Many outrageous things happened around the world during the course of last week. But, judging by both the level of popular interest in the story and reaction to it, the most heinous was the decision of a mother to send an invoice to the parents of a boy who did not turn up to her son’s birthday treat. A demand for £15.95 was slipped into his schoolbag after he missed the outing to a local ski centre.
The adverse sentiments seem to be partly based on the feeling that it was inappropriate to introduce the principles of markets – a price was charged – into purely social relationships. Hostility to markets is a very widespread phenomenon. Many people get apoplectic at the idea of markets being introduced into the NHS. It was actually the post-war Labour government which began the process in 1951, charging for teeth and spectacles. But why let facts get in the way of a faith? Firms which fill gaps in the market by providing loans to high credit risk individuals are regularly pilloried for the rates of interest which they charge.
But the whole history of progress is based upon the gradual spread of markets across the range of human activities. In the distant mists of pre-history, humans were organised into tiny, self-sufficient groups in which markets were unknown. As the American anthropologist and best-selling author Jared Diamond points out in his latest book, The World Until Yesterday, life was pretty unpleasant. Nasty, brutish and short, as a famous philosopher once said.
Diamond has a wealth of evidence from areas like New Guinea, where primitive forms of human social structures survived almost until the present day. Contact with other small bands of people was largely based upon the principles of rape, pillage and murder. Strangers were intensely feared and liable to be killed on the spot.
As a species, it took us many thousands of years to start to work out that, in order to benefit from what other groups could produce, it was better to use markets and trade rather than invade and loot. In modern times, societies which have tried to suppress markets, like Stalin’s Soviet Union, Mao’s China and contemporary North Korea, have merely perpetuated grinding poverty for the masses. On a much less serious note, Ed Miliband’s pledge to buck the market and freeze energy prices has just left him looking foolish.
The real problem with the birthday party was that the bill was sent after the event, without prior consent of the participants. Places on the trip were limited, and telling people in advance that no shows would be charged would have been an efficient way to ration scarce resources. Otherwise, the only sanction would be social disapproval. And social norms are always open to exploitation by free riders. An example is in the NHS, where a modest charge to visit a GP would go a long way to reducing pressures on surgeries. Most people behave reasonably, but a minority abuse the system. We need more markets, not less.
As published in City AM on Wednesday 28th January 2015
Executive bonuses are back in the news. The Goldman Sachs pot of £8.3 billion has been prominent. German executive pay has overtaken that in the UK for the first time. Top management seems to have no shame. Some bad publicity today, but the fat cheque remains safely in the bank account.
How one longs for the days of Cedric the Pig! This was the unfortunate nickname bestowed upon Cedric Brown, the Chief Executive of British Gas whose salary was increased by 75 per cent to £475,000 at the end of 1994, at a time when the company was making staff redundant. This works out at just over £700,000 at today’s prices. We can usefully contrast this with the remuneration package of Iain Conn, the newly installed Chief Executive of Centrica, parent company of British Gas. We read on the Centrica website that his basic salary is £925,000. Well, perhaps not an indecent amount more than poor Cedric. But the text goes on ‘to provide continuity of incentive opportunity prior to new arrangements being established two transitional awards will be made’. ‘Continuity of incentive opportunity’ means he could be in line for share awards of up to three times his base salary, plus pension contributions and ‘other benefits’.
Compared to many leading companies nowadays, the remuneration committee of Centrica has acted with a certain amount of restraint. Last year, the average FTSE Chief Executive was paid 143 times the salary of their average workers.
Perhaps economic theory can be used to justify these various payments? An essential component of any basic course in economic principles is the so-called marginal productivity theory of wages. ‘Marginal’ here does not have its everyday meaning in English, but is a piece of scientific jargon. It means the additional value contributed to the firm by a particular worker. According to the theory, the massive increases in executive remuneration over the past two decades or so are entirely justified. People are paid what they are worth. Certainly, this sentiment is prominent in corporate justifications for pay packages. World class individuals are needed, who can deliver world class performances.
There are many practical criticisms of this description of how pay is determined. Yet even within the abstract confines of economic theory itself, it cannot be justified. Economics has no theory with which to explain the distribution of income. This result, which required many pages of maths to prove, was established as long ago as the early 1970s. The lineage is impeccable. Gerard Debreu received the Nobel Prize for his work on equilibrium theory, and Hugo Sonnenschein went on to become President of the free-market oriented University of Chicago. But only high level graduate students, once they have been thoroughly socialised as economists, are taught these theorems.
The simple fact is that executive pay is almost entirely determined by social values and norms. The sense of restraint, of noblesse oblige, which characterised much of Britain’s post-war history, has vanished. Until top management learns to behave respectably again, the problem will remain.
As published in City AM on Wednesday 21st January
Youth unemployment remains a serious problem in Europe. There is the tiniest glimmer of hope in that the number of young people under 25 unemployed in the Euro zone is 58,000 lower than it was a year ago. But that still leaves 3.4 million without a job. In Italy, the youth unemployment rate is 44 per cent, in Greece nearly 50 per cent and in Spain 53 per cent.
In principle, many of them could set up their own small businesses. A generation or two ago, this would not have been feasible. Economies were much more dominated by capital intensive industries. An unemployed steel worker, for example, could hardly set up a plant in his backyard. Massive industrial plants relied upon what economists call increasing returns to production to generate their efficiencies. In other words, the more a factory made, the lower would be its unit costs of production. But the key feature was the initial investment required to start the process in the first place.
In the modern service oriented economy, the capital requirements to set up a business are minimal. We are moving back in part to an economic structure which existed before the Industrial Revolution. Then, most producers were peasant farmers or specialist master craftsmen. If they employed anyone at all, it was on a small scale. It was the world described by the great early economists such as Adam Smith.
This is by no means a matter of pure historical curiosity. It led to a theoretical concept which still underpins a great deal of modern economic theory, albeit now heavily disguised by advanced mathematics. This is the idea known as Say’s Law. Put simply, it says that supply creates its own demand. A fully functioning market economy should never have any persistent involuntary unemployment, it pulls itself up by its own bootstraps. All that the unemployed have to do is to set up in business, and the market mechanism will take care of the rest.
The boom in self-employment and flexible hours working in the UK is entirely consistent with what appears on the face of it to be a highly abstract and unrealistic view of the world. But all scientific theories have to make assumptions and simplifications, the question is how realistic they are. For most of the 250 years since Adam Smith was writing, Say’s Law did not apply because of the structure of production. It is starting to become relevant again. Anyone who can read and write and has access to a computer can, for example, create an internet based business.
Part of Europe’s youth unemployment problem is cultural. They rely on the state for solutions. But the constraint of needing some capital to start a business might bite at a very low level. One policy to overcome this could be just to give Europe’s young unemployed a one-off payment of a few thousand Euros. Most of the money would be wasted, but some of them might take the chance to try and shape their own future.
As Published in City AM, 14th January 2015
Will 2015 be the year in which fantasy economics in Europe is finally put to the test? Somewhat to the surprise of many commentators, in December the Greek political class failed to elect a new president even after three attempts. Parliament has now been dissolved and an election will take place on 25 January. The left-wing Syriza party currently leads in the polls.
In Scotland, the nationalists have rebounded following their heavy defeat in the referendum and seem poised to annihilate Labour in the May 2015 General Election. Paradoxically, this could very well ease their path into a Labour-SNP coalition and accelerate effective independence in Scotland.
Syriza’s leader, Alexis Tsipras, invites the Greeks to believe that most of their debts can be written off, austerity policies abandoned, and the country can still keep the Euro as its currency. Both Alex Salmond and the new SNP leader, Nicola Sturgeon, keep straight faces when they tell the Scots they can be independent, rich, stay in the EU, have high public spending and their banks supported by the Bank of England.
The clear warning provided by Russia, moving into deep recession after the collapse of the oil price, does not seem to have given the SNP pause for thought at all. Indeed, Mr Putin and Ms Sturgeon apparently share the gift of clairvoyance. They both assure us that the fall in the oil price is merely a temporary dip and it will soon return to a level above $100 a barrel.
Tempting though it is to wish Syriza and the SNP in power to test their theories, this does not seem the most likely outcome. The Greek leftists currently lead the conservatives by only 3 per cent in the polls, and there is all to play for in the British general election.
But there is much more to it than this. The financial crisis has simply not brought fantasy parties into power. Despite the banker bashing rhetoric and the cries from academic economists to abandon austerity, the electorates still seem, stubbornly, to prefer middle of the road governments. In the Netherlands in 2012, for example, the Socialists at one point led in the polls during their election campaign, but were defeated. In Scotland itself, the Yes campaign lost decisively. France is a possible exception, but Hollande is now exceptionally unpopular.
Prospect theory, developed by Nobel Laureate Daniel Kahneman and Amos Tversky, helps understand why this has been the case. This theory in behavioural economics describes how people choose between alternatives that involve risk. Hilaire Belloc anticipated it a century ago in his poem ‘Jim’, a boy who ran away from his nurse and was eaten by a lion: “Always keep a hold of Nurse, for fear of finding something worse”. A key element in prospect theory is precisely that losses hurt more than gains feel good. Maybe Syriza is right and the Greeks can have it all. But if it goes wrong, the consequences could be very unpleasant indeed.
As published in City AM on 7th January 2015
As the seventh anniversary of the start of the economic crisis approaches, it is an appropriate moment to take stock. At the time, the recession was simply not recognised by conventional economic forecasts. These continued to foresee positive growth until the collapse of Lehman Brothers in the autumn of 2008. But the latest national accounts data now show that output began to fall in most Western countries during the winter of 2007/08.
The initial falls in GDP were sharp, but the overall outcome was in general better than that of 1930, the first full year of the Great Depression of the 1930s. The most dramatic contrast is America. Output was less than 1 per cent lower in 2008 than in 2007, in contrast to the 9 per cent fall in 1930. The financial crisis was a severe shock, but by the end of 2009, the worst seemed over. The standard definition of a recession is a fall in GDP over two successive quarters, and it ends when output grows again. As early as the autumn of 2009, this was the case in almost every Western country. Looking back to 1931, the second year of the crisis of the 1930s, output had continued to drop virtually everywhere, often at an accelerated rate. In Germany, for example, GDP was reduced by 6 per cent in 1930, followed by a further 10 percent collapse in 1931.
Optimism rose markedly in 2010 as a result. The nightmare of a potential repeat of the 1930s looked to be well and truly squashed. But as we move into 2015, the similarities between now and the 1930s become closer and closer. Across the West as a whole, the number of countries in which GDP is still below its 2007 peak level is almost the same as it was in 1936, seven years into the Great Depression. In Spain, output is 6.5 per cent below its previous peak, in Italy 9.5 per cent and in Greece a massive 26 per cent.
The total losses in output during the crisis in some economies are terrifying. To obtain this, every year we calculate the amount by which GDP falls short of its previous peak level, and sum these up to get the cumulative total. In Italy, the overall shortfall in output is 43 per cent of the value of GDP in 2007, and in Ireland it is 53 per cent. The Greek loss of 106 per cent may by 2016 exceed the highest previously recorded, which is the 132 per cent loss experienced by the United States 1929-1939.
The big difference between the 1930s and the late 2000s in North America and the UK is that the authorities followed expansionary monetary policies such as quantitative easing, which they did not do in the earlier period. It is hard not to conclude that the policies of the European Commission and the Central Bank have been catastrophic. The size and duration of this recession is set to break all records in several Euro zone economies.
As published in City AM on 16th December 2014
Very strange things have been happening in government bond markets. The yield on 10 year US bonds is currently around 2.25 per cent. It makes intuitive sense that the Germans, with their longstanding reputation for fiscal prudence, are enjoying a much lower rate, some 0.8 per cent. Similar levels obtain in most of the countries which we might now reasonably think of as Greater Germany, those with close ties to the Federal Republic. So rates are at or below 1 per cent in countries such as Austria, the Netherlands, Finland and the Czech Republic.
Yet it seems to defy reason that rates in other EU countries are below those of America, sometimes considerably so. 10 year French government bond yields are only 1 per cent. Almost incredibly, in both Italy and Spain they are under 2 per cent, lower not just than those in the US but fractionally lower than in the UK.
The massive falls in bond yields during 2014 are of course good news for the indebted countries. And the implication that the markets consider the risk of default to have virtually disappeared seems to be to the benefit of all.
But the worldwide trend to lower yields on long dated government bonds carries some gloomy implications. In the weird and wonderful world of economic theory, there is a marvellous concept that capital is ‘putty-clay’. An institution sits on a pile of cash, which as it stands can be made into almost anything. But once it is invested in, say, a research and development project, a new Big Data base or in building a new office, it becomes much more difficult to change. The putty has become clay.
At least, that is, for the time being. Given sufficient time, the clay can be transformed back into a much more flexible form. If we pull an even more fundamental tool out of the box of economic theory, that of long-run equilibrium, this tells us that the rate of return on all types of assets should tend to be the same. For the economy as a whole, where investments are made in machines and buildings, the rate of return is simply the rate of inflation plus the real rate of growth. And the same formula applies, in the long run, to government bonds. In the long run, both bonds and fixed investments are putty, not clay.
No-one ever made money using this simple algorithm, but in a mad sort of way it makes sense. Bond yields of 1 per cent or less do not just tell us that inflation is expected to be very low. So, too, is economic growth. Intriguingly, the yield on bonds in Poland, which is just as closely tied to Germany as the countries mentioned above, is some 2.6 per cent. And Poland has been the most successful EU economy in terms of growth over the ‘long run’ of the past twenty years. But for the rest of the EU, the message from the bond markets is gloomy.
As published in City AM on 9th December 2014
The riots in Ferguson, Missouri continue to dominate headlines around the world. Even the brutal dictatorship of North Korea has got in on the act, accusing the United States of being a ‘human rights tundra’. The disturbances follow a grand jury decision not to indict a police officer for the fatal shooting of a black teenager, allegedly because of racial bias.
Liberal opinion everywhere appears to regard the American judicial system as being irredeemably racially biased. Amnesty International, for example, proclaimed that ‘African Americans are disproportionately represented among people condemned to death in the USA. While they make up 12 percent of the national population, they account for more than 40 percent of the country’s current death row inmates, and one in three of those executed since 1977’. But simple declarations such as this are no real use as evidence of bias. Violent crime rates are much higher amongst ethnic minorities than they are amongst whites. So the former will be convicted more frequently than the latter.
A sophisticated analysis of the decisions of courts in the US is published in the latest issue of the American Economic Review. Alberto Alesina of Harvard and Elena La Ferrara of the Universita Bocconi in Milan examine sentences of capital punishment for evidence either that blacks convicted of murder are more likely to be sentenced to death or, importantly, that such punishment is more likely if the victim is white. They use a very neat approach, which takes advantage of the appeal system in America. Capital sentences imposed by the initial court are automatically appealed, first to the state court and then, if they are upheld, in a federal habeas corpus petition. If the initial court is unbiased, Alesina and La Ferrara argue, the reversal rate of sentences by the upper courts should be the same, regardless of the race of the accused or the victim.
The overall finding is that there is indeed evidence which is consistent with racial prejudice. The lower courts do give more death sentences which are then reversed in cases which involve a minority defendant killing white victims. The reversal rates are 3 per cent higher for minority defendants at the first level of appeal than they are for whites, and 9 per cent at the highest level. These are not dramatic, but they do indicate some bias exists. The authors carry out extensive checks to make sure that their results are valid. An interesting one is that it does not matter whether the judge in the higher court has a Democrat or Republican background.
The most intriguing aspect is that the bias is entirely confined to the Southern states. Cultural attitudes can be remarkably persistent. It is 150 years since Americans fought each other over slavery, but the echo of the differences can still just be heard today. In the rest of the United States, justice is indeed blind.
As published in City AM on Tuesday 2nd December
It has been a wretched week for Emily Thornberry. The high-flying MP for Islington was sacked as Shadow Attorney General, and widely pilloried in both social media and conventional newsprint for tweeting a picture of a white van and England flags in Strood. Yet the saga tells us more about perception, about the narrative which emerges around a story, than about the objective reality of the event itself.
One of Thornberry’s defences was that she had grown up on a council estate, and so was very familiar with the world of the working class. She had indeed successfully presented a image of herself within the Labour Party of having a humble background. This was no disadvantage in her rise, in the so-called People’s Party, to a position of being a close ally of its Leader. However, her Wikipedia entry paints a subtly different picture. Her father was a successful academic, who went on to become United Nations Assistant Secretary General. Her mother was a teacher and Mayor of their local town. Image triumphed over reality.
Her misdemeanour is an even more striking example of the importance of perception. It was a week in which the England football team had played and won two matches. Imagine if Nigel Farage had tweeted an image of the now famous white van and the three national flags draped over the house. Suppose further that the former stockbroker had posted the identical comment ‘I’ve never seen anything like it in my life’. Now, we will never know for certain what his reception would have been. But it seems plausible that it would have been seen as a eulogy to patriotism and to the success of our boys on the field. Instead, Thornberry was ridiculed as a patronising snob. Exactly the same actual event, completely different consequences.
The impact of macroeconomic policy shares this same characteristic. The narrative which evolves around an event is even more important than the facts. It was a great coup by David Cameron and George Osborne in the aftermath of the 2010 General Election to succeed in presenting the government as being financially prudent.
It is even more impressive that the markets still believe them. On coming to power over four years ago, the government projected that borrowing in the current financial year, 2014/15, would be just under £40 billion. It is on track to be around £100 billion. What is more, over the first seven months of this financial year, borrowing is even higher than it was in 2013/14. The increase is not great, £3.7 billion according to the Office for National Statistics, but it is still up, not down. The stock of outstanding government debt sits at around 80 per cent of GDP, a figure similar to that of Spain
Against this, the government suffers politically for what is believed to be its austerity programme, one which scarcely exists in reality. The increasing importance of perception and narrative confound the attempts by mainstream economics to build mechanistic models of the economy.
As published in City AM on Wednesday 26th November 2014
That said, there are undoubtedly serious problems with corporate tax regimes across the developed world. The increasing complexity of the legislation offers many opportunities for ingenious but perfectly legitimate avoidance schemes, such as Google’s “double Irish Dutch sandwich” described by Zucman. We can go down the route of trying to get greater international consensus on the treatment of tax, and steps have certainly been made in this direction. But it is a long and arduous process with no guarantee of success.
Recently, we have seen a very effective piece of forward guidance. Ed Miliband’s statement that Labour would bring in a mansion tax on properties worth more than £2 million has had a dramatic impact. The market for expensive properties in London has more or less ground to a halt, with very few transactions taking place. The tax would, of course, reduce the value of the properties, so waiting to see the result of the election before buying a property is sensible.
This is an example of what economists call rational expectations, a concept of fundamental importance to modern economic theory. People are assumed to have a reasonably good idea of how the economy works. In scientific terms, they have a good model, and they all have more or less the same one. When they need to make predictions about the future, they use their model, their concept of how the economy operates. So, when Ed Miliband says there will be an extra tax on certain houses, the model which most people have in their heads is that this will cause their prices to fall.
This seems plausible enough. But by no means all markets work in this particular way. A gang has been jailed in France for conducting a very profitable operation which ferried illegal immigrants into the UK. We might think that this would be a textbook example of a free market, in which price is determined by supply and demand. But the feat of the criminals was to set up a fixed price offer, in which the different categories had different prices. For the 800 Euro economy package, you would be smuggled into the back of a lorry with many others, and the driver would probably not know you were there. The 4000 Euro luxury offer provided a personalised space in a car boot, and the complicity of the driver.
The gang took advantage of the fact that in this situation it is effectively impossible for the consumers – the would-be entrants to Britain – to form rational expectations. How can a Somali, say, arriving in Calais after a long and arduous journey put together a good scientific model of the decision which he or she faces? There are just too many imponderables. But the fixed price, branded nature of the product made it very attractive to potential customers. It seemed like a regular retail offer, like the suppliers really knew what they were doing. It enabled the clients to construct a narrative, to tell themselves a story, that the gang would get them into the UK successfully and that they would not, for example, risk death in the process.
Many decisions have to be made in situations even more complex than this. For example, should HS2 be built? Should Britain pull out of the EU? Here, the policy maker is faced with different opinions from different experts, each using a different model of the economy with a different view of what the impact might be. Rational expectations just do not apply.
As published in City AM on Tuesday 11th November