A key concept in modern economics is, to use the jargon term, rational expectations.
The idea has dominated orthodox macroeconomics over the past 30 years. Not all economists have been persuaded of its merits by any means, but nevertheless, its influence has extended far beyond academia, into finance ministries and central banks around the world.
The basic idea is simple, even though the maths of the macroeconomic models which use rational expectations can rapidly become hair-raising.
When forming a view about the future, an individual chooses the model which best describes how the economy works. It is then simply a matter of running the model and using the values which it outputs as your expectations.
An obvious criticism seems to be that economic forecasts are very often wrong, but this is easily handled by the rational expectations enthusiasts. Each individual forecast in a sequence of months or years can be wrong. The key thing is that the errors over time cancel out. On average over time, the forecasts are correct.
The idea is not as absurd as it may appear to the layperson. For example, the Federal Reserve Bank of Philadelphia has published the Survey of Professional Forecasters since 1968.
This does what it describes on the label. It takes a wide range of forecasts by academic, commercial, financial and governmental bodies. Information on the average forecast for, say, GDP growth one year ahead is published, as well as details of the spread around the average.
Remarkably — and exactly in line with rational expectations — comparing the predictions with the actual growth over many years, the errors do indeed balance out. Spectacular errors have been made for individual years, but the over and under-predictions cancel out over time.
A more telling attack is that economists themselves do not seem to agree on what constitutes the correct model of the macroeconomy. Different groups have different models.
The standard defence is that the best model will eventually prove its superiority and will drive the others out of existence. But the problem here is that this has just not happened.
The concept of rational expectations can be applied directly to the predictions of the epidemiological models. These purport to describe how a virus spreads. So to form a view about the future, make a set of assumptions about the key inputs, and use the forecasts generated by the model.
It should be much easier in epidemiology for the best model to eliminate its competitors than it is in economics. Economics has a wide range of variables to predict, such as inflation, GDP, unemployment, public borrowing, interest rates. The focus of epidemic predictions is much narrower and their models are in general mathematically simpler than those of economics.
The Covid pandemic set up a competition between epidemiological modelling groups of fierce Darwinian intensity. The efforts of many years of academic debate have been concentrated into a handful of months.
But no group seems to have admitted yet that its model is not up to scratch — and huge differences in forecasts persist.
As published in City AM Wednesday 29th July 2020
Image: Opposites via Pxfuel
Another day, another lurid, headline-grabbing number of deaths to expect from Covid-19.
This time, it was a study from the Academy of Medical Sciences. A second wave, we were warned, could kill 120,000 this winter in hospitals alone.
To be fair, this study was a projection rather than a forecast. A forecast is what is thought to be the most likely outcome. A projection looks at what could happen under a particular set of conditions.
The Academy essentially assumed that behaviour would revert to the same as it was before the crisis, with people acting as though the virus had never appeared.
The researchers made their assumptions clear. But entirely predictably, the media seized on the 120,000 figure for deaths. The qualifications made around that number faded into the background.
The plain fact is that the assumptions of the report were wholly implausible. Even if lockdown were lifted completely, behaviour is not going to immediately revert to exactly what it was before the Covid crisis. Will people shake hands? Of course not. The concept of a typical way of life has irrevocably changed.
The entire history of the world can be cited in evidence of this proposition. In the face of an epidemic, people alter their behaviour. They do not need to be told to do so by governments.
Of course, how much behaviours will change is ultimately a matter of judgement. But it is one where the social sciences, including economics, can make a valuable contribution. Epidemiology is currently too important a subject to be left in the hands of the epidemiologists.
It is something of a mystery why the numbers churned out by various epidemiologists retain any credibility. Their models in general take no account of behavioural change when a pandemic occurs.
In March, we all remember the Imperial College study claiming that without lockdown there would be 500,000 deaths in the UK. This was ludicrous — and economists such as Gerard Lyons and I quickly attacked it.
In April, a very similar model was run on Swedish data. It claimed that there would be 40,000 deaths by the beginning of July. In fact, even with no lockdown, there were only some 5,000, the majority of which took place in care homes.
Forecasts such as these make economic forecasts seem like Platonic ideals of precision.
This is far from a mere spat between scientific disciplines. Poor models and their resulting projections can lead to poor policy decisions. They generate a wholly unwarranted climate of fear among the population. This reduces economic activity, meaning less money available to fund health services, and greater poverty with its associated illnesses such as depression.
The number of deaths in England and Wales peaked on 8 April. The average time from infection to death tells us that the number of cases peaked in the week 18–25 March. Lockdown was only introduced on the evening of 23 March. This shows that behaviour had already altered dramatically.
No more credence should be given to epidemiological projections which do not assume behavioural change.
As published in City AM Wednesday 22nd July 2020
Image: UK Government Coronavirus by Gustave iii via Wikimedia CC BY-SA 4.0
The Prime Minister is now demanding that offices reopen to revive economic activity in the centres of towns and cities.
But there is not much sign of a return to work.
The preferences of the workforce are an important factor in the very slow pace of return. Fears expressed about the safety of public transport may or may not be genuine, but it is certainly true that many prefer to avoid the time spent commuting and enjoy the extra leisure time this brings.
But why do offices cluster together in urban centres anyway?
It is easy to see that in the old days industries such as steel and coal clustered geographically. One was a key supplier of the other. Being near at hand minimised transport costs.
Today’s offices span a wide range of diverse industries, from consulting to law to oil companies. The reasons why they locate in close proximity are more subtle.
The views of economists on this are still shaped by the writings of Alfred Marshall. He established the faculty of economics at Cambridge in 1903 and was then probably the world’s leading economist.
Marshall described the tendency of businesses to cluster near each other as “agglomeration”. He gave three key reasons why this colocation is observed.
In addition to the savings on the costs of transporting the materials needed in industrial processes, Marshall developed a theory of labour market pooling, in which firms located near one another can share labour.
Further, he believed that “intellectual spillovers” were important. Firms locate near each other in order to learn and speed up the process of innovation. Think of Silicon Valley, formed nearly a century after Marshall wrote.
A large number of detailed studies in recent decades confirm that these are not just mere theories. They have strong empirical support. The Harvard economist Ed Glaeser, for example calculated that in the US in the 2000s each of Marshall’s three reasons were of roughly equal importance.
There have been very distinct benefits to agglomeration. Throughout the developed world, the greater the density of employment in an area, the higher is its productivity. Head offices contain more highly skilled staff and so will be more productive than the average. But in city centres, their productivity is even higher than their skill levels suggest they should be.
Has Covid-19 changed all this? Or more specifically, has the crisis enabled people to see that new technology could overturn two centuries of experience in urban centres in industrialised countries?
Certainly, tech platforms such as LinkedIn offer the potential for efficient hiring of relevant skills and for employees to discover opportunities through their networks. But new recruits need to be integrated. And younger people probably still need a combination of social and remote interaction to develop their own professional networks.
It is less clear that remote working can encourage innovation in the same way. Much of the informal contacts needed for this cannot be captured by video conferences.
Yes, there will be an increase in working from home. But Marshall’s insights into the benefits of agglomeration still hold true.
As published in City AM Wednesday 15th July 2020
Radical leaders such as Jacinda Ardern in New Zealand and Nicola Sturgeon in Scotland have gained plaudits through their relentless focus on eliminating Covid-19.
But this comes at an obvious economic cost. Tourism is some 15 per cent of New Zealand’s GDP, and major destinations such as Queenstown in the Southern Alps have been devastated. Here in the UK north of the border, Scottish businesses are increasingly frantic about the economic damage done by the rigorous lockdown.
Health experts and epidemiologists have not helped. They have remained firmly enclosed in their own silos of expertise, unable or unwilling to see the broader picture.
But good policy is not made in a vacuum. A key concept in economics is that of trade-offs.
An obvious health related example is road accidents. As a society, we trade off the 1,800 deaths and 250,000 injuries a year in road accidents against the benefits of using vehicles.
Trade-offs between alternatives have always been central to our economic policy and political debate. Lockdown is no different to any other policy. It has both benefits and costs.
The benefits of lockdown were never in doubt: the policy was intended to save lives. But there is now increasing awareness of the potential economic costs. Ironically, some of those most shrill in favour of lockdown are now crying out for jobs to be saved.
David Miles, an Imperial College economist and former member of the Monetary Policy Committee, along with two medical specialists published last week a valuable assessment of the overall costs and benefits of lockdown.
Miles argues that we must normalise how we view Covid-19. Its costs and risks are comparable to other health problems, such as cancer, heart problems and diabetes, where governments have made resource decisions for decades.
The lockdown is a public health policy, and Miles and his colleagues value its impact using the standard tools developed by the National Institute for Health and Care Excellence to guide healthcare decisions in the UK public health system.
A key concept in this is QALYs — quality of life adjusted years. Essentially, the benefits of any policy in terms of QALYs are compared with its costs.
Economists have developed a broad consensus on the value of saving a single quality of life adjusted year. Macabre though it may seem, some metric like this is necessary in order to have any meaningful assessment of the costs and benefits of different decisions.
Miles’ conclusions are stark. The estimate of lives saved by lockdown in his analysis is deliberately chosen to be the one at the very top end of the range of such estimates. This way, his team cannot be said to be underestimating the benefits of lockdown.
Even so, in the authors’ own words: “we find that having extended the lockdown for as long as three months consistently generates costs that are greater — and often dramatically greater — than likely benefits”.
Gerard Lyons and I warned in early April that, while it was necessary to introduce lockdown, it needed to be relaxed rather swiftly because of the costs it would entail. The work of Miles and his colleagues confirms, in impressive detail, this view.
As published in City AM Wednesday 8th July 2020
One silver lining of the Covid-19 crisis has been a surge in innovation.
Enterprising firms have invented both new products and different ways of delivering existing ones.
Innovation is the life blood of any prosperous economy. Innovation is much more than a scientific invention. It turns inventions into things of practical and affordable use to people.
The ability to deliver innovation in a sustained way is the one single quality which distinguishes capitalism from all other forms of social and economic organisation.
Yet our understanding of it remains imperfect.
MIT Nobel laureate Robert Solow laid the foundations for the modern theory of economic growth over 60 years ago. His neat mathematical model postulated that growth was caused by increases in the amount and quality of both capital and labour used in the productive process, and by innovation.
But when the theoretical model was applied to real world data, it created a problem for economics. The increases in the inputs which could be readily measured — capital and labour — could only explain a small fraction of the growth which had taken place.
By implication, most of the huge growth experienced in the west was due to innovation. But innovation itself was not explained in the Solow model.
Despite various attempts to do better, including an ingenious one which won the Nobel Prize for another MIT economist Paul Romer, economists are still far short of a convincing explanation of innovation.
Matt Ridley, the author and scientific polymath, has made a valuable contribution in his recently published book How Innovation Works.
Ridley describes how major innovations arose in a wide range of sectors, such as energy, public health, food, transport and computing.
From this mass of detailed, empirical description, he synthesises some general principles, the vital ingredients for success.
A classic image of innovation is Archimedes jumping out of his bath shouting “Eureka!” But Ridley makes clear that such moments are exceptionally rare, even if the story is true. This is for two reasons.
First, innovation is almost always a gradual process. It involves re-combinations of existing ideas and methods of production rather than single revolutionary events.
Second, innovation is, as Ridley puts it, a team sport. The myth of the isolated genius is deeply ingrained, but it is a myth. Innovation requires collaborations and building on what went before. Even Isaac Newton, one of the greatest minds in world history, acknowledged that he “stood on the shoulders of giants”.
Innovation also requires an acceptance of failure. When Edison perfected the electric light bulb, he had tried 6,000 different materials for the filament before discovering what really worked.
The book ranges far wider than just the science. For example, Ridley argues that the EU has evolved into a system in which innovation simply cannot flourish. Of Europe’s 100 most valuable companies, not a single one was formed in the past 40 years. What a massive contrast with America.
Innovation is key to a successful recovery from the Covid crisis — and Ridley’s book offers excellent insights on how to make it happen.
As published in City AM Wednesday 1st July 2020
Image: Silver Cloud by lfranks via Pixabay
The NHS contract tracing app has been scrapped in favour of a system developed by Google and Apple.
Although health secretary Matt Hancock has been heavily criticised for this failure, the UK is by no means alone.
For example, Denmark, Germany and Italy each tried to build their own app, based on the same type of centralised system as was attempted in the UK. But they have already ditched their efforts and taken up the decentralised approach of Apple and Google.
Australia is widely perceived as having had a “good” Covid-19 crisis. But the same cannot be said of its tracing app. It seems to have had serious problems working with iPhones at all. The Aussies, too, are now taking the Google/Apple approach.
The simple fact is that most technological innovations fail.
The government can be criticised legitimately for not appreciating this fundamental feature of new technology. But it is a more subtle critique than merely pointing to the failure itself.
Given the importance of the tracing app, it would have been perfectly reasonable for the government to have pursued parallel tracks. At the same time as trying to develop its own NHSX app, it could have been collaborating with Apple and Google too.
Critics might have tried to pan this as an example of waste. But there is rarely such a thing as wasteful competition.
Spending on two completely different approaches at the same time would have been a hedge against the uncertainties which are inherent in the development of new technology. No matter how smart you are, or how much prior information you gather, you just do not know whether an innovation really will work.
The tech companies themselves protect against this uncertainty by holding far more cash than conventional economic theory regards as rational. At the start of the Covid crisis, Apple, Microsoft and Google’s parent company Alphabet between them held over $450bn in cash or marketable securities.
Pharmaceutical companies face a similar challenge Most new drugs fail. They fail when they are still in the lab, and they fail once they go out for testing to get regulatory approval.
In America, for example, there are three phases to the test process, each more demanding than the last.
The time scales are long. Andrew Lo, an MIT polymath, and his colleagues published a paper last year in the journal Biostatistics. They gathered a sample of over 400,000 clinical trials carried out between 2000 and 2015. Even after all the initial development work in the lab was completed, the typical successful drug took 8.3 years to obtain approval.
This puts into perspective the current frantic efforts to develop treatments and vaccines for Covid-19.
The probability of obtaining regulatory approval varies widely across categories. But overall, when a candidate drug enters phase one trials, its chances of eventual success are less than 10 per cent.
The government should embrace the idea that money spent on technology or drugs which fail is not money wasted. Indeed, the real mistake is not to risk enough, to stake everything on a single project.
This is the true failure of NHSX.
As published in City AM Wednesday 24th June 2020
Image: Covid tracing app by Gerd Altmann via Pixabay
Slavery has certainly been in the headlines in the past couple of weeks.
Given this sudden interest in this area of history, it is worth considering the economic lessons it can teach us, as well as the moral ones.
Slavery was abolished in England itself in the twelfth century. Then in 1772, Lord Mansfield gave his famous judgment that as soon as any slave set foot on British soil, he or she was automatically freed.
Clearly, some people became rich by trading or owning slaves abroad. There is nothing new or unusual about this. Taking a broad sweep of human history, the societies in which slavery does not feature form a very distinct minority.
It was Karl Marx who coined the phrase the “ancient mode of production” to describe the economies of both Ancient Greece and Rome. Greece, of course, gave us the concept of democracy itself. Yet, ironically, its economy was built on slavery.
Rome developed the concept even further. With a plentiful supply of labour from its military conquests, the aristocracy owned vast tracts of land, maintained by slaves.
Yet although individuals became rich through slavery, Rome as a society did not.
When the Empire was at its maximum extent in the second century AD, the living standard of the average Roman citizen was the highest the world had yet seen. Indeed, it was probably not surpassed until the early modern era.
Yet the Roman economy, prosperous though it was, remained at the living standard of purely agrarian societies. It never got “lift off”, as Europe did in the eighteenth and nineteenth centuries.
The fundamental problem was that an economy based on slavery has little incentive to adopt new, more efficient ways of working. Indeed, for the individual slave there is virtually no incentive at all. If a particular task can be done better and more quickly, there is always another one which he or she will be given. Innovations, when they did happen, spread only very slowly.
The inherent inefficiency of slavery as a method of production is clear from the experience of Stalin’s Soviet Union and Mao Tse Tung’s Communist China — the two great slave societies of the twentieth century.
The labour camps, filled with the so-called enemies of socialism, represented a huge drain on their economies. Output was low, and large amounts of resources were needed to run and maintain the system.
Slavery is of course morally repugnant, a stain on the histories of civilised societies. But it is also economically detrimental to the societies it ostensibly appears to benefit. The fact is that no society based on slavery has ever come anywhere near to delivering decent living standards for the average person.
The only system which has is capitalism. Britain and other areas of north west Europe started to become rich through a system based on the rule of law, the ability of individuals to profit from innovation and not be expropriated, and the freedom of labour to negotiate contracts.
Morality undoubtedly played a part in Britain’s leading role in abolishing slavery. But by the early nineteenth century, it had become an anachronism. Resources employed in slavery could be put to much more productive use under capitalism.
Perhaps, then, we should remove not just statues of British slave owners, but erase the whole corpus of Greek and Roman art, financed as it was by Marx’s slave-based ancient mode of production.
As published in City AM Wednesday 17th June 2020
Image: Antique Statues via Wallpaper Flare
Economic policy is returning to its usual position of prominence.
Fears of a major rise in unemployment are starting to worry the government more than fears around Covid-19.
The chancellor’s imaginative schemes concerning furlough and other measures to protect jobs create potential problems elsewhere. So much money is being borrowed that the ratio of public sector debt to GDP has soared above 100 per cent.
The last time we were here was at the end of the Second World War. Then, the debt ratio was a massive 250 per cent.
The Labour government of that time has a reputation for being the most left-wing in British history. It nationalised the mines and railways, and created both the modern welfare state and the NHS.
But it reacted to the massive level of public debt with impeccable orthodoxy. Between 1947 and 1951, Labour ran public sector surpluses to help pay off the debt. These were huge, averaging some £50bn a year at today’s prices.
Will Rishi Sunak be forced into similar levels of austerity, cutting spending and raising taxes?
A timely and fascinating Policy Exchange paper issued last week argues that this would be completely the wrong thing to do. The authors — Gerard Lyons, Warwick Lightfoot and Jan Zeber — are not noted for any previous enthusiasm for fiscal activism, which makes the treatise all the more interesting.
They note that there was a further, perhaps more important, way in which the public debt mountain was brought back under control, in addition to the immediate post-war austerity.
The 1950s and early 1960s saw strong economic growth. A famous phrase coined in 1959 by the then Prime Minister Harold Macmillan was “you’ve never had it so good”. This, plus a modest rate of inflation, helped erode the debt burden steadily and surely.
The point is that the debt which the government issues is denominated in money terms. If you buy a bond for £100 now and hold it to maturity in 10 years’ time, you get precisely £100 back.
During the 1950s, GDP grew in money terms at an average annual rate of seven per cent. The debt to GDP ratio is, quite simply, the outstanding stock of debt divided by GDP. There was essentially no net addition to debt in this period. But the growth in nominal GDP meant that the ratio was halved.
To tackle today’s debt, Lyons and colleagues call for a strategy of growth. Their most striking demand is to change the remit of the Bank of England from one of controlling inflation to one of controlling GDP in money terms — a combination of inflation and real growth in the economy.
The Federal Reserve in the US is also tasked with taking the real economy — output, jobs — into account, but others such as the European Central Bank remain shackled by a pure inflation target.
This proposal would certainly shake up the Bank of England after years of complacency under Mark Carney. Given the Prime Minister’s new-found interest in the economy, it could be an idea whose time has come.
As published in City AM Wednesday 10th June 2020
Image: Bank of England via Flickr CC BY-ND 2.0
Can we learn from history?
An excellent book by Ben Gummer on the Black Death in fourteenth century Britain, The Scourging Angel, shows that we can.
Published 10 years ago, the book offers many intriguing parallels with the Covid-19 crisis.
Of course, the Black Death was almost incomprehensibly more lethal. Around 50 per cent of the total UK population died in 1348–49. That is 33m deaths in current terms.
Modern scholarship has overturned the long-held idea that the plague was spread exclusively by fleas on rats. Contemporaries knew that it was spread from person to person by breath. The new coronavirus is transmitted by droplets from the nose and mouth. Both diseases lingered on clothing and objects.
People back then worked out very quickly how plague might be avoided. Those who could fled from infected areas. If possible, they locked themselves away in castles or monasteries.
The peasantry — the vast bulk of the population — had far fewer options. But they did try to cut off contact with the world outside their own immediate village as much as possible.
Then, as now, there were inequalities in health outcomes. Because of their greater ability to practise social distancing, the nobles and church leaders had much lower death rates. Even so, these were still some 20 per cent.
There were arguments over the Medieval equivalent of PPE. In London, the demand for gloves rose dramatically. Master glove makers enticed away their rivals’ employees. Unlicensed glove production, often of dubious quality, soared. The city fathers had to step in and enforce the regulations more effectively.
On a lighter if macabre note, a “William of Liverpool” was convicted of a different scam. A neighbouring village had no burial ground. For a substantial fee, he agreed to take the bodies and bury them on what he claimed were his extensive fields. Essentially, he then fly-tipped the corpses on his way home.
Then there is the economy. The current chancellor has had to be very innovative with his schemes to preserve jobs. The Black Death created the opposite problem: a massive shortage of labour.
But an equally innovative and imaginative solution was found. Maximum wage rates were fixed by legislation. The local nobility and gentry were given an incentive to enforce it: any fines collected from workers paid more than was legal could be offset against the overall amount of tax due from the county.
Two positive themes emerge towards the end of the book.
First, the authorities then took steps to try to mitigate the impact of any second wave of the plague almost as soon as the first had passed. The streets of London, for example, unimaginably filthy to modern eyes, were kept cleaner.
Here is a key lesson for Covid-19. If a new wave arrives in the winter, there is no excuse if the government is not prepared. The time to start is now.
The second point is that economic activity recovered remarkably quickly. London in particular was soon buzzing again. It was not state action which delivered this — it was confidence on the part of both entrepreneurs and consumers.
Now, as then, confidence is the key to recovery.
As published in City AM Wednesday 3rd June 2020
Image: Coronavirus street art by Evelyn Simak via Geograph CC BY-SA 2.0
In London, the Covid virus is disappearing rapidly. Hospital trusts are increasingly reporting days with no new cases at all.
During the crisis, there has been a proliferation of home-made signs in rural locations telling city dwellers, with varying degrees of politeness, to turn back and go home. Will we now see messages at junctions with the M25 saying “Yokels, keep out!”?
There is one thing which areas such as Cornwall have been very happy to let in. This is of course the huge subsidies which the regions receive from taxpayers in London and the South East.
This is nowhere more so than Scotland.
Scottish regulations prevent you from travelling more than five miles from home. So English people are effectively banned from entering Scotland. But our money continues to flow across the border.
It is not just that Scotland receives its fair share of the fiscal surplus generated by London. It gets extra special amounts under the so-called Barnett formula, devised by the Labour government of the 1970s in a vain attempt to hold the SNP at bay.
The Covid crisis has ruthlessly exposed the emptiness of the nationalist case for independence.
Before the crisis, the Scottish government ran what was by some margin the largest fiscal deficit in the whole of Europe. Figures produced by the Government Expenditure and Revenue for Scotland showed the nation running a public sector deficit of 7 per cent of GDP.
In the 2014 referendum on Scottish independence, the SNP assumed that much of the gap could be filled by oil revenues. An average oil price of $120 a barrel was assumed, a figure which attracted disbelief at the time. Between 2015 and 2019 the actual average was less than half of this, at $57 a barrel.
During the recent crisis, the price has of course fallen still further, and it is hard to see it getting back even to $60 in a sustained way.
But the overwhelming question is: how would an independent Scotland have paid for the Covid crisis?
UK government borrowing in the month of April was easily the highest on record, at £62 billion. The Bank of England both issued debt and intensified the amounts spent on quantitative easing. So far, the market continue to have confidence, even though the Bank has, in crude terms, been printing large amounts of money.
How would Scotland have met the massive increase in its already large fiscal deficit?
If the country were in the Euro, the European Central Bank would not allow it to print money. If it kept the pound, the same would apply to the Bank of England.
In the financial crisis, as banks such as the Royal Bank of Scotland collapsed, it was the English taxpayer who rescued Scotland.
As Marx said, history repeats itself first as tragedy then as farce. It is a tragedy that once again we have to bail Scotland out. It is a farce that we are not allowed into the country while we do this. Time to call it a day on subsidies for Scotland.