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This year’s Nobel economics laureates have made the world a better place

This year’s Nobel economics laureates have made the world a better place

This year’s Nobel Prize in economics, announced on Monday, was a ray of sunshine amid the prevailing media gloom.

The Prize was awarded for the work the new laureates had done on the alleviation of global poverty. This is one reason to be cheerful about it. Another is that Esther Duflo became only the second ever woman to win the prize, along with her close collaborators Abhijit Banerjee and Michael Kremer.

In addition, the winners have made important developments in how economists go about solving problems. These individuals are a key part of the drive to move economics on from an obsession with pure theory towards making it much more empirically-based.

At first sight, the award is very conventional. The laureates retain the basic view of economists: poor people are essentially rational agents, trying to take decisions which are in their own interests.

They may have much more difficulty in accessing relevant information than others, and face many more constraints on their ability to make the best decision. But they are just as rational as everyone else.

The similarity with tradition ends there. For the laureates’ main innovation is to introduce the use of randomised controlled trials (RCTs) into economics.

One hundred years ago, the British statistician Ronald Fisher was revolutionising the principles of statistical analysis. The maths that he developed enabled the testing of new medicines to become much more scientific.

The basic idea is to have a group of people who take the new drug and a group who do not.  The key thing is to assign them into the groups purely at random. This way, any difference in the outcomes of the group which was treated and the group which was not can reasonably be thought to be due to the impact of the drug.

Duflo and her colleagues, along with others they have inspired, have addressed a wide range of real-life policy problems in the developing world using the same approach, with hugely successful results.

Examples include discovering how best to get farmers to use more effective fertilisers, how to increase the uptake of safe water filters, how to improve patient safety in hospitals, how to spread advice most effectively about tuberculosis using community-based counsellors, and how to improve safety in public service vehicles.

The technique of RCT has even been applied in developed world settings. For example, experiments have been carried out with job applications, sending them out with names which strongly imply the ethnic background of the applicant and seeing if the response differs across groups. (It does.)

The approach of RCT is not without critics in economics, even now.  An important issue, for example, is that experiments are typically on a small scale, and there may be issues when they are scaled up.

But Duflo and colleagues, unlike some past economics laureates, have definitely helped to make the world a better place.

As published in City AM Wednesday 16th October 2019
Image: Nobel Prize by Florian Pircher via Pixabay
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Forget ‘reparations’, scrapping subsidies is the way to help get Wales back on its feet

Forget ‘reparations’, scrapping subsidies is the way to help get Wales back on its feet

Get ready to put your hands deep into your pockets for the boyos and girlos of the Welsh Valleys.  Adam Price, the leader of Plaid Cymru, called last week for the UK to pay “reparations” to Wales for the crime of reducing the country to poverty. For centuries, Wales has (apparently) been stripped of its natural resources and “deprived of its inheritance”.

Price’s demands are almost beyond parody. But they could become a frightening reality if a coalition government led by Jeremy Corbyn and various nationalist and green parties wins the next election.

The then-Labour leader of the Welsh Assembly, Carwyn Jones, set the new tone of Welsh whingeing the day after the Brexit vote in 2016.  “Wales,” he declared, “must not lose a penny of subsidy”. Wales, of course, had voted Leave.

There, in a sentence, was the economic policy of the Welsh government: hold out the begging bowl.

Wales is the poorest of the economic regions of the UK. Household income per head in 2017 – the latest date for which figures are available – was only £15,754, compared to the UK average of £19,514. The gap with the wealthiest regions is massive – the south east has an income per head 43 per cent higher, and London is no less than 77 per cent ahead.

It has not always been like this. In the early decades of the Industrial Revolution, the valley towns were probably the richest in the world.

Merthyr Tydfil, now a byword for poverty even by the standards of Wales, led the way. It was the first genuinely industrialised town in the history of humanity. In 1831, 96 per cent of its labour force worked in manufacturing and mining.

Many forces are at work in the story of Wales’ decline, but in modern times, it has often not exactly helped itself. The key to a successful economy is a skilled labour force, but in 2001, the Welsh government scrapped the publication of league tables for the performance of schools. This both deprived parents of information, and reduced the incentive for poor schools to improve.

The outcome was predictable. A Bristol University study estimated that it led to a fall of 1.92 GCSE grades per pupil. In 2015, the Welsh Assembly reversed the decision, but a lot of damage had been done to the human capital of Wales. For over a decade, students were less well educated than they could have been.

This lack of a skilled talent base inevitably holds back enterprise. This, along with other counter-productive decisions, may be why Wales is increasingly dependent on public sector jobs. Overall, Wales raises £14bn a year less in taxes than it spends on public services.

Might Wales be able to turn its fortunes around if it were forced to consider its economic decisions more carefully? After all, the policy of subsidising underperforming regions has been tried for decades. It has made no difference.

So instead of paying reparations, perhaps we should consider withdrawing subsides, as New Zealand did with great effect. By removing the handouts which are distorting Welsh decision-making and causing a vicious cycle of subsidy demands, we can give Wales the chance to restore the enterprise which used to flourish in the nation.

As published in City AM Wednesday 9th October 2019
Image: Welsh Assembly by Anne Siegel via Wikimedia Commons licensed under CC by 2.0
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What kind of person crosses the Nevada desert to investigate UFO conspiracies?

What kind of person crosses the Nevada desert to investigate UFO conspiracies?

Area 51 is a mysterious place.

Located deep in the Nevada desert, it is home to highly classified US military operations. Rumours abound that it harbours secrets about extraterrestrial life.

In June, a podcaster released an interview with someone who claims to have studied flying saucers in Area 51. The video spread like wildfire on the internet.

A proposal for an event took shape, labelled “Storm Area 51, They Can’t Stop All of US”. The idea was for large numbers to gather on 20 September in a couple of tiny Nevadan towns next to Area 51. The security defences would be overwhelmed. Citizens could then see for themselves the aliens being kept secret by the military-industrial complex.

Around two million individuals pledged on Facebook to attend. Estimates vary, but it seems that in reality only some 2,000 turned up in the nearby towns. Of these, a mere 200 or so actually arrived at the security fences which guard the area. No one tried to cut or climb over the barriers.

The event has subsequently attracted a great deal of ridicule in both the mainstream and social media. But it usefully illustrates two important principles in economic theory.

The first is the so-called free rider problem. It occurs when some individuals fail to contribute their fair share to the cost of a shared product or services.

An everyday example is that of a shared kitchen space in an office block. Provided enough people are willing to keep it clean, there is an incentive for others to free-ride and enjoy the clean kitchen without doing anything themselves.

The problem is that where free riders exist, the product or service in question tends to be under-produced. In the kitchen example, the supply of people willing to clean may drop off.

Exactly the same thing took place outside Area 51. Everyone wanted the razor wire fences to be cut, so they could consume the “product” of entering the site to see if it contained aliens. But not enough – in fact no one at all – was willing to cut the wire and incur the potential cost of being shot.

The event also illustrates the importance of revealed rather than stated preference.

Economists traditionally attach little weight to surveys in which people are asked hypothetical questions about what they might do or pay in different situations. These constitute stated preferences.

Instead, economists prefer to infer preferences from the actions people actually take. If you always buy Pepsi rather than Coke, you have revealed your preference between the two.

Pressing a button to say you “like” something merely states your preferences.  The cost of doing this is virtually zero. Revealing preferences may involve substantial costs, such as travelling to the Nevada desert.

This fundamental point is being lost in many of the reactions of decision-makers to events on social media. Far too much importance is being attached to actions which are almost costless.

The UFO buffs of Area 51 have done a public service by providing a clear example of this principle, and of evidence that “likes” do not necessarily equal action.

As published in City AM Wednesday 2nd October 2019
Image: Area 51 by RJA1988 from Pixabay
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In such volatile times, the safest assets aren’t necessarily what investors think

In such volatile times, the safest assets aren’t necessarily what investors think

Given the climate of intense uncertainty, the FTSE index remains remarkably resilient.

It currently sits almost bang in the middle of the 7,000-7,600 range, where it has been since the beginning of January 2017.

Brexit does not seem to trouble share prices. Nor do the threats by John McDonnell, Labour’s shadow chancellor, to carry out extensive raids on shares and put workers on the boards of companies.

These risks and uncertainties are “priced in” by the market. The concept of market efficiency, revered by economists, means that all available information is taken into account in the process of setting share prices. The implication is that pension funds and traders alike appear to attach only a small probability to a disruptive Brexit or to Labour forming a government.

Of course, it is precisely when an unexpected disruptive event takes place that the market ceases to be efficient. Market participants need time to absorb and process the implications of the new environment, and do so at different speeds. There is widespread disagreement about what the “rational” price of an asset is, and as a result volatility abounds.

So despite the sanguine way in which the market is currently behaving, there must be many investors in shares of various kinds who are casting anxious eyes back over their shoulders.

They can take comfort from an article published in the latest Quarterly Journal of Economics by Oscar Jorda, of the University of California, and colleagues. Its findings represent an important addition to scientific knowledge.

The authors publish estimates of the annual total returns on equities, housing, long-term government bonds and short-term fixed interest government securities (three-month Treasury bills in the UK). The impressive nature of the work is not simply that it covers 16 advanced economies. Data is provided for every year between 1870 and 2015.

Government debt in countries like the US and the UK is considered a “safe” asset. But one of the most remarkable findings of the research is that the real return (in other words gains after allowing for inflation) on such assets has been very volatile, often even more so than the supposedly “risky” assets such as equities.

This is quite contrary to the conventional view of how the world is supposed to work. If one asset gives a higher return than another, the expectation is that its price is more volatile. There is a trade-off between risk and return. But this seems not to be the case in reality.

Intriguingly, both equities and residential real estate have yielded total real gains of no less than seven per cent a year. Housing outperformed shares from 1870 until the Second World War, and the position has been reversed since then.

Governments come and go, as indeed have two major world wars. But over the course of well over a century, holding equities and not worrying about short-term fluctuations has yielded rich rewards.

Obviously, the past is not necessarily a guide to the future – but the past here spans evidence from nearly 150 years. Something to think about if you’re looking to invest at a time of such global political uncertainty.

As published in City AM Wednesday 25th September 2019
Image: Investment via Pixabay
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Britain’s car industry could weather a storm of tariffs better than you’d think

Britain’s car industry could weather a storm of tariffs better than you’d think

The latest American Economic Review contains a timely paper. Keith Head and Thierry Mayer, at the University of British Columbia and the Banque de France respectively, estimate the consequences of changes in tariff and non-tariff barriers to the car industry.

They look at both US-led protectionism and Brexit, and calculate how these might change the location of production.

The car industry is of course the tradeable industry par excellence. For example, 50 per cent of cars sold in OECD markets are assembled in locations that are neither the headquarter nor the consuming country.

The United States had threatened to impose so-called Section 232 tariffs of 25 per cent on cars imported from Canada and Mexico on national security grounds. And President Trump did bring in such tariffs in aluminium and steel, although in the summer America reached separate bi-lateral agreements with Canada and Mexico.

Head and Mayer estimate that Section 232 tariffs would have devastated the Canadian and Mexican car industries. Even if the two countries retaliated, car production would have fallen 40 per cent in Mexico and 67 per cent in Canada.

A key reason for these massive numbers is that almost all the brands made in Canada (11 of 12) and Mexico (10 of 14) are also made in the US. Under tariffs, there would be a strong incentive to shift production to America.

The results for the Brexit scenario are quite different.

The simulation is of a hard Brexit. UK exports face the European Union’s 10 per cent Most Favoured Nation tariffs, and Britain reciprocates at the same rates. The authors assume that we cannot roll-over existing EU agreements with third-party nations, and that the tariff structure with them reverts to the same basis.

The EU runs a large trade surplus with the UK in cars, so higher tariffs mean that we have less to lose. The British car industry actually gains through the protective effect of tariffs.

Overall, Head and Mayer estimate a fall in production of only four per cent. This arises purely from their calculations of trade with countries such as Turkey and South Korea.

The paper is impressive in its detail and in the rigour of its analysis. These are the great strengths of much modern economics.

Of course, it also has its weaknesses. The analysis is, to use a jargon phrase, a purely static one: it takes the technology and the structure of production as given, and traces how tariffs, by changing costs and so the incentives of firms to produce in different locations, work through the industry.

It does not take into account any dynamic changes: how productivity or innovation (which alter the structure of production) might respond to changed circumstances.

Assessing these factors is a much harder task. Most would agree, for example, that a hard Brexit under Jeremy Corbyn would lead to ossification, although this is a matter of judgement and not analysis.

Still, despite these limitations, the study shows that the impact on production of a hard Brexit even in an industry which thrives on trade would be negligible. It makes interesting reading at a time when hysteria over a no-deal Brexit is once again reaching a fever pitch.

As published in City AM Wednesday 18th September 2019
Image: Final Assembly by Brian Snelson via Wikimedia is licensed under CC BY 2.0
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