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The intellectual imperialism of economics

The intellectual imperialism of economics

At this time of year, most people are focused on leisure. The holiday you have just had, the one you are on now, or the one you are just about to go on.

With exquisite timing, the 1 August issue of the top Journal of Economic Perspectives has a symposium of papers about work.

The opening sentences in the summary of the first of these reinforces the impression that economists can sometimes be rather unworldly. This is despite the fact that the author, Edward Lazear, occupies a chair at Stanford Business School and replaced Ben Bernanke as Chairman of the Council of Economic Advisors in 2006.

“Labor is supplied”, the summary proclaims, “because most of us must work to live. Indeed, it is called “work” in part because without compensation, the overwhelming majority of workers would not otherwise perform the tasks”.

It is an excellent illustration of the technique outlined by the 1950s British satirical writer Stephen Potter about how to gain the upper hand in a conversation about business. In his book One-Upmanship, he describes his ‘Economics B’ technique as the ‘Approach of Utter Obviousness’.

To be fair, the paper itself has real content. Lazear points out that economics as a science has made good progress in specifying how compensation and the forms in which it comes influences worker effort.

The results are sometimes surprising. For example, Bengt Holmström, the 2016 Nobel Laureate, concluded his Prize lecture with the statement that “one of the main lessons from working on incentive problems for 25 years is that, within firms, high-powered financial incentives can be very dysfunctional and attempts to bring the market inside the firm are generally misguided”.

The other two papers are much less about conventional economics. They focus on the psychology and meaning of work.

Greg Kaplan at Chicago and San Schulhofer-Wohl of the Chicago Federal Reserve examine how changes in the distribution of occupations since 1950 have affected the aggregate non-monetary costs and benefits of working.

The physical effort of work has obviously declined a lot over the decades, so that is a benefit. But the authors find that the emotional impacts of the changing occupation distribution vary substantially across demographic groups.

Compared to 70 years ago, work has become happier and more meaningful for women, but more stressful and less meaningful for men. And most of these changes are concentrated on workers with lower educational qualifications.

The final paper, by Lea Cassar of Cologne and Stephan Meier of Columbia is even further removed from the traditional areas studied by economists. They tackle the massive topic of work as a source of meaning in people’s lives.

The authors develop an initial theoretical model which incorporates the three psychological needs at the basis of self-determination theory: autonomy, competence, and relatedness. Intriguingly, they suggest that the concept of meaning at work can be examined using existing tools in economics such as labour supply theory and principal-agent analysis.

Economics has a strong streak of confident imperialism. Increasingly, it intrudes into a wide range of other social sciences.

As published in City AM Wednesday 15th August 2018

Image: Holiday by Pxhere is licensed under CC0 1.0 Universal
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From supply and demand to game theory, football is full of economics lessons

From supply and demand to game theory, football is full of economics lessons

The football transfer window closes tomorrow, and the opening days of August have seen the usual flurry of activity at all levels.

The window in the rest of Europe stays open until the end of the month. Do we detect here the hands of Monsieur Barnier, in another dastardly European Commission plot to do us down?

Sadly, the reality is more prosaic. The Premier League clubs themselves voted this year to bring the official Fifa deadline forward. They were concerned about the negative impact of transfer uncertainty and speculation on their players.

Obviously, clubs buy players to try to strengthen their team. And there is no doubt that money talks. The more you can offer in wages, the better the quality of the player who will be interested in playing for you. The more cash you have, the more you can afford to buy them.

The correlation between spend and success is not perfect. But as a rule of thumb, teams in the top six of the Premier League spend on players’ wages at least twice the average amount of the bottom six.

Both the wages paid to an individual player and the amount paid in a transfer fee contain implications for economic theory.

In a modern economy, very few markets operate in complete conformity with the standard supply and demand model of the textbooks. The football market is no different.

All scientific theories have to make assumptions. One of the assumptions in this basic model is that the commodity being traded is homogeneous. In other words, each individual product which is bought and sold in the market is identical to every other one in the same market.

In this idealised world, price is determined by the balance between supply and demand. But products can differ in many subtle ways.

If they differ too much, they are no longer operating in the same market. The journeymen players in Leagues One and Two – the bottom two – are not competing in any way with the likes of Harry Maguire of Leicester and the England team, who is the subject of strong speculation of a bid from Manchester United.

Within the same market, supply and demand get you to a benchmark region, but not to the final price.

Ben Gibson, who has been in the England squad but has not yet played for the national side, has just been bought by Burnley from Middlesbrough. Burnley wanted a good defender. Middlesbrough, which narrowly failed to return to the Premier League last season, needed the cash. So supply and demand played a part in the transaction.

But why was the fee £15m? Middleborough could not have realistically asked for £50m. You get a world-class defender for that amount. Burnley could not have offered £5m. They would have been shown the door.

Supply and demand feature in setting a fairly broad range for the price. But within this band, it was indeterminate. Game theory is needed to understand the process which led precisely to the £15m figure.

Increasingly, a lot of modern economic theory is about bargaining, rather than the basic supply and demand curve. It makes it much more difficult for students, but more realistic.

As published in City AM Wednesday 8th August 2018

Image: Premier League Football Pixaby is licensed under CC0 1.0 Universal
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Facebook, facts, and alternative fictions: How to predict the narrative of the future

Facebook, facts, and alternative fictions: How to predict the narrative of the future

Last Thursday, Facebook suffered the biggest one-day loss in the history of Wall Street.

The company’s shares dropped nearly 19 per cent.

Rather incredibly, Facebook reported an increase in revenue of no less than 42 per cent over the same quarter last year, and a rise in profits of 31 per cent.

But the narrative which swept the markets was wholly negative. Investors focused on the less-than-expected growth in new users, and on the company’s projection that its profit margins will fall in 2019 – from its current 44 per cent to just the mid-30s.

A wholly plausible alternative story would have been that the company continued to grow very strongly, but there would be some slow-down from the recent stratospheric rates of expansion. And the board was fully aware of the situation – this was not an adverse surprise.

The facts could have been used in support of either of these narratives. Yet one of them prevailed, and the other got no traction at all.

Objective evidence was perhaps a stronger element in the 20 per cent fall in the Twitter share price the day after the Facebook plunge. The company reported a drop of one million users following its action to delete fake and offensive accounts.

But even here, a different story could readily be concocted. A potentially major problem had arisen, but the company had taken decisive action to deal with it. Further, its efforts to monetise the platform were starting to work.

John Maynard Keynes emphasised the importance of narratives, rather than mere facts, in financial markets. He described what has subsequently become known as the Beauty Contest Game.

In the politically incorrect 1930s, newspapers would run competitions based on pictures of young women in bathing costumes. But the winner did not have to judge which of them was in some objective sense the most beautiful. Rather, they had to guess which one most entrants would select as the best.

Keynes pointed out that this can rapidly become even more complicated in the markets. As he put it so elegantly: “We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”

Scientific advances in the twenty-first century are making it possible to anticipate which narrative around a particular event will predominate.

There are two separate aspects of this. The first relates to our understanding of how ideas or stories either spread or are contained across networks of individuals. It turns out that where a narrative gets its initial traction in the network can be much more important than its actual content.

The second of course is the development of artificial intelligence and big data. These technologies enable the networks which connect people, whether on Twitter or in financial markets, to be mapped in detail.

It is not just hedge funds but central banks such as the Bank of England that are interested in these exciting new technologies. There is power to be had in mapping alternative narratives and predicting the future.

As published in City AM Wednesday 1st August 2018

Image: Social Media by Pxhere is licensed under CC-BY-1.0
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The UK’s capacity to innovate matters far more than panic over consumer spending

The UK’s capacity to innovate matters far more than panic over consumer spending

The debate about Brexit has become mired in a virtually incomprehensible quagmire of detailed and technical negotiations between the UK and the rest of the EU.

Yet the campaign itself in 2016 was dominated by broader questions of political economy.

In addition to the hurly burly of claims about extra NHS spending or Project Fear, both sides took a serious, longer-term view of what was needed to sustain Britain’s prosperity. All this has been lost sight of, but the fundamental issue has not gone away. So does Britain have an economy which is fit for purpose in the twenty-first century?

At one level, the evidence seems to side with the Remain camp. Growth in the UK since the depth of the recession in 2009 has been decidedly unbalanced compared to much of the rest of the EU.

We can break down the growth of the total economy – GDP – into categories defined by who is doing the spending: how much is done by individuals as consumers, how much by firms in terms of capital investment, and how much by the public sector. We also have the net balance between our exports and imports.

Looked at this way, Britain’s growth since 2009 has been concentrated in a seemingly unhealthy fashion on consumer spending. This accounts for no less than 58 per cent of the total growth in the economy 2009-18. Investment by companies takes up another 29 per cent, and there has been a slight deterioration, amounting to just three per cent of GDP, in our net exports.

This is in sharp contrast to Germany. The increase in investment is similar, making up 27 per cent of the total increase in GDP. But consumption is just 32 per cent, and net exports have boomed, accounting for 22 per cent of the increase in German GDP. No wonder President Trump has concerns about German trade surpluses.

This pattern is similar in countries closely connected to Germany. Compared to the UK, increases in consumer spending are only a relatively small part of the total expansion of the economy since 2009 in Austria, Belgium, Denmark, France, the Netherlands, and Sweden.

Surely an economy which relies less on spending by individuals is better placed than one in which they splurge every last penny?

Well, up to a point. For one thing, public spending accounts for a larger proportion of total growth in the Greater Germany group than it does in the UK. The rise in public spending in Britain makes up just eight per cent of total growth. In France, it is 25 per cent.

But the key evidence comes from the US. Here, spending by individuals makes up no less than 75 per cent of the total expansion of the economy since 2009. Yet America remains the most dynamic and innovative economy in the world.

Economic theory has long identified the capacity to innovate as being the key determinant of long-term growth, not who spends what. The debate over post-Brexit Britain should be about how to boost innovation, and whether the European Commission is a help or a hindrance to this.

As published in City AM Wednesday 25th July 2018

Image: Regent Street & Oxford Street by Tony Webster is licensed under CC-BY-2.0
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Investors should intervene to stop high executive pay, before the regulator does

Investors should intervene to stop high executive pay, before the regulator does

Shareholder discontent over executive pay continues to rise. Last week, the outgoing boss of BT, Gavin Patterson, was in the firing line.

At the company’s annual general meeting, 34 per cent of investors voted against the remuneration report, which included a £1.3m bonus payment to Patterson.

Concern about top pay has spread even to the regulatory bodies in the United States. Traditionally, they adopt a rather hands-off approach, and yet, when they do decide to act, they act decisively.

About 40 years ago, the typical compensation of a chief executive in America was around 30 times more than that of the average employee. By the mid-1990s, this has risen to a ratio of 100 to one, and now it is some 300 times as much.

True, share prices have boomed over this period, but the rate at which the economy has grown has fallen.

Between 1957 and 1987, real GDP in the US grew by 3.5 per cent a year, but by only 2.5 per cent from 1987 to 2017.

Chief executives have not got better at expanding the rate at which goods and services are produced, but they have got better at free-riding on the rise in equity markets.

Against this background, in September last year, the US Securities and Exchange Commission mandated that companies must disclose the ratio of the chief executive’s compensation to median employee pay.

Some may see this as bureaucratic meddling. But the behaviour of board members both here and in America has given rise to what economists describe as an externality.

The decisions to reward the relative failure on the part of executives have consequences outside of the decisions themselves. So while capitalism is by far the most successful economic system ever devised, the perception that executives are receiving unfair levels of compensation is undermining belief in capitalism itself. This is the externality.

In economic theory, the existence of externalities provides a sound justification for intervening in the workings of the free market.

A fascinating paper published a year ago by Ethan Rouen of Harvard Business School provides strong evidence that unwarranted executive pay levels adversely affect firm performance.

He obtained very detailed data, some of it not publicly available, from the US Bureau of Labor Statistics for 931 firms in the Standard and Poor’s 1,500 between 2006 and 2013, including total employee compensation and the composition of the workforce.

Overall, Rouen found no statistically significant relation between the ratio of executive-to-mean employee compensation and performance. This is telling in itself.

His results went on to show “robust evidence of a negative (positive) relation between unexplained (explained) pay disparity and future firm performance”. In other words, people do not mind high pay – when it can be justified. It is when the snouts are in the trough that resentment rises and performance suffers.

Shareholder opposition to excessive executive packages is certainly rising, but has rarely been decisive. Investors need to act if they are to avoid the regulators really clamping down.

As published in City AM Wednesday 18th July 2018

Image: Fat Cat by Linnaea Mallette is licensed under CC-BY-1.0
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Never mind who wins, the World Cup is a treasure trove for curious economists

Never mind who wins, the World Cup is a treasure trove for curious economists

Our boys make progress – and I don’t mean on Brexit.

On a visit to Glasgow last Thursday, a popular Scottish newspaper had a mock-up photo of Harry Kane lifting the cup. In massive type, the headline shrieked “This Would Be the End of the World”. Yes, it would rather put the Highland Clearances into perspective.

There is a general perception this year that the football has been more entertaining than usual. This is reflected in the fact that the average number of goals per game – 3.18 – is the highest since the 1958 finals.

The qualifiers for the last 16 generally followed the form book, with only three of them – Russia, Denmark, and Sweden – edging out teams placed above them in the FIFA rankings before the tournament started.

But the patterns in the results show once again how close many of the teams are in ability. One team has to win, though it is not obvious which one.

Germany’s own qualifying group illustrates the point. A key concept in economic theory is that of transitivity. It essentially means that preferences should be well-structured.

If I prefer product A to product B and product B to product C, the assumption is that I prefer A to C.

If we carry this over into team sports, it seems logical that if A beats B and B beats C, then A should beat C.

None of these “transitive triples”, as the jargon puts it, were observed in Group F. Mexico beat Germany, who beat Sweden. But Sweden beat Mexico. Sweden also beat South Korea, who beat Germany.

The conclusion is that the teams in this group were very evenly matched. It was largely a matter of chance rather than superior ability that Mexico and Sweden qualified.

In the round of 16, three of the eight games ended in draws and the result was by penalty shoot-out. Two of the others were decided by goals deep into injury time. And one of the quarter finals was won on penalties.

Again, the implication is that there is a great deal of randomness in the outcome. Even in England’s famous victory over Colombia, the opposition goalkeeper got his hand to the final penalty shot but could not prevent the ball entering the net. Move his hand by just a few centimetres, and he saves it.

To round off this football economics analysis, finally and frivolously, is winning the World Cup good for the economy? I looked at the eight years from 1974 when European countries won.

As a control group, I examined the US and Australia, two western economies where soccer is a minor sport. Growth in a World Cup year was higher than in the previous year seven times, and lower nine times. Growth was higher in the year after the World Cup nine times and lower seven. So the pattern here looks completely random.

In the countries which won, growth was higher in the World Cup year than the previous on four occasions, and lower on four. But in contrast to the control group, growth in the year after victory fell six times out of the eight.

Winning the World Cup is bad – or so the statistics say!

As published in City AM Wednesday 11th July 2018

Image: World Cup 2018 by RonnyK is licensed under CC-BY-0.0
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