The phrase ‘industrial policy’ seems to take us decades back in time. In 1964, a powerful catchphrase of the new Labour Prime Minister, Harold Wilson, was the need for Britain to embrace the ‘white heat of the technological revolution’. Sadly, by the 1970s this vision had deteriorated into a list of institutions, stuffed with dull businessmen and trade unionists, meeting to decide how to prop up yet another failed sector of the UK economy.
But the concept is now back in vogue. Perhaps surprisingly, given the historical experience, the coalition chose to preserve Labour’s Technology Strategy Board (TSB) quango. The TSB has a budget of £400 million to “accelerate UK economic growth by stimulating and supporting business-led innovation”. A key way in which it plans to do this is through the purchasing decisions of the public sector.
In October, Sir Andrew Whitty, CEO of GlaxoSmithKlein, produced a report commissioned by the Department for Business, Innovation and Skills on how universities can better support economic growth and drive exports. Whitty calls for the creation of “Arrow Projects”, supporting cutting edge technologies and inventions where the UK leads the world, with, in an excruciating pun, “universities at the tip”. Universities and Science minister David Willets eulogised the report. In language redolent of Soviet Five Year Plans, he stated that “we are making strides to help commercialise the work of universities under the Eight Great Technologies”.
It is easy to mock both the symbolism and the content of speeches and reports such as this. But the intention deserves to be taken very seriously. Thinking back again to the decades of the 60s and 70s, far-left radicals used to denounce the ‘military-industrial complex’ of the United States. Yet it has been precisely the interplay between the defence and security sectors and high-tech commercial companies that has led to America continuing to lead the world in technological innovations.
A fascinating new book by Bill Janeway, Doing Capitalism in the Innovation Economy, gives many such examples. The creation of the internet is well known, others include automatic speech recognition and digital computing. Janeway has made a personal fortune, not by financial speculation or by trading complex derivatives, but by developing and leading the Warburg Pincus Investment team which provided financial backing to a whole series of companies which built the internet economy.
A fundamental point which he makes is that both scientific research and invention, and its subsequent exploitation through practical innovations, necessarily involves a great deal of waste. This is something which British bureaucrats have, in the past, been unable to grasp. Ideas which are genuinely path-breaking cannot be conceived in advance. And, equally, the value of their practical applications is something which cannot be imagined before it happens. This means that many such ventures will fail. They cannot be conceived in advance. And, equally, the value of their practical applications is something which cannot provide the box-ticking security of projects which add tiny amounts of knowledge, or which make trivial improvements to an existing technology. So, Arrow and the TSB are to be welcomed, provided that they, and the Public Accounts Committee, recognise that most things fail.
As published in City Am on Wednesday 4th December 2013
Britain is becoming more sharply divided on ethnic lines, according to a study just published by the think-tank Demos. During the past decade, more than 600,000 white people have moved out of London to areas which are more than 90 per cent white. The effect is strongest amongst white Britons with children, with a fall of almost 20 per cent in the number of them living in London.
The Demos project is chaired by Trevor Phillips, the former head of the Equalities Commission. At face value, the numbers suggest that racial prejudice is alive and well. It is not just whites who are seeking out white areas. According to Phillips, ethnic minorities are becoming more tightly clustered in areas where their own personal minority is well represented. But Phillips insists that the overall evidence does not show increased prejudice at all. In fact, personal prejudice is declining. How can this be? Prejudice is allegedly falling, yet we are becoming more segregated along ethnic lines in terms of where we live.
The answer to this seeming paradox was provided over forty years ago by the brilliant American academic Thomas Schelling. Schelling, based at the University of Maryland, has carried out highly original work in areas such as national security and nuclear strategy, using a game-theoretic perspective. Along the way, he picked up the Nobel Prize in economics in 2005.
Schelling imagined a checkers (draughts) board, with many more squares than a standard one, on which an equal number of black and white checkers are placed at random. A small percentage of squares are left empty. The rules of Schelling’s game are very simple. One of the checkers is chosen to see if it wants to change location. Each square is surrounded by eight other squares. So including its own square, it looks at nine squares in all to see who else lives in its neighbourhood. Suppose the checker is white. Provided that in total there are five white checkers in the nine squares, it is happy to stay put. It does not mind living with black checkers on the other four. But if it is 4-5 rather than 5-4, it moves to one of the empty squares.
The players in this game have a very mild preference for living amongst players like them. They are happy to live with a large minority of the other colour. What happens as the game progresses? Each checker can decide, one at a time whether or not to move. Then they all get another chance to move if they want, given the new pattern of location. Remarkably, the board segregates very rapidly into dense blocks in which the checkers are all the same colour. It appears as if the players have a very strong preference to live near players of the same kind, which is not the case at all.
Schelling’s game is of course highly abstract, but it has profound practical insights. Increased tolerance and increased residential segregation need not be incompatible at all.
As Published in City Am on Wednesday 27th November 2013
The World Chess Championship is underway, and the current champion – the Indian Viswanathan Anand – is trailing his young rival Magnus Carlsen by three to five. In the opinion of many, Carlsen is set fair to become the strongest ever human player.
The match is an absorbing spectacle, but the game of chess is not just interesting in its own right. It tells us a great deal about the nature of the environment in which individuals and firms make decisions, and how these decisions are actually made. Herbert Simon, possibly the greatest social scientist of the second half of the twentieth century, used chess to illustrate his key ideas about decision making.
Simon won the Nobel Prize in economics. He also received the Turing Award for his contributions to artificial intelligence, and the American Psychological Association conferred on him an prize for his Outstanding Lifetime Contributions to Psychology. His day job, as it were, was as professor of industrial management at Carnegie Mellon.
Simon believed that the way in which economists assume people take decisions was profoundly wrong. A Rational Economic Person gathers large amounts of information on the alternative choices available in any particular situation, compares them to his or her preferences, and then makes the best possible decision – the “optimal”, as economists say. But Simon argued that, in most situations, the environment is so complex that the optimal decision can never be known. Instead, we use what he called “rules of thumb”: simple rules which give reasonably satisfactory outcomes – until they do not.
This is not merely of academic interest. The economic models in both finance ministries and central banks are based on the concept of rational decision making. A great deal of regulation is designed to correct so-called deviations from “rational” behaviour, both by consumers and firms. How does this relate to chess?
The game of chess is in principle very simple. There are about a dozen rules, which can be learned easily. The object of the game is unequivocal, to capture the opponent’s King. And you know everything your opponent has done. But in most situations in the game, the optimal move cannot be computed. Many bad options can be eliminated, and players like Carlsen will do this much more effectively than an average player. Even at world championship level, this is how most games are lost and won. It is not often a matter of superior rational calculation of the consequences of a move. It is the judgment about what constitutes a good move.
Do computers help? In chess, all possible positions with six pieces have now been solved. But there are 32 pieces, and the computational complexity scales super-exponentially with the addition of each piece.
The environment in which firms operate is also enormously more complicated than the game of chess. Competitors, for example, can innovate and invent entirely new pieces and new rules. We live in a radically uncertain world in which, as John Maynard Keynes once remarked, “we have, as a rule, only the vaguest idea of any but the most direct consequences of our acts.”
As published in City Am on Thursday 21st November
A currently fashionable pessimistic topic is the lifetime prospects of children born into the middle class. Graduate debt, lack of finance to buy homes and job insecurity after they graduate, the list goes on. Alan Milburn, the government’s ‘social mobility tsar’, put the seal of approval on this prevailing angst last month. His Social Mobility and Child Poverty Commission pronounced that children from families with above-average incomes are now set to enjoy a worse standard of living as adults than their mothers and fathers.
Certainly, the cohort of young people unlucky enough to enter the labour force during the last few years is likely to find things tough. Unemployment rose sharply during the recession of the early 1980s, and the negative impact of being unemployed at the start of a career has followed this particular group of young people through the past three decades. However, employment is rising strongly again, so this particular problem is becoming less serious.
An intriguing paper by William Emmons and Bryan Noeth of the Federal Reserve Bank of St Louis suggests that the financial crisis has already disadvantaged all age groups, not just the young, with the exception of those in their 60s and older. As they point out, it is not obvious in theory whether young, middle-aged, or older families are likely to fare better during various economic and financial cycles. Job losses obviously hurt the age groups which participate more in the labour force. So does balance sheet leverage. The more the amount of debt used to finance the family’s assets, the more are falls in asset prices multiplied into proportionately greater falls in net worth. Against this, asset price falls hurt the elderly more, simply because they have more of them.
Emmons and Bryan show that empirically the young and middle aged have lost out, not just since the crisis, but over the past 20 years. Comparing those in their 60s now with those in their 60s twenty years ago, median net worth has risen by 70 per cent In contrast, the median net worth of those with young families now is 30 per cent lower than it was for their counterparts.
Looking ahead, most people acquire assets by working, and by saving part of their earnings. Given the rapid rate at which technological progress is taking place, there is no reason why the group entering their 20s now should not prosper. Economic growth is basically determined by inventions and innovations, and the overall prospects are good.
The problem is that many young people, even many of the highly educated, are not well placed to benefit properly from the technological revolution. To understand Big Data and social media, strong mathematical skills are needed. Google, for example, made its founders unimaginably rich. But the company is basically formed on a mathematical concept called an eigenvector, which will mean nothing to anyone who knows no matrix algebra. The opportunities are there aplenty, but only a minority has the skill set to take real advantage of them.
As published in City Am on Wednesday 13th November 2013
Do consumer choice and competition between suppliers improve the quality of outcomes for consumers? The answer might seem so obvious to many readers that it is hardly worth asking. But a powerful strand of political opinion is building up to an attack on the concept.
Mary Creagh, the new Labour shadow Transport Secretary said last week she was ‘open’ to the idea of returning all train services to state control. The damaging reports on the Islamic free school in Derby have led to sustained attacks on the whole concept of free schools. Certainly, a substantial part of the electorate appears to be opposed to profit-oriented companies providing services in sectors such as education and health, as a Policy Exchange report showed last year. This is not quite the same as a blanket dismissal of competition, but there is a general unease about markets, especially in the light of the financial crisis.
Ever since cars were invented, railways have faced competition, and the spread of car ownership after the Second World War intensified it. The post-war peak in rail journeys was some 1.1 billion in the mid-1950s, a figure which fell steadily to a trough of around 750 million in the mid-1990s. Following privatisation, massive investment programmes have been carried out. Journey numbers have risen, passing the 1 billion mark in 2003, to the current level of 1.5 billion, a figure not seen since the early 1920s, when road competition was very weak.
The key to this success was the much-maligned institutional framework which was set up by privatisation. In the form of the train operating companies, there is now, for the first time ever, a distinct part of the industry whose priority focus is the consumer. They only make money if people use their services. They may be imperfect, but they have doubled the number of journeys during the two decades of privatisation.
A very interesting article in the latest issue of the American Economic Association’s journal Economic Policy looks at the impact of introducing competition into the NHS. In 2006, the NHS mandated that all patients requiring treatment be given the choice of five different hospitals and adopted a payment system in which hospitals were paid fixed, regulated prices for treating patients. Because the prices were fixed, managers had to compete on quality.
The analysis has to encompass some highly technical issues, but the results are very clear. Amidst all the rows about closures of local hospitals, what actually happened was that “the share of patients bypassing their nearest hospital increased for better hospitals while it clearly decreased for worse hospitals”. Further, the policy saved lives without increasing costs.
Markets are neither the simple supply and demand diagrams of the basic textbooks, nor are they the unregulated free-for-all of contemporary fears. Choice and competition can be introduced successfully into highly regulated and complex institutional structures such as rail and health. And where this has happened, there have been very clear benefits. This message cannot be repeated often enough.
As Published in City AM on Wednesday 6th November
The recovery in the British economy is now firmly established. Output in the services sector, the largest part of the economy, is above the previous peak level prior to the crash in 2008. There is a widespread myth that the recovery is fueled by debt-financed personal spending. Yet since the trough of the recession in 2009 the economy as a whole has grown faster than spending by consumers.
Some people, however, are never satisfied. It is the wrong sort of growth. More precisely, it has been too lopsided in its geographical distribution. Research by the Centre for Research on Socio-Cultural Change at Manchester University shows that since 2007, when the slow down began, London and the South East have enjoyed 47.8 per cent of the total amount of growth in the UK, compared to only 37.3 per cent 1996-2007. The ranges of years chosen for the comparison are slightly unusual, but their point is surely true. London in particular has pulled out of recession much faster than the rest of the country.
The fundamental problem which the rest of the UK (RUK) faces is that their economy simply does not have a big enough export base. Exports in this context do not refer just to goods and services which can be sold to Beijing or Bonn, but also to Basingstoke. Anything which provides something useful to outsiders in return for the money the RUK receives is part of the export base, so this includes tourism, call centres, universities, as well as manufactures. Producing things which people outside the RUK want to buy is the only way to ensure sustainable prosperity.
In part, the weak export base is due to the fact that the RUK is uncompetitive. It needs a real devaluation, not least against London and the South East. Given that the UK is a monetary union, this cannot be achieved by an exchange rate movement. The plain fact is that wages in many sectors of the RUK are too high, not helped by the national wage rates which prevail in the public sector. The Grangemouth plant illustrates this very clearly. The plant had become uncompetitive, and it was only the brutal strategy of actually closing it that finally got the message through to the workforce.
Bob Rowthorn of Cambridge University predicted the geographical pattern of recovery in 2010 in an excellent paper ‘Combined and uneven development: reflections on the North-South Divide’. The RUK had already experienced a long run decline in its export base, but this was disguised by the transfer of public services and jobs, especially under Gordon Brown. However, “the problem of the North will become more obvious during the coming period of fiscal retrenchment”.
The prosperity of any area ultimately depends upon its productivity and ability to export, as countries like Greece have discovered only too dramatically. More infrastructure, more money for its best universities can help the RUK. But what is really needed is a cultural change, and a determination to create its own prosperity.
As published in City AM on Wednesday 30th October 2013
Energy prices are in the news. The recent actions of some of the energy companies can plausibly be described as provocative, no matter how well founded their decisions might be. They run the risk of provoking the ire of both the Opposition and the Government.
One interesting aspect of the debate is that it has become even clearer that decisions taken by Ed Miliband himself in the Brown government are partly to blame for our high energy bills. The plethora of green taxes and subsidies has become very expensive for consumers.
But how effective have such policies been? Not very much, seems to be the answer. Max Luke of the Breakthrough Institute in California has looked at the global numbers very carefully. Since 1950, he finds that natural gas and nuclear technology together prevented 36 times more carbon emissions than wind, solar, and geothermal. Nuclear avoided the creation of 28 billion tons of carbon dioxide, natural gas 26 billion, and geothermal, wind, and solar just 1.5 billion.
The Breakthrough Institute has an interesting bunch of people, with an eclectic mix of views which are neither dogmatically Right or Left, pro- or anti-market oriented solutions. So, for example, they point to the crucial role of the public sector in enabling innovative technologies such as fracking to be developed in the first place.
But then they go on to show that fracking in the United States has been incredibly effective in cutting energy consumption and greenhouse gas emissions. Between 2007 and 2012, for example, the share of electricity generated from natural gas in America increased from 21.6 to 30.4 percent, while electricity from coal declined from 50 to 38 percent. Changes which they describe as taking place at ‘light-speed in a notoriously slow-moving, conservative sector’. In contrast, both the use of coal and carbon emissions continues to rise inexorably in Germany, a country lauded by environmentalists for its commitment to renewable energy.
Green taxes and higher prices caused by allowing huge subsidies for green technologies do reduce energy consumption and carbon emissions. But even the current levels which we see in the UK and much of the rest of the EU have not been sufficient to cut the absolute level of such emissions. In order to achieve this, prices would have to rise so much that it is hard to see any government getting re-elected which allowed this to happen.
Investment in innovation and new technologies seems to be by far the most effective way of dealing with the problem of climate change. France and Sweden have done so over the past 40 years by investment in nuclear technology and hydro-electric power. And, to the rage of environmentalists, it is America which is leading the world in reducing emissions.
Al Gore starred in the film An Inconvenient Truth about climate change. It is an inconvenient truth for progressives like Gore that on this topic, the Right seems to have the best tunes. Natural gas and nuclear are the best ways to save the planet.
As published in City AM on Wednesday 23rd October 2013
Young adults in England have scored almost the lowest result in the developed world in international literacy and numeracy tests. A study by the Organisation for Economic Co-operation and Development (OECD) shows how England’s 16 to 24 year olds are falling behind their Asian and European counterparts. England is 22nd for literacy and 21st for numeracy out of 24 countries.
New Labour and the educational establishment harangued us for years about the stupendous success of the system, as record numbers of both passes and A-grades in GCSE and A-levels were registered year after year. The OECD study, by no means the first of its kind, confirms what many suspected. Grade inflation was rampant, and the statistics had as much meaning as the pronouncements about production levels made in the Soviet Union. Actually, that is unfair. When the Soviet Union said 10 million boots had been produced, they really had been. They might have been poor quality and all left-footed, but the boots did exist. It now turns out that many people with GCSE passes can barely read and are virtually unable to add up.
The usual excuses are being made by metropolitan liberal commentators. It is because of poverty or, even better, government austerity. These points were not made when the meaningless grades were being obtained, under Gordon Brown’s control of the domestic policy agenda from 1997. More importantly, poverty itself is not a barrier to educational achievement. The careful work of scholars such as the late EG West shows that functional adult literacy and numeracy in Britain in 1900, when most people really were poor, was almost 100 per cent. It is lower now than it was over a hundred years ago.
Setting schools targets of grades to be achieved was the root cause of the problem. People react to incentives, the key insight of economics. So teachers, with an incentive to deliver good grades, began to steer pupils away from subjects like, physics and foreign languages to the Mickey Mouse topics where higher grades were easier to achieve. Some of the exam boards subtly signalled that the content of their courses was changing. No-one was crass enough to say openly that the exam was being made easier so that more schools would take their exam rather than those of their competitors, but the effect was the same.
A vicious spiral of declining standards was set in motion. A Gresham’s Law in education was observed, in which the bad drove out the good. The schools had to hit targets and created an implicit demand for easier subjects and easier exams. The suppliers, the exam boards, competed with each other for business, and were obliged to follow each other down to lower and lower levels of quality.
Setting effective incentives is often a very difficult task, especially in systems like education where feedback can magnify the initial effect many times over. Fortunately, Michael Gove understands that the problem can only be solved by a complete break with the past.
As Published in City AM on Wednesday 16th October
The Treasury’s amendments to the Banking Reform Bill mean that senior bankers could face up to seven years in jail for ‘reckless misconduct’ which leads to the collapse of a bank. Certainly, the behaviour of prominent individuals in the run up to the crisis left much to be desired. If only we could have put a few of them on show trial in 2009 and given them 20 years in jail, regardless of their objective guilt! But this option was never available, we live under the rule of law.
We need evidence to establish the case for conviction. How are we to judge what constitutes ‘reckless’ behaviour? We can hardly apply the elephant test. Describing an elephant may be difficult, but everyone knows one when they see one. But the concept of ‘reckless’ can be seen from different perspectives.
From the pensioned security of their bureaucracies, regulators exhibit a deep-seated tendency to judge outcomes with the benefit of hindsight. If something went wrong, someone must be responsible. The idea that in many ways the future is inherently unknowable rarely crosses the bureaucrat’s mind. We have seen this in the case of Britannia, where the then-FSA vetted its loan book prior to its absorption by the Co-op in 2009. But we are now told, after the event, that it is these very loans which are at the root of the Co-op Bank’s problems.
Even more importantly, the regulatory bodies themselves bear a heavy responsibility for the crisis. The dominant methodology of assessing risk on assets, Value at Risk, assumed that the statistical distribution of returns followed the bell-shaped curve of the so-called normal distribution. Very large changes are exceptionally rare, indeed beyond a certain size would be unlikely to be observed during the entire lifetime of the universe. Various bits and pieces were crafted on, but this basic assumption remained at the heart of the regulatory approach to risk assessment.
From a scientific perspective, physicists had established by 2000, beyond any conceivable doubt, that this assumption was not warranted. Asset price changes do follow approximately the normal distribution, but they have ‘fat tails’. This means that whilst extreme events remain rare, they are very much more frequent than would be observed if the normal distribution described all the data. The polymath Benoit Mandelbrot established the result decades ago, but by the early 2000s there was a flood of scientific papers demonstrating fat tails in asset markets of all conceivable kinds.
Why did the regulators not insist that banks used these findings in their Value at Risk models? If the current legislative proposals had been in place at the time of the crisis, who would have gone on trial, the bankers or the regulators? Regulation, too, can be reckless. It can succumb to the fallacy that everything is knowable, especially with hindsight, and through sheer inertia can ignore advances in knowledge. More amendments should be tabled, to enable the regulators themselves to be dealt with if they are shown to have been ‘reckless’.
As published in City Am on Wednesday 9th October 2013
The performance of the BRIC economies over the past decade or so has been mixed. Russian growth, though impressive by Western standards, has lagged that of both India and China. This is particularly true since 2008. I got an insight into the problem at a conference last week at the Economics Institute at St Petersburg University. Incredibly, it has a total of 64,000 students. Cynics might say that a country which produces so many economists is bound to perform badly.
We went to the Rector’s office. On the staircase immediately outside was a massive bust of Nikolai Voznesensky, Chairman of the State Planning Commission in the Second World War, responsible for organising the entire Soviet economy. Voznesensky was described to me in glowing terms as ‘a great man’. But there, too, were photographs of all the previous Rectors, prominently displayed. There had been a very rapid turnover in both 1937 and 1938, with one man lasting only six weeks in the job. Why?
I looked up the Collected Works of Stalin. Anticipating Andy Warhol by decades, he wrote ‘Under socialism, everyone will have the right to be Rector of Leningrad University for 15 minutes’. Well, of course, this last bit has been made up. The years 1937/38 were the very height of the Soviet show trials and purges, and all the Rectors had been shot in rapid succession.
So, standing in front of these rather moving and haunting photographs of leading intellectuals, all victims of socialism, I was receiving a eulogy of the man who ran the Stalinist command economy. This seems to encapsulate Russia’s problems. What is the dominant narrative? Is it to break with the past, honour those whose lives were destroyed, and in so doing move forward? Or is to look back with nostalgia at the apparent security of the planned economy?
Talking to the students, there were much more optimistic signs. They were lively, enthusiastic, wanting to speak better English and do interesting work. We could almost have been anywhere. But even here, a theme ran through the narrative, the overall view of the world, which they had constructed about Russia’s future. None of this group wanted to restore socialism, the idea did not even cross their minds. Nor were they entirely sure of the blueprint to try and follow. But the financial crisis has clearly compromised the view that the Western model is the one which must be followed to generate successful economic development.
The recent crisis has simply not been on the same scale as the Great Depression of the 1930s, when output in the US fell by nearly 30 per cent. Mere facts, however, do not shake a settled narrative. The psychological impact of the crisis has been to give countries like China and Russia even more confidence that they can reject the free market, private property, liberal democracy model of development. Outside the developed economies, it is a seductive message.
As published in City AM on Wednesday 2nd October