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Scotland’s fiscal fantasy and the impact of an OUT vote

Scotland’s fiscal fantasy and the impact of an OUT vote

A short visit to the Highlands last week was refreshing. The scenery is just as spectacular as ever, and the people just as welcoming.  But elsewhere, the tectonic plates are shifting.  Last week, a televised debate took place amongst the political leaders contesting the elections to the Scottish Parliament in May.   It resembled a bidding contest in which each participant had to outdo the previous one in terms of boasting about how much public money they would spend. The excellent Ruth Davidson from the Conservatives was the conspicuous exception.

The sense of unreality was heightened when visiting the prosperous market towns of Perthshire, which would not be out of place in the Home Counties. Yet the polls suggest that they are about to vote for the SNP in large numbers, waiting to be fleeced to subsidise the less energetic denizens of the old industrial belt of Central Scotland.

Under the SNP government, the health service has deteriorated markedly and education has gone backwards. But it seems they will be returned to power with a large majority.  These problems are not believed to be the fault of the Scottish government but, in some mysterious way, the English.

If we plump for Brexit and North of the Border they do not, the strategy is to vote for independence and apply to be a member of the EU. But would the EU want them?  To put it in perspective, no one imagines that Portugal, say, is an important country which possesses clout in the European Commission.  Yet its population is over 10 million, and there are only 5 million Scots.

In addition, the public finances are shot to pieces. The Government and Expenditure Review Scotland announced earlier this month that the deficit in Scotland’s public finances is almost twice that of the UK as a whole.  Scotland’s net fiscal deficit was £16.7 billion, some 9.7 per cent of its GDP, compared with UK figures of £89 billion and 4.9 per cent.  The EU already has enough basket cases in the Mediterranean.  Why would the Germans welcome another country which they would have to bail out?

The Alice in Wonderland flavour is heightened by the posturing on tax. The SNP had been firmly committed to a top rate of income tax of 50p.  At the start of last week, Nicola Sturgeon pronounced that it was not possible.  Why?  She had just discovered that only 17,000 people in Scotland earned enough to pay it.  But these contribute no less than 14 per cent of the total take from income tax, and may simply move.  In the leader’s debate, she was once again in favour of the 50p rate, but only in the sense of St Augustine: “O Lord, make me chaste, but not just yet”.

Scotland epitomises the problems which all centre-Left governments face. They want high public spending, but the electorate will not pay the necessary tax.  They cannot finance it by issuing debt for very long.  The only solution is to find a kindly uncle who will pay, in this case the English.

As published in CITY AM on Wednesday 30th March 2016

Image: St Andrew’s Flag by Jim Bradbury is licensed under cc by 2.0

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The IMF is in trouble – and not just due to its poor forecasts

The IMF is in trouble – and not just due to its poor forecasts

The International Monetary Fund (IMF) has played a prominent role in world financial affairs in the post-Second World War period. In the 1950s and 1960s, its main purpose was to support the system of fixed exchange rates. Since then its activities have evolved to embrace developing economies and both banking and sovereign debt crises.

The top ranked mainstream Journal of Economic Perspectives is hardly the place we would expect to read a strong criticism of the IMF.  But in the latest issue, this is exactly what Barry Eichengreen of Berkeley and Ngaire Woods of Oxford have done.

They argue that the effectiveness of the IMF has many similarities with that of a football referee. A great deal depends upon whether the players and spectators perceive it as being competent and impartial.  Eichengreen and Woods level charges against the IMF on several counts.

Perhaps the most serious is its track record on monitoring the world economy and warning of potential crises. Keynes, who was a great enthusiast for creating the IMF, envisaged that a key role would be as a ‘blunt truth teller’.  Elected politicians may try and fudge and obfuscate, but the IMF should tell things how they really are.  It would be unrealistic to expect anyone to have anticipated and warned of the US sub-prime crisis, the global financial crisis and the Greek sovereign debt crisis.  But, as Eichengreen and Woods put it “the IMF batted 0 for 3 on these three events, which suggests that its capacity to highlight risks to stability leaves something to be desired”. Using a different analogy, if a doctor fails to spot the symptoms of a disease, why should we trust his proposed cure?

The IMF’s track record on cures for sovereign debt crises is the second point of criticism. Judging whether a debt burden is sustainable is another tricky problem.  But the IMF has in general erred by lending for too long and postponing the inevitable restructuring.  This allows private investors to cut their losses, creating the infamous ‘moral hazard’ problem.  If you think the IMF will allow private lenders to escape, you will be more inclined to make a loan which is otherwise too risky.  The Fund’s decision not to insist on Greek debt restructuring in 2010, allowing French and German banks to bail out, is a case in point.  The overall effect is that when the restructuring does come, it is more expensive and disruptive for the economy which the IMF is trying to save.

Their criticism of the governance structure of the IMF is much less effective. For example, major decisions require an 85 per cent vote.  America has 16 per cent of the votes and so has a veto, which they argue reduces the legitimacy of the IMF.  The problem with widening the franchise is that standards of behaviour vary enormously across the world.  FIFA is the example of what is likely to happen when every country has one vote.  So on this charge, at least, things are better left as they are.

As published in City AM on Wednesday 9th March 2016

Image: World Money by Japanexperterna.se is licensed under CC BY 2.0

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What game theory tells us about David Cameron’s EU deal

What game theory tells us about David Cameron’s EU deal

Game theory is the study of how rules and tactics affect outcomes, and it is pervasive in academic economics. The opening sentence of one of the economics courses at Cambridge pontificates: “Optimal decisions of economic agents depend on expectations of other agents’ actions”. Translated into English, this means that, for someone in a negotiating situation to get the best possible outcome, he or she needs to take account of how the other side might react. It sounds pretty obvious.

But the maths of game theory soon gets hair-raising. Would David Cameron have done better in Brussels if he had mainlined on straight economics at Cambridge rather than dallying with PPE at Oxford?

Game theory has had some spectacular successes. In 2000, the UK government held an auction for licences for the new 3G mobile phones spectrum. Economists Ken Binmore and Paul Klemperer were commissioned to design the structure. The auction raised no less than £22.5bn for the Treasury, five times more than had been expected, and it was widely described as the biggest ever auction. Binmore and Klemperer were more modest, pointing out that, adjusting for inflation, in 195 AD the sale of the entire Roman Empire by the Praetorian Guard netted more cash.

The theory was really useful in this context, where there was a limited number of players, all of them highly sophisticated companies such as Orange and Vodafone. The companies themselves employed teams of economists and had a lot of information about their rivals and the sorts of moves they might make.

But, somewhat paradoxically, when dealing with less rational decision-makers, knowledge of game theory can be a decided handicap. A well known game is the so-called Beauty Contest. The rules are simple. Each one of a group of people is invited to select their own confidential number between, say, zero and 100. The winner is the one who chooses the number closest to the number which is half (or some other fraction) of the average of all the numbers chosen.

If you assume everyone else is rational, as was reasonable in the spectrum auction, the number to choose is zero. The logic is: suppose the average is going to be 40, then I should choose 20. But this means everyone else will choose 20, so I should choose 10, and so on. The problem is that you do not know how sophisticated the other players are. The smart game theorist will lose every time by opting for zero when playing in real life. If you are playing with economists, by all means choose zero. But in experiment after experiment, most people do not, even in repeated plays of the game. To win, you have to judge the levels of rationality of your opponents.

At a political gathering in Brussels, this is self-evidently a challenging task. In addition, the complexity of the game makes formal analysis difficult. There are 28 players, each operating from a fluid set of motivations. Maybe the worldly wisdom of PPE at Oxford was the best training for Cameron after all.

As Published in CITY AM on Wednesday 24th February

Image: Backbenchers by brett jordan licensed under CC BY 2.0

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Why Julian Assange shows that only intelligent machines can be truly rational

Why Julian Assange shows that only intelligent machines can be truly rational

Is Julian Assange rational? There are no prizes for guessing the responses of most City A.M. readers to this question. He faces questioning over allegations (which he denies) in Sweden, and he claims that America will try to extradite him and put him in prison for a very long time. Assange has chosen instead to live within the confines of the Ecuadorian embassy in London for over three years.

On one level, economic theory can easily account for his behaviour. As a rational decision-maker, he estimated the potential costs and benefits of alternative courses of action, compared them to his preferences, and made what for him was the best possible decision. He probably considers the embassy to be preferable to life in a maximum security US jail. All standard economics textbook stuff: the costs of leaving the embassy outweigh the benefits.

But in forming his views on the costs and benefits, Assange had to make some quite difficult assessments of the likelihood of future events. What are the chances of him being charged by the Swedes? What is the probability of the Americans both trying and succeeding in getting him extradited? What is the likelihood of being found guilty if he is ever bundled over to the US? The answers are not obvious and there is no easy solution.

Even his ploy of getting the ludicrous United Nations panel to pronounce that he has been “arbitrarily detained” shows the inherent uncertainty around future events. Assange could have been almost certain that it would find in his favour. But it would have been hard for him to anticipate the ridicule with which this has been received, even among the liberal left. Making choices which involve future consequences is a much more difficult problem than simple economic choice theory might lead us to believe.

Assange could perhaps have benefited from the remarkable algorithm developed by a team at Google Deep Mind, and described in a paper in the top scientific journal Nature last month. Their work seems to be a very important step towards creating intelligent machines. The programme defeated the European Go champion 5-0. “So what?” you might say. But Go is an immensely harder problem than chess to attack by purely straightforward computational power. Success depends much more on a deep intuition of what does or does not constitute a good position. The astonishing feature of the algorithm is that it makes moves, in positions which have occurred previously in human games, which even the strongest human players simply cannot understand.

The implications spread far beyond the game of Go. The algorithm faced a challenging decision-making task. The precise consequences of a move cannot be computed. The optimal solution is so complex that it is infeasible to approximate. Yet the algorithm succeeded. Maybe humans have created the first truly rational thinker.

Paul Ormerod

As Published in City AM on Wednesday 10th January 2016

Image: Julian Assange by Global Panorama licensed under CC BY 2.0

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A Christmas competition with a difference…

A Christmas competition with a difference…

… and the chance to win a bottle of champagne.

For the prolonged holiday break, a quiz is appropriate. But one with a difference: not just questions, but comments to go with them. A prize of a bottle of champagne to the best answers – just email them to me.

The last couple of years have seen the rise of populist left-wing movements. Syriza in Greece is the most prominent example. Podemos in Spain polled well in the general election in that country on Sunday, securing just over 20 per cent of the vote. In neighbouring Portugal, the ruling conservatives were displaced this year after internal constitutional wrangles involving a motley alliance of leftists. Even in the United States, Bernie Sanders, the senator who openly proclaims himself a socialist, is attracting support in the Democratic primaries. Socialist incumbents were re-elected last month in Seattle, the home of Microsoft.

Many people have serious doubts about the practical viability of the programmes of these parties. But criticism is not limited to the right. The Labour Prime Minister James Callaghan notoriously pronounced at the height of the economic crisis of the 1970s that “we used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, in so far as it ever did exist”. But which famous socialist went even further and once said, and where: “certain comrades deny the objective validity of the laws of political economy under socialism. These comrades are profoundly mistaken”?

Thinking of workers’ rights, Sports Direct has come under intense criticism this month for the alleged way in which it treats its staff. The chairman of the Public Accounts Committee, Meg Hillier MP, has called for an HMRC investigation into low pay and the “humiliating and demeaning” working conditions at the company. Whatever the truth of the allegations (and Sports Direct has insisted that it is acting within the law), working in a warehouse on low pay isn’t much fun at the best of times. But things could be worse. Where and when could workers be sent to jail for being late for work twice within a single year and with what offence were they charged?

On a lighter note, England is in action in the first Test against South Africa in Durban beginning on Boxing Day. Brian Statham, the great England fast bowler (and great Lancastrian) wrote over 50 years ago that he expected all the batting records to end up eventually in Asia. It looks like a good prediction. The highest all-time partnerships for the first five wickets are now held by Indians, Pakistanis and Sri Lankans, including the highest of all, the 624 for Sri Lanka’s third wicket against South Africa in 2006.

But our boys still hold one truly outstanding record. Jim Laker’s match statistics of 19 wickets for 90 runs against Australia in 1956 is still by far the best bowling return, not just in Tests but in any first class match. As an approximation, what is the probability that this will be beaten in 2016? Extra marks for your reasons why. Happy Christmas.

Paul Ormerod

As published in City AM on Wednesday 23rd December

Image: Champagne by Sam Howzit licensed under CC BY 2.0

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Valuing the Future. Why Climate Change Agreement is Hard

Valuing the Future.  Why Climate Change Agreement is Hard

The two week long Paris conference on climate change seems to drag on interminably.  There are obviously many reasons why such summits find it difficult to reach meaningful agreements.  But a fundamental one is that the electorates of the West are being asked to bear substantial costs right here and now, in return for a stream of benefits which will only become apparent well into the future.  Closer to home, we see similar issues with major infrastructure projects such as the new airport runway in London and the high speed rail project HS2.  We pay for them upfront, and the gains appear later.

Economists have a way of analysing this problem.  They even, as usual, have their own special phrase to describe it, namely ‘social time preference’.  The Treasury publishes the Green Book, which describes the methodology to be used in the appraisal and evaluation of the use of public funds in investment projects.    A substantial part of it is devoted to how to compare the value of costs incurred now and benefits received in the future.  If you are offered the choice between being given £100 today or £100 next year (inflation adjusted), you will naturally prefer to have the money in your hand immediately.  But how much more would you need to be offered to persuade you to wait?

The Treasury calculates, citing some impressive academic work, that the rate to be used on public projects is 3.5 per cent a year.  So if an investment yields a benefit of £103.50 next year, this is essentially the equivalent of receiving £100 today.  The impact cumulates strongly, so that a benefit of £100 in twenty years’ time is only the same as £50 today.  The numbers for Crossrail, for example, were ground through the same process, and came out positive.  The scheme was calculated to be worth building despite the high initial costs involved in money and disruption.

In the case of climate change, the predicted benefits of taking action now stretch hundreds of years into the future.  But the impact of the social time preference rate is ruthless.  Very long term benefits become worth more or less nothing when translated into today’s value.  Yet people in the West are being asked to bear the costs now.

This was the problem faced by Lord Nicholas Stern in his famous review written for Gordon Brown in 2006, the Economics of Climate Change.  His advocacy of spending 1 per cent of the world’s GDP immediately to combat climate change has been very influential.  But to get the numbers to stack up, he had to set the rate of social time preference close to zero.

Martin Weitzman of Harvard wrote an important paper nearly 20 years ago arguing that the discount rate should be reduced for the ‘far distant’ future.  The Treasury do acknowledge this, and their 3.5 per cent rate only applies for the next 30 years.  Even so the basic dilemma remains.  Pay now, and your grandchildren might benefit.  No wonder democratic politicians struggle to sell the idea.

As published in City AM on Wednesday 9th December

Image: To change everything we need everyone by Alisdare Hickson licensed under CC by 2.0. 

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