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Surviving the pensions crisis means encouraging work

Posted by on April 28, 2016 in Behavioural Economics, Economic Theory, Employment, Politics | 0 comments

Surviving the pensions crisis means encouraging work

The Queen’s 90th birthday has quite rightly dominated the media over the past week.  Her Majesty continues to break all sorts of records, spending longer on the throne than Queen Victoria and being our oldest ever reigning monarch.  But longevity should no longer give cause for surprise.  The oldest participant in the London Marathon was 88, a mere whippersnapper compared to the 92 year old who ran the event in 2015.

Robert Fogel, an economic historian based at Chicago, was one of the first people to draw attention to the dramatic lengthening not just of life spans, but of active life which was about to take place.  In his Nobel Prize lecture in 1993, he correctly predicted that the number of older people in the US would rise much more rapidly than the Census Bureau was predicting.  Now, there are 45 million Americans over the age of 65, a big chunk of the entire population of the UK, and 6 million aged 85 and over.

Fogel worried about the implications for health care and pension costs, concerns which are widespread in policy making circles today.  In terms of pensions, the obvious solution is to raise the retirement age.  But governments face resistance to this.  Even George Osborne has not dared to go further than legislating for an increase in the pension age to just 67 – in 2028!  Retirement is popular.  A key reason, as Fogel pointed out, is the vast increase in the supply and the quality of leisure time activities for what he quaintly described as the “laboring classes”.  In addition, the relative prices of leisure services such as movies, television and travel have fallen substantially.

Yet there are signs of behavioural change taking place from the bottom up.  Last November, the Department of Work and Pensions (DWP) published a report on the employment statistics of workers aged above 50 over the past 30 years.  The number of people in employment over 50 has grown faster than the population aged over 50.  A lot of the growth has been amongst women in the 50 to 64 year old age group.

In addition, the employment rate for people over 65 has doubled since the mid-1980s, from 4.9 per cent of the relevant population to 10.2 per cent.  Initially the rise was in the 65-69 age group, but over the most recent decade, the over 70s have increased their participation rate in the labour force to 9.9 per cent.

The problem of how to fund the pension costs of an ageing population remains a serious one.  We need to encourage more older people to work.  Economics can help, but the mainstream approach has its limits.  This essentially describes an equilibrium situation, and then tells us what the new equilibrium will look like after a change has disturbed the old one.  But the pensions issue is about how we adapt as a society to a situation which is out of equilibrium, how we manage the process of change in disequilibrium.  Behavioural economics has more potential to help.

As published in CITY AM on Wednesday 27th April 2016

Image: Chelsea Pensioners by Defence Images is licensed under CC BY 2.0

Forget avoidance outrage: this is what we really think about tax

Posted by on April 22, 2016 in Corruption, Economic Theory, Taxation | 0 comments

Forget avoidance outrage: this is what we really think about tax

Rather like a quantitative version of Hello! magazine, the Panama papers made headlines everywhere. Read all about the vast amount of money a particular celeb has got stashed away. Salivate, be titillated or be outraged, according to your fancy.

The story was covered heavily by the Guardian, the in-house newspaper of the metropolitan liberal elite. But the popular reaction was not quite what they were hoping for. Many people seem to regard the revelations contained in the Panama documents as just the way the ultra-rich and powerful are meant to behave. Rather like Conservative MPs and sex scandals, tax evasion and foreign dictators seem to go together quite naturally.

John McDonnell, the shadow chancellor, demanded an immediate and full public inquiry in the House of Commons. He could perhaps consult Yanis Varoufakis, one of his economic advisers, who of course was so successful in running the economy during his time as Greek finance minister.

Or the Left could more usefully ponder a fundamental principle in economic theory, the concept of so-called revealed preference. Economists attach relatively little value to surveys of opinion. This extends far beyond political opinion polls, though these serve to illustrate the point. In the 1980s, for example, survey after survey showed large majorities in favour of higher public spending financed by higher taxation. Yet the electorate consistently returned Margaret Thatcher to power when they had to make an actual decision.

Just because voters dislike tax avoidance by global companies and the super-rich, it does not mean that they themselves want to pay any more tax. We saw this in the general election last year, where there was a decisive swing away from Ed Miliband’s Labour to the tax-cutting Conservatives in the marginal constituencies of England and Wales.

Economists believe that it is only by their actions that people reveal what their preferences really are. Faced with a hypothetical question, their answers are unreliable, so we observe what they genuinely think by the decisions they make. The Journal of Economic Perspectives had a symposium on this question in one of its 2012 issues. The discussions are technical, but the top MIT econometrician Jerry Hausman summed it up neatly when he wrote: “what people say is different to what they do”.

The plain fact is that we have data going back over 50 years on the total amount of tax which governments are able to levy on the British people. Regardless of who has been in power, no government has been able to lift the percentage of national income which goes in tax above the 38 per cent mark. This includes all taxes: income, capital, corporation and the rest.

Politicians have to understand the wishes of the electorate if they themselves want to stay in power. Gordon Brown might have doubled the size of the tax manual when he was in power, but the tax take was if anything slightly low when he was booted out in 2010, at 34.9 per cent of GDP.

For all the fine sentiments expressed in surveys and the outrage over tax dodging, the revealed preference of the British electorate is to keep taxes low.

As published in CITY AM on Wednesday 20th April 

Image: Taxes by Got Credit is licensed under CC BY 2.0

From golf to GDP, why unlikely events confound forecasters

Posted by on April 18, 2016 in Behavioural Economics, Economic Theory, GDP, Markets | 0 comments

From golf to GDP, why unlikely events confound forecasters

Life imitates art, as the sporting world has shown this week. The Grand National was won by a horse which had never previously won a steeplechase. The US golf Masters was won by Danny Willett, who nearly did not take part at all because of the birth of his son. With only nine of the 72 holes remaining, last year’s winner Jordan Spieth held a massive five shot lead, but blew it.

In soccer, Leicester City has secured a place in next season’s Champions League, and looks certain to clinch the Premier League title. The last team apart from Arsenal, Chelsea or the two Manchester teams to win was Blackburn in 1995. The most successful Rugby League side in history, Wigan, was taken to pieces 62-0 in the third heaviest defeat of its entire 121 year existence by Wakefield, a club which escaped relegation last season by the skin of its teeth.

Every single one of these events would have offered long odds against beforehand. The 33-1 of the National Winner represented by far the most likely of the four examples. Wigan has played well over 5,000 games in total, yet was slaughtered by a team it usually beats comfortably.

These things capture our interest precisely because they are unexpected. On a much more serious note, the financial crisis of the late 2000s also came as a complete surprise to most. It was a shock to financial institutions to discover that asset prices follow what is called a fat-tailed distribution. Very large changes are indeed rare events. But they are hundreds or thousands of times more likely to happen than on the assumptions which both banks and regulators made in the run up to the crisis. In their models, very large price changes could effectively never happen at all.

Humans do seem to have difficulties in anticipating the unusual. The Survey of Professional Forecasters (SPF) in America publishes information on a wide range of economic variables predicted by numerous outfits in the country. A centrepiece is the forecasts for quarterly GDP growth, where there is a track record going back almost 50 years.

One quarter ahead, the predictions are a bit like the curate’s egg, both good and bad in parts. The good bit is that, averaged out over every single quarter since 1968, the forecasts are spot on. But very large errors can be made in predicting any specific quarter. For example, when the recession had already begun, the average prediction reported by the SPF for the final quarter of 2008 was a fall in GDP of 1.1 per cent at an annualised rate. The actual number was a collapse of 8.2 per cent.

Recessions fortunately remain rare. But even just nine months into the future, the SPF has never predicted negative GDP growth at all.

I once tried to give up forecasting for Lent, but it is a difficult addiction to cure. Perhaps we should all employ an artist or science fiction writer to help us envision unlikely events.

As published in CITY AM on Wednesday 13th April

Image: Horses racing by Roger Blake licensed under CC BY 2.0

Bank bail outs are no model to follow for British steel

Posted by on April 18, 2016 in Corporate Structure, Economic Theory, Markets, Networks, Politics | 0 comments

Bank bail outs are no model to follow for British steel

The potential closure of the Tata steel plants, and the plight of Port Talbot is a tragedy for those directly affected. A key question is: if the banks could be saved, why not steel?  From a purely political perspective, the topic has legs.  The loyal, hard working Welshmen, fearful for their families’ futures, contrasted with the arrogant pin striped bankers, ripping everyone off.  It is a difficult narrative for the government to counter.

Away from the hurly burly of politics, the challenge takes us to some issues at the very heart of economic theory. Economics for beginners starts off with a simple diagram showing how much firms would supply of a product at different prices, and how much consumers would demand.  The point where these two curves cross tells us the price which exactly balances supply with demand.  In the technical phrase, the market clears.

A fundamental question in economics has been whether it is possible to prove that a set of prices can be found which would clear every single market, so-called ‘general equilibrium’. Supply and demand would be in balance everywhere, and so there would be no unused resources.  It is a problem which is easy to state, but exceptionally hard to prove.  No less than seven out of the first eleven Nobel prizes were awarded for work in this area.

Readers may recall having to solve quadratic equations at school. It has been proved that there is a formula which solves every such equation.  Plug in the numbers, and out pops the answer.  The general equilibrium problem is similar, but at a much harder mathematical level.  Can some formula, as we can think of it, be found which proves that a set of prices can be found for every economy?

The work may be esoteric, but it has great practical influence. Much of regulatory policy, for example, is designed to try and remove impediments to the workings of markets, to try and bring about the desired state of general equilibrium, where all resources are fully utilised.

A crucial problem for this work, in many ways the crown jewel of economic theory, is that it has proved very hard to establish that money has any special significance. It is simply another commodity. This thorny theoretical issue was highlighted by the financial crisis, which the mainstream, equilibrium models could not explain. In essence, both money and steel are equally as important.  Economists will realise I am compressing points here, but in this framework if the banks can be saved so, too, can steel.

Economists not obsessed with equilibrium, like Keynes, often take a completely different view. Money is decisively different, because it is the only product which appears in every single market.  Disruptions to money are not confined to a particular part of the economy, but have an impact everywhere.  Milton Friedman believed that the Great Recession in America in the 1930s had a monetary explanation for this very reason.  Money is fundamentally different to steel.  The banks had to be saved, steel is just an option.

As published in CITY AM on Wednesday 6th April 2016

Image: Steel by Ben Salter licensed under CCY BY 2.0

Scotland’s fiscal fantasy and the impact of an OUT vote

Posted by on April 18, 2016 in Economic Theory, Euro-zone, Infrastructure, Politics, Uncategorized | 0 comments

Scotland’s fiscal fantasy and the impact of an OUT vote

A short visit to the Highlands last week was refreshing. The scenery is just as spectacular as ever, and the people just as welcoming.  But elsewhere, the tectonic plates are shifting.  Last week, a televised debate took place amongst the political leaders contesting the elections to the Scottish Parliament in May.   It resembled a bidding contest in which each participant had to outdo the previous one in terms of boasting about how much public money they would spend. The excellent Ruth Davidson from the Conservatives was the conspicuous exception.

The sense of unreality was heightened when visiting the prosperous market towns of Perthshire, which would not be out of place in the Home Counties. Yet the polls suggest that they are about to vote for the SNP in large numbers, waiting to be fleeced to subsidise the less energetic denizens of the old industrial belt of Central Scotland.

Under the SNP government, the health service has deteriorated markedly and education has gone backwards. But it seems they will be returned to power with a large majority.  These problems are not believed to be the fault of the Scottish government but, in some mysterious way, the English.

If we plump for Brexit and North of the Border they do not, the strategy is to vote for independence and apply to be a member of the EU. But would the EU want them?  To put it in perspective, no one imagines that Portugal, say, is an important country which possesses clout in the European Commission.  Yet its population is over 10 million, and there are only 5 million Scots.

In addition, the public finances are shot to pieces. The Government and Expenditure Review Scotland announced earlier this month that the deficit in Scotland’s public finances is almost twice that of the UK as a whole.  Scotland’s net fiscal deficit was £16.7 billion, some 9.7 per cent of its GDP, compared with UK figures of £89 billion and 4.9 per cent.  The EU already has enough basket cases in the Mediterranean.  Why would the Germans welcome another country which they would have to bail out?

The Alice in Wonderland flavour is heightened by the posturing on tax. The SNP had been firmly committed to a top rate of income tax of 50p.  At the start of last week, Nicola Sturgeon pronounced that it was not possible.  Why?  She had just discovered that only 17,000 people in Scotland earned enough to pay it.  But these contribute no less than 14 per cent of the total take from income tax, and may simply move.  In the leader’s debate, she was once again in favour of the 50p rate, but only in the sense of St Augustine: “O Lord, make me chaste, but not just yet”.

Scotland epitomises the problems which all centre-Left governments face. They want high public spending, but the electorate will not pay the necessary tax.  They cannot finance it by issuing debt for very long.  The only solution is to find a kindly uncle who will pay, in this case the English.

As published in CITY AM on Wednesday 30th March 2016

Image: St Andrew’s Flag by Jim Bradbury is licensed under cc by 2.0

How technology is driving inequality

Posted by on April 18, 2016 in Behavioural Economics, Markets, Networks | 0 comments

How technology is driving inequality

Inequality is one of the major political topics of our times. Rather like a Shakespearean tragedy, the current splits in the high command of the Conservative Party have many themes. But an important one, and the ostensible reason for Iain Duncan Smith’s resignation, is the treatment of the working poor, a concept which until fairly recently seemed to have been banished forever.

Like sending ten year olds up chimneys, the idea that people in work would not really have enough money to cope belonged to the distant past – well, to the depression years of the 1930s rather than the child labour of Dickensian times, but it was all a very long time ago.

Increasingly, this is no longer the case. A snippet from the arts world illustrates the point. The famous actor Robert Lindsay is president of the Royal Theatrical Fund, a charity which helps struggling actors. In the Sunday Times, he is quoted as saying that “there are household names who are now earning so little, people stop them in the street and ask for their autographs, but the spotlight has gone out for them”.

A survey of nearly 1,800 British actors by Casting Call Pro in 2014 found that no less than 75 per cent of them had earned less than £5,000 during the previous year. Only 2 per cent had earned more than £20,000, a figure which itself is only approximately what someone on the Living Wage in London and working 40 hours a week would make.

A key driver of rising inequality is technology. Fears abound that robots and artificial intelligence will destroy up to half of all existing jobs, but history suggests they will be replaced by completely different ones. The problem is more subtle. The stupendous proliferation of data and information in cyber society is changing fundamentally the way in which people make choices.

In more mature markets, such as the fast-moving products in supermarkets, consumers are still able to operate in ways described in the economic textbooks. They are familiar with the different brands and their various qualities and are able to compare prices. So they make choices essentially on the features of each of the various alternatives on offer, as “rational” choice theory says they should.

But in other contexts, people are bombarded with so much information that it is literally impossible to process it in this way. Eric Beinhocker of the Institute for New Economic Thinking estimated that, in New York City alone, consumers are presented with a potential 10bn different choices every day. They have to find some different way in which to navigate the maze. A good rule of behaviour is just to choose something which is already popular: you think other people have done the work for you, and have decided it is a good choice.

This self-reinforcing behaviour drives highly unequal outcomes. Things become popular simply because they are popular. Footballers, actors, film directors who are thought to be good get a bigger and bigger share of the pie. In cyber society, everyone loves a winner.

As published in CITY AM on Wednesday 23rd March 2016

Image: Scales of Justice by James Cridland licensed under CC BY 2.0

Why we are much better off than the official statistics say

Posted by on April 18, 2016 in Behavioural Economics, Infrastructure, Markets | 0 comments

Why we are much better off than the official statistics say

The oldest surviving map of Britain was created in Canterbury a thousand years ago. Our ancestors had a good idea of how to get around. The country is depicted in its familiar shape. Understanding of the world outside Western Europe remained sketchy for centuries.  The phrase ‘here be dragons’ was allegedly used to conceal ignorance about substantial parts of the world.

Sir Charles Bean’s Independent Review of UK Economic Statistics was published last week.   It is an impressive and well argued document.  But it leaves the distinct impression that the state of our knowledge about how to measure the size of the economy is not much better than that of the Canterbury map makers.  The Office for National Statistics knows how to guide us around the old, familiar parts of the economy.

The second paragraph of the Bean report hones in on the dragons: “The Review was prompted by the growing difficulty of measuring output and productivity accurately in a modern, dynamic and increasingly diverse and digital economy.” An anecdote illustrates the point. Last week, our old washing machine finally packed up.  My wife went onto the internet in the afternoon, did some searches, read some price and quality comparisons sites and blogs, and placed the order.  Thanks to just in time stock control and vastly improved logistics, the new one was safely installed and working the next morning.

Even thirty years ago, the whole process would have required much more time and nervous energy. Perhaps writing to get catalogues, visiting retailers to inspect the machines, trudging around to compare prices, finally placing the order, and hoping that there wasn’t a six week wait for your chosen model, then finding someone to install it.

None of these savings of effort or improved quality of service appear in the national accounts. The national accounts just see a retail purchase, a delivery and an installation: exactly what they would have seen thirty years ago. Yet economic statistics are, again as Bean puts it, “central to monitoring, understanding and managing the economy, at both national and regional levels”.

A major issue for policy makers is the so-called productivity puzzle. Since the trough of the recession in 2009, output has grown by 12.6 per cent and employment by 7.0 per cent.  So productivity, output per worker, has only expanded by just over 5 per cent, or less than 1 per cent a year.  By historical standards, this is pitifully low, especially during a period of economic recovery.  Companies need to be sure that demand is growing before they take people on, so employment growth lags behind output growth and productivity rises sharply.  Or, at least, it did in every other recovery since the Second World War.

The Nobel Laureate Bob Solow, still going strong in his 90s, presciently remarked as long ago as 1987 “You can see the computer age everywhere but in the productivity statistics”. We can rely on employment data, based as it is on PAYE returns to HMRC.  But the Bean report implies we have been grossly underestimating output in the digital economy.

As published in CITY AM on Wednesday 16th March 2016

Image: Old Map by rosarlo flore as licensed under CC BY 2.0

The IMF is in trouble – and not just due to its poor forecasts

Posted by on April 18, 2016 in Debt, Economic Theory, Financial Crisis, Inflation, Markets, Uncategorized | 0 comments

The IMF is in trouble – and not just due to its poor forecasts

The International Monetary Fund (IMF) has played a prominent role in world financial affairs in the post-Second World War period. In the 1950s and 1960s, its main purpose was to support the system of fixed exchange rates. Since then its activities have evolved to embrace developing economies and both banking and sovereign debt crises.

The top ranked mainstream Journal of Economic Perspectives is hardly the place we would expect to read a strong criticism of the IMF.  But in the latest issue, this is exactly what Barry Eichengreen of Berkeley and Ngaire Woods of Oxford have done.

They argue that the effectiveness of the IMF has many similarities with that of a football referee. A great deal depends upon whether the players and spectators perceive it as being competent and impartial.  Eichengreen and Woods level charges against the IMF on several counts.

Perhaps the most serious is its track record on monitoring the world economy and warning of potential crises. Keynes, who was a great enthusiast for creating the IMF, envisaged that a key role would be as a ‘blunt truth teller’.  Elected politicians may try and fudge and obfuscate, but the IMF should tell things how they really are.  It would be unrealistic to expect anyone to have anticipated and warned of the US sub-prime crisis, the global financial crisis and the Greek sovereign debt crisis.  But, as Eichengreen and Woods put it “the IMF batted 0 for 3 on these three events, which suggests that its capacity to highlight risks to stability leaves something to be desired”. Using a different analogy, if a doctor fails to spot the symptoms of a disease, why should we trust his proposed cure?

The IMF’s track record on cures for sovereign debt crises is the second point of criticism. Judging whether a debt burden is sustainable is another tricky problem.  But the IMF has in general erred by lending for too long and postponing the inevitable restructuring.  This allows private investors to cut their losses, creating the infamous ‘moral hazard’ problem.  If you think the IMF will allow private lenders to escape, you will be more inclined to make a loan which is otherwise too risky.  The Fund’s decision not to insist on Greek debt restructuring in 2010, allowing French and German banks to bail out, is a case in point.  The overall effect is that when the restructuring does come, it is more expensive and disruptive for the economy which the IMF is trying to save.

Their criticism of the governance structure of the IMF is much less effective. For example, major decisions require an 85 per cent vote.  America has 16 per cent of the votes and so has a veto, which they argue reduces the legitimacy of the IMF.  The problem with widening the franchise is that standards of behaviour vary enormously across the world.  FIFA is the example of what is likely to happen when every country has one vote.  So on this charge, at least, things are better left as they are.

As published in City AM on Wednesday 9th March 2016

Image: World Money by Japanexperterna.se is licensed under CC BY 2.0

A radical idea to revive the North

Posted by on April 18, 2016 in Economic Policy, Education, Employment, Infrastructure | 0 comments

A radical idea to revive the North

The Head of OFSTED, Sir Michael Wilshaw, warned last week that secondary schools in Liverpool and Manchester were ‘going into reverse’. Too many pupils in Northern towns and cities are simply not prepared for the next phase of their education, training or employment. In Liverpool, for example, four out of every ten schools are judged to be either inadequate or, in the bureaucratic jargon, ‘requiring improvement’, which basically means they are just not delivering the goods. The proportion of children securing five good GCSEs has fallen in many areas of the North.

All this is in sharp contrast to the dramatic turn around which has taken place in recent years in the performance of schools in London, whose results, particularly amongst poorer pupils, are now amongst the best in the country At the other end of the ability spectrum, the North falls short. The area from Cheshire and South Yorkshire up to the Scottish border has nearly 30 per cent of the total population of England and Wales. But in terms of A-level results, only 12 schools from this area make it into the national top 100 of state schools – leaving aside the massive domination of London and the South East in terms of private sector exam results.

This gloomy picture does not bode well for the future economic prospects of the region. Increasingly, growth is being determined not by physical investment but by the more intangible, but nevertheless real, concept of the stock of productive knowledge of an area. Not everyone can be a biochemist or work at the frontiers of artificial intelligence. But the ability to innovate and adapt to changed circumstances is required at all levels.

A visionary and challenging solution to the economic problems of the North is put forward in the unlikely setting of the academic journal ‘Environmental Planning: Planning and Design’. The author, Mike Batty, is an extremely distinguished professor in University College London’s Centre for Advanced Spatial Analysis. I work with Batty, so maybe this colours my view of his ideas. But despite many billions of pounds of public money having been spent in conventional ways in recent decades in trying to close the North-South divide, the situation has only got worse. A Liverpudlian himself, Batty is characteristically blunt about the prospects of new infrastructure projects making an impact: ‘None of this is going to work. If it does, it would have done so years ago’.

Instead, we need to break the vicious circle of cumulative causation, the forces which cause people from the North, especially the skilled and talented, to drift South. Not just in the UK, but across the West as a whole, many students in top universities stay on in the places where they studied. The dominance of the London-Cambridge-Oxford golden triangle needs to be challenged. Instead of spending on HS2, the monies should go to Northern universities to transform some of them into world class institutions. Mergers need to be forced through, and the poorly performing departments axed. It is a radical concept, but it might just work.

As Published in City AM on Wednesday 2nd March

Image: Angel of the North by Stuart Richards licensed under CC BY 2.0

What game theory tells us about David Cameron’s EU deal

Posted by on February 27, 2016 in Behavioural Economics, Economic Theory, Euro-zone, Uncategorized | 0 comments

What game theory tells us about David Cameron’s EU deal

Game theory is the study of how rules and tactics affect outcomes, and it is pervasive in academic economics. The opening sentence of one of the economics courses at Cambridge pontificates: “Optimal decisions of economic agents depend on expectations of other agents’ actions”. Translated into English, this means that, for someone in a negotiating situation to get the best possible outcome, he or she needs to take account of how the other side might react. It sounds pretty obvious.

But the maths of game theory soon gets hair-raising. Would David Cameron have done better in Brussels if he had mainlined on straight economics at Cambridge rather than dallying with PPE at Oxford?

Game theory has had some spectacular successes. In 2000, the UK government held an auction for licences for the new 3G mobile phones spectrum. Economists Ken Binmore and Paul Klemperer were commissioned to design the structure. The auction raised no less than £22.5bn for the Treasury, five times more than had been expected, and it was widely described as the biggest ever auction. Binmore and Klemperer were more modest, pointing out that, adjusting for inflation, in 195 AD the sale of the entire Roman Empire by the Praetorian Guard netted more cash.

The theory was really useful in this context, where there was a limited number of players, all of them highly sophisticated companies such as Orange and Vodafone. The companies themselves employed teams of economists and had a lot of information about their rivals and the sorts of moves they might make.

But, somewhat paradoxically, when dealing with less rational decision-makers, knowledge of game theory can be a decided handicap. A well known game is the so-called Beauty Contest. The rules are simple. Each one of a group of people is invited to select their own confidential number between, say, zero and 100. The winner is the one who chooses the number closest to the number which is half (or some other fraction) of the average of all the numbers chosen.

If you assume everyone else is rational, as was reasonable in the spectrum auction, the number to choose is zero. The logic is: suppose the average is going to be 40, then I should choose 20. But this means everyone else will choose 20, so I should choose 10, and so on. The problem is that you do not know how sophisticated the other players are. The smart game theorist will lose every time by opting for zero when playing in real life. If you are playing with economists, by all means choose zero. But in experiment after experiment, most people do not, even in repeated plays of the game. To win, you have to judge the levels of rationality of your opponents.

At a political gathering in Brussels, this is self-evidently a challenging task. In addition, the complexity of the game makes formal analysis difficult. There are 28 players, each operating from a fluid set of motivations. Maybe the worldly wisdom of PPE at Oxford was the best training for Cameron after all.

As Published in CITY AM on Wednesday 24th February

Image: Backbenchers by brett jordan licensed under CC BY 2.0