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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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Our automated future is brighter than Karl Marx or Mark Carney would ever suggest

Our automated future is brighter than Karl Marx or Mark Carney would ever suggest

Mark Carney, the governor of the Bank of England, hit the headlines at the weekend, claiming that Marxism could once again become a prominent political force in the west.

Automation, it seems, may not just destroy millions of jobs. For all except a privileged minority of high-tech workers, the collapse in the demand for labour could hold down living standards for decades. In such a climate, Communism may seem an attractive political option.

Karl Marx as an economist is a bit of a curate’s egg, good in parts. In the late eighteenth and early nineteenth centuries, it was obvious that the system of factory production was dramatically different to anything which had ever existed, but it was thought that might disappear just as suddenly as it had emerged.

Marx was the first major economist to see that the accumulation of capital in factories represented a new, permanent structure of the economy: capitalism. He developed a theory of the business cycle, the short-term fluctuations in economic growth, which is much more persuasive than the equilibrium-based theories which dominate academic macroeconomics today.

But he was completely wrong on a fundamental issue. Marx thought, correctly, that the build-up of capital and the advance of technology would create long-term growth in the economy. However, he believed that the capitalist class would expropriate all the gains. Wages would remain close to subsistence levels – the “immiseration of the working class” as he called it.

In fact, living standards have boomed for everyone in the west since the mid-nineteenth century. Leisure hours have increased dramatically and, far from being sent up chimneys at the age of three, young people today do not enter the labour force until at least 18.

Marx made the very frequent forecasting mistake of simply extrapolating the trend of the recent past.

In the early decades of the Industrial Revolution, just before he wrote, real wages were indeed held down, as the charts in Carney’s speech show. The benefits of growth accrued to those who owned the new machines. Marxists call this the phase of “primitive accumulation”.

But such a phase has characterised every single instance of an economy which enters into the sustained economic growth of the market-oriented capitalist economies, from early nineteenth century England to late twentieth century China.

Once this is over, the fruits of growth become widely shared.

In fact, Carney’s own charts give grounds for optimism and contradict the lurid headlines around his speech. One is headed “Technology driving labour share down globally”. In other words, the share of wages and salaries in national income has been falling. In the advanced economies, this was some 56 percent in the mid-1970s and is 51 percent now. But all the drop took place before the mid-2000s. If anything, the labour share has risen slightly since.

Similarly, inequality has increased over the past 40 years, but almost all the increase took place in the 1980s. Depending which measure we take, it has either stabilised or fallen since 1990.

The future looks more optimistic than either Marx or Carney suggest.

As published in City AM Wednesday 19th April 2018

Image: Car Factory by Jens Mahnke is licensed under CC0.0
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Why can PwC charge such superhuman fees? It’s all in the power of bargaining

Why can PwC charge such superhuman fees? It’s all in the power of bargaining

The liquidation of Carillion continues to feature prominently in the news.

Last week, the story was the fees being charged by PwC, the accountancy firm tasked with salvaging money from the wreckage.

It emerged that PwC’s fees, which take priority in terms of being paid over the various creditors and pensioners, amounted to £20.4m for the first eight weeks’ work. The special manager with overall responsibility has a rate of £865 an hour.

The fees were described in parliament as “superhuman”.

We might reasonably ask how these rates are determined. Why are they not half their actual value? The remuneration would still be very substantial. Equally, why are they not double?

The answer from a basic economics textbook would be that it is a matter of supply and demand. The wage – if such a proletarian term is acceptable in these elevated circles – is set at a level which ensures that there are just enough bean counters to carry out the amount of work which exists.

But it is hard to sustain this argument. The Big Four accountancy firms in the UK take on around 5,000 graduates every year. They receive almost 100,000 applications. There is a long process of whittling down. Eventually, nearly 10,000 get to the final stage, an interview with a partner.

Clearly, many graduates have very strong qualifications. But the wage rate is not bid down by this over-supply.

The argument about how prices, in this case the hourly PwC rate, are set goes back a long way in economic theory.

In the decades just before the First World War, two highly accomplished mathematicians who occupied the top chairs in economics, Alfred Marshall at Cambridge and Francis Edgeworth at Oxford, wrangled over the issue.

Appropriately enough in the week following Cambridge’s triumph in both the men’s and women’s boat races, Marshall was the victor at the time. But, to employ another sporting analogy very much in the news, there was a certain amount of ball tampering along the way.

Edgeworth thought that, in most situations, there was an inherent indeterminacy about the price which emerged. He wrote: “it may be said that in pure economics there is only one theorem, but that it is a very difficult one: the theory of bargain”.

Marshall simplified matters dramatically. He assumed that there are so many economic agents in a market that no single one of them can influence the price. This enabled him to draw, in his own best-selling textbook, the supply and demand curve diagrams familiar to generations of students.

But it was a simplification too far. If no one can influence the price, how is it set?

A lot of modern economic theory is about developing Edgeworth’s view that economics is essentially about bargaining. It makes it much more difficult, but more realistic.

There is no inherent economic justification for the hourly rates which the Big Four accountants charge. They have simply got the best of the bargaining process. Companies need to wake up and start to insist on lower fees.

As published in City AM Wednesday 28th March 2018

Image: PWC by  Bjørn Erik Pedersen is licensed under CC by ShareAlike 3.0
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The balance between wages and capital is shifting – rent seekers had better beware

The balance between wages and capital is shifting – rent seekers had better beware

The first column of a new year is the time for a prediction.

By far the hardest part of forecasting is to identify tipping points. The success rate of calling a break in an established trend is very low.

Accompanied by suitable health warnings, 2018 looks like the year in which the longstanding relationship between capital and labour looks set to change.

The use of the words “capital” and “labour” does not mean that the two are antagonistic in the Marxist sense. Once a country has properly embraced capitalism, there is not a single instance of it ever being abandoned. And “labour” in particular is a very mixed category indeed, covering both university vice chancellors and the people who clean their offices at night.

But it is a useful simplification to describe the players in the evolutionary game of how to divide national income between profits and wages or salaries.

Over the past three decades or so, capital has been winning. The share of profits in national income across the west has risen, and the share of wages has fallen.

The reaction of a number of major companies to President Donald Trump’s cut in corporation tax rate from 35 per cent to 21 per cent suggests that the game is turning.

Almost immediately, firms like AT&T and Boeing announced special bonuses for their workforces. Even the banks got in on the act, with Wells Fargo, for example, raising its hourly minimum wage 11 per cent, to $15 from $13.50. Additionally, the bank plans to donate $400m to community and non-profit organizations in 2018.

The share of wages in American GDP has already started to stabilise. Since 2014, there have been no further falls. Short-term trends like this can be misleading, but for four years the wage share has been constant.

More generally, the surge towards greater globalisation which has characterised recent decades seems to have halted.

Strong political blocs have grown in the west that share a dislike of the liberal, open border consensus which has done so much to hold down the real wages of the less skilled.

The election of Trump is the obvious example. We see it in the vote on Brexit. We see it in the hostility to the free movement of labour shown by governments in Eastern Europe.

On a more parochial level, scrutiny of the “emoluments” (“pay” is too vulgar a word for these panjandrums to use) of chief executives and vice chancellors is intensifying on almost a daily basis.

There is very little resentment of monies made by those who are perceived to have earned it by their personal skill and effort. Entrepreneurs and footballers alike are held in high regard in this respect.

In contrast, there is distinct antagonism towards rent seekers: those at the top who get paid not on their merits, but merely on the basis of the position they hold.

The balance of forces is shifting. Smart politicians and business people should pay close attention during the coming year.

As published in City AM Wednesday 3rd January 2018

Image: Tightrope by Tom A La Rue is licensed under CC by 2.0
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Comparison sites are forcing businesses and economists to rethink price theories

Comparison sites are forcing businesses and economists to rethink price theories

The competition and Markets Authority (CMA) published a report about Price comparison sites at the end of last month. They seem simple enough, but these straightforward sites raise interesting issues for economics.

Overall, the CMA was pretty positive about the DCTs – digital comparison tools, to give them their Sunday best name. The conclusion was that “they make it easier for people to shop around, and improve competition – which is a spur to lower prices, higher quality, innovation and efficiency”.

DCTs offer two main benefits. First, they save time and effort for people by making searches and comparisons easier. Second, they make suppliers compete harder to provide lower prices and better choices to consumers. In short, they bring the real world closer to the perfectly informed consumers and perfectly competing firms in the ideal world of economic theory.

But even in this market, there is an issue which goes right to the heart of much of the information which can be accessed through the internet: how do we know whether we can trust it?

The main problem is that the comparison sites typically provide their services free of charge to consumers. They make money by charging a commission to suppliers.

This creates an incentive for a DCT to promote those suppliers which pay it the most commission. An effective way of doing this on the internet is by the order in which the information on the various suppliers is presented.

It is not that DCTs deliberately provide misleading information, or even that a site leaves off a major supplier which does not pay the particular website enough. But they can put those that pay the most at the top of the list.

Notoriously with Google searches, people rarely click through to anything which is not in the top three results of the search.

Allegedly, 60 per cent of the time, only the site which comes at the very top of is accessed.

Obviously on a DCT, consumers are likely to look at more. That is the whole point of using the site. But although the CMA does not provide hard data on this, it expresses a clear concern about the ways in which the sites rank the suppliers.

How the DCTs themselves set their prices raises a more general question for economics. The basic rule, described in the textbooks since time immemorial, is to set price equal to marginal cost – in other words, at the point where the revenue from one extra sale equals the cost of producing that extra item.

The standard assumption made in teaching generations of students their introductory course to economics is that as the level of output increases, marginal cost first of all falls but eventually rises.

But on the internet, once the site is set up, the cost of dealing with an extra user is effectively zero. The time-hallowed formula of economics is a recipe for bankruptcy.

The internet is forcing companies to innovate in their pricing strategies. And it is forcing economists to rethink some of their theories.

As published in City AM Wednesday 18th October 2017

Image: Man and Laptop by Pexels is licensed under CC by 0.0
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Beware the dysfunctional consequences of imposing misguided incentive systems

Beware the dysfunctional consequences of imposing misguided incentive systems

Following the disclosure of salaries at the BBC, it has hardly seemed possible to open a newspaper or switch on the television without being bombarded by stories about pay.

By pure coincidence, an academic paper entitled “Pay for Performance and Beyond” has just appeared. So what, you might ask? Except that it is one of the 2016 Nobel Prize lectures, by Bengt Holmstrom, a professor at MIT.

Holmstrom’s work began in the 1970s on the so-called principal-agent problem. This is of great practical importance. For example, how should the owners of companies (the “principals”, in economic jargon) design contracts so that the interests of the directors (the “agents”) are aligned as closely as possible with the interests of the shareholders?

Many aspects of economics have a lot of influence on policy making. But this is not yet one of them. We have only to think of the behaviour of many bankers in the run up to the financial crisis. Stupendous bonuses were paid out to the employees, and, in examples such as Lehman Brothers, the owners lost almost everything.

It is not just at the top levels that scandals occur. Towards the end of last year, Wells Fargo had to pay $185m in penalties. Holmstrom cites this prominently in his lecture. The performance of branch managers was monitored daily. They discovered that one way of doing well was to open shell accounts for existing customers. These were accounts which the customers themselves did not know about, but they counted towards the managers’ bonuses.

A culture of pressure to perform against measured criteria can lead to problems even when the organisations involved are not strongly driven by money.

The education system in the UK has many examples. But the one given by Holmstrom is even more dramatic. The No Child Left Behind Act of 2001 in the US was very well intentioned. But the test-based incentives eventually led, around a decade later, to teachers in Atlanta being convicted of racketeering and serving jail sentences for fixing exam results.

Holmstrom is in many ways a very conventional economist – his Nobel lecture rapidly becomes full of dense mathematics. He believes that, given the right information and incentives, people will make rational decisions.

This is why his conclusion is so startling.

He writes: “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 whole trend in recent years has been to bring even more market-type systems inside companies, from bonuses for meeting potentially counter-productive targets, to devolving budget authority away from the discretion of mangers and handing it to specialised departments.

Holmstrom’s conclusion implies the need for a pretty radical rethink of the way incentives are structured, in both the public and private sectors.

As published in City AM Wednesday 26th July 2017

Image: Lehman Brothers Headquarters by Sachab is licensed under CC by 2.0
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