Tuesday, 30 December 2008


The Ponzi pub crawl (via FT Alphaville and Dan Hon's blog)

Economic worldviews

To maintain an insight into the economic news and a reliable interpretation of it, you can do one of two things:
  1. Pick someone (or a few related people) that you trust and read everything they write. Your choice may be Paul Krugman, Mark Thoma and Brad DeLong if you're broadly left-wing; or Greg Mankiw and Arnold Kling if you're rightish. Or shall I replace 'left' and 'right' with 'Neo-Keynesian' and 'Monetarist-Austrian'. This has the advantage of providing a (fairly) consistent viewpoint and lots of additional evidence to confirm that it's true.
  2. Read both, try to reconcile the differing viewpoints on the same issues and figure out which one is correct - or even if the truth is somewhere in between or outside of both.
Needless to say, the second is more challenging and perhaps leads to more accurate views - but of course there is a much higher cognitive load. And you still have to do some kind of filtering - for example do you also read all the political and sociological viewpoints as well as the economic ones? And just within economics, there are more extreme views - Marxists, libertarians and even Marxist libertarians to keep track of.

It's much more efficient to decide which worldview is correct and then ignore the others from then on. Maybe with an occasional review to make sure you are still right. But is it worth it? What level of rational ignorance can you afford?

Monday, 22 December 2008

Powers and strategies for central banks

Robert Peston is looking back at the powers that the Bank of England should have had to help forestall the asset price bubble of the last few years. It's an interesting angle, because it also sheds some light on the question of what powers the Bank should have now.

He correctly points out that interest rates are too blunt a lever. When a central bank wants to be able to achieve multiple objectives - to do more than just target the inflation rate - it needs multiple tools.

Interest rates are a two-sided tool - they can be raised in peak times to moderate activity, and cut in a recession to revive it. It's instructive to ask of any proposed solution: "does it work in reverse?" to see whether it meets this standard of having symmetrical power.

The solution Peston discusses is adjusting the capital requirements of banks. In an asset boom, capital reserve requirements would be increased to reduce banks' ability or inclination to lend against assets. This would control prices.

The drawback of this solution is that it's hard to imagine us wanting to reduce capital requirements in a situation like today's. There are certainly some hints that banks should relax their criteria a little, lend more and therefore reduce the amount of capital they hold during the next year. But it's commercially and politically tricky to imagine the banks actually doing this.

An alternative solution which I'm exploring is to give central banks the ability to influence not just the amount of debt in the economy but also the amount of equity. If the Fed had the option to directly stimulate investment, this would help to address one of the problems in today's economy - that productive investment is potentially threatened. It could do this by making equity investment in certain private companies.

Government doesn't have a great track record of being an equity holder, so this would need to be done at arms-length through the central bank or another body. But if such a body did exist, it could potentially short equity assets in a price bubble (such as in 2000) as an automatic stabiliser, just as interest rates can be raised or lowered according to the projected inflation rate.

If the asset in question is property - as in 2005-2007 - then trading in debt instruments seems to have some effect. Currently we're seeing banks buying property-linked debt in the form of mortgage-backed securities, which should provide some support to the property market. Could we imagine them selling such debt in a boom? Quite possibly.

We'll never engineer a situation where each variable in the economy - consumer prices, asset prices, investment rates, saving rates - can be independently tweaked by adjusting a single dial. But mathematically, it makes sense that the number of variables to control is the same as the number of tools available to manipulate. The better our models are, the better we can predict which tool to adjust and by how much; but there's always going to be some trial and error.

Saturday, 20 December 2008

Theories of one versus many

One of the causes of the fallacy referred to in my last post is that people forget there's a difference between one and many.

It may be true that it's better for me to go home at 7.30 than 5.30, because the tube is quieter. It does not follow that it's better for everyone to go home at 7.30.

And similarly, just because I can defer my consumption from this year to next year by saving, does not mean everyone can.

This is because I am embedded in a large system where my actions can be counterbalanced by others, and this enables us both to specialise. Specialisation normally refers to production but can apply to consumption too - you specialise in consuming an egg today, and I specialise in consuming one tomorrow; therefore one chicken can feed us both.

Interestingly, this leads to the insight that some choices are asymmetrical in time. If everyone prefers to consume now instead of tomorrow, today's production will increase, though maybe not enough for everyone. Those who get a share of today's production will be satisfied, and many of those who don't will probably settle for tomorrow instead. Total production across both days may increase or at least will not decrease substantially.

On the other hand, if everyone decides to consume tomorrow instead of today, today's production will collapse and when we all show up at the factory tomorrow, the machines can't run fast enough to satisfy us all. Total production (and satisfaction) across both days will be significantly reduced.

Some goods can be held in stock which partly solves this problem; but others (for example most services) cannot.

Just to be really concrete: let's imagine we want a massage. If we all show up looking for a massage today and there's only one masseur, one of us will just have to come back tomorrow. Perhaps the masseur will work more hours today, which will let the majority of customers have their massage today - and perhaps when there's spare time tomorrow someone will come back for a second one.

If we all decide to save our money today and show up tomorrow instead, the masseur's time has been wasted today and tomorrow it is too late - someone is going to go without a backrub.

Clearly this analysis can be made more sophisticated: the masseur's unexpected leisure time may have some value to him; more generally, net utility is not just given by consumer benefit but by that benefit minus the disutility of the supplier; and in the second scenario, some customers will just come back on a third day, as the real world is open-ended in time.

But the basic lesson remains: if everyone tries to reduce their consumption in the short term, some amount of consumer welfare is lost forever. An economic resource sits idle and the total amount of massages in the world shrinks. Alternatively, if everyone tries instead to increase short-term consumption, the total amount of consumer welfare increases.

This is the fundamental argument for a fiscal stimulus. Total utility over all time is higher if demand is shifted to an earlier date, because utilisation rates of resources increases.

I would expect this argument to be modified slightly if investment substitutes for consumption - if nobody shows up on day one, does the masseur spend the time training in better massage techniques or building a better massage table? I don't, however, believe that is what happens in a realistic situation. Instead, higher consumption demand will stimulate investment - better that an entrepreneurial carpenter builds the new table while the masseur is busy providing massages. I admit, though, that this is speculative and will look for some data to test the hypothesis.

Borrowing from the future

"The crisis is caused by excessive debt"
"We have borrowed prosperity from our grandchildren - transferring consumption through time"

Economic illiteracy, all of it. We can only consume today what we can produce today. Was your iPod made in a factory built in 2016?

Monetary transfers (i.e. debt) cannot create new goods or services. You cannot transfer consumption from the future.

But it is a common fallacy to think you can. There are three kernels of truth in this viewpoint, and some of them give us a clue to the real answer:
  • Individuals can transfer consumption from the future to the present by borrowing money from other individuals. But there is an entry on the other side of this ledger - the lender is transferring their own consumption from present to future. The net effect on the whole system is nil.
  • Countries can do the same - if America (or American people) borrows money from China (or Chinese people), they can move today's consumption from China to the US in return for moving tomorrow's consumption from the US to China (assuming China can enforce this promise in the future). But the whole world cannot.
  • In the long run, debt (and especially writeoffs of debt) can change incentives, and this could affect the ultimate capacity of the economy. But this fact does not tell us what the optimal level of debt is, or how or by whom it should be held. Perhaps 300% of GDP is a better level of debt than 100%, and either is probably preferable to zero. Debt does give a way for different production and consumption choices to be made than would be available without debt, and this can enhance the efficiency of the economy (see the Megan McArdle link below).
The closest this viewpoint comes to reality is that it hints at recognising a fundamental truth: consumption today may be at the expense of investment today, which will reduce consumption tomorrow. Investment is the only real way of "transferring" consumption through time, and money is just a way to account for whose consumption happens when.

But debt does not intrinsically favour either investment or consumption. Debt is not the problem here. Productive (i.e. nonresidential) investment did not grow strongly between 2001-07 in Western economies, though it did exceed the rate of economic growth and was immense in China. I have not been able to find a worldwide figure so any contributions would be welcome.

However, even reduced investment does not immediately cause reduced consumption - it just shrinks the capital base on which future consumption depends. So this is not the proximate cause of the current recession.

A deep recession such as we appear to have now is caused by two related phenomena:
  • a coordination problem between the component parts of the economy
  • a confidence problem which results in self-feeding reduction in demand and utilisation of capacity
If we can solve these problems with debt, then debt is a good solution. The only long-term danger for the world economy is that our solutions reduce productive investment; but there is no reason to suppose that they will. The other danger is that some economies or governments become indebted and others do not; this could force a reduction in investment or consumption by the debtors, to the benefit of creditors. Which is all part of the argument for coordinated fiscal stimulus.

Bailouts for writers but not for cars

More on bailouts:

Paul Greenberg in the New York Times says we should bail out writers. Of course, he doesn't analyse the economics properly - but what should we expect - he's a writer. No doubt it would be useful to reduce the oversupply in the writing market; but should we also then be paying bloggers not to post? Is this how farm subsidies got started?

And Richard Posner follows up an earlier article about the US automotive bailout arguing that the three big US car companies are fundamentally insolvent but it is better to support them another couple of years and then let them go bust. I sympathised initially with this view but the comments on that posting - mostly taking the opposing view - are actually quite persuasive. If the companies are going to go bust anyway, maybe now is the time to get the bad news out of the way; rather than wait till a fragile confidence is taking hold and then shatter it again.

Posner's argument is (I think rightly) psychological; but so is the counterargument. The dilemma is: will too much bad news at once really destroy people's faith in the economy; or will spreading the bad news out over a longer period prolong the recession and waste the opportunity to create an upward-sloping confidence curve sooner.

Friday, 19 December 2008

Who and how to rescue

So Jaguar might be "rescued" by the UK government. Robert Peston gives a summary of some of the arguments. Even more quickly, here they are:
  • The company is not able to refinance its loans, but is still fundamentally a good business
  • 15,000 people are employed by Jaguar and up to 60,000 second-order jobs are dependent on it
  • It is one of the remaining UK-based manufacturers with substantial ongoing R&D
  • It is owned by Tata, the (profitable) Indian multinational
  • There's a risk of moral hazard - if Tata can get finance for its UK operations like this, why wouldn't other companies do it and use their scarce private funds elsewhere?
There is no doubt that Peter Mandelson is aware of these arguments - he makes it pretty clear in the interview with Robert Peston. What other criteria or safeguards might he use to make sure that public money is genuinely providing a public good which would not be financed by the private sector; and that it gets a positive return?

  1. Finance provided on terms profitable for the government. If Jaguar can't get finance elsewhere, the government can demand a good price.
  2. Equity in return for the investment. This will disincentivise companies from going to the government unless they have little or no other choice.
  3. Viability of the business. There's no point lending to a company which is going to fail a year later anyway.
  4. An estimate of multiplier effect. It does seem that car companies always advertise their huge multipliers - the suppliers and employees who will be laid off, and the devastation wrought on Midlands towns which lose their anchor employers. It's true that a local economy highly centred around one employer may suffer its own mini-depression if that company disappears; an equivalent job loss dispersed around the country will more easily be absorbed by other employers. This argues for a rescue of Jaguar which would not have applied to Woolworths, and it argues for rescues in times of recession which would not be appropriate in boom times.
  5. An estimate of positive externalities from the company's operations. Jaguar apparently has extensive R&D operations, which arguably have a knowledge spillover effect that helps other businesses to be more productive.
  6. A demonstration of why we should ignore the signal of private lending being unavailable. If Jaguar can't borrow elsewhere, that tells us something. If it means Jaguar is a hopeless case, the government should not lend either. If it simply means that external problems in the finance markets - illiquidity or friction - has stopped credit being available even for a good company, then that might be different.
  7. Benefits to both supply and demand. For example if people want to buy Jaguars, and Jaguar wants to make them, but both are stymied by lack of credit, then government intervention would support both sides of the economy.
The first three criteria would apply to any private investment. The last four are specific to the government, and may make a sufficient case for an investment which would not happen privately.

How does Jaguar stack up against these criteria? 1 and 2 are under the control of the government and can be incorporated into any offer it might make. 3 is probably a yes - the company looks viable on balance.

4 and 5 are probably yeses; 6 and 7 would require further research but I would certainly not assume a yes.

Overall then, there is not yet a clear-cut case for rescue (based on the information I have) but with further work, such a case might develop. I may revisit this posting and add further criteria.

Two items I did not add (despite many of the comments on Robert Peston's article linked above):
  • Jaguar is owned by a foreign company - completely irrelevant. The government needs to protect itself by criteria 1 and 2 above, to dissuade any private concern from illicitly taking advantage of public funding. Whether the company has Indian or British shareholders or is profitable - is beside the point.
  • Jaguar cars are probably not the most environmentally friendly on the market. Well, the market needs to be guided by carbon taxes or other mechanisms to make sure that buyers of Jaguars are willing to pay the cost of their pollution. As long as that happens, this factor once again becomes irrelevant.

A hidden theme in four parts

Lots to write about today, but not much time. Here are the topics. See if you can spot the connection:
  1. The myth of hollowing-out. Frank Furedi (see Tuesday's post) gave an interesting talk but I still see this as the main flaw in his argument. I have started to work on some more concrete theory to help quantify the contribution the knowledge economy makes to consumer benefit.
  2. Government intervention/rescue of businesses. Jaguar in particular - definitely a firm on the "productive" side of Furedi's distinction - is a candidate for some kind of financial assistance. Can government choose the right businesses to rescue or set specific criteria for doing so? What should it get in return?
  3. Zero interest rates. At some point it isn't the price of money that stops people borrowing or lending; it's the challenge of paying it back. What else can the state do other than print money?
  4. Related topic: what should people do with their fiscal stimulus? More to the point, what should government want them to do? Save, spend or invest? How can we encourage them to make the choice that's best for the economy?
That's probably enough for now. I'll be completing these posts over the next 12-15 hours and try to bring them together in a final recommendation after that.

Tuesday, 16 December 2008

Economic misconceptions

This evening I am going to see a lecture by Frank Furedi, "The Political Significance of the Economic Crisis". It's at the LSE but despite that, there doesn't seem to be a lot of economics in it.

Here is Prof. Furedi's article in Spiked in which he outlines the argument that I imagine he'll discuss tonight.

A couple of sentences really put me on edge:

Without the securitisation and financialisation of the economy, the accumulation of capital and a sense of prosperity could not have been maintained in Britain and the US. Outwardly it appeared that economies such as Britain’s and America’s were doing well during the past decade.

By the time of the credit crunch, the financial sector accounted for around 30 per cent of the British economy. On both sides of the Atlantic, industry continued to decline.

This is another variant of the myth that our economy is based on some kind of pyramid scheme where everyone thinks they are making something but actually nobody is.

Some responses to this:
  1. The facts are: in the US and UK over the last 15 years the output of goods and services in the economy has grown by around 50%. If we have a 5% downturn now, at the upper end of estimates, we're still far better off than before.
  2. The financial sector does not represent 30% of the British economy but 7-8% (and only 4% of employment). Those figures are from Goldman Sachs, but other estimates are similar or even smaller. The 30% figure represents "financial and business services" which includes a myriad of other things such as software development, the law, accounting, consultancy and marketing. Maybe these services don't directly contribute to consumer utility but they are an essential part in enabling consumers to get the goods and services that they want.
  3. Are people so easily fooled that they think they are getting better off when actually it isn't true?
  4. If the population is now getting more of its happiness from services (massages, visits to restaurants, cinemas) than from cars, coal and chocolate, what's wrong with that? There is nothing illegitimate about non-material benefits. Indeed this is one reason that economic growth in developed countries now uses far less carbon than it used to. That's a good thing.
I certainly don't think the growth of financial services in recent years has solved all our problems or even that it results in the ideal allocation of resources; but it's not a bad try.

I will report back after the lecture - perhaps some of these issues will come up.

Making perfect sense

Robert Peston again - the government is now:

...excluding from the calculation of the risk premium payable to taxpayers the great surge in the perceived riskiness of banks that took place in September and October.

In effect, the Treasury has converted the Credit Guarantee Scheme from an insurance policy, which was designed to provide comfort to markets that banks wouldn't collapse for want of access to funding, into a new and substantial source of finance for banks, to replace the funds that have disappeared with the de facto closure of wholesale markets.

Well, kind of. There's a good argument that the banks are much less risky now - not least because they have been recapitalised by the taxpayer. This in turn justifies a lower premium.

Indeed, the most present risk to the banks was not that they would fundamentally become insolvent through writeoffs. It was that they would be unable to either refinance their short-term borrowings or call in their long-term loans. Securitisation used to allow them to sell the long-term loans if they needed money, but as Robert says that market is now closed.

But if the banks can get long-term borrowing from the government, this risk goes away. Once again that justifies a reduction in premiums.

Negatives of this:
  1. The short/long risk is transferred to the government - which in theory may have its own challenges in raising long-term debt. But in extremis, the government can print money to finance this - it should never have to default (the UK government is in the fortunate position of both borrowing and lending in pounds, at least for now).
  2. It creates an increase in the amount of short-term money available in the economy - wholesale lenders which would previously have lent to banks can now lend in the corporate or consumer markets instead. In theory this is a distortion to the normal structure of the money markets but with everything else that's happening, it just cancels out a distortion that's already happening.
And don't get the impression that the government is only displacing foreign lenders. Over 75% of debt owed by UK banks, companies and individuals is owed to others within the UK. About £309 billion is net foreign debt, but our foreign assets still make us more money than we pay out on the debt. Surprised?

Monday, 15 December 2008

The economics of copyright expiry

I plan to write a lot more about this in the coming weeks. But for now I want to respond to Andrew Gowers' and Andy Burnham's debate in the FT.

Reading either article in isolation, you might be convinced. On the one hand by Gowers' assertion that extending copyright creates no economic incentive to create new work, and incurs administrative costs out of proportion with the benefit to the owners. On the other, by Burnham's sympathetic picture of retired vegan musicians losing their sole income and seeing their work abused in foie gras advertisements.

Maybe I'm betraying my inclination in this argument. But despite broadly agreeing with Gowers on this, I do understand the political logic and compassionate aspect of Burnham's position.

Economically it's a tricky issue, and Burnham is actually on the side of economic orthodoxy. Economists tend to consider that property rights are an incentive for people to create, husband and market their assets. They also assume that transaction costs are minor, or can be reduced to the point where they don't matter; so that property is allocated to those who can generate the most value from it.

However, how would you go about tracking down the various owners of a 60-year-old track and negotiating compensation with them in order to use a sample in a club remix? Just imagine the logistics. And then work out what return you would make from the remix. It would never be worth it.

So, contrary to common economic assumptions, the transaction costs in many cases probably outweigh the economic return from using the property. This makes property rights an inefficient way to generate economic value.

The case of publicly owned geographical data is another prominent recent example of this phenomenon. There is a campaign to release Ordnance Survey-owned data into the public domain. The premise is that it could generate up to £1 billion of economic value if available for use without the restrictions applied by Ordnance Survey (which earns only around £100 million under the current ownership rules and business model).

Note the mooted "death of the classical music industry" mentioned at Marginal Revolution. Under this scenario, the vast majority of recordings will never be heard or re-released because digital rights are owned by so many people that it is prohibitive to incur the cost of clearing them.

But it seems that the majority of Andy Burnham's objectives could be achieved without the need to extend copyright. A continued income to older musicians can be provided without restricting individual usage of individual tracks. A reasonable levy on either the sale of certain digital technology, the commercial release or performance of music, or simply a tax-financed fund, would substitute for all royalty revenue that would otherwise be earned in this way.

In order to make a good policy decision we would need to understand the amount of money at stake. I can't imagine we are talking about more than a few million pounds a year - the PPL now collects just under £100 million a year for all recordings, of which the vast majority must be from the last fifty years.

Another figure given by Charlie McCreevy recently is an average of €2,000 per musician per year (I could convert it into pounds but it's a bit of an empty gesture these days). One could imagine that there may be as many as a few thousand session musicians in the UK of the relevant age, but not many more.

There are many economic situations where we give up perfect equity in return for much greater efficiency: a fixed price for all first-class stamps, whether sending 5 miles or 500; publicly funded entry to museums and art galleries; a fixed £25/month cable TV package covering 40 channels, regardless of which ones you watch. In all these cases, the extra cost of administering the exact apportionment of charges would far outweigh the benefits of improved incentives.

It looks to me like recorded music - at least of a certain age - obeys the same rule. I certainly feel there must be a more rigorously demonstrable, less ad hoc formula than "50 years later", and this must apply also to the distribution of money from any fund that's set up (should it be based on the musician's earnings in the 49th year?). Much more to explore on this in future postings.

Reducing the capital needs of European companies

According to Robert Peston, European corporations are going to have to repay about $1 trillion of debt in 2009. $800 billion is owed by financial companies and $200 billion by non-financial, which provides some reassurance - no doubt much of the financial debt is owed to other financial companies and some will net out.

But without further huge government guarantees (and we might get them anyway) I think we are going to have to restructure some businesses to operate on less capital.

Here is a list of ways in which they may be able to do that:

  1. Change in revenue and pricing models. One example is a method called structured pricing, where payment for goods and services is made after the fact based on the value they create. I have developed a model which shows that this can reduce the capital requirements of the economy by around 7-10%; I will be posting a more detailed paper on this within the next few weeks. Of course there are many other examples of how to do this, but it is definitely achievable.
  2. Greater efficiency and faster turnaround. One of the main reasons to hold capital is to cater for delays in the supply chain. With cheap money available over the last few years, technological progress has not been directed towards this end. Much economic effort in the coming years will be diverted into creating more just-in-time structures which will minimise the need for working capital.
  3. Greater use of equity instead of cash. This could be a very healthy change - for example increasing employee share participation in companies is likely to be good for motivation and give people a longer-term, more meaningful relationship with their employers. Generally increasing the proportion of equity investment relative to debt makes companies less risky (though possibly less profitable).
Your ideas are welcome - please leave a comment with your suggestions of how to create a low-capital economy.

Update: According to the FT, companies worldwide are sharply reducing their inventory levels; this makes perfect sense in the above context, although the article puts a slightly different interpretation on it.

Possibly supporting this argument or possibly not, another FT article points out that European companies have successfully issued record volumes of bonds in the last two months, including substantial bank debt issued without government guarantee. Maybe next year won't be so bad after all.

Sunday, 14 December 2008

How much SHOULD Blagojevich have asked for?

Rod Blagojevich has been caught exploiting something given to him by the Illinois legislature – his right to appoint the state’s next senator. But isn’t he just doing what economics orthodoxy says he should – making sure the position goes to whoever can create most value from it?

Ronald Coase demonstrated that the seat will go to the person who values it most in any case – the only question is who has the property rights and therefore who will get paid for it? Now, Coase does exclude transaction costs from his analysis and there is certainly the potential for Blagojevich to incur a very high cost for this transaction. But in principle, selling the seat is not (economically) a sin. The doubtful aspect of what he has done is to appropriate the benefits of selling the seat to himself, instead of letting them be distributed to the media and electorate of Illinois via the campaigning process.

But what I want to know is: how smart was Blagojevich? How much is a Senate seat worth and was he going to get himself the right price?

There are various ways to answer this question.

1. Discounted cashflow. 

We can analyse the expected value of the seat by looking at the salary of a US Senator, the expected length of term, and the other benefits that accrue to the holder of the office, and comparing them to the expected earnings that the holder would have achieved without the appointment. A senator is paid $169,300 per annum. Fully 62% of appointed senators lose their position or do not stand at the next election and the average length of service for senators elected in the second half of the 20th century is 12.5 years (interestingly, this compares to only 8.5 years for the first half). So the expected length of term is around 62% of 2 years plus 38% of 12.5 years – a shade under six years. Working out an appropriate discount rate is tough in the current market but choosing 2.45% (the price of a 10-year Treasury bill and reasonably close to the long-run GDP deflator) we get a figure of about $955,000 dollars for discounted salary.

We can compare this to the candidate’s existing expected earnings over the same period – some candidates were members of Congress (with the same salary as a senator), one was a state senator ($67,833) and one a lawyer (probably earning more than a senator already). The state senator (Emil Jones) is 73, but it isn’t unusual for senators to stay in office well into their eighties, so I don’t adjust the expected length of term for him. The incremental salary for him therefore is $572,000 assuming he would have otherwise retained his state senate seat. As it happens, he had actually announced his retirement prior to recent events, so the value to him of the seat is closer to the $955,000 figure.

However salary is not the only material value of a seat in the Senate. The first and less significant benefit is pension. The discounted value of pension rights are heavily dependent on the age of the candidate and their likely length of service, but these are funded primarily by deductions from salary, so the value in addition to the salary figure is not substantial (the Club for Growth does ascribe a high value of $1.8 million to pension rights but they have taken account of neither how these are funded nor the opportunity cost of existing pension rights).

More significant is enhanced earnings after leaving politics. A recent paper by Eggers and Hainmueller analyses the value of office to British Members of Parliament and concludes that Conservative members earn approximately an additional £1 million during their lifetime compared with equivalent people who were not elected – with a cleverly chosen control group of people who were narrowly defeated in parliamentary elections. Labour Party members do not seem to benefit the same effect, which the authors ascribe to greater organisation and control by trade unions. Similarly, Diermeier, Keane and Merlo (2005) find that the value to a sitting US Senator of retaining a seat is around $1.6 million including monetary and non-monetary benefits. They do not calculate the value of the seat to a non-senator, so there is likely to be a value already gained by initial election to the Senate which is not reflected in this figure. Based on the doubling of lifetime wealth estimated in E&H’s paper, we could hypothesise a doubling of post-political salary for the average senator. DKM derive a 17% increase as a result of the first re-election, giving a 70% increase from initial election. Thus the $1.6 million value in situ is dwarfed by the approximately $6.5 million value of the first election. Intuitively this seems reasonable – the prestige of having a Senator on your board is arguably more important than how many terms they have served.

Again we may want to reduce this based on an “appointment discount” where an appointed senator who loses their seat at the next special election will not receive all the benefits. We have little data to base this on, but if the seat value is reduced by, say, two thirds for those who are not re-elected, the net value of the seat is $3.8 million.

2. Market price.

We believe that one candidate was offering $500,000, another was offering $1 million and a third was offering “nothing but appreciation”. We don’t know what the President-Elect’s appreciation is worth, but apparently it’s less than $1 million. Given that there is a monopoly supplier of this position and a limited number (1) of the commodity available, the highest price offered by any buyer is the one that will clear the market. So on this method, $1 million is the answer.

However, other Senate candidates have paid much more for their elections – for example Jon Corzine for example spent about $63 million of his own money to achieve election to the Senate. Again we might reduce this by the “appointment discount” leaving about $24 million.

That fee was perhaps paid at a peak in the Senatorial market, and by a non-price sensitive buyer. This year, according to the New York Times, around $100 million was spent on the 35 Senate races – a combined average of $3 million per election for both candidates (the average Democrat spent $2 million to $1 million for the Republican). However only about 12 races were genuinely competitive, so spending in safe states was likely to be lower. Therefore the market price of a new seat is up to three times higher than the $2 million Democratic spend.

3. Marginal returns. 

Finally we need to consider the marginal value of this one seat, given that all the others except Minnesota have already been allocated. With the Democrats holding the presidency and controlling the House, the 60-seat threshold in the Senate is crucial. A senator controlled by, say, the banking or automotive industry could extract immense rents from the state by voting for or against cloture on a bailout vote. In the current environment there are likely to be hundreds more opportunities in the next two years alone; re-election is virtually an afterthought in this context.

With $350 billion of the TARP still to be released by Congress, a $15-100 billion automotive bailout in the works, and a $500-600 billion fiscal stimulus to be designed and released, the influence of a swing senator surely must be worth tens of billions of dollars. Just how “swing” this senator will be depends on the result of the ongoing recount and ballot challenges in Minnesota. Recent rulings favourable to Franken, the Democrat in that race, make it more likely he will win and increase the weighted value of the Illinois seat. Imagine Blagojevich offered it to a Republican! This measure surely gives us the highest of the three values – I will conservatively estimate it at $1 billion.

The price

What was Blagojevich’s asking price? The market had not yet cleared, so presumably Blagojevich wanted more for the position than he had so far been offered.

Reportedly he wanted his wife appointed as head of a newly established charity which would pay her $100-150,000 per annum. No doubt she has an existing economic value so this would not be pure additional income. But it seems plausible this job was meant to be a sinecure and not a full-time post – otherwise why would he be so keen on it? If we take the average of $125,000 and discount it by a third to reflect the opportunity cost of taking the position, and assume a ten-year lifetime discounted as above, the price was $746,000.

Alternatively, he was looking for an appointment to cabinet as Secretary for Health and Human Services. This has a salary of $181,300 which discounted over a four-year period is worth around $737,000.

Given the figure of $1 million being discussed as the amount one of the candidates could “raise”, it seems likely that this discount represents the transaction cost of receiving the payment in a way that would provoke less suspicion.

However, why the huge discount to the potential multi-billion dollar value of the seat under the “marginal returns” scenario? Some possible explanations:

  1. The discount for risk of discovery is bigger than we think. It is estimated that the discount on fencing of shoplifted items, for comparison, is around 90%. Unique items such as major artworks tend not to be sold but instead ransomed (seemingly 5-10% of face value is again typical); so it would perhaps have been an option for Blagojevich to threaten to appoint a Republican or other “unacceptable” person unless rewarded.
  2. The property right is not defensible. The Illinois legislature is now deciding whether to strip the governor of his power to appoint; the Senate itself can expel a member of whom it does not approve; and the appointed senator may themselves not act in accordance with any prior agreement. All of these factors tend to devalue the item.
  3. Repeated iterations. In the ultimatum game, prisoner’s dilemma and numerous other tests of rational decision making, the optimal choice for a single game may not be the same as for a repeated game where your relationship with the other party will continue. More prosaically, companies sometimes choose not to extract the highest possible price from a customer in order to preserve long-term loyalty.
  4. Blagojevich didn’t know the value of what he had. Is it possible that he didn’t think of the possible value of the seat to an automotive company or a major bank?
The final possible conclusion, which I’m sure you’ll agree with, is that Rod Blagojevich was just too honest to sell the seat for its maximum possible value. Anyone who’s been in business for a while will have had a desperate customer who would have paid well over the odds for your services...and been just too squeamish to actually charge that much. It's pleasant to imagine that the governor was just ethical enough for that. What do you think?

Saturday, 13 December 2008

500 years of ancestry determines your wealth

An amazing piece of research is published today in VoxEU.

Louis Putterman and David N. Weil have discovered that the proportion of a country's ancestry which lived in Europe in 1500 explains 44% of the variation in per-capita GDP in 2000.

This is a huge influence and should have a big impact in understanding how countries - and people - achieve economic success.

The VoxEU article speaks for itself really, so have a look.

Possible areas to follow up:
  • How is the migration distributed through time - for example if most emigration to the US happened in the 1800s, the dominant effect may not be 500 years old but only 150.
  • Today's ethnic classifications express only roughly the ancestry of individuals. How many ancestors do you have who were alive in 1500? The answer is: around a million (assuming 25-year generations and minimal inbreeding!). I don't think the survey purports to account for the fact that these people must have almost certainly come from more than one country.
  • As the authors suggest, the really interesting area is to try to work out what it is that is passed down from these ancestors which is expressed in today's GDP figures.

Tim Harford on perceptions and economic behaviour

Interesting article this weekend from Tim Harford in the FT. He says that economic behaviour is not mainly determined by media-influenced perceptions. These perceptions - which contrary to popular belief, are not only controlled by Robert Peston, but occasionally other journalists too - may impact consumer confidence but this doesn't drag the real economy down.

He quotes Neal Gandhi (who I met yesterday at Entrepreneur's World) as saying of Peston “because of his influential position, his predictions come true almost exclusively because he has predicted them”. While I agree with Tim that this is going too far, there is still a big question about what influences economic behaviour.

The economist's contention (and this is at the heart of Tim's book The Logic of Life) is that rational incentives control behaviour more than intangible psychological factors. But Tim does not mention one major factor. Incentives depend on how we believe the world will behave in the future, not the present. And this is not completely predictable without perfect information.

In a fast-changing economic environment the problem is exacerbated. Our information is incomplete and we have to go on assumptions about how we think other people will behave, in turn based on what we think they will think about how others will behave, and...so on*.

This calculation is impossible to carry out accurately and most people, in most situations, do not bother trying. Instead, they use heuristics to substitute for analysis (see this paper by Colin Camerer of Caltech for an interesting review of relevant neuroeconomic research). These heuristics originate partly from a person's character and personality, built over the long term and changing slowly if at all. And they also come from the short-term conversations we are involved in. That includes the influence of the media, as well as the chats we have in the pub and what we hear when talking to customers or colleagues.

So would you buy a house today? If not, why not? Would you be influenced by a media report saying that house prices are falling?

Would you invest in the stockmarket today? Would you be influenced by a media report saying that the stockmarket is going to decline?

And would you spend £300,000 on opening a new retail outlet? Would you be influenced by what an article in the FT says about future consumer consumption? Even if you think the article's predictions are wrong, would you be concerned about what your potential customers, investors or lenders might think when they read it?

So if this is true, why didn't the economy go into a permanent spiral of decline when we last entered a recession? I believe there are basic pro-growth biases which in the long run will counter short-term confidence issues. These include technological progress, the continuing growth of knowledge and the basic desires of humans to make our lives better.

Ultimately, as Tim says, economic decisions do run into hard limits - people will end up having to make certain decisions because the money in their pocket runs out, or because their car breaks down and must be replaced eventually. But these limits are not universal constants. They are influenced by prior economic performance, which has been affected by the very perception issues we are talking about.

The simplest economic impact of negative media coverage is on investment; investment is a function of expected returns, and expected returns are by definition a function of expectations. Perhaps more research is needed on this, but it can't be right to dismiss the impact of the media completely. If nothing else, Tim Harford's media report provoked me to spend a productive economic resource (a chunk of time) writing this article. I hope the positive utility of reading it made a difference to your day.

* Yes, game theory gives us a way to deal with this but please don't tell me that anyone in real life is using that to make their decisions.

Thursday, 11 December 2008

DeLong's answer

Brad DeLong has solved the financial crisis (co-opting the help of Keynes, Bernanke, Trichet, Brown, King, Geithner and Summers).

I must admit the conclusion he came to was not the one I expected. Note particularly that:
  • he disagrees with me on crowding-out - he thinks there is still net business investment to be crowded
  • regardless, he believes that business investment will not be a substantial source of demand in the near term
That's a bit disappointing, if he is right. I was hoping for a more positive outcome but I suppose that's why it's called a depression.

Wage reductions in a downturn

Robert Peston raises the old chestnut about wage reductions. According to neoclassical theory, wages should reduce in a downturn as workers realise there is less demand for their services and cut the price accordingly. In the case of Corus and JCB, two British manufacturers, this is exactly what is happening - the unions have proposed a 10% wage cut in order to prevent plants from closing altogether.

However, adjustment rarely happens this way and there are some competing explanations for this - game theory and anchoring being the top two.

Here is an article from the Economist giving some of the alternative viewpoints.

But I would add two things:
  1. Despite what Robert Peston says, the MPC was probably right not to assume this would happen. It would never have taken place if the union and workers were not immersed in the conversation about the savage recession we are expecting.
  2. Wage stickiness has a positive economic effect - both to combat deflation and also to maintain gross demand. It helps to force employers to reduce their saving, acting as an automatic stabiliser in a downturn. Therefore this cut is not necessarily a good thing (I realise that there are positive aspects to it too - it is not clear to me where the balance lies).
Update: Corus is now asking the government to consider subsidising its wage costs in the short term - based on a Dutch scheme which aims to avoid the destruction of valuable company-specific skills through layoffs. My feeling is that this is a role for an equity investor rather than government. At most, perhaps government might be persuaded to share some of the benefits of continuing to get income tax revenue, or avoiding unemployment benefit. It feels like a slippery slope.

Tuesday, 9 December 2008

Freakonomics: Coolness inequality declines

Over the last forty years, the American General Coolness Survey has asked subjects the following question:

"Taken all together, how do you think you shape up these days? Would you say that you are: very cool, pretty cool, or not too cool?"

In a new paper published today I demonstrate some dramatic results: coolness inequality has diminished hugely in the four decades covered by the survey. Simultaneously, overall coolness has increased substantially.

In 1968, 5% of people reported themselves to be "very cool". A further 10% were "pretty cool" and 60% "not too cool" (a substantial proportion of respondents did not answer this question).

By the 1970s, coolness had increased but so had inequality. 40% were very cool, 28% pretty cool and 30% not too cool. In the late 80s and early 90s, however, overall coolness fell and society became more equal - with a majority reporting themselves "not too cool" again.

By the time of the 2008 survey, coolness had definitely got its mojo back and equality has returned. The results today are: 31% very cool, 50% pretty cool and 14% not too cool. Notably the number of non-respondents has diminished substantially to only 5%.

Comparing two different measures of inequality - the standard deviation of the distribution of the survey results and the number of people reporting "pretty cool" - inequality is at a historic low. The question is, why would this be? Especially since other measures traditionally correlated with coolness - such as skin colour - are at historically high levels of inequality in an increasingly diverse American society.

We hypothesise that...no, it's no use, I can't go on.

These results are, of course, nonsense. There is no coolness survey. If there were, its results would be a referendum on the evolving usage of the word "cool" and not on any meaningful measure of how cool people really are.

Surely the Freakonomics guys - Justin Wolfers and Betsey Stevenson, who wrote a paper on this in August - can see that? Their paper is on inequality of happiness and not coolness. But really. How can this possibly be a meaningful result?

Outside of major exogenous events (let's say the Second World War, and even then, only the beginning and end of it) people's reported happiness is much more a result of their own attitude to life and the word 'happy' than anything to do with social conditions.

If there were some objective, repeatable way to measure happiness that might give useful results. But using self-reported happiness to measure actual happiness is no more valid than using self-reported sexual activity to measure the birth rate.

Admittedly there may be some significance in the results relating to race or sexual orientation, but the authors conclude that the largest component of the effect is independent of this.

Yesterday Justin wrote a gently mocking article about someone else's results on happiness. Fair enough. I am sure he can take a bit of it too.

Saturday, 6 December 2008

Economist's View: Crowding-Out and Crowding-In

Just a quick note to point you to a much more detailed analysis of the crowding-out question. As usual on Economist's View, the posting itself is good and the diversity and depth of thought in the comments are perhaps even better. I can't think of another blog anywhere in the world where that's true.

Thursday, 4 December 2008

Cass Sunstein on informational cascades

This article is from October, but germane to my discussion of fiscal salesmanship.

Cass Sunstein: Wall Street's Lemmings: Why policymakers need to understand psychology as much as economics to solve the financial crisis.

A couple of comments below the article point out that psychology is not the only cause of the financial crisis, but Sunstein is not claiming that. Undoubtedly it makes a big contribution and turning it around (he uses the example of Roosevelt, maybe the best fiscal salesman ever) is within the powers of politicians - Barack Obama of course being the one most capable of it, for many reasons.

Tuesday, 2 December 2008

Selling the incentives

I’ve been thinking more about fiscal salesmanship – the concept that people will not just spend their fiscal stimulus – it has to be structured or presented in a certain way. I asked myself, as an entrepreneur, what would I do if I wanted to change the behaviour of a large group of people? I would do some marketing.

People don’t just respond to pure incentives. Of course incentives do make some difference; when a consumer decides what to spend in the shops today, one of the factors will be that most products are 2% cheaper. But it’s only one of many influences, and people simply don’t have enough processing power to automatically incorporate all available incentives in their decision-making process.

Indeed, financial incentives can usually be overridden or even inverted by the right kind of sales or marketing effort. BMW salespeople don’t cut their prices because of the signal it might send about their quality. Ryanair makes people think it is the cheapest airline by the clever ploy of treating them really badly; but often they are not at all cheap. If consumers made these decisions on a rational, financial basis they would not behave as they do.

New mechanisms are especially challenging, because of inertia. People already have a large set of behaviour options in their minds, and to add another one has a mental cost. Therefore new options are less effective than they rationally “should” be.
Policymakers therefore need to consider salesmanship in everything they do. What is the psychology of the situation; how can we get people to do something different; and especially, how can we get best leverage? No private company would be willing to spend the amount of money that a government does, in order to achieve the small amount of behavioural change that they seem to be happy with. Clever application of money and brand messages are much more effective, per pound spent, than brute force.

Government certainly knows this in some scenarios; instead of financially incentivising people not to drink and drive, they spend far less money on some very effective advertising. They take advantage of cultural trends to make the behaviour less socially acceptable. And yes, there are concrete incentives too (fines and imprisonment) but they are only part of a mix.

This is not to deny that macroeconomic changes make a difference. Of course if there is more liquidity in the banking system, or more money in the economy, people will spend more. But the advantage you get from changing the mental attitudes of the consumer will multiply the effect of any stimulus.

Monday, 1 December 2008

The psychology of contagion

Another interesting blog from Robert Peston...London Scottish, a small bank, has had its deposits fully guaranteed because of the risk of contagion if it were allowed to fail. It is too small to matter systemically in itself, but it is felt that the message it would send is too dangerous and would result in lots of other small banks having funds withdrawn to the point where many of them would collapse too.

It's a barely avoidable decision, the way Peston tells it.

But there's a big question here.

Where does it stop? First, all major (too-large-to-fail) bank deposits were implicitly guaranteed. Now, all small banks are guaranteed. You might think bank deposits are privileged. But what about deposits in credit unions or Christmas hamper schemes? They are quite like banks.

Now what if I have put money into some other kind of scheme - say a cash ISA. If that's not guaranteed, will people take all their money out of those?

What about other types of investment fund? Life insurance? Pensions?

What if I buy a bond from a car manufacturer?

What about if I lend money to a small private company?

What if I lend money to my nephew?

What if I buy shares in a company?

A year ago, nobody would have seriously suggested that any of these would be candidates for a government guarantee. If any particular one failed, it would be assumed that the particular investment (or the particular nephew) was a bad bet, and nobody would draw conclusions about the wider system.

But now, at least to some extent, expectations have changed. Not because of any fundamental difference in the operations of those businesses, but because people now assume a greater correlation between a group of companies than they previously did.

Oh no - my nephew has gone bust... we must withdraw our money from all nephews!

This is a creeping process - as each type of company is affected, the next type becomes contaminated. And even though it is a purely psychological process, it feeds on itself and the correlations have the potential to become real.

And yet it is neither possible nor desirable for the government to stand behind every debt in the whole economy. Perhaps we need some kind of firebreak - if the government pre-announced that it would not guarantee debts of a particular class of entity, one that is not at risk, it would affect expectations in other firms. And yet this in itself would create a problem - the very fact that the government announces (say) that the liabilities of oil companies are not guaranteed, might create a run on oil companies. Even though those liabilities are already not guaranteed!

The real answer is to understand the pattern recognition mechanisms that people use. Why is it that London Scottish Bank is not just an individual failed institution but an exemplar of a whole sector? What makes us think it is more similar to another bank than, say, to another company with Scottish in the name?

As Peston suggests, some clear principles about what will and will not be guaranteed, and over what timescale, might help with this. But it would be better still to create a conversation that distinguishes different kinds of company, different types of debt and still gives people an incentive to hold non-guaranteed debt.

Perhaps this is the time for that negative interest rate Brendan Brown was talking about. Hmm. Maybe not such a good idea after all.

Macroeconomics needs to be supplanted with a discipline of macropsychology. Like my fiscal salesmanship post last week, we need to find ways to make a clear case to a large population so that they don't enter into self-reinforcing, self-damaging behaviour. Anyone want to buy shares in advertising companies?

Investors are human too

I read Paul Krugman's latest NYTimes column (via Economist's View) and it got me wondering. Why does crowding out not happen?

In other words, why does an increase in long-term public debt not result in a reduction in long-term business investment? There's a school of thought which argues that there is money which would otherwise go into productive private investment, but instead is diverted into lending to government (which is likely to lead to less productive spending). Due to less money being available, this pushes up the price of borrowing for businesses and means some otherwise-viable investments will not happen.

Krugman gives part of the answer - that a (successful) stimulus encourages economic growth which in turn makes business investment more, not less, likely.

But there's another reason. This is that business investment is not happening anyway. There is not a large pool of money going into long-term business investment now. Why? Because investors weight short-term returns much more highly than long-term returns, and there are few short-term returns around in a recession.

There are two reasons for this, which I believe are linked.

The first is informational. It is very hard to predict the future in an environment like this. It becomes exponentially harder as you go further out. Even if we are confident of an overall return to growth in a couple of years, it is still very tough to predict the performance of any individual investment opportunity. Think of the weather. We can predict that in April it is going to be warmer than it is now. But nobody can tell me the exact weather in a given place or on a given day even 8 days in advance.

When uncertainty is high, there is a premium on short-term returns because they reduce risk, but also because they are a signalling mechanism. If a project is capable of giving a return quickly, it more quickly proves that it is viable in principle. It's much easier if you can see the money start to flow in three months, to believe that it is going to keep flowing thereafter.

The second reason is behavioural. We all put a high discount on returns in the near term. The most famous experiment which shows this is to offer people $100 now or $120 in a year. They are much more likely to take $100 now, even though 20% is a pretty impressive interest rate. But offer them $100 in three years or $120 in four years, and their preferences reverse. They are more likely to take the $120 in four years, even though it is still a 20% return - and even though they can see that three years from now, they will be in exactly the same position as the first offer puts them in today.

So people have a high discount on returns in the present, even though this is, in economic terms, irrational. It is plausible that there are biological reasons for this - the juices start flowing when you smell that steak, and your body wants to build up its fat stores.

However, I think actually that this is a deep-rooted human instinct originating from precisely the informational problem given above. In most imaginable contexts in which a human could live, information is at a premium. Mostly, the person offering you something now might not be around in a year, or at least you won't know where to find them. This, combined with the short-term nature of our memories and predictive systems, encourages us to act in the moment and forget - or discount - the long term.

Two final notes of interest. First, it seems that people's ability to think long-term and overcome their discount-of-the-now instincts improves as they get older. So even though an older person has less of a future to think of, they spend more time thinking about it. Perhaps reduced supply increases the price of future life, or perhaps they are just smarter.

Second, it would be interesting to know if the limbic (emotional) system in the brain has a specific short-term bias. I suspect that decisions influenced by it are made with a short time horizon, partly because its decision-making mechanisms are only capable of considering the very near future. If anyone has any knowledge on this please post a comment; I have a future post coming on decision-making which will draw on this.

Turning up the synergy

I love the following description from Forbes via Mish, in "19,000 WaMu Employees will be Synergised Out of a Job":

Up to 19,000 employees of Washington Mutual face being laid off this weekend as JPMorgan Chase turns up the synergy on its recent acquisition.

Mish proceeds to demolish this newly invented weasel word for firing people. Remember the good old days when we only had downsizing?

Also in the news, Jose Manuel Barroso puts his foot in it with an interview surely calculated to do maximum possible damage to the cause he is notionally espousing. What was he thinking?