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Showing posts from February, 2009

Government insurance and a paradox of externalities

HBOS today announces losses of about 6% on its total corporate loan book, according to Robert Peston (ignore the 47% figure that he also gives - that is only generated by cherrypicking the scope of the statistic to get the most serious-looking number).
Can a bank charge a sufficient additional premium on its interest rates to cover this size of loss? It's unlikely. Small businesses regularly pay a spread of 6-10% over base (I've heard from some bank managers that they are charging up to 15% to some) but most loans are to much larger companies which have been able to get much better terms in the past.
So, if a bank can't charge enough money to cover its costs, should it stop providing the service? Strict microeconomic logic says yes: the service is not viable in the marketplace at the current price, so its price should go up and the volume of loans provided should be much lower.
But this is a classic example of market failure due to uncompensated externalities. Most discussion…

Fred Goodwin's pension

Robert Peston has another example of an economic decision which looks odd from a simplistic rational point of view, but makes perfect sense when perceptions and expectations are taken into account.
Firing someone often makes an important statement about the direction of a company. But (as most of us would certainly wish) it's difficult for a company to fire people at will. Thus, companies usually have to pay off the individual - whether with a pension or a lump sum.
For a company the size of RBS, a £16 million payoff (or whichever part of this was actually discretionary) is easily worth the improvement in public image that comes with such a major break. Of course the payoff itself - since it inevitably has to be made public - has a perception impact, but that's probably much smaller than the damage of keeping the same person in charge.
Would you argue that Goodwin's actions were egregious enough to justify sacking without compensation? Most people have made judgment calls at …

Transparency and mendacity

The Richard Thinks blog has an item about transparency today. It implies that The Economist has fallen for the self-serving nonsense of some anonymous traders:'not having full-transparency allowed them to fully exploit the potential of secret trading strategies and that with full disclosure they would have little incentive to correct market inefficiencies through arbitrage.' And: 'when investors start thinking that other people are privileged to lots more relevant information and that they have an unfair disadvantage they are likely to resist activity in the market.
So "[s]ymmetry, not the amount of information, matters"' How convenient for the financial institutions!
The first argument is clearly fallacious. Arbitrageable market inefficiencies only arise from lack of transparency. If the markets were transparent, the market inefficiencies would be visible and there would be an immediate and high profile incentive to correct them. And a much stronger one - since i…

Confiscated savings and bank runs

One year ago, you invested £100,000 in a money market investment account.
Unfortunately, you chose to keep it with a small UK bank which has lent too much money to subprime borrowers. You signed up for a fixed-term deal where you receive 6% interest for four years in return for keeping your money in there.
Reading Robert Peston's blog one day, you find out that the bank is about to get into trouble. It has had to write off 15% of its asset base. Your deposit is not covered by government insurance and the bank is going to be partially liquidated; you are going to lose 11% of your money! Overnight your balance will drop to 89% of its previous value. The bank is still going to keep trading so you won't get your money back - the term deposit will remain in place, but at least they will keep paying interest on the reduced balance. What remains of the bank will be taken over by the government so there seems to be no risk of a further writedown.
You figure there is about 30 seconds to a…

Practicality versus justice

Some commenters on Stephanie Flanders' blog (and of course in other places) are suggesting the banks simply be liquidated - no nationalisation, no bailouts.
This has the appeal of being fair - creditors who made bad decisions lose money.
But it may not make the system work well. If it destroys liquidity and causes people to become irrationally risk-averse, then justice may be served at the expense of the common good. By forcing a subset of creditors to take a hit to their assets - particularly those which are liquid and immediately available - we might cause knock-on effects which would destroy far more economic value than the counterfactual, the cost of a bank bailout. This is what the phrase 'cut off your nose to spite your face' was invented for.
It's impossible to know for sure what would happen if we did let banks fail. Some people are working out ideas on this. But the feeling in government is clearly that the damage would be so great that it's worth putting hun…

Word cloud, B2B pricing and value modelling

Thanks to all Marginal Revolution readers who have stopped by in the last couple of days. I am looking forward to generating next week's economics word cloud on Sunday and will summarise whatever trends emerge in comparison to this week.
Eric Mitchell at the Professional Pricing Society has an interesting article about pricing in a B2B environment. I broadly agree with the comments of John Burdass and Rick Robinson; pricing should, as far as the supplier can influence it, be driven by value and not by either cost or competitive comparisons.
However they imply a focus on objectively demonstrable financial value. For me, value is highly subjective; and perceived value is driven by framing and other cognitive factors distinct from the objective attributes of a product. This is especially true in B2B service provision where direct comparison of a service - either against another supplier or against a similar service purchased in the past - is difficult.
Much of our recent research at Ino…

Misunderstanding management decisions

Robert Peston posts an odd blog today, which implies that he thinks all business decisions are either absolutely right or wrong, and not contingent on the situation or on business judgment.
He cites £1.5-2bn of costs which Fred Goodwin did not take out of RBS - despite his reputation as a cost-cutter - and which Stephen Hester has now identified.
Well, surely in today's business environment some costs are no longer appropriate which were nevertheless justified in 2007. The private plane which he cites may be the perfect example. When there is competition among investment banks to win new M&A instructions or IPOs, being able to pick up executive in a private plane for meetings in your office could be a good marketing investment. When there is no competition - or indeed no mergers - or when the executives become much more price-conscious, it may no longer be cost-effective.
As we've discussed before, it's dangerous to assume that apparently-extravagant expenditure is really…

Why are recessions bad?

Stephanie Flanders (and earlier, Tim Harford) raise an interesting question today. As they point out, changes in individual circumstances tend to dominate the macroeconomic aggregates - increases and decreases in individual income are usually much greater than the 3% increase or decrease in the output of the whole economy.
Of course, a 3% decline in GDP means that a few more incomes have fallen than risen - but on the face of it, this is a minor effect.
So what explanations could there be for the fact that we worry so much about recessions?
First, some of the effects are very visible. Lots of people lose their jobs - and a million more people out of work will always create some high-profile news stories.
Second and related, the media (and the public) select stories which confirm their overall narrative. Any newspaper whose main focus of the last two weeks was on the 9,000 new jobs at KFC rather than the 850 job losses at Mini would not look credible - its narrative would be out of step wi…

Sticky policy making

Three posts in 24 hours, Mr Peston? Back from your holiday and full of energy it seems.
One of the enduring phenomena in macroeconomics is stickiness. This most commonly shows up in the idea of 'sticky prices', which in some models are responsible for business cycles. In short, prices of goods and wages increase beyond the level of stable demand (perhaps driven by higher short-term demand or by inaccurate expectations of rising demand). The demand curve turns out to be a bit lower than was thought, but prices do not immediately adjust downwards in response. Therefore the amount of goods supplied is less than the optimal (equilibrium) amount and we get a recession.
There are many other examples of stickiness, or as I referred to it in an earlier post, friction. But one that I have not seen discussed is policy stickiness. Robert Peston highlights this in an item today about Northern Rock.
The British government is changing its original policy of running down Northern Rock's loa…

The economics zeitgeist, 22 February 2009

Image
This is a word cloud from all economics blog postings in the last week. I'll be generating this every week so please subscribe using the links on the right if you'd like to be notified each time it is published.

It has been constructed from a list of economics RSS feeds mainly generated from the Palgrave Econolog, and uses Wordle to generate the image, the ROME RSS reader to read the RSS feeds, and Java software from Inon to process the data.
You can also see the Java version in the Wordle gallery.


Thanks to an anonymous poster on an economics blog somewhere for the idea. Unfortunately I haven't been able to find the original reference but if anyone can remind me who was asking for this within the last month or so, please let me know.

Surprised at the WSJ

The Wall Street Journal today says that the UK government"...has already spent £600 billion on its financial bailout" This is simply misleading. The government has made a lot of liquidity available in exchange for other assets through several Bank of England schemes. It has barely spent anything at all; even if you include the bank recapitalisations, which are also in exchange for equity, the figure is around 5% of the number quoted.

While this kind of stuff is to be expected from the Daily Mail and other tabloids, I am pretty surprised at it in the Wall Street Journal. I'm glad that the FT still maintains a standard of reporting that allows us to rely on its interpretations as well as its raw facts.

Your advice wanted - starting a business in a recession

My friend Margie, who's at business school, is less optimistic than me about the recession. She thinks things will be dismal for a long time yet.
However, she's still considering starting a business when her course is finished. So what kind of company would you recommend starting up in a recession?
And if I'm right after all and the recovery starts soon, what sort of companies would be especially successful in a recovering economy?
Please suggest your answers in the comments, or by email to leigh@inon.com and I'll post a selection. The best recommendation wins a free skinny latte (other coffees are available).

BearingPoint (ex-KPMG) is bankrupt

Ed Kless at VeraSage points out that BearingPoint has filed for Chapter 11 protection, wiping out shareholders equity.
VeraSage campaigns for a switch from hourly-based to value pricing (mainly among accountants) and so Ed asks how BearingPoint could possibly have lost money on hourly contracts, unless most of its consultants were sitting around doing nothing for months on end.
However, even though BearingPoint came out of KPMG, I doubt they were charging on an hourly rate for most projects. In my experience consulting and IT firms are much more likely to use fixed-price agreements than accountants.
A number of such firms have made serious losses on these agreements in recent years - IT projects of course being notorious for going over budget. I would expect that this is the reason for BearingPoint's problems. While government IT projects used to be notorious for going over budget at the taxpayer's expense, they are now getting just as bad a reputation for causing losses on the s…

A story about evidence

There were two traders who used to cross the desert in Kenya, carrying incense from one city to another and metalwork back the other way. The trip was a long and hot one, and they travelled with two camels each and always with just a bit more food and water than they strictly needed.
For many years their trade carried on successfully - occasionally with a sandstorm, once losing some goods and camels to a thief, but never with a real crisis. Their wealth gradually accumulated, and they were able to expand their caravan to six and eventually ten camels; but no matter how rich they became, they never forgot to carry an extra waterskin and packet of cured beef: they were wise enough to know that riches cannot stop you dying of thirst.
But still it came to pass that on one difficult trip, the wind was strong and they had to camp for an extra day; when they reached the next oasis it was dry; and the spare water was soon gone. With three days to walk to the next water, and the sun stronger tha…

Bizarre blog links

Every so often someone links to an article on this site - recently, it's usually the "stimulus for bloggers" article, but occasionally something else. I usually discover it through Technorati or by noticing a new referrer in the server stats.
Generally this is simply because somebody found the article interesting and linked to it. Often they copy a few lines of the article to give context to their readers.
Today, however, I discovered a very odd phenomenon at this blog. My article on behavioural economics and the knowledge firm has been linked, but it seems to have been put through a machine translator - twice! As far as I can tell it has been translated into another language (the blog is in South Africa, so I would guess Dutch or Afrikaans) and back to English. Google Translator doesn't produce these specific results though, and neither does Babelfish. Anyone seen this phenomenon before?
The original, from my article here, was:
This blog has two primary themes: behaviour…

Reshaping economics

I'm linking to Gregory Clark's article not for the same reason that some people have - enjoyable though it is to poke fun at professors - but to examine his suggestion that economics as a discipline is being reshaped.
There are a number of details which qualify only as interesting gossip - the suggestions on academic economists' salaries and the dismissal of the "not real" "Nobel" prize.
But the substance of the article is that: the "mathematical contortions of academic economics" are uselessnobody predicted the downturneconomics has not advanced in 80 years; the terms of the bailout debate date back to the 1920s and 1930sI'm conflicted about the last point. Selfishly, I want to believe it because, if true, it opens up more space in the discipline for new research such as my own. But I don't want to be working in a intellectually moribund field; and I want to believe that the rich and interesting range of work done since 1940 is actually …

Schizophrenic inflation forecasts

Stephanie Flanders expresses an opinion which seems to reflect the conversation throughout most economics blogs, as well as - she suggests - in the City. That is, we are either due for severe deflation or high inflation - nothing in between.
Interestingly, the deflation story mainly comes from the authors of the blogs, while the runaway inflation opinion is mostly in the comments. You might say that shows which opinion reflects economic orthodoxy, but not necessarily which one is more likely to be accurate.
The most likely scenario may in fact be "both" rather than "either". Deflation in the short term, which we hope will be arrested by the immense monetary and slightly-less-immense fiscal stimuli coming out of most rich-country governments. Followed by inflation in a couple of years, which central banks will try to contain by mopping up excess money supply - with no consensus on their likelihood of success.
Most economists would say that the inflation is a price wort…

"In the real world...": aggregate demand versus price

"(In the real world things are more complicated, but never mind.)"The rallying cry of economists through all history. This time it comes from Paul Krugman (the paper is a few months old but he points to it in today's column), but I don't mean to pick him out unfairly. It's just a less formal way of saying "we need to simplify our models otherwise we don't know how to work with them". Sometimes, though, it would be useful to be explicit about how far from the real world we believe our models are.
I just want to take up one point in the paper. Paul assumes that, under normal circumstances the AD (aggregate demand) curve slopes down and the AS (aggregate supply) curve slopes up. His point is that in a liquidity trap (like now and in the 1930s) the AD curve may not slope downwards after all, so standard results about the equilibrium point are not applicable.
Fair enough. But I would question whether the AD and AS curves behave as described even in normal …

Obama's Elf

I believe this piece is referring to the position of Secretary of 'Elf and 'Uman Services.

Behavioural economics and the knowledge firm

This blog has two primary themes:behavioural economicsthe economics of knowledgeI believe they are closely linked, because behaviour is derived from the knowledge that people have about the world (or more strictly their mental model of the world, which may not actually be accurate knowledge).
Knowledge, in the economy, is influenced by many things. But at least one type of entity specialises in influencing it: the knowledge firm.
Knowledge firms include professional services firms, consultancies, marketing and media companies. Their distinguishing characteristic is that their work is not about manipulating physical objects but influencing the minds of people. This is done by creating messages and communicating them.
Therefore, knowledge firms are in the business of second-order influence of behaviour. Traditional firms offer products to which people respond based on their existing perceptions and preferences. Knowledge firms actively change the perceptions and preferences that people use…

BMW cuts 850 jobs and one shift

It's been accepted by most analysts for years that the global car industry has substantial overcapacity and that factory closures, or even closures of whole companies, are needed. Now BMW is cutting 850 jobs at its Mini plant - even though Mini sales are up this year. So is this a good thing?
Probably not - at least not right now - because it causes a reduction in aggregate demand, and that means reduced GDP growth, or a deeper recession.
But that's true of capacity reductions at any time. So why would it have been good before and not good now? What is the difference?
The first thing to understand is why a cut would have been desirable. Let's imagine that, in more normal times, a car company (Chrysler for example) shuts down. The immediate beneficiaries of a company closing would be the other car companies. With less competition they could sustain higher prices; some people who would have bought Chryslers will now buy other cars, boosting both revenue and profits at the remai…

A generally applicable skill of management

Just a pointer to an excellent article on management by Daniel Davies, which fits nicely into the vision of my think tank, Intellectual Business. Thanks to Brad Delong for the pointer.
Another article, this time on homo economicus and by Gavin Kennedy. I have started reading Kluge and though it is not broadly speaking a book about economics, it still has some useful things to say for behavioural economists.

If we can't eliminate friction, we need a stimulus

Synthesising the whole stimulus debate into a few lines, there seem to be a small number of messages:Stimulus is good because it gets idle resources producing somethingStimulus is bad because it moves productive resources into less productive useStimulus is bad because its cost has to be paid back, reducing future efficiencyStimulus won't work because rational consumers will save as much as the government spendsStimulus is good/bad because government spending is efficient/inefficientThese messages are not necessarily contradictory - some of them are orthogonal. The truth of each assertion all depends on your model of how the economy works - and especially on one big factor: how much friction is there?
In an economy without friction, much of the argument would disappear. Idle resources would be immediately reallocated to some other use, since there is always somebody with savings that they could switch to consumption. Prices would adjust. Resources would always go to the most produc…

Do Click: twitter vulnerability

If you are at this page, you probably clicked on a "Do Click" link on twitter.
Well done - you know how to follow instructions. If you were one of those rebellious types, you might have clicked on the "Don't Click" link which is also propagating on there.
Fortunately you aren't like that. If you were, you would probably have been the victim of a cross-site scripting vulnerability (explanation at Coding Horror). This runs some Javascript which starts posting messages in your name on twitter.
In this case the message seems relatively harmless - it simply posts another copy of itself to try to spread itself to other twitter users. But, not having clicked on it, I can't say for sure that it is innocuous. In general it's dangerous to click on this kind of thing.
One way around this is to insist on using the 'preview' feature on tinyurl. Any tinyurl link (such as the one that's being passed around with the "Don't Click" message) can …

Bounded cognition and the stimulus bill

According to the Sunlight Foundation, nobody (outside of the ten-person committee that negotiated it) has yet been allowed to see the stimulus bill which the House and Senate have agreed. This includes the members of the House and Senate who are supposed to vote on it today!
I know that I've argued that cognitive limits and imperfect information act as a constraint on economic efficiency; and no doubt also on political efficiency. But that doesn't seem like a good reason not to publish the bill. Maybe they have slipped in that clause on a stimulus for bloggers and they want to get it passed before the twitter crowd start asking for their own version.

Utility versus income

Greg Mankiw asks us to spare a thought for the top ten percent of earners who apparently bear the main burden of the economic downturn.
I wish he had figured out how to measure whose utility has been hurt the most, as opposed to just whose consumption has fallen. Unfortunately this is a blind spot of many economists. Poor people simply get more value out of a dollar than rich people. This also means that they are hurt more by a smaller fall in income.
Diminishing marginal returns have been part of economic theory for two hundred years, so I'm not sure why people keep forgetting it.

Illiquidity measures

Continuing the discussion of a few days ago, Nick Rowe joins in correcting Niall Ferguson's "average debt" logic. Maybe we should give the guy a break - he is only a historian, not an economist. No doubt whenever a historian writes a book about the history of [X], they get brickbats from all the practitioners of [X]. But then that's the price of intellectual engagement.
The comments on Nick's post set me thinking about better ways to measure the total impact of debt in the economy. One commenter (Patrick) reminded me of the issue of debt maturity mismatch, which seems to have been a major contributor to of the current financial crisis (aside from the effect on the real economy). Here's the response I posted there:

It sounds attractive that there would be some meaningful measure that at least partly captures the way in which debt influences the economy. We could certainly build models where a large amount of gross debt has almost no effect at all (e.g. A owes B,…

Price of a Senate seat, revisited

In December I calculated the price of a US Senate seat at conservatively $1 billion.
I'll disregard for now the $2.5 trillion secondary effect of the new Tim Geithner bank rescue plan, and whether we might therefore revise the value of the marginal seat upwards to $5-10 billion.
But Brad DeLong has worked it out in a different way. The price of three Republican Senators is 600,000 jobs. So let's crunch the numbers.
At 200,000 jobs per senator, and one senator per billion dollars, it's easy to work out the price per job: $5,000. This compares extremely well to the $280,000 per job estimated by Greg Mankiw.
Even on the enhanced valuation of $5-10 billion per senator, we are still only looking at $25-50,000 per job. Perhaps the stimulus plan can be restructured to focus on buying the seats of Republican senators and converting them into jobs. Obama's goal of 4 million jobs could be achieved for as little as $20 billion, by simply buying up twenty of the remaining Republican s…

Nationalisation and the knowledge problem

In pure asset-allocation terms, nationalisation of bust banks seems to be the most reasonable option. Shareholders have taken big risks (or allowed their appointed representatives to do so), the risks did not pay off, and government now has to step in and help. Therefore, government should now own the banks.
I have broadly supported this argument, but it does hide a big problem: the knowledge problem. (There's a whole blog about this subject)
In order to best allocate economic resources, those who control them need to have knowledge about where they can get the best return. This knowledge is distributed all over a population of billions of people. Therefore how can we ensure the information can most quickly and reliably find its way to the person who controls the resource?
First we need to note that 'knowledge' is a tricky concept. At the risk of stepping through a vast minefield of epistemological thought, I'll assert that nobody knows anything about the world with absol…

A bad Barclays

According to Robert Peston, Barclays' share price appears not to reflect the underlying state of the bank. It raised £10bn in new (private, not public) capital last year and made £6bn in pre-tax profits (between £4bn and £5bn post-tax). Thus, in theory, its balance sheet should contain around £15bn of new capital since this time last year. Not to mention whatever was on there before.
And yet, its shares are valued at under £9bn. Presumably this is because of uncertainty about the value of some of its assets, and the fear that they will be written down - eliminating the capital base of the bank.
So why doesn't Barclays take - on its own initiative - the advice many economists have given to the US government, and create its own "bad bank"? It could simply split itself into two or more pieces, with the better half of the assets in Bank A and the riskier half in Bank B; and provide the minimal required capitalisation to bank B. B would carry off a big chunk of capital but,…

Behavioural models of pay, and the agency problem

One of the primary criteria in designing any system of pay is to influence the recipients' behaviour.
Traditional pay structures work on the assumption that people behave rationally. Thus, they will pay people for generating profits for their company; on the basis that if you pay them more for higher profits, they will generate more profits. This has the attraction of simplifying the manager's job - assume that the employee can figure out the best way to make profits, and leave it to them.
However, this structure has at least three intrinsic problems. One is asymmetry: you can pay someone for making profits, but you can't penalise them for making losses. Virtually no employee will work for a company if there are circumstances in which they would have to pay for the privilege.
The other is the agency problem: the employee has control over the company's resources but does not get all of the benefits of using them in the most productive way. Thus, a temptation exists for the…

Computers more ironic than humans

Visiting Daniel Little's Understanding Society blog I noticed the following automatically generated news headline in the right-hand column: Computers cleverer than humans will create even greater inequality Financial Times, UK I am more worried that artificial intelligence will greatly increase the inequality of wealth and power among humans. You have viewed your allowance of free ... Not quite so clever yet...

How much debt is too much?

Another article (this time by Niall Ferguson, of whom more later) on the too-much-debt theory. The subtitle is: "Governments cling to the delusion that a crisis of excess debt can be solved by creating more debt".
Well, this isn't a crisis of excess debt. To the extent that credit problems are responsible for the recession, it is a reduction in the availability of credit that has triggered it.
Ferguson may think that companies and individuals owe too much. But who do they owe it to? Er, other companies and individuals!
He doesn't present much evidence for the "too much" theory, except an assertion: The Western world is suffering a crisis of excessive indebtedness. Governments, corporations and households are groaning under unprecedented debt burdens. Average household debt has reached 141% of disposable income in the United States and 177% in Britain. Worst of all are the banks. Some of the best-known names in American and European finance have liabilities 40, …