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Forward guidance is just another delusion foisted on us by mainstream macro

Forward guidance is just another delusion foisted on us by mainstream macro

The governor of the Bank of EnglandMark Carney, was on good form last week when he appeared at the Treasury Committee of the House of Commons.

Asked what “forward guidance” meant, he answered smoothly: “The thing about forward guidance is that it is guidance that is forward. Which is not to say it is meant to be in any way accurate. Indeed, it would be surprising if it were. The most important thing about forward guidance is that the underlying economic determinants should be correct, not that it should be helpful.” Cue collective bafflement of the assembled MPs!

But the statement actually tells us a great deal about how mainstream macroeconomists believe the economy operates.

“Forward guidance” has been the key element in policy-making by the Bank since Carney himself introduced it in the summer of 2013. It is meant to give guidance about the economic circumstances in which the Monetary Policy Committee (MPC) will start to raise interest rates.

The first attempt was certainly not in any way accurate. The governor stated that the MPC would not consider raising interest rates until unemployment fell to 7 per cent, which he predicted would take about three years. It took less than six months. By January 2014, the rate of unemployment had fallen to 6.9 per cent.

This just seems to have been a piece of poor analysis by the Bank. But it does not detract from the more fundamental reason economists think that forward guidance will not usually turn out to be accurate.

The forward guidance is deliberately based on the assumption that behaviour will not change. Yet the mere fact that the central bank makes a pronouncement about the future might induce people to alter their behaviour. And if behaviour changes, the forward guidance might very well prove to be inaccurate.

It is actually a sensible addition to the Bank’s armoury of policy levers. Properly managed, it might enable the Bank to nudge behaviour in directions which it believes will give a better outcome than would otherwise be the case.

The final part of Carney’s statement appears the most gnomic: “The most important thing about forward guidance is that the underlying economic determinants should be correct, not that it should be helpful”.

The governor meant that forward guidance should be given on the basis of a model of the economy which is correct.

In each of the various different macroeconomic models which exist, the assumption is made that consumers and firms form expectations about the future as if their particular model, and no-one else’s, were correct. Yet despite many years of intensive research, macroeconomists still do not agree on what constitutes the model of how the economy works.

There is a challenging academic literature on the theory of how people go about learning the correct model of the economy. But in practice economists are unable to apply it to themselves. We might reasonably conclude that it is the theory which is wrong. Forward guidance is just the latest technocratic delusion foisted on us by mainstream macroeconomics.

As Published in City AM on Wednesday 23rd November

Image: Mark Carney by The Financial Stability Board is licensed under CC BY 2.0

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Dump opinion polls for social media to understand people’s real preferences

Dump opinion polls for social media to understand people’s real preferences

So the pollsters got it wrong again.  After the general election last year and then Brexit, it is perhaps not surprising.  What is surprising is just how wrong they were.  The real problem is the enormous confidence with which they pronounced that Clinton would win.

The Princeton Election Consortium was probably top of the class, stating that Clinton had a 98 to 99 per cent chance of winning.  Even the top Bayesian statistician, Nate Silver, who shot to fame by calling all 50 states correctly in 2012, gave Hillary a 71.4 per cent probability of victory.

Economists have been suspicious of opinions elicited by surveys for a long time.  A fundamental concept in economic theory is that of “revealed preference”.  The idea goes back much further than Adam Smith, the 18th century founder of modern economics.  In the Bible, we find the phrase “by their deeds, ye shall know them”.  In other words, it is not what people say what matters, it is what they do.  If someone says repeatedly that he prefers Pepsi to Coke, but never buys Pepsi and always buys Coke, we can reasonably infer that, despite his words, he does in fact prefer Coke.  His actions reveal his preference.

Readers above a certain age will recall the 1980s. Then, pollster after pollster reported that public opinion was firmly in favour of both more public spending, and higher taxes to pay for it.  Yet in election after election, voters just as firmly returned Mrs Thatcher and the Conservatives to power. They revealed a preference for lower spending and lower taxes.

A great deal of environmental policy is guided by hypothetical questions in surveys of what people would be willing to pay to, say, preserve a species of newt or prevent an oil spillage.  This approach even has its own name, that of “contingent valuation”.  Peter Diamond is an MIT economist who has won the Nobel Prize.   Jerry Hausman, also of MIT, might very well get one.  Referring to a paper they co-authored in the early 1990s, in 2012 Hausman wrote “at the time Peter’s view was that contingent valuation was hopeless.  I was merely dubious.  But 20 years later, after millions of dollars of government funded research, I have concluded that Peter was correct”.

A fundamental problem is that people overstate how much they would be willing to pay in such surveys, compared to how much they will pay when they really have to – just like the British electorate in the 1980s.

A great deal of expertise has been built up over the years in how to put together carefully constructed surveys to find out what voters and consumers think.  But their useful life is at an end.  Instead, social media conversations have the potential to discover what people really do prefer.  For all their chaotic and often incoherent nature, these unstructured conversations can reveal what people really are thinking and doing.  Economists, with their concept of revealed preference, need to make common cause with computer scientists.

Paul Ormerod

As published in City AM on Wednesday 15th November

Image: Trump with supporters by Gage Skidmore licensed under CC BY 2.0

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What climate warrior Twisleton-Wykeham-Fiennes teaches us about punishment

What climate warrior Twisleton-Wykeham-Fiennes teaches us about punishment

Natalie Twisleton-Wykeham-Fiennes: don’t you just love her? One of the Black Lives Matter campaigners, our Nat caused chaos by occupying the runway at London City Airport, on the grounds that climate change is racist.

She and eight others, including a former member of the Oxford University Croquet Club, were sentenced by the courts last week. For many, their punishments were derisory: token fines and suspended prison sentences.

Would harsher treatment deter future protests like this and the one which disrupted Heathrow last month? Anecdotal evidence suggests it would.

In the town where I grew up, nestling in the foothills of the Pennines, the police would often drive miscreant youths late at night to remote hamlets up on the moors and make them walk home. It helped if it was raining, which it usually was. The more recalcitrant were likely to discover that the damp made the steps of the local police station unusually slippery. Compared to today, crime was low.

But this is mere causal empiricism, and there is a vast academic literature on whether or not harsher punishments deter crime. As a broad approximation, criminologists themselves tend to be sceptical about the impact of punishment as a deterrent.

A few years ago, I was at a seminar on the topic in which a criminology professor at Middlesex University asserted, without a trace of irony, that crime was caused by capitalism. In contrast, economists, who believe that agents respond to incentives, often claim that deterrence works.

Economists base their conclusions not just on theory, but on statistical analysis of detailed databases. Even so, the results might not be straightforward to interpret. For example, if prison sentences are increased and we see a fall in crime, is this because potential criminals are deterred, or because prolific criminals are in jail and can’t commit crimes?

Francesco Drago and colleagues published an influential paper in the Journal of Political Economy in 2009. They exploited the natural experiment provided by the Collective Clemency Bill passed by the Italian Parliament in July 2006. This provided for an immediate reduction of three years in the sentences of existing inmates, and as a result 22,000 of them were released. But if they re-offended, they had to serve all the suspended time, plus whatever extra they were given.

The study showed decisively that an additional month in expected sentence reduced the propensity to re-commit a crime by 1.24 per cent. Steve Levitt, in his bestseller Freakonomics, described similar results obtained by smart analysis of American data.

Perhaps the way forward is to experiment with another fundamental concept in economics, that of externalities. Twisleton-Wykeham-Fiennes believes that flying, while convenient for the individual, imposes costs on others through its negative impact on the climate. Other people bear these costs, which are external to the benefits to the person flying.

The airport protests inconvenienced many others. So the fines should be in proportion to the external costs created by the crime. The assets of the well-heeled protestors would vanish in a trice. Anyone for this natural experiment? Future Twisleton-Wykeham-Fienneses might prefer croquet instead.

Paul Ormerod

As Published in CITY AM on Wednesday 21st September 2016

Image: Croquet by Aren’tYouAlex-Spencer? as licensed under CC BY 2.0

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Sorry, Prime Minister: Legislation won’t end excess in the boardroom

Sorry, Prime Minister: Legislation won’t end excess in the boardroom

A key platform of our new Prime Minister is to curb what she perceives to be boardroom excesses.  “It is not anti-business to suggest that big business needs to change”, she said.

One of her proposals is to allow employee and worker representatives to sit on company boards, a suggestion which has not gone down well in the corporate world.  The debacle at the Co-op, with its legion of elected directors, has been cited many times as an argument against Mrs May’s idea.  First Group already has employees on the boards not just of its component companies, but of the group plc itself.  However, given that one of the companies is Great Western trains, one of the most notoriously unreliable of all the rail operators, this has not proved to be a panacea.

May is keen on making shareholder votes on executive remuneration legally binding.  True, in the spring, a clear majority, some 60 per cent, rejected BP boss Bob Dudley’s £14 million pay.  But only 33 per cent of shareholders failed to back Martin Sorrell’s package at the WPP AGM last month, even though both Standard Life and Hermes, two of Britain’s most influential fund managers, voted against the pay report.

Board members receive emoluments.  Shop floor workers get pay.  Yet however we describe them, the gap between the two has opened up in dramatic fashion in recent decades, with no obvious economic justification.  In the United States, for example, the average compensation of CEOs in the top 350 firms is some $15 million a year.  This enormous sum is 300 times higher than the amount the companies pay to the typical worker.  In the mid-1970s, the ratio was not 300:1 but only 30:1.  Even in the mid 1990s it was around 100:1.  This latter figure would still hand the average CEO some $5 million today, not a bad sum to have.  The American economy has done well, but it also did well in the decades immediately after the Second World War, when remuneration disparities were much narrower.

Legislation is the brutal option, but there is no guarantee it would work.  The fundamental challenge is to alter the set of values which has become dominant.  The social norm at the top of industry has become one in which it is perfectly acceptable to be paid very large amounts, virtually regardless of performance.  This behaviour has influenced remuneration in non-market sectors of the economy, such as the pay of top management in universities, and in particular that of Vice-Chancellors.  Their average salary in 2014/15 was £274,000.  Incredibly, the Vice-Chancellor of Falmouth University – it does in fact exist – received £285,000.

There is a simple policy which could radically alter attitudes and behaviour.  The Prime Minister should let it be known that no-one who behaves in an ostentatious way on this matter will either be knighted or elevated to the Lords.  Indeed, such honours might be reserved for captains of industry who volunteer for substantial pay reductions.  Miracles might then happen and social norms drastically changed.

Paul Ormerod

As published in CITY AM on Wednesday 20th July

Image: Home Secretary, Theresa May, speaking at the Girl Summit, by DFID – UK Department for International Development  licensed under CC BY 2.0

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How Stalin’s right-hand man could help the UK in EU exit negotiations

How Stalin’s right-hand man could help the UK in EU exit negotiations

The topic of behavioural economics is very fashionable. But many economists remain rather sniffy about it, arguing that it often does not really add to what the discipline already knows. But one of its most distinctive and strongest results from a policy perspective is its emphasis on what is called the “architecture of choice”.

Economists love jargon phrases. But this particular one is in essence very simple. In any given context, the rules which are drawn up for the process of choice can have an absolutely decisive impact on the actual decisions.

For example, before the referendum the government struggled against opposition in the Lords to get through a bill on trade union political funds. At present, the costs of any political fund operated by a union are automatically deducted from a member’s dues. A member has to positively opt out if he or she does not want to pay it. The proposal was to make all members “opt in” so they would only pay into the fund if they take action to do so. The government has partially backed down on the measure, and it will now only apply to new members.

The reason the opposition has been so bitter is because how the choice is put will have a dramatic effect on the outcome. The “architecture of choice” will determine whether most union members pay the political levy or whether most do not. From a purely rational perspective, the only additional cost under “opting in” is trivial. It is the few minutes it would take to fill the form in. But in practice under “opt in”, most people would not bother.

The UK faces a crucial architecture of choice problem with the now notorious Article 50 of the EU’s Lisbon Treaty. In order to leave the EU, a member state has to invoke the article. Once this is done, there is a period of two years under which the terms of exit are negotiated. When the two years are up, the deal is simply what it is at the time. In theory further changes can be made, but since these would require the unanimous consent of all EU member states, it would be highly unlikely to happen.

So once we invoke Article 50, the EU has us over a barrel. The French, say, could simply sit there stalling for time and blocking all our proposals. Of course, they would never stoop so low. But if some other country did, we would just have to take what the EU gave us at the end of the two years. This is why we have to have extensive informal negotiations before Article 50 is triggered, which EU leaders say mustn’t happen. The Swiss drew up their first treaty with the EU in 1972 and are still negotiating.

The only alternative is to adopt the strategy of Molotov, Stalin’s right-hand man, at the United Nations in the middle of the last century. He simply said “no” to virtually everything. Until we get informal talks, we turn up at the Council of Ministers and veto every proposal on any subject whatsoever, regardless of its merit. A suitable job for Michael Gove, perhaps.

As published in CITY AM on Wednesday 6th July 2016

Image: LC-USZ62-135316 by National Museum of the U.S. Navy is licensed under CC 1.0

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Don’t give in to Twitter mob: Social media is just an echo chamber

Don’t give in to Twitter mob: Social media is just an echo chamber

Greater Manchester Police staged a simulated terror attack in the massive Trafford Park retail complex last week.  As with many real life atrocities, the carnage began with the cry “Allahu Akbar!”   Following a storm of protest on Twitter, the police felt forced to apologise.  Almost at the same time, a frenzied chorus rose up demanding the resignation of the BBC’s political editor, Laura Kuenssberg, for having had the temerity to suggest that the local election results were something less than a complete triumph for the Great Leader and Teacher, Jezza.  This campaign was halted by the extremely sexist nature of many of the comments posted by left wing Twitterati.

The way the Kuenssberg saga ended is in fact very unusual.  Following a storm of outrage on social media about a statement or an action, the ‘guilty’ party almost invariably confesses his or her crime and issues a heartfelt apology to the raving crowd.

Social media is a new and radically disruptive technology.  It is hardly surprising that traditional institutions and social norms have not yet adapted to the challenges which are raised.  Many thousands of voices were raised against the police for their allegedly racist opening cry, with virtually no one springing to their defence.  It seemed that public opinion was firmly against them, and so they bowed to pressure and apologised.

But Twitter, along with other social media outlets, is in many circumstances simply an echo chamber.  When the polling booths in the Scottish referendum closed in 2014, many in the SNP leadership were convinced they had won.  Their researchers has carried out seemingly sophisticated analysis of social media, and concluded the ‘Yes’ campaign was ahead.  The actual result gave rise in turn to all sorts of conspiracy theories, bouncing backwards and forwards between die hard pro-independence Scots.  Late last summer, the US Army carried out a routine training exercise called Jade Helm 15.   This sparked a torrent of concerns on social media, a prominent one being that the federal government was planning to invade Texas and civil war was imminent.

Guido Caldarelli at Lucca and Gene Stanley at Boston published a paper in January this year in the prestigious Proceedings of the National Academy of Science.  They find that the problems are widespread in social media, with users frequently forming communities of interest which foster confirmation bias, segregation and polarisation.  Biased narratives fomented by unsubstantiated rumours, mistrust and paranoia proliferate.

How do we know whether to take a trend on social media seriously, of whether to just dismiss it as a bunch of fruitcakes egging each other on?  Santa Fe-based scientists Rich Colbaugh and Kristin Glass (I am currently working with them) have found that a topic which has only a small number of mentions in each of several different social media communities is potentially far more significant than one which has a huge number in just one.  Public bodies need to learn how to differentiate between social media topics, and not just routinely capitulate to the mob.

As published in CITY AM on Wednesday 18th May 2016

Image: Twitter by Esther Vargas is licensed under CC BY 2.0

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