the substantive effect of the reduction is not as bad as it sounds, so long as everyone else is working less too.

Masters of the Universe II

2007-08-08T11:32:00.000+01:00

Three further thoughts on the Barksy interview below:

1. When you have “the most profitable industry in the history of mankind” enjoying a “quirk” in regulation, you simply have to ask questions about influences on the political process.

2. Market wages do not necessarily reflect the true, long-term "usefulness" of work (except under very strong assumptions). Many professions pay more than others because they deviate from a perfect market, not the reverse: medicine is a good example. Taxes which are used to pay for workers (firemen, nurses, scientists) who are under-valued by the market can then be seen as rightly rewarding productive work by using the excess rewards which accrue to those in over-valued sectors. (The fact that estimates of the extent to which different kinds of work are over- and under-valued are both very rough and highly politicized does not invalidate this general defence of taxation.)

3. 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?

Masters of the Universe

2007-08-08T11:09:00.000+01:00

Are people in finance overpaid? Should hedge fund managers be able to pay a lower tax rate, as they do in many cases? I'm sure regular readers can guess my views on these and related questions, but it was interesting to read an interview in the New York Times with hedge fund manager Neil Barsky, which touched on some of these questions. Barsky is certainly a “finance type” and used to be a reporter at the Wall Street Journal, so he's certainly no leftie. Some excerpts:

[On tax rates]
First, let me state the obvious: there is no public policy reason for hedge fund and private equity managers to pay a lower tax rate than teachers, doctors, or lawyers... I suspect that this debate is the result of a quirk in the tax code... No legislator in his right mind ever said, “We have to tax hedge fund managers this way, otherwise they’ll have no incentive to work hard!” So let’s not kid ourselves — the tax code is a gift to the industry. Of course, accountants and some managers will find clever ways to circumvent the new laws, so perhaps the proposed bills won’t generate the revenue they are meant to...The notion that the most profitable industry in the history of mankind (I hyperbolize, but on a per-person basis, this might in fact be true) requires a lower tax rate to take risk and make investments, simply does not square with logic. I know of no manager who would stop working or stop investing as a result.

[Short-termism in business thinking driven by financial markets]
This is a great question: does the presence of short-term-oriented investors such as hedge funds alter the behavior of the companies they invest in? Let me throw a few more questions out there: To what extent does widespread options issuance create an incentive for a CEO to focus on his or her stock price to the exclusion of building long-term business value? Does the ubiquity of earnings estimates cause companies — unconsciously or, ahem, intentionally — to distort their business practices in order to please investors? Does all the money sloshing around hedge fund coffers allow them to throw their weight around and often force managements to make bad business decisions? My answers would be: Yes. A lot. Yes. Yes. Short-term thinking infected Wall Street some time ago, and I would suggest it was performance-obsessed mutual funds that got the ball rolling back in the 1980s bull market.

[Social and labour market effects of hedge funds]
I don’t believe hedge funds necessarily provide a social good, but I also do not believe they are a social evil (generalizations are always dangerous, but bear with me here). And it is unfortunate that the “best and the brightest” no longer seem to want to go into government or medicine or teaching (I did say I’d be generalizing here), and instead seem to gravitate to the best-paying professions... In general, the compensation differential between jobs in finance and jobs in virtually every other part of society is sad.

Rent-seeking

2007-08-06T09:47:00.001+01:00

James Surowiecki writes on "rent-seeking" in the US student loan business in this week's New Yorker:

[Student loans] ...isn’t a free market in any meaningful sense of the term, because the government effectively determines prices, insures against losses, and subsidizes volume. In this environment, most of the competition among private companies is really just squabbling over how to split up the spoils. Economists call this behavior—when a company seeks to manipulate economic conditions rather than actually create value—“rent-seeking.” It’s common in areas where the fetish for privatization has taken hold, such as the outsourcing of homeland security to private contractors and the boom in private Medicare insurers. (The private insurers are less efficient than Medicare and receive billions in subsidies from the government.) Outsourcing tasks to private companies is supposed to let government reap the benefits of the free market. But sometimes it just ends up uniting the worst of government and the worst of the private sector into one expensive mess.

If you're in the UK, does any of this sound familiar? Isn't rent-seeking exactly what's been going on in many of the botched attempts at privatisation, from the railways to Heathrow?

First They Came

2007-08-06T09:37:00.000+01:00

First they came for the Jews
and I did not speak out
because I was not a Jew.
Then they came for the Communists
and I did not speak out
because I was not a Communist.
Then they came for the trade unionists
and I did not speak out
because I was not a trade unionist.
Then they came for me
and there was no one left
to speak out for me.
Pastor Martin Niemöller

-- Attributed to Pastor Martin Niemöller (1892–1984)

Why does Bergman matter?

2007-08-01T14:05:00.000+01:00

Ingmar Bergman's death has triggered off a mini-debate about the merits of art cinema. Here is one example, from today's Times; last night's Newsnight is another. The question being asked – and I welcome the fact that it is being asked – is why we should care about film-makers whose films are not popular, and which are in the opinion of many, unenjoyable.

This question goes to the heart of what art really is. If art is meant to be enjoyable (in some broadly defined sense) and if each person's view counts as much as any other, then surely, the argument goes, the Farrelly Brothers are greater artists than Bergman ever was.

Appealingly democratic though this argument is, I think it misses out on an essential aspect of enjoying art, which is adaptation. Our response to a given stimulus is not fixed from birth to death, but capable of undergoing change. In many cases, enjoying something involves learning: we have to undertake an initial investment to even be able to appreciate the thing. This initial effort may not be enjoyable at the time, but is undertaken in the hope that it will lead to greater joys in future.

Consider what happens with food. The first time we go from fish fingers and ketchup to good tomatoes and olive oil, it doesn't seem nice (or at least it didn't to me), but over time you learn to enjoy food in a way that makes the entire process of eating more fun, not less. A business invests money, foregoing profits in the present to add to profits in the future. In the same way, this sort of training is a hedonic investment: a decision to enjoy a little less in the present in order to enjoy more, or more sustainably (I'll write more on this aspect in a later post), in the future.

So what has all this got to do with art? You could argue that art is essentially a sort of product or service whose enjoyment requires specialized training. The idea is that learning to appreciate the artform opens up new possibilities for enjoyment, and it is in the hope of realizing these possibilities that anyone bothers. Of course, there is a strongly subjective component to all of this, so each individual has to make a guess as to exactly which hedonic investments are likely to pay off for her. (Typically this is done by looking at people who we assess to be in some way like ourselves, and who have clearly learned to enjoy something, and then following the route they've taken. In other words, we use role models.)

Coming back to the specific case of Bergman (or for that matter any relatively unpopular but feted artist) I think what tends to happen is that at a given point in time, only a small number of people make the effort, or even have the inclination, to seriously get into cinema. Over time, their tastes certainly evolve away from the mainstream, but there is a sense in which these film-buffs are getting more out of their trips to the cinema than the average person. They love Bergman, and we can appreciate their specialized ability to enjoy film, even if we do not share it, so we take note when he dies. This seems perfectly reasonable to me.

Furthermore, since most film-makers tend to themselves belong to this small set of serious cinema fans, over time these arthouse films influence more popular work, to eveyone's benefit. Indeed, many of today's popular films – Pulp Fiction or the Usual Suspects say - would have seemed far too complicated for popular consumption in the 1950s. But their makers are film-nerds. They themselves made hedonic investments, devouring films that others may have thought unenjoyable, and learning how to enjoy, and use, storytelling devices which were not common in the mainstream. Years later, they've been able to use that learning to craft widely enjoyed but relatively sophisticated entertainment. That sounds like progress to me.

I Know Which "Times" I Prefer...

2007-07-27T19:05:00.000+01:00

Dan Kennedy draws attention to the state of US cable news in the Guardian. UK television news is certainly much better than in the US, but when it comes to newspapers and magazines, in my view the best publications in the US are far better than their British counterparts.

These days UK newspapers - yes, even the "broadsheets" (for non-UK readers, these are the four "serious" newspapers, namely the Times, Telegraph, Guardian and Independent) - contain little more than re-worded press releases plugging some product or another ("10 best stir-fry pans" etc.), or paraphrased versions of the Reuters wire. There is nothing remotely equivalent to the serious journalism you see in the New York Times. By this I mean pieces where the journalist makes the effort (and has the background) to understand the issues for herself, and then puts the evidence together into a coherent story.

The opinion pages are even worse. In the UK papers, opinion pieces are droll enough, but very rarely have the depth of the best of the New York Times or Washington Post's op-ed pages. I really can't imagine a serious economist like Paul Krugman having a regular column in the Times of London. Instead we get the likes of Boris Johnson: a funny enough writer, but a literate generalist with absolutely no expert knowledge of anything.

Finally, where are Britain's magazines? America has the superb New Yorker, the New York Review of Books, and the more mainstream Newsweek and Time (light, but readable enough). Germany has Der Spiegel and Stern. Leaving aside the Economist, which is a much more specialist outlet than any of the above, we have nothing comparable.

Thank heaven for BBC news...

Youth unemployment

2007-07-26T23:53:00.000+01:00

I've written previously on how difficult it is to compare rates of joblessness between countries. One of the trickiest areas is the youth labour market. Suppose countries A and B each have 1 million 16-20 year olds. Out of this population, each country also has the same number - let's say 50,000 - of youths who are neither at work nor in education. Now, country A is less generous with funding for education, so 450,000 of the the 950,000 kids at school there work part-time. Country B offers more support for education, so only 50,000 of the kids at school there work. Now, the unemployment rate is, by definition

number unemployed / (number unemployed + number employed)

Thus, the formal youth unemployment rate in country A is just 10% but in country B a whopping 50%. Both countries have exactly the same number of kids who are not usefully occupied, but A's situation looks better simply because it has more of its students at work. (You could even argue that B's position is better, since the long-term pay-off of good education is high, and it may well be the case that it's preferable if students don't have to work.)

There's a good argument to be made that the US currently resembles country A, and France country B. As economists John Schmitt and David Howell report:

At 22 percent, the nominal youth unemployment rate in France is double the U.S. rate of 11 percent, and even further above the U.K. rate of 9.9 percent...

Yet:

...for male youth the unemployment-to-population rate is 8.3 percent in the United States and 8.6 percent in France...

And there are of course differences in the rate at which young people work:

In the United States, 23.1 percent of 16- to 19-year-old students were also working, compared to only 1.8 percent of French teenagers. This disparity creates most of the higher statistical unemployment rate.

Be wary of unemployment rates: they really are the most heavily politicised of economic indicators...!

What's the rush?

2007-07-26T19:29:00.000+01:00

I've posted previously about working hours, and at various times talked about the relationship between conventionally measured economic output (i.e. in terms of GDP) and well-being. This piece:

http://www.cepr.net/index.php?option=com_content&task=view&id=1039&Itemid=45

by David Rosnick from the Center for Economic and Policy Research does a really good job of bringing these strands together in one article. And given what a rush many of us are in - although thankfully not the Compulsive Theorist - it's nice and brief. Well worth a read.

The key point I would draw attention to is the fact that these issues are not ones we can decide upon in isolation. Choices of this kind pretty much have to be made collectively: this is an area where we really need politics and not just individual choice.

Starving the NIH

2007-07-26T12:08:00.000+01:00

Very rarely do I find myself agreeing with anything in the Washington post, but this piece is spot-on:

http://www.washingtonpost.com/wp-dyn/content/article/2007/07/23/AR2007072301364.html

NIH-funded research, and associated spin-offs, have been for many years arguably the most potent source of biomedical innovation in the US, if not the world. Yet the Bush administration - which when it comes to tax cuts seems swayed by far more tenuous arguments about innovation and technology - sees fit to reduce its support. The effects are substantive. From my own small circle, I can think of several top young scientists - all very smart and enormously hard-working - who have, largely as a consequence of these changes, now reluctantly left the academic sector.

Keeping our heads above water

2007-07-26T11:01:00.000+01:00

A couple of observations about the UK floods:

- First, in my view, the UK response so far has been superb. The emergency services have been combing through flooded areas looking for kids and old people who may have been left behind, airlifting people when necessary and generally making sure that serious losses (as in deaths and serious injuries) are prevented. There's been a real community spirit and so far no reports of looting or anything of that kind that I can think of. The news media have been shrill, but they have been holding the government to very high standards. Last night the BBC news led with a piece on how drinking water dispensers in Gloucester haven't been filled often enough. The piece highlighted this failing and the reporter put the criticism directly to the Prime Minister Gordon Brown, who really had to say it would be fixed. Here's the thing: if he doesn't get it right, tonight's news will be scathing. I couldn't help contrasting what's happened with Katrina: the looting, the sign outside someone's house (“I have a big gun and an ugly wife”), FEMA's complete mismanagement of the crisis and Bush's now-infamous response (“Brownie – you're doing a heckuva job”).

- Second, I doubt you can put these floods down to global warming, but what they do highlight is the kind of economic devastation climatic changes will wreak in the years ahead. The so-called “economic” case against action (“it'll cost too much”) is totally bogus. As the Stern report has argued at length, even very conservative estimates regarding the frequency of events like this make a compelling economic case for action.

Why should we care about sustainability, if China and the US don't?

2007-07-26T09:19:00.000+01:00

I live in the UK, and a question some people here ask is this: why should we bother about emissions in our small country when any small change on our part will be as nothing next to the impact of China and the US? In my view, this argument is wrong-headed because it ignores the manner in which preferences shift over time.

Consider slavery. At some point, in some "liberal" enclave, some people would have started thinking that slavery was morally wrong. At that point, a nay-sayer could reasonably have pointed out that all the total amount of slave-owning in the room was tiny compared with the vast mass of slave-owning in the Deep South, say. Yet it should be clear in retrospect that the efforts of an initial minority to argue a morally correct case can pay off, as more and more people start to listen and see their own values change. (It seems to me that such changes can be seen as propagating through a network, and can be highly non-linear, such that after a slow start things can really gather pace.)

Moving back to the present, when we in Britain see some European countries recycling and controlling their output of rubbish more effectively than we do, and when we see Germany's sustainable energy use at 12% and rising, it affects our political debate. Equally, when policy experts elsewhere look at our rapid adoption of leading standards for sustainable fishery (MSC) and forestry (FSC), they can see that it is possible to make these issues important to consumers.

These effects are certainly going to be subtle at first, but nonetheless very real. It's just much more powerful to be able to point to a policy choice that is already in place elsewhere, rather than an abstract idea which has not been tried. In addition, technologies or standards which are already working elsewhere are relatively easy to import. We hear this argument all the time in the context of the diffusion of technology, but I think it's just as applicable to ideas.

It therefore makes sense for a small country (or individual) to "go green" on three counts. First, the reduction in impacts, however small, is a good in and of itself. Second, there is a political and moral “ripple effect” which can be a potent source of change, both within and between countries. Third, the push to develop new technologies, standards, accounting practices in one place give late movers elsewhere working tools which can then be rapidly adopted.

Tax and Spend

2007-07-12T18:18:00.000+01:00

I'm back again after (another) long-ish absence. Here's a comment from one Robert Waldmann on the excellent Economist's View which caught my eye:

George Bush said

"No nation has ever taxed and spent its way to prosperity."

He is, of course, totally wrong. No country which is not sitting on oil or made of guano has ever achieved prosperity without taxing and spending the money on public education. It's not like the pure private sector approach to schooling has never been tried -- it was tried and failed for millennia. So far in history the rule is no tax and spend no industrialization.

Tax and spend is so under-rated...

The solution to unemployment

2007-04-20T01:00:00.000+01:00

It's now virtually an article of faith that the the US economic system is a marvellous engine of job creation, especially when compared with Europe, and that the source of this vitality is its flexible labour market and relative lack of social welfare. As I've mentioned previously, what is less well known is just how huge the US prison population is (around 2.2 million, or many times higher per unit population than any other wealthy country), and how this affects our view of unemployment.

Bruce Western at Princeton has tried to account for the effect of the prison population on unemployment numbers, and among other things, has found that the Black male unemployment rate during the 90s boom was a whopping 39%. Put this alongside France's much publicised 20% rate for its minorities, and you have the seeds of an interesting debate about which country is actually doing worse for it's “underclass”. Along with Katherine Beckett, Western has also shown that if you account for prison numbers, US unemployment was consistently higher than Europe's in the 90s. This is a remarkable turnaround of the conventional wisdom. Writing in the mid-90s, when the prison population was a mere 1.6 million, Western predicted that to keep official unemployment low, the prison population would have to rise further. Indeed, in the decade since, it's gone up a whopping 37% to around 2.2 million.

But why should we account for incarceration when we are interested in unemployment? I think the answer to this lies in thinking for a second about why it is we care about unemployment in the first place. We care about unemployment because it is unpleasant to be unemployed. That's it. It's the well-being of the jobless that is the issue. If the unemployed, were, for some reason, perfectly happy to be without work, and if the rest of the labour market was functioning just fine without them, the issue would cease to be of consequence.

Yet being incarcerated is surely at least as bad as being unemployed (and taking into account endemic features of violence, sexual assault and psychlogically devastating things like solitary confinement probably much worse). At the time the standard measures of economic well-being were formulated the prison population was so small - as it still is in most of the world - that it was unnecessary to account for it in national measures of economic health. But the population affected by the criminal justice system in the US is now so large that neglecting to account for it means missing out a huge part of the labour market in that country, and, in my view, leads to a much too rosy view of unemployment there.

These prisoners are not only not gainfully employed, but deprived of basic liberties, and in many cases lose many rights for life. Furthermore, their sorry outcome, unlike that of the unemployed in Europe, is simply erased from the economic accounts (well, actually all the guarding and prison building actually adds to GDP, but that's another story). Personally, I find the way in which the outcomes of these millions of people are effectively erased from US measures of well-being really disturbing, because mass incarceration not only reduces well-being, but perversely gives the impression of increasing it.

Viewed in this way, perhaps Europe's greatest "failing" is actually trying to count all its citizens in economic measures. How much better would European unemployment look if we simply imprisoned a large chunk of the poor and unskilled, and hired some of the remainder to guard them?

Urban America

2007-04-07T00:39:00.000+01:00

In just over a year living in the USA, perhaps nothing has surprised me more than the contrast between the much-vaunted wealth and dynamism of this country and the often mediocre quality of life in its urban areas. This post from urban planning writer Josh Stephens makes this point far more eloquently and passionately than I can:

http://www.planetizen.com/node/23517

A nice, and in my view very accurate, observation from the piece:

Many Americans rightfully take pride in so-called gems like San Francisco, New York, Portland, and even Los Angeles on a clear day. But Mercer's analysis indicates that we're fooling ourselves: we're so far from the top that, in true Platonic fashion, we can't even imagine what the top looks like.

You could say that Stephens is being a little tough on the US here. Perhaps US life is fundamentally centred around the car, and that it is this fact that changes everything in terms of how cities are designed. To be fair, I know Americans who dislike European cities because they have pedestrian zones and public spaces and because you have to walk between shops: so perhaps it's just a case of to each his own.

Unemployment in Germany and the US

2007-04-05T17:45:00.000+01:00

A standard piece of conventional economic wisdom says that Germany's labour-friendly regulations and high level of social benefits result in a high level of unemployment. It's not unusual to see unemployment figures as high as 12% quoted in the press, usually in juxtaposition to a US rate of 5% or thereabouts.

But is the difference really as great as that? The German government's numbers are calculated in a very different way from the US. As far as I'm aware, in Germany if you work upto 15 hrs a week but register a desire to work longer, you count as unemployed. In the US, if you work just 1 hour a week, you're employed. The OECD tries to correct for these sorts of accounting difference in its "Standardised Unemployment Rates". The current rates for Germany and the US are 7.7% and 4.6% respectively:

http://www.oecd.org/document/50/0,2340,en_2825_495670_38234290_1_1_1_1,00.html

However, Germany's social benefits in themselves surely increase the chance that an unemployed person is formally recorded as unemployed: he or she has much to lose by being "off the books". This "pull" factor is very likely much weaker in the US, so I'd expect a greater chunk of the unemployed in the US to be unrecorded than in Germany. Admittedly, this is hard to correct for. Also, the US figures don't include that country's enormous prison population of well over 2 million. It seems reasonable to assume that a good chunk of these people would be unemployed if they were not incarcerated. Accounting for these differences would surely add at least 1% to the US figure bumping it up to around 5.6%.

Finally, while you can never control for all the many relevant factors, there's one event in recent German history that simply cannot be ignored. This is, of course, reunification. If unemployment is three times higher in the East than West, a back of the envelope calculation suggests that unemployment in West Germany is probably around 6%.

This leaves us with a very minor difference in unemployment rates between the US and West Germany. Put this together with the fact that West Germany had really low unemployment for decades previously, and this must surely put a question mark over the claim that social welfare must lead to joblessness.

Milk into babies

2007-03-30T23:26:00.000+01:00

In a recent article in Nature, Holmes and O'Connell discuss the depressing state of affairs for women in academia. One of the issues they raise concerns child-friendly policies at Universities:

More universities should provide paid family leave for graduate students and faculty members. Only one-third of PhD-granting institutions provide any sort of daycare for graduate students and most have no childbirth policy.

We're richer than we've ever been. We now have hourly productivity levels which would allow us to work less, at least for those critical years, the technology to facilitate flexible working, and the resources to build the infrastructure we need to make raising children really compatible with work. Yet basic things like good, onsite daycare remain a rare perk rather than the standard provision they could be. What is missing is the political and social climate to make it happen. Perhaps the very fact that we use phrases likes "child-friendly" says it all - when was the last time you heard of a "life-friendly" organization?

Part of the problem is that policies of this kind tend to be seen as leftist and uneconomic. But even if you discount all the non-monetary gains that would flow from a "family-friendly" re-thinking of how we work, the economic benefits are undeniable. Accounting for costs and benefits over a lifetime, there's surely no greater economic good than a well-raised child. Or, as Churchill famously put it: "There is no finer investment for any community than putting milk into babies."

All under one roof

2007-03-23T04:06:00.000Z

Parents of young children typically have a hell of a time looking after the kids, while balancing mid-career workloads. So they end up spending lots of money on day care, nannies, etc. Yet, in many cases, their own parents would gladly take over, at least for short periods. This seems like a double payoff: the work gets done and the person doing it enjoys it.

One way to make this happen more would be to think up a new kind of old-fashioned family home. Have grandma in her own mini "in-law" unit, so you can meet every day,or at least very often. But, crucially, make sure that physically and psychologically there's just enough distance to stop it feeling like a re-run of the kids teenage years.

Would this be so hard to achieve? I don't think so. We just need some creativity to re-imagine this most ancient of set-ups in a new way. Any ideas?

Robots can't cut hair

2007-03-23T03:28:00.000Z

Year-on-year, advancing technology automates processes that once required human effort. This puts people out of work in one sense, but in another sense it frees up that same human effort for other things, which are often - though certainly not always - more pleasant or creative. Thus, while a generation or two ago I would almost certainly have been plugging away as a clerk in a monstrous Kafkaesque insurance firm, today I get to do fun research. Wait, I hear you say, there were scientists two generations ago, surely? Yes, but very few, and as a consequence, the only full-time ones were probably vastly more talented than I am, and probably luckier too.

In general, it's the things machines are bad at that become the work of tomorrow. Who would have thought, in 1950, say, that there'd be as many hairdressers as there are today? Hairdressing requires the kinds of motor skills and creativity that is hard to automate, and lots of people enjoy getting what were once movie-star-only treatments. Hence the trend.

But not all creative professions grow. Ones in which the product can be replicated by technological means can actually shrink. A classic example is musicians: once upon a time you had to hire one in order to even hear a tune, now you can put on a CD and listen to Herbie Hancock or Itzhak Perlman or whoever, which has increasingly put medicore players out of business.

So the formula is this: jobs which are both hard to automate and can't be easily replicated tend to be the ones that grow. With that in mind, what occupations might swell their ranks in the years ahead? Research (of course!), and I think especially applied and translational work, which there could be so, so much more of. But also less obvious things like personal services - cooking, surgery, hairdressing etc. Maybe personal shoppers: technology is making shopping for clothes harder, inasmuch as there more choice, so I think there might be a growing demand for experts who do it all for you. Professional childcare should rise: surely everyone wants a Super Nanny on call? Teaching should keep growing, at least until classroom sizes grow small enough that no one cares about further reductions, and demographic changes mean there aren't actually many kids to teach.

So close your eyes and wonder: what would you like to have done for you, if it were really cheap? Whatever it is, odds on your grandchildren will be doing it, having it done for them, or, if you're a really demanding dreamer, still be wishing for the same thing.

You're my superstar

2006-02-03T14:24:00.000Z

A number of years ago, Sherwin Rosen wrote about a “superstar” effect in economics*, whereby a single individual can, using modern technology to disseminate a product, reach a huge market, and thereby enjoy potentially enormous gains, perhaps at the expense of others in the same field. According to this view, the neighbourhood pianist of yesteryear is out of a job because virtuoso performances can now reach millions of people through CDs, high-quality radio broadcasts etc.

A heartening contrast, at least for those of us who are not superstars, is the emphatically one-to-one nature of human relationships. It takes so much time and effort to build a good relationship, that almost by definition superstar effects are excluded – you can only genuinely provide love to a small number of people. This puts an interesting twist on some of the phrases we use: “Daddy’s princess”, “you’re my superstar” etc.

*Here’s a short version of one of his essays:
http://www.geocities.com/valencia_aaup/The_Economics_of_Superstars.html

Escaping the pin factory

2006-02-01T10:37:00.000Z

Adam Smith’s much quoted story of the pin factory (see e.g. http://divisionoflabour.com/archives/000006.php) emphasises the importance of specialisation in raising productivity and living standards. But some of the time, we all actively choose to expend our effort in ways that are clearly inefficient. Here’s one example from a few Sundays ago. I spent an hour cooking dinner, and my wife roughly the same amount of time baking a cake.

Why is this inefficient? Well, cooking is something I’m not really very good at, and in comparison with a professional set-up my kitchen is not really ideally equipped. This makes my productivity at cooking laughably low. In contrast, my productivity at work is much, much higher. The same is true for my wife’s baking versus her professional work. Why then, did we not spend Sunday afternoon at work, and then spend some part of the extra money on eating out, or buying a cake, in effect trading our specialised professional output with that of the chef or baker?

The answer of course is because of the joy of novelty. It’s actually fun to do something different, even if it is, in a narrow sense, inefficient. The reductio ad absurdum of specialisation would be horrible: imagine always doing your specialist work, stopping only to consume. No DIY, no cooking, probably not even much childcare, just monotonous, efficient, formal work. Count me out!

Who needs working-hours regulations?

2005-08-22T12:18:00.000+01:00

Perhaps the bits of Euro-legislation most derided by experts in the English speaking world are those concerning working-hours restrictions. The standard argument against such legislation is based on liberal economic principles and really does sound pretty good. It goes like this: why not let individuals decide for themselves how much they want to work, and stop interfering in their free choice? According to this view, the best course of action is to minimize regulations, and simply let market mechanisms deal with the whole issue of working hours.

This sounds very convincing, but a serious problem arises from the nature of choice in employment. Let’s digress very briefly to look at choice in a more canonical market. Suppose I choose to buy 100 grams of coffee beans at a supermarket. The fact of my purchase is a reasonable indicator that I wanted 100gms, and not 90, or 110, provided the vendor sells beans by the gram. (Even if she doesn’t, if she has a large number of competitors, in the absence of any kind of collusion, someone in the same town should offer the choice I want.) Now, if we assume that I myself am the best person to judge what makes me happy, we can treat my buying behaviour as information that reveals the amount of beans I really want.

Unfortunately, choosing the number of hours you work is nothing like choosing the number of grams of coffee beans you want to buy. There are at least two major differences. The first is that except for a few professions, you can’t just decide on your own how much you want to work. Work is mostly a team effort, so everyone needs to be there at the same time for the organization to function effectively. As a consequence, you can’t just unilaterally decide to work fewer hours (or more) and necessarily be able to do it.

The second and maybe more important difference is that there are typically only a very small number of organizations in a given area that can effectively use a given worker’s skills. There is, in any practical sense, limited competition for labour, and a limited choice of employment options available to most workers. This departure from the continuum of choice we face when buying coffee beans can lead to strange market outcomes. Here’s one example. Suppose all the workers at a car factory really want to work 40 hours rather than 45, such that in every sense their well-being is better served by working fewer hours. Suppose also that there is no union, and that management present the option of a 45 hr week or no job to each worker individually. If there is no other car factory in the area, or at least none offering a 40hr week, the choices facing workers look like this: a) Accept 45hrs, b) Quit (and move your entire family in search of another job with exactly the right number of hours... bearing in mind that this ideal job, if at all it exists, may be 1000 miles away from all your friends and your elderly mom!). So rationally enough he chooses a). But this free choice has delivered a weird result: labour has chosen an outcome that is suboptimal for all of them! The outcome is the best of the very limited options available, but the 40hr week outcome which everyone would have preferred is just not on the table.

Employees simply do not get a realistic continuum of working hours at a given job they’re trained to do, in the exact same location. If they did (some workers probably do, work-from-home translators maybe?) we could treat the number of hours actually worked as a meaningful "revealed preference". But in real life employment choices are very, very limited. The real choice would be more like: work x hours a week at something you're trained to do, or <x hours on something totally different, or be unemployed. Given these choices, even someone who wants <x, usually just puts up with it.

We could reasonably view this problem as a sort of market failure in the provision of leisure time. It then becomes easier to see why some sort of intervention may be necessary to ensure outcomes that are closer to optimal. Such interventions may be through trade unions, regulation, or some other means. I’m not sure if the Euro approach is the right one, but the question of working hours does seem to be one that cannot be solved simply by leaving things to the magic of the market.