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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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Believe it or not, Britain is getting happier

Believe it or not, Britain is getting happier

The dominant economic narrative in the UK is a pretty gloomy one just now.

True, employment is at a record high. But, counter the whingers and whiners, zero hours contracts and low pay proliferate.

The political discourse is full of the struggles of the JAMs – the Just About Managing The public sector moans about its pay. During the election, Labour played ruthlessly on the fears and anxieties of the elderly about inheritance and the value of pensions.

All in all, the picture seems bleak. But a much more positive vision is given by the Office for National Statistics (ONS) in its measure of well-being.

The Measuring National Well-being (MNW) programme was established in November 2010 under David Cameron. It is not without its critics. But if we take it at face value, compared to a year ago the country is definitely happier.

As the ONS puts it: “the latest update provides a broadly positive picture of life in the UK, with the majority of indicators either improving or staying the same over the one year period”.

There seems to be a bit of a glitch. The ONS boasts of using no fewer than 43 separate indicators to measure well-being. But they go on to state, in the very same sentence, that of these 43 measures, “15 improved, 18 stayed the same and two deteriorated, compared with one year earlier”. Perhaps the relevant statistician here received his or her basic training at the Diane Abbott School of Arithmetic.

No matter, it could be that some of the series have simply not been updated at all. Certainly, many people might not be too concerned to learn that “on environmental sustainability, the proportion of waste from households that was recycled fell over a one-year period, while remaining unchanged over the three-year period”.

But compared to a year previously, on some key indicators, as a nation we were more satisfied with our jobs, felt our health was better, and enjoyed our leisure time more.

This does not fit readily with political discussion recently in the mainstream media.

One possible reason is that many of the ONS measures rely on conventional survey techniques. These can take some time to carry out. So the ONS only release new data every six months, and the latest one was in April. The indicators could just be out of date.

However, a very similar story is told by a real-time analysis of Twitter data, which I have been carrying out with my UCL colleague Rickard Nyman since June 2016 (admittedly just for the London area).

We use advanced machine learning algorithms which essentially measure the sentiment level of a tweet as a whole, rather than relying on the now obsolete approach of looking for specific positive and negative words.

Sentiment in London started to rise quite sharply last autumn, dipped down slightly in April and May, but is now back up again.

Many conventional economic statistics are not really designed for the modern economy. So, despite, all its faults, the ONS well-being measure may be a step in the right direction, and regardless of what the media tells you, Britain may indeed be getting happier.

As published in City AM Wednesday 19th July 2017

Image: Happiness by Geralt is licensed under CC by 2.0
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Less austerity will always mean more tax

Less austerity will always mean more tax

There is a great deal of discussion, following the election, of relaxing or even abandoning austerity.

There is an equal amount of confusion about this, because the same word is being used to describe two quite separate concepts.

The consequences of the government changing its policy on austerity are dramatically different, depending on which one it is.

One meaning of the word is what we might call “social austerity”. From any given pot of money available to a government, its supporters believe that, in general, tax cuts should be promoted rather than public spending increased. Opponents argue that public spending as a result has become underfunded. Local councils, education, and the NHS all need more money.

Social austerity can be relieved, as even the DUP and some Conservatives argue, by increasing spending appropriately, and funding it by increases in taxation. This was an important aspect of Labour’s manifesto, and the tragedy at Grenfell Tower has intensified the discussion around it.

The main risk is purely political. Are voters really and truly willing to pay more tax, rather than just wanting someone else to pay it?

There are some potential adverse economic consequences if the policy of higher taxation is pushed too far. Former French President Francois Hollande’s 75 per cent tax rate led to several hundred thousand skilled young people leaving France, mainly for the UK. If companies are taxed too heavily, they may choose to locate to another country. Both skilled labour and capital are geographically mobile.

But, within reason, social austerity could be relaxed without perhaps too many fears in this direction.

“Economic austerity” is quite a different matter. Opponents of this want to increase the gap between government spending and tax receipts – the so-called fiscal deficit. This is funded by issuing government bonds. So the deficit in any given year goes up, and the outstanding stock of government debt also rises.

Any relaxation of social austerity is paid for by higher taxes now. Any relaxation of economic austerity is paid for by borrowing more now.

But the debt has to be repaid at some point, and the interest payments on it must be met. So taxes in the future will be higher. Either way, less austerity means more tax.

John Maynard Keynes himself made it very clear that increasing public spending at a time of full employment would simply lead to more inflation. There are areas of the country where there probably are people registered as unemployed who genuinely do want to work – the Welsh Valleys, for example. But the rest of the UK is at full employment.

The number of people in employment is at an all-time high, at 32m. This has risen by 2.8m since 2010. Meanwhile the unemployment rate has fallen from 7.9 per cent in 2010 to just 4.6 per cent today.

Any major fiscal stimulus to the economy now would simply bid up wages, leading to higher costs and higher inflation.

The public mood on social austerity may have shifted. But the case for economic austerity is stronger than it has ever been.

As published in City AM Wednesday 21st June 2017

Image: People’s assembly by Peter Damian is licensed under CC by 2.0
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Don’t fear robots taking your job – worry about them cutting your wages

Don’t fear robots taking your job – worry about them cutting your wages

Robots and artificial intelligence (AI) seem to be in the news all the time, and breakthroughs are announced regularly.

Last year, it was an AI programme which beat the world champion at Go, a game immensely more complex than chess. Now, in the austere American journal the Proceedings of the National Academy of Sciences, comes news of a big step forward in the task of getting AI programmes to think like humans.

Once we have learned to ride a bike or swim, we can remember how to do it, even after a lapse of many years. In the meantime, we will have learned many other skills as well.

This is straightforward for humans. But it has proved to be extremely difficult for AI. When an algorithm such as a neural network learns a new task, the challenge is to prevent it from “forgetting” how it solved previous ones, how to stop its knowledge from being overridden. A big team from Google’s Deep Mind and Imperial College London claims to have solved the problem.

Scientific progress such as this is uplifting and inspiring to read about. Yet there always seems to be a downside. On almost the same day as the Deep Mind paper was publicised, the latest in a series of gloomy reports about the impact of robots and AI in general on jobs was released by PwC.

“Up to around” 30 per cent of existing UK jobs are susceptible to automation by the early 2030s, intones the firm’s blog on the report. Many others have come up with similar sorts of numbers.

For economists, the question of the impact of AI on the labour market is not so much about the eventual impact on jobs. It is about the level of real wages at which jobs will continue to exist.

We have seen massive technological progress for over 200 years. Huge numbers of jobs have been destroyed, but many others have been created. Professor Len Shackleton of Buckingham University points out that, in the census of 1841, domestic servants made up one quarter of all jobs. Lots more were in what he calls the “horse economy”, for railways had scarcely begun. Almost all of these disappeared long ago. Now, we have behavioural pet therapists instead.

Bob Rowthorn at Cambridge and Stephen DeCanio at the University of California have both separately extended the standard model of economic growth to include a robot (AI) sector. DeCanio’s summary is almost a popular caricature of economists: “an increase in robotic labour can have either a positive or a negative effect on wages”. But both of these highly technical papers are serious attempts to grapple with trying to understand the circumstances in which AI will either raise or depress real wages. The answer is not obvious.

Apart from a brief surge of interest in the 1990s, the mainstream model of economic growth has not really been worked on since its inception in the 1950s. But it offers a powerful framework for understanding the impact of AI. Economists should start to focus on it again.

As published in City AM Wednesday 29th March 2017

Image: TOSY Ping Pong Playing Robot by Humanrobo is licensed under CC by 2.0
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Claims that a low tax, low regulation UK would be a disaster are rubbish

Claims that a low tax, low regulation UK would be a disaster are rubbish

Dame Minouche Shafik, Deputy Governor of the Bank of England, is leaving to become Director of the London School of Economics.  Last weekend, she gave her final interview wearing her Bank hat.

Shafik issued what was described in the media as a “thinly veiled warning” to the Chancellor, Phillip Hammond.  She stated that it was an “illusion” to believe that transforming the UK into a low tax, low regulation economy would give it a competitive advantage.  Indeed, Shafik went further and offered the opinion that such polices risked “hugely disastrous consequences for the economy”.

We have heard such prognostications before. In the run up to Brexit, the Treasury claimed that unemployment would rise by 500,000 by the end of 2016 in the event of a leave vote.  It actually fell.  The Bank signalled a similar opinion, that Brexit would be bad.  Doom and gloom was prophesised by the OECD and the IMF.

These institutions seem permeated by what we might call “Davos liberalism”, the sorts of opinions which would be congenial to George Clooney.  Of course clever, well meaning people can design policies and regulations which will benefit ordinary people, who after all cannot be expected to understand these things and might hold incorrect views!

Shafik claimed that the UK economy has lost 16 per cent of GDP relative to trend because of the financial crisis. Looser regulation would run the risk of an even bigger loss in future.  But the French economy is much more highly regulated than that of the UK.  It has lost at least 20 per cent of GDP relative to trend, some £80 billion more than the UK.  And France has at least 1 million more people who are unemployed.

Shortly after the Shafik statement, the government announced a major review of how the UK can become the world leader in artificial intelligence (AI) and robotics.  We can take with a pinch of salt the unnervingly precise estimate that £654 billion can be added to the British economy by 2035 if the growth potential of AI is achieved.  But we are clearly already a world leader in this area and, equally clearly, if we succeed in capitalising on this, GDP will be boosted by a very big number.

An essential ingredient for success is to attract the innovative thinkers who will push out the frontiers of the science, and the entrepreneurs who will help turn the ideas into practical tools.  It is of course possible that a system of high personal and corporate tax rates could succeed in attracting such people.  But it seems plausible that low tax rates are more likely to do the trick.

The high taxes imposed by President Hollande in France illustrate the point.  Young French people have flocked to the UK.  London is now the sixth largest French city in the world in terms of the population of native French speakers.

Our borders need to remain open to highly skilled individuals.  But we need policies which continue to attract them rather than drive them away.

Image: French President François Hollande by Foreign And Commonwealth Office is licensed under CC by 2.0
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The people of Burnley and Bradford have a point about the impact of immigration

The people of Burnley and Bradford have a point about the impact of immigration

The scenes as the migrant camp was cleared in Calais once again provoked bitter divisions in British society. Metropolitan luvvies and liberals tweeted their virtue and called for no restrictions on immigration. In more traditional areas, there is active resentment at the possibility of even further inflows of foreigners.

When New Labour decided in the early 2000s to allow large-scale immigration from new EU member states, we were seriously invited to believe that an influx of immigrants on a scale unprecedented in our history would only have positive economic effects and would boost economic growth.

Economics certainly suggests that an increase in labour supply can increase growth in output. But in the so-called neoclassical growth theory of economics, even in the post-endogenous variety made notorious by Ed Balls in his previous incarnation, by far the most important source of sustained growth is innovation.

A truly modern economy does not rely on more and more capital and labour being fuelled into the machinery of production. That was the old Soviet model.

A modern economy relies instead on innovation. So there are at best limited benefits from importing more and more labour. True, immigrants can bring new skills, found innovative new businesses and, as they tend to be younger, they can slow down the ageing of society. But they, too, get older eventually, so this is not a long-term solution.

The anxieties about immigration are not couched in the arcane language of economic theory. But a fuller appreciation of the theory does enable us to understand why people worry so much. Underlying the theory are the assumptions that supply and demand balance in labour markets, and that the prices of the various kinds of labour – in other words, wages – are set at appropriate levels.

A recent paper in the Journal of Economic Perspectives by Christian Dustmann and Uta Schönberg of University College London shows that large-scale migration in fact creates serious imbalances and mismatches in labour markets.

They provide extensive evidence of what economists call “downgrading”. “Downgrading” occurs when the position of immigrants in the labour market is systematically lower than the position of natives with similar education and experience levels. The authors calculate that, in Germany, recent immigrants have wages which are on average 17.9 per cent below those received by natives with similar age and skill profiles. In the US, the figure is 15.5 per cent and in the UK 12.9 per cent.

Dustmann and Schönberg illustrate the disruption which mass migration can cause even more starkly. They calculate that while 69.7 per cent of immigrants in their samples can be classed as high skilled in terms of their education, only 24.6 per cent are in high skilled jobs. In their dry terminology, this means that “immigrant arrivals to the United Kingdom were a supply shock in the market for low-skilled workers”.

Mass migration has not simply meant more people competing for jobs. It has meant that people with higher skill levels are competing for your job. In other words, the people of Burnley and Bradford have been right all along, and the metropolitan liberal elite completely wrong.

 

As published in CITY AM on Tuesday 1st November

Image: Calais Jungle by malachybrowne is licensed under CC by 2.0

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