Saturday, 31 January 2009

Martin Wolf in Davos

Robert Peston interviewed Martin Wolf in Davos (along with Roger Carr and Richard Lambert, but they needn't concern us at the moment; Lambert did display a useful clarity, requesting nothing but opening of the credit markets). Martin, as always, had some exciting things to say and said them in his unique way. My paraphrasing:

The UK is the most vulnerable economy in the G7 because the financial sector is so important, because the housing boom was so large and because household debt is sensationally high, and we are also highly dependent on the rest of the world which is suffering a recession too. And our underlying fiscal position related to these vulnerabilities is much worse than anyone thought 2 years ago.
It's interesting that the fact of a recession is the problem - that is, a reduction in GDP, rather than the actual level of output or consumption. If the UK has benefited (as it undoubtedly has) from huge growth in the financial sector and housing-related investment over the last ten years, and we now have a brief slowdown from a peak of economic activity, you might think it isn't something to regret.

However, there seems little doubt that negative growth is perceived as a big problem by both consumers and businesses, when compared with a hypothetical scenario of slightly slower but more stable growth. My post from Wednesday discussed this, but in that item I neglected to consider the psychological effects of today being worse than yesterday, and what it implies about tomorrow. So unless we collectively get used to volatility, then Martin is right that over-reliance on an unsustainable financial economy will have intrinsic problems.

And yet... I am not convinced that our finance sector is unsustainable. I have started to build a model to try to work out an optimal level of finance and business services activity in a modern economy. My intuition is that the optimal level is far higher than most people suspect, and that with hindsight we may not blame the City as much as it's now being blamed.
Politicians undoubtedly get that there is a massive cyclical downturn, but people don't get that it's a structural change. 2006 is not coming back with its consumer-led debt boom driven by the English-speaking countries. We might get back to past growth - I hope we will - but the world will have to be rebalanced. Governments are doing a good job of short-term stimulus and saving the banking system. A sensational level of stimulus! But for stability, healthy private sector demand is needed. Lots of changes are needed that China, the US and UK don't yet get, but they are essential in getting back to a healthy economy.
I guess the message here is that China is storing up too many claims on the US and UK economies, which are likely to lead to problems in the future. The US and UK (among other countries) are consuming China's output now, and instead of paying for it now by exchanging our own services, we are exchanging promissory notes to pay later. Fair enough, and the Chinese are willing to let us do it, but there must be a risk in this.

Just as some private borrowers will keep borrowing as long as the lender is willing to stump up, but when it is time to repay, start quibbling. Have you come across those services which supposedly allow you to write off your consumer debt by challenging the terms and conditions under which it was lent? I feel there's something basically dishonest about that course of action, but perhaps there is an analogy.

I suspect Martin is hinting that the overhang of debt between creditor and debtor economies will tempt politicians to these kind of escape routes; and even if they resist, the scale of the debt will automatically cause distortions in trade and investment.

So perhaps we need to figure out what we have to offer the Chinese consumer. China does buy a lot of investment goods from the West - industrial machinery, software and other technology - but fewer consumer goods or services. Perhaps we have expertise in media, well-designed and marketed consumer goods, high quality food and consumer infrastructure that they would be interested in. But I don't know what policy routes Martin would suggest that governments take to stimulate trade in these goods.
[The changes are beyond most people's understanding] We need to protect emerging economies now - change the way we finance them and expand the IMF; and have a serious, intelligent dialogue with the Chinese to make their growth more compatible with the global economy - the US and UK need to change too, and make the world financial system work better - because it has worked terribly.
Again Martin's beautiful turn of phrase and charming voice - Robert Peston may think he's a sensationalist but Martin Wolf can frighten him under the table.

I am very much warming to the idea of supporting emerging economies with the stimulus. I am convinced that the underemployed resources in the Western economies could create something useful for poor countries, if the stimulus is designed correctly. I hope to write something more on that next week.

Other than that, I look forward to hearing just what the Chinese, American and British governments are supposed to do to encourage Chinese consumers to buy more from Western suppliers. Undoubtedly there is a way. Perhaps we need another Martin - Sorrell - to come to the rescue.

Update: Ahem - I just discovered Martin Sorrell is at Davos, also blogging for the FT!

Friday, 30 January 2009

Government stakes in private companies (again)

An update on my proposal (and Roger Farmer's) from the beginning of this month:

The Japanese government has proposed buying equity stakes in small to medium sized companies. Not via the central bank, but the (state-owned) Development Bank of Japan. The plan will be considered by the cabinet next month.

Thursday, 29 January 2009

Iceland and Woolies

The most unusual juxtaposition of 'Iceland' and 'Woolies' in the news in recent months:

People in Iceland - a country currently in desperate economic trouble - have shipped jumpers and blankets to pensioners in England this week, to keep them warm in the winter.

A container of woolies arrived in the north-east of England after an appeal on an Icelandic radio station. They were handed to local charities in Hull on Thursday.

Definitely up there with Kerry Katona as amusing coincidences go.

Wednesday, 28 January 2009

Comparative growth and shrinkage

The IMF thinks that the UK economy will shrink by 2.8% in 2009 - the worst performance among "advanced nations". Quite an amusing locution, that. But, bad as it sounds, what does this performance actually mean?

We could look at it in one of two ways:
  • A reversal of most of 2007's growth. Real growth in 2007 was approximately 3%, so this contraction would cancel most of it out. Not good, but if we had had just 0.1% growth for a couple of years rather than +3 and -2.8, would we feel differently about it?
  • Cancelling out a quarter of the 'excess growth' of the last eight years. Long-run estimates of UK productivity growth are around 2%. GDP growth has averaged 2.7% between 1992 and 2008. Thus, we have benefited from an economy about 12% larger than it would have been under long-run conditions. If the price of this is to lose a quarter of this growth while the economy retrenches, then it was worth it.
Naturally there are plenty of variables. Is long-run productivity growth the right measure to use? Would we still have achieved (some) above-trend growth if we had regulated away some of the financial instabilities that have contributed to the recession? Is the IMF's forecast correct?

But in context, this recession may not be so bad, and may well be a price worth paying for the higher growth and standard of living that we have achieved in the last two decades.

That's not to say we shouldn't mitigate the recession in any way we can. Just because a price is worth paying doesn't mean you don't try to get it cheaper.

GDP data taken from Office of National Statistics.

Monday, 26 January 2009

The state of economic debate

A good writeup from Sloped Curve of some of the flaws in the debates taking place among leading economics bloggers.

It's followed by some suggestions about how to structure the US mortgage market which are not so compelling, but worth a read anyway. Maybe this is a good structure for an article - lead in with something that's interesting, even gossipy, to get the attention of the reader. Discussion of other bloggers always gets a few points. Then subtly insert your policy recommendation at the end. Bait and switch, I think it's called.

Saturday, 24 January 2009

Address to a Haggis

Many people find it difficult to understand the more obscure words of Rabbie Burns's poems; leading scholars of Scots literature are still convinced that he made half of them up. His odes to the haggis and to the mouse are famously mellifluous but quite hard to translate.

So, in time for Burns night, I offer you this annotated guide to one of his classics, Address To A Haggis. It's not a literal interpretation, but Burns never intended this poem to be read literally. It's more than a metaphor - it is in fact, as will become clear, a prophesy.

Fair fa' your honest, sonsie face,
Great chieftain o' the puddin-race!
Aboon them a' ye tak your place,
Painch, tripe, or thairm:
Weel are ye wordy o' a grace
As lang's my arm.
What few people know of Burns is that, as a contemporary of Adam Smith, he was a keen amateur economist. And in this verse, the haggis represents not the meaty goodness of leftover pieces of sheep, but the British economy.

In the last line, Burns even foreshadows the development of arms-length regulation of the City of London.

The groaning trencher there ye fill,
Your hurdies like a distant hill,
Your pin wad help to mend a mill
In time o' need,
While thro' your pores the dews distil
Like amber bead.
This verse develops the theme. The distant hill is a reference to the agricultural sector; the mill to the (at the time) booming British manufacturing industry. This breakdown of economic activity is of course somewhat out of date; but while Burns can be considered a founder of the knowledge economy, he wouldn't have been so arrogant as to suggest it would represent 40% of GDP by 2009.

The scene set, Burns proceeds to develop the narrative of the poem. All is not well with our economic haggis.
His knife see rustic Labour dight,
An' cut you up wi' ready sleight,
Trenching your gushing entrails bright,
Like ony ditch;
And then, O what a glorious sight,
Warm-reekin, rich!
"Rustic Labour" refers to low-income workers who have borrowed from Northern Rock; the knife is the credit crunch. The economy's entrails gush, and the rich end up warm and reeking in a ditch.

Then, horn for horn, 
they stretch an' strive:
Deil tak the hindmost! on they drive,
Till a' their weel-swall'd kytes belyve,
Are bent lyke drums;
Then auld Guidman, maist like to rive,
"Bethankit!" 'hums.
"They" is thought to represent the media - salivating at the prospect of an exciting, newsworthy recession. Auld Guidman is of course Robert Peston.

Burns now offers some normative policy prescriptions. He clearly has a preferred strategy for resolving the crisis, and some harsh words for those with a more laissez-faire attitude. In passing, the fiscally conservative strategies of the French and Italian governments are condemned.
Is there that owre his French ragout
Or olio that wad staw a sow,
Or fricassee wad mak her spew
Wi' perfect sconner,
Looks down wi' sneering, scornfu' view
On sic a dinner?
And some words for political leaders who don't support fiscal stimulus:
Poor devil! see him ower his trash,
As feckless as a wither'd rash,
His spindle shank, a guid whip-lash,
His nieve a nit;
Thro' bloody flood or field to dash,
O how unfit!
The weak, do-nothing constituency - neither physically nor emotionally dominant; English; and frankly prissy - holds no attraction for Burns. He suggests that they are unfit to fight the battle against recession. The beliefs and upbringing that contribute to this are signified by the food they consume. Notes that Burns left alongside the manuscript of this poem remind us of his love for puns: "these people have never Eton haggis in their life".

However, help is at hand. At least one leader is ready to step up to the challenge:

But mark the Rustic, haggis fed,
The trembling earth resounds his tread.
Clap in his walie nieve a blade,
He'll mak it whissle;
An' legs an' arms, an' heads will sned,
Like taps o' thrissle.
This verse needs little interpretation; I will point out simply that "walie nieve" is Scots for "big clunking fist".

Finally, Burns ends (perhaps surprisingly) with a dig against Scottish nationalism, and an appeal to the European Court ("Ye Pow'rs") not to listen to any appeal for independence. As he says, Scotland needs the British economy, again represented by the haggis.

Ye Pow'rs wha mak mankind your care,
And dish them out their bill o' fare,
Auld Scotland wants nae skinking ware
That jaups in luggies;
But, if ye wish her gratefu' prayer,
Gie her a haggis!

Thursday, 22 January 2009

The endowment effect, willingness to trade and the scale of the US economy

Driving through the US it is slightly hard to believe that a place with such a vast and humming industrial economy could have a recession. But it's all relative, and it is entirely possible that the $60-70,000/head GDP of this region could decline by $2,000/head in a year or so.

I was provoked to wonder about how the US economy can sustain what appears to be a much higher level of consumption and infrastructure than the UK. On the surface there are no great insights or mysteries here - the US has more natural resources and space, therefore needs to spend fewer resources on working around those shortages; it spends proportionally less on public goods, and (arguably) its infrastructure is of lower quality - built quicker but also decaying faster. People work more hours and therefore create more resources (which are included in GDP), but spend less time on leisure (which isn't).

But I wonder to what extent this is not to do with explicitly differing preference, but with multiple equilibria - with the US economy simply in a higher-activity equilibrium than the UK. For example, if people are working more hours and eating out more often, rather than making their own food, it's probably a more efficient way of preparing food. Workers who make $40/hour are probably willing to spend $25 on dinner if it saves them half an hour of shopping and half an hour of preparation, but it certainly doesn't cost $25 for the restaurant to make it.

The consumer surplus that's generated is shared between restaurant owner and hungry labourer. This is a decision that is economically efficient in both the US and UK, but it seems to happen much more in the US (UK spend on eating out is around £12bn according to Keynote - note that the linked page has an erroneous statistic for the number of meals per person; in the US, more like $600bn, or about seven times the spending per person).

In this sense the US may just be at a more advanced level of specialisation than the UK. It seems plausible that this is technologically available to the UK, but we are stuck in a less efficient equilibrium. But it raises the question of how we could switch from one to the other. Workers can only afford to spend $25 on dinner if their employer will pay them for an extra hour - therefore the economy needs to already be at a sufficient level of activity in order to make this a stable situation. Hence the multiple equilibrium argument.

I would posit that moving from the UK to a US-style equilibrium requires a kind of cultural mindset which we might call "willingness to trade". Arguably people in the US are more willing to pay others to carry out services for them which in the UK the consumer provides for themselves. Americans are, if this model is correct, more willing to sell their time for the highest achievable value and spend money instead of time on personal services. This willingness may take time to build up, as the minds of individual workers and consumers are subject to inertia. One could perhaps model the time and effort taken to overcome this inertia as a type of investment good, which may give us a way to estimate its value and see what kind of return the US gets for having made that investment.

I would imagine that this figure would be correlated with measurements of the endowment effect - which is also based on people's willingness to trade something they already possess for something that (in a rational model) may have more value to them. If there are any experiments comparing the endowment effect among citizens of different countries, it would be very interesting to measure its correlation with the size of various personal-services sectors - foodservice, childcare, taxis, home decoration. Anyone know if that research is out there?

Economics of UK-US trade

I would like to come up with a justification in economic theory for mentioning this, but so far I haven't. In reality I just want to complain that, on the week of my first visit to the US in seven years, the pound has fallen to its lowest level against the dollar since 1985.

Aside from the possibility that all 2 million of Tuesday's visitors to Washington came from Britain, exchanging billions of pounds into US currency on the same day, I don't think I can manufacture a connection. Just bad luck. Is there a macroeconomic theory for that?

Models of bounded rationality and the credit environment

I've had an article published today in VoxEU:
Models of bounded rationality and the credit environment: Responses to the recession should not be based on unrealistic expectations of rational behaviour. We now know enough about real, flawed human psychology to be able to take some account of it in policy setting.
Mark Thoma has linked to it and there are some interesting responses in the comments to his posting.

Wednesday, 21 January 2009

A beautiful day in Washington

Not so many posts this week as I am in Washington, DC.

Today was both a very moving and a spectacular day. Watching the inauguration from beside the Washington Monument, there were undoubtedly a few moments in the speech that the people around us found very special. My own favourites:

"Now, there are some who question the scale of our ambitions — who suggest that our system cannot tolerate too many big plans. Their memories are short. For they have forgotten what this country has already done; what free men and women can achieve when imagination is joined to common purpose, and necessity to courage."

"And so to all other peoples and governments who are watching today, from the grandest capitals to the small village where my father was born: know that America is a friend of each nation and every man, woman, and child who seeks a future of peace and dignity, and we are ready to lead once more."

"...because we have tasted the bitter swill of civil war and segregation, and emerged from that dark chapter stronger and more united, we cannot help but believe that the old hatreds shall someday pass; that the lines of tribe shall soon dissolve; that as the world grows smaller, our common humanity shall reveal itself; and that America must play its role in ushering in a new era of peace."

"To those who cling to power through corruption and deceit and the silencing of dissent, know that you are on the wrong side of history; but that we will extend a hand if you are willing to unclench your fist."

Indeed it was full of such minor starbursts. Perhaps this is the greatness of the text - that everywhere you look, there are messages that speak to the heart of someone or some question. President Obama - as we can now call him - offers no universal solution but challenges us to join him in seeking the right answers for our time.

I intend to do that and invite you to do the same.

Sunday, 18 January 2009

Borrow, borrow, borrow

Just as we have been discussing levels of debt, Robert Peston informs us that the UK government will be guaranteeing billions of pounds more of corporate and consumer lending, starting tomorrow. This is somewhere between the US government's guarantees of Citigroup and Bank of America's debts, and a giant credit default swap (CDS). Quite clever, in that respect.

CDSs were a good business for lots of insurance companies for a long time, and now that the worst of the losses have probably been written off by banks already, they could be a good business again. CDSs do, I believe, increase economic efficiency by aggregating a portfolio of risks and allowing capital to flow to the most productive destination without being hampered by the "one bottle of poison" problem.

The state is by far the best provider of these services, because there is no counterparty risk, and because control is correlated with a positive return. That is, because the government has the ability to directly contribute to keeping businesses from going under.

The only real risk of public involvement in this business is that it might lead to underpricing of the risks; but the government has a genuine cost advantage over private companies in providing this service, so that is unlikely.

But I do object to Peston's characterisation of the situation:
"the paradox is that the Government wants to make more credit available to reduce the severity of a recession that was caused by a decade-long, crazy lending binge."
In fact, I am coming round to the view that the recession was not caused at all by lending, but by the contraction of lending - and that the appropriate level of debt may well be higher than it is. See my last post for a more detailed discussion of this point.

And on the other moral hazard issue - the idea that we are bailing out banks which should be suffering for their reckless decisions - let's remember two things:
  1. We are now substantial shareholders in several of these banks, and we will benefit too if they return to health
  2. We are being paid an insurance premium in return for these guarantees
  3. "The banks" are not an evil cabal who are the deadly enemies of the rest of the economy. They are an integral part of it, and their success enables and contributes to the success of all other companies. Punishing the banks would be cutting off our nose to spite our faces. At most, we may want to further dilute the equity of bank shareholders, and perhaps regulate the rewards of some bank executives; but even that is far from a proven case.

More debt please

While the amount of net debt across the world is always zero, the amount of gross debt is not. And gross debt has reduced substantially in the last year as firms and consumers are deleveraging.

An interesting post from Steve Waldman at Interfluidity praises this trend. I'm not convinced by his conclusion but he does contribute something rarely visible in economics commentary - a good philosophical understanding of what debt is.

"Credit, also known as debt, is one of several arrangements by which a party with the power to command resources but lacking aptitude or interest in managing a productive enterprise delegates wealth to another party who is capable of creating value but unable to command sufficient resources."

I would put it slightly more generally: Debt is a promise to give resources to another party in the future. On this view, the gross amount of debt in the world is a representation of the number of promises we have made to each other.

A promise is a restriction on your future freedom, but one that you have voluntarily entered into to increase your freedom in the past. It could certainly be argued that this restriction on freedom is not a good thing - presumably freedom in general is beneficial. But we do accept all sorts of restrictions on freedom because they benefit us - we agree to obey laws, submit ourselves to an elected government, drive on the correct side of the road, and make general social accommodations with the people around us.

The restrictions must be measured against the benefits gained. The network of promises embodied in debt are a powerful factor binding together humans in a common enterprise where we agree to make life better for each other.

Indeed, debt is not an absolute loss of freedom - it is a promise that you can break, though there are usually consequences to doing so. Throughout our lifetimes, past and future, actions and consequences, interact in complex ways, and debt is one of the integrating structures for our lives.

As Steve points out, it's not the only one:

"You would be forgiven for not noticing, given how habitually we misuse credit, but supplying credit is really just a subspecies of the practice that used to be called "investing". There are a variety of other arrangements that serve the same economic function. Perhaps you have heard the terms like "common stock" and "cumulative preferred equity"? In fact, credit is to investing what heroin is to painkillers: Unusually appealing, in a certain way. Hard to kick once you're on it. Almost certain to, um, cause problems, eventually."

He rates equity as preferable to debt (for investment purposes) which is a view I'm sympathetic with because it makes the economic system less brittle. However he doesn't much like consumer debt. That I'm not so sure about. I'm not yet ready to defend it strongly but I don't feel Steve makes a convincing argument against it:

"Credit availability creates winners (self-today) and losers (self-tomorrow), while interest payments reduce the size of the overall pie available to the time series of selves."

However, total utility generally is increased when wealth is transferred to a poorer party (self-today) from a richer one (self-tomorrow), because the marginal utility of money is greater when you have less of it. Does this outweigh the cost of interest? That question has a case-by-case answer, but in general why shouldn't it?

Finally he argues for transfers from wealthy to non-wealthy people as an alternative to debt. Of course, this is happening anyway as part of the fiscal stimulus that most countries are implementing - but I assume he would like to go further.

"The world is full of human want, which we should strive to meet by working to increase our capacity to produce. Problems arise when want and purchasing power are misaligned. We can improve that by redistributing some of the purchasing power from those with lesser to those with greater use for current consumption. If that sounds Commie to you, note that is precisely the function that consumer credit traditionally serves, just without all the residual claims, a large fraction of which will prove to be illusory (at least in real terms). That is, transfers are just a more honest way of doing precisely what a credit expansion does, except without the trauma that comes from learning that much of the money lent to fund current consumption will never be repaid."

Politically I see the appeal of this as an aspiration, but I don't think it is very realistic. The amount of resources that could be forcibly transferred, in any democratic political system, is small compared to the amount that people can borrow when they promise to pay it back. In addition, transfers only make sense as a mechanism to move money from rich people to poor people. Debt allows people of similar wealth also to exchange their wants through time - lots of debt, perhaps most, is held by middle-class people and comes from the savings of other middle-class people.

The amount of consumer debt that will "never be repaid" even in a crisis like 2008's is surely less than 5% of all outstanding consumer debt, which makes this quite a radical fix for a system which is not really broken.

I even believe it's plausible that the optimal amount of debt could be much higher than today's level (though I'm not sure). Quick thought experiment:

If someone could make a transformational difference in your productivity or quality of life, wouldn't you be willing to commit (say) 10%, 20% or even more of your income to them in return? (If you say no, you have presumably never been married or had children.) If you think that borrowing money can't make that kind of difference in your life, then I say you need to be more imaginative. It undoubtedly can, when invested well; and as Nick Rowe pointed out to me, the line between investment and consumer spending is far from clear.

Thursday, 15 January 2009

Stimulus that employs the unemployed

On this blog, as well as on several others, there's a strand of opinion supporting fiscal stimulus aimed at investment rather than consumption. Of course investment, depending on the multiplier, leads to a certain amount of consumption anyway. But the argument is that direct government spending should be weighted towards investment, either because there is a deficiency of investment in this phase of most recessions; because there has been underinvestment in the last few years which needs to be made up; or because it's a more "responsible" way to spend public money.

A typical goal in designing an investment program is to create demand for things that can be provided by currently-unemployed people. This encourages unused resources (people) to be brought into use, so the stimulus gets an economic free lunch instead of diverting resources that are already economically productive.

The challenge is that people are unemployed typically because their skills are less useful in the marketplace - i.e. the things they know how to make or do, are not things that people want very much.

So how about this as a way to do it:

Create a range of training goals for unemployed people, based on the skill gaps that they have in comparison with those who are productively employed. Offer free training, and incentivise the recipients by paying them for achieving specific goals or qualifications.

Training could be in a number of different fields - green infrastructure, healthcare, information technology, education, or indeed literacy and other basic skills for those who need them. Ideally the types of training offered should be guided by the market; for example:
  • by a measure of skills shortage (perhaps by comparing salary earned with number of years education required to fill the post; or by taking international benchmarks)
  • better, by involving private companies who would gain from successfully placing the trainees into jobs, proportionate with the salary earned

Training is an efficient good to offer to a large number of people - it has good economies of scale. This is an investment which directly benefits the poorest in society as well as raising the productive capacity of the economy as a whole. And as a stimulus it works well, because it does not act as a deadweight on resources that are in productive use, and the money goes to those who are likely to spend it - increasing the multiplier.

A minor drawback is that low-income people pay less tax, so the amplification effect of marginal income tax (see Paul Krugman's columns this week) will be less. I think that effect is both countered by the reduced propensity to spend and outweighed by the public good that the proposal creates.

A more substantial drawback is that some kinds of training would take a long time to ramp up. However I anticipate there will be some types of course that are ready to go right away. In the UK we have ready-made training courses for home energy assessors; intermediate labour market opportunities for installers of home insulation; and a big vocational/further education infrastructure which - though it is well utilitised at the moment - could undoubtedly take more students. The US, I imagine, will have some similar structures.

I think it would be possible to estimate the direct stimulus value of this program as well as the value of some longer-term secondary effects; any takers for that?

Wednesday, 14 January 2009

Mystery quotation

If art and associated attitudes are not to become pleasing-appearance ready-made goods, but a living, albeit perhaps fleeting, organism, art should be able to improve exactness of its message in the time allotted to it and thus, paradoxically, define itself in history. This improvement of exactness means that its individual, selectivesieve can cover the so-called objective sieve. Where their nodes do not coincide, ‘free space‘ opens. Energy of the free space is proportional to the power of sharing, or, more precisely, it is the sum of the freely pulsating words which, in this context and in each specific time, is able to define (tangle up) different meanings naturally through spontaneous intuition. These screen points are spatial holograms of historical memory, experience, and therefore each such new overlap becomes another non-linear tangle to the naked eye.

A prize to the first person who can guess where this comes from (or what it means) without Google.

Monday, 12 January 2009

Credit insurance trap for UK retailers

Robert Peston discusses the difficulties that retailers (or their suppliers) are having getting trade credit insurance.

Fundamentally, information asymmetry combined with efficient use of capital causes this problem. The reason suppliers want insurance is because the economy is shrinking and a (small but significant) percentage of retailers and wholesalers are going to go under. Even though the number is small (I'd estimate 3 to 5 per cent), the problem is that nobody knows which ones. Therefore unless suppliers stop trading altogether, they want to be covered for the risk.

I read a nice analogy recently: if someone gave you ten bottles of water and you knew one was poisoned, you probably wouldn't drink any of them. Even if you were really thirsty.

This combines with the (quite correct) desire of retailers to minimise the amount of working capital tied up in their supply chain in order to be price competitive and profitable. Therefore they extend payment terms to the degree that suppliers have a substantial risk of not getting paid at all.

Suppliers therefore want insurance. Insurers are certainly going to ramp up rates in a recession - to the 3-5% level that will cover them for failures. This is a big extra cost which will ultimately passed onto the retailer (though suppliers might need to absorb some in the short term).

Unfortunately there is a well-known problem of adverse selection in insurance markets - if the insured parties know more about their circumstances than the insurers, which is definitely true in this case. It works like this:

Solid retailers, who are much less likely to go bust, will not want to pay a 3-5% premium on all goods they buy. Therefore, if someone (let's say Marks and Spencer, or Tesco) can demonstrate their stability to the extent either that insurers offer a lower rate, or that suppliers are willing to be uninsured, they will effectively withdraw from the risk pool.

This forces the retailers who remain to bear a higher premium - let's say 10%, and incentivising the next tier of mid-stable retailers to somehow prove their solvency - at least to the degree where they can get cheaper insurance.

Finally, you will be left with a group of companies who cannot or will not be transparent enough to prove their stability, and will become uninsurable. They will be forced to pay upfront to suppliers, which with their likely financing costs, is likely to put them under - as it did with Woolworths and Zavvi. Sadly, the group who can't prove their solvency is likely to be bigger than the group who actually are insolvent. So we may end up with the 3-5% level being amplified to 6, 10 or 20%. Essentially all the risk in the system will get funneled onto the least stable companies who can afford it least.

There are only two ways out of this:
  1. We accept the collapse of lots of retailers
  2. The retail sector is required to increase its capitalisation across the board to increase working capital in the supply chain - probably with a corresponding increase in transparency of corporate books, or possibly as an alternative to that
Will the government assist in providing that capital? It's possible, though "yet another bailout" is not something anyone wants to hear.

Perhaps we will end up with two classes of retailer: those (M&S) who choose to provide full transparency to prove their creditworthiness, and those (whoever is the next Zavvi) who choose instead to participate in a risk pooling arrangement where extra capital is provided in return for insurance premiums payable to the government, or higher taxes on future profits.

Would these conditions make the "risky" retailers uncompetitive and therefore more likely to collapse? Maybe. It does seem inevitable - both due to the recession, and due to the continuing substitution of online shopping for retail - that more retailers are going to go under. I believe a solution like this can be engineered to make sure the number that does collapse is not artificially increased by this trap.

Update: Land of Leather has asked the stock exchange to suspend its shares and has gone into administration.

Sunday, 11 January 2009

List of UK economics blogs

I haven't found a list of UK-based economics blogs out there, so I thought I'd make one. Alphabetical order by name of blog:
  • 2UBH: low-volume blog on economics among other things. By Tim Chapman
  • Adam Smith Institute: highly free-market, not especially UK-focused subject matter but based in London
  • Adam Smith's Lost Legacy: Free-market oriented economics blog written in Edinburgh, at the moment mainly providing commentary on other blogs
  • Alex Singleton: Politics and economics within the Telegraph blogs stable
  • Bluematter: Interesting links to economic and political news, and occasionally some analysis too
  • Business Angel Blog: by charter, it's not about economics - but like many business blogs, it has crept recently into the more exciting territory of discussing the economic crisis
  • Capital Chronicle: This isn't UK-based, but the author has some UK history and writes about British news frequently. The phrase "mustn't grumble" tips the balance
  • Cautious Bull: thoughtful commentary on stockmarket investment and related issues.
  • Clive Crook (FT): Not really economics, but his politics touches on the economy often enough that I'll include it
  • Daily Telegraph Economics Pulse: The Telegraph blog, filtered to economics articles
  • Economics Help: A site explaining some basic concepts in economics and relating them to the news
  • Economics UK: written by David Smith (economics editor of the Sunday Times) and contains his Sunday Times columns as well as some other, mainstream-for-UK-economists-type writing
  • Economists' Forum (FT): columns by major economists, broadly discussing economic policy, edited by Martin Wolf and including his own FT columns
  • Economonkey: Doesn't the name say it all? No? A rather sarcastic and entertaining discussion of economic news
  • Enlightened Economist: A blog about economics books by Diane Coyle (former economics editor of the Independent) - not quite full reviews, but useful discursion on new and old economics authors and texts
  • The Filter: Disseminates academic ideas and research for a mainstream audience, in a readable way. It covers various subjects but I have linked to the economics subset, written mainly by Anthony Evans who is a lecturer at the ESCP-EAP business school.
  • Flip Chart Fairy Tales: Strictly speaking, perhaps more business than economics, but definitely touching on macroeconomic issues
  • Free Exchange: The Economist's blog - not particularly UK-focused but published from the UK
  • Global Economics and Structures: a blog about the global economy and international institutions and structures, written in the UK
  • Globalisation and the Environment: while this is about global issues, it seems to be mainly from a UK perspective
  • Globalisation Institute: their site seems to have gone AWOL for now - I will check again later. However, see Alex Singleton above
  • Idle Scrawl: blog from Paul Mason, economics editor of Newsnight. Covers the latest news and gives some macroeconomic analysis. If he posts a bit more frequently, there's no reason why this shouldn't be more popular than Robert Peston - though I think its relative anonymity at present improves the quality of the comments
  • Institute of Economic Affairs: articles from "the UK's original free-market think-tank"
  • JKA on Economics UK: John Ashcroft's blog about the UK economy - most postings contain analysis in response to the latest economic news
  • Knowing and Making: This blog here. Long-term themes are how economics applies to knowledge (intellectual goods), and how knowledge affects economics (through behavioural and mental models). Also with occasional light-hearted economic analyses of the news, and commentary on the economics zeitgeist
  • Labour and Capital: covering the interface between UK politics and economics
  • Macroman: "Satisfaction guaranteed or your money back". A blog about macro data, written by an American in London
  • Maverecon (FT): Willem Buiter's idiosyncratic, famously lengthy, but always thought-provoking blog
  • missmarketcrash: A somewhat poetic narrative on financial markets, the economy and some more personal, introspective ponderings relating to family and self
  • NEF Triple Crunch: A blog from the New Economics Foundation, a think tank
  • New Economist: Miscellaneous economic analysis and comment from a London-based economist. Dormant at the moment - no postings since August 2008
  • Our Word is Our Weapon: Not all economics-related, but enough. Officially about development and social policy, but quite eclectic
  • Oxonomics: Economic analysis from Oxford University
  • Peston's Picks: Technically the BBC's business editor, but most of his postings are about macroeconomic policy
  • The Price of Everything: A mostly finance-oriented blog by Tim Price - noticeably sceptical about government bailouts and the risk of inflation
  • Richard Thinks: Covering current economic/finance news alongside a range of business and knowledge management ideas
  • Stephanomics: The predictably-named successor to Evanomics, this blog is written by Stephanie Flanders, the BBC's economics editor since mid-2008. At time of writing the blog has only just started, but looks to be of good quality - Flanders is an authoritative writer and the prose is in the usual well-written BBC style
  • Stumbling and Mumbling: about politics and economics; particularly criticising managerialism in politics
  • Tim Worstall: a mix of economics and news commentary; hard to classify the economics part
  • Economics In The News: an economics blog from the head of economics at Eton College
  • Undercover Economist (FT): Tim Harford's blog on the economics of everyday life
  • Warwick University: Not exactly a blog so much as an aggregator, but Warwick University has set up a blog platform for its students and staff, and the link points to a collection of posts by everyone in the Economics department
If you have a UK-based economics blog or know of one that I've missed out, please email me or leave a comment. Criteria are: blogs which are predominantly about UK topics and/or written by authors based in the UK. If you write one of the blogs above and would like me to change the description, let me know that too.

In compiling this list I spent much longer than I expected, reading far more economics blogs than I thought I ever would (over 300 of them). Some thoughts from that traumatic experience:
  • It would be great if there were a way to objectively gather trends, key discussion points and consensus views; there's a big danger of being influenced mainly by whatever you read most recently, or whatever confirms your prior assumptions. For example, can Google News be adapted to summarise stories from a specified subset of sites?
  • There seem to be fewer UK blogs than one would expect, considering the population, and the number in the US, Australia, Canada and elsewhere. Is this because the UK is more centralised? I suspect those living in San Francisco or Melbourne who want to talk to their peers in Massachusetts or Canberra use blogs as a convenient channel; while those in London see each other at local seminars or round the pub.
  • This despite the fact that the UK has two of the most-cited economics publications (theFT and The Economist - though perhaps surprisingly, the FT gets a lot more links than the Economist does).
  • Does this explain why the centre of gravity of UK economics blogs is much further to the right than those in the US (and worldwide)? I suspect that in the current political environment, those who hold more free-market and less interventionist views feel outside of the mainstream - and thus are more likely to promulgate their views in blogs than in person at conferences.
  • And just how many blogs does Joshua Gans have??
Paul Ayres at Intute has a quick survey of economics blogs and some ideas on why there may not be so many UK-based economics blogs, and has also written a guide for UK academics about economics blogging.

Latest updates:
15 January 2009: added Enlightened Economist books blog, 2UBH, The Price of Everything, Labour and Capital, JKA on Economics UK and Global Economics and Structures.
24 January 2009: added missmarketcrash, Idle Scrawl and Flip Chart Fairy Tales
28 January 2009: added Stephanomics
8 February 2009: added Richard Thinks
11 February 2009: added The Filter
12 August 2010: added Cautious Bull

Rigour? In a blog?

Brad DeLong has an impressively clear (although, or perhaps because, a bit technical) piece on risk appetite and fundamental values of assets. I feel I should respond to it, but it's such a tour de force of clear and explicit assumptions, rigorous logic and thunderous conclusions that I feel I barely can.

I particularly loved this statement for pure bloody-minded literalism (that's a good thing, by the way):
The fundamental values of asset prices are the money-metric values that the costate variables associated with the commodities would have in some reasonable utilitarian central-planning social-welfare-maximization exercise under reasonable utilitarian preferences.
However, here is what comes to mind:
  • Given that asset prices rarely approach the values Brad ascribes to them, could this be because there is competition for the limited amount of savings capital available in the world? If I, as a productively investing business, want to get access to some of it, I probably need to pay a lot more than 2% (I have anecdotally heard figures as high as 19% for small business loans recently, and that's for a loan 75% guaranteed by the UK government; perversely, I also saw a firm quote of 11.49% for an unsecured loan). Then again, I can definitely make a more than 2% return so I wouldn't mind paying more.
  • Is it true that default risk is or should be minimal? One argument quoted (by David Smith of EconomicsUK) against a proposed £50 billion state guarantee of business lending is that the Treasury estimates losses of up to £12 billion on it.
  • While long-run productivity growth should indeed be the guide for average investment returns, a dynamic economy is likely to produce lots of businesses which increase productivity by 5, 10 or 40% a year, and others which stagnate, shrink or fail. More and more investments in the context of a 'knowledge economy' are intangible assets which are mostly written off in the latter scenarios, and thus the successful businesses need to generate much higher returns to compensate. This implies both demand for, and supply of, higher-yielding assets. And again, a high default risk.
Against all these points, Brad is probably talking about average returns for (say) equities across the whole class, rather than expected return of any individual asset. If half of today's equities will be worthless in 10 years, then they each need to have an overt return much higher than the 2.3% target, in order to average out.

(An interesting aside: this argument indicates that equities should have lower annual returns in the short term than the long, because the long-term return has to take into account a higher risk that the company won't survive that long. However, equity investors, especially in the angel and VC markets, always insist on high early returns, to minimise their risk and force the company to reveal/prove information that reduces uncertainty.)

But perhaps more fundamentally, I suspect the information discount is higher than he believes it should be. Risk is easier to arbitrage, or average, away than information is; a big information gap not reflected in his analysis is knowledge about future behaviour. This makes it hard for people to optimise consumption to their ideal time preference - you might die next month before cashing in that T-Bill, or Ben might inflate it away. It also makes competition between assets difficult, and that may lead to a rational undervaluation.

These are just some initial thoughts, late at night and without the level of self-confidence and technical muscle that is bulging from Brad DeLong's posting. He does remind me of Krugman in that way. I wonder whether the Keynesians are simply more confident, have more testosterone, or just more confidence in the system to work right, than the less interventionist Mankiw-Cowen-Kling school.

Thought-provoking, anyway.

Saturday, 10 January 2009

Arbitrage by piracy

When the Sirius Star oil tanker was captured by pirates on 15 November, the crude oil price was around $55 a barrel.

It contains about 2 million barrels of oil, now worth $40 each, so its value has fallen from $110 million to $80 million in the intervening period. Thus, aside from the rumoured $3 million ransom payment, the owners have lost $30 million in value of the commodity - plus whatever it costs to borrow $80 million for two months (not much these days).

Yesterday, with oil getting close to its lowest point in a couple of years, the tanker was released.

What possible economic explanations are there for this behaviour? And what does it tell us about oil prices?
  1. The owners may expect that prices are going to fall further, and decided that now is the time to get their oil back and sell it. Therefore they were motivated to deal now rather than putting it off.
  2. The pirates may expect that prices are going to fall further, and decided that their likely ransom would diminish. Therefore they were motivated to make a deal now, before having to renegotiate.
  3. The owners may expect prices to rise, and that the pirates' demands would increase. Therefore they want to make a deal before the pirates realise this.
  4. Both parties may be keen to deal as soon as possible, but transaction costs and information asymmetries meant that it took two months to reach a market-clearing price.
In theory, if the first of these scenarios were the real one, the owners could simply hedge by selling 2 million futures contracts instead of the physical oil - though they'd be exposing themselves to the risk that the tanker still isn't free by the time the contract expires. Given that the tanker is owned by the Saudi government, though, they'd probably manage to cover it somehow. So we should believe in factors 2, 3 or 4.

No doubt some combination of these factors applies. But if you're looking for insights into the future direction of oil prices, look at the behaviour of those who may have inside information.

The owners of the tanker, as a state-owned Saudi company, could possibly hold privileged information about planned future Saudi oil supply levels. And the pirates might also know something about future increases or decreases in piratical activity off Somalia.

Factor 2 implies that the pirates think piracy is going to decrease, reducing the future price of oil. If this were true, it would also encourage the Saudis to deal, because the moral hazard effect of doing so would be reduced.

Factor 3, on the other hand, implies that the Saudi government thinks supply will decrease, increasing the price of oil.

Of course, both of these factors might be true - after all both parties have willingly entered into this deal. At the margin, the two factors should balance each other. What's more, eight of the pirates have been drowned after taking their share of the ransom money, which will also reduce piracy.

In which case your best bet is to find other commodities subject to piracy, whose price will also fall if piracy drops, and sell them. Anyone currently holding Ukrainian tanks is advised to get out of the market now.

Friday, 9 January 2009

Behavioural causes

Just discovered a site I wasn't aware of before: Baseline Scenario. They have a nice summary of Daron Acemoglu's paper which has a focus on behavioural (mental/perceptual) reasons for the financial crisis.

I have written on this subject recently and will post a link to the paper here if and when it is published.

The solution to recession

The Professor brightened up again. 'The Emperor started the thing,' he said. 'He wanted to make everybody in Outland twice as rich as he was before — just to make the new Government popular. Only there wasn't nearly enough money in the Treasury to do it. So I suggested that he might do it by doubling the value of every coin and bank-note in Outland. It's the simplest thing possible. I wonder nobody ever thought of it before! And you never saw such universal joy. The shops are full from morning to night. Everybody's buying everything!'

– Lewis Carroll, "Sylvie and Bruno"

Wednesday, 7 January 2009

The stimulus - spend, invest or incentivise?

Hal Varian in the WSJ (via Mark Thoma and Marginal Revolution) has touched on a topic I have been thinking about for a while: how is the fiscal stimulus best spent? On consumption or investment?

There are essentially two tools available for the stimulus: tax cuts and government spending. And there are five main sources of demand in the economy: private consumption, private investment [optionally divided into business and residential investment], government consumption, government investment and exports. I am not going to address all ten combinations, but focus on private investment - should we promote it, and if so, which are the best tools to do so? I am a priori neutral between tax cuts and spending; tax cuts are good because they let people allocate spending by efficient private choice; spending can be good if it achieves public goods that are not best purchased in the marketplace.

My intuition, like Hal's, is that private investment is important. But is there a clear argument for this? Here's an attempt to work it out.

Arguing for increased investment:
  1. Private investment is likely to be artificially depressed at the moment. Many companies cannot raise long-term debt, which is the most common way of financing investment.
  2. Investment should have the same multiplier effect on demand as consumption spending, but has the benefit of increasing long-term growth as well.
Against that, however:
  1. One could argue for reducing investment in a recession if we agree that it's beneficial to smooth consumption. Crudely speaking, if you're starving it's OK to eat seedcorn.
  2. Investment means resources are used for future instead of current consumption. Although investment might support employment (or allow it to be reduced by less), the recession might then show up in reduced living standards instead of unemployment.
Both of the 'anti' arguments apply if total demand and GDP are reduced below potential. If this year we can generate only 90% of the goods and services we did last year, then we may want to reduce investment in order to still spend the same amount on food and holidays. But if, by stimulus, we can maintain total demand at roughly its potential level, then there is no need to cut investment in order to boost consumption. If investment is at a normal rate, consumption will naturally be at a normal level too.

Government can't really choose an optimal level of investment - it depends on the time preferences of consumers as well as the existing stock of capital. Japan and Germany, for example, seem to have much better public infrastructure than the US - and so for them, it might make more sense to boost consumption than investment. Also, different populations have different preferences for future versus current consumption.

Therefore, it seems reasonable to take the average long-run rate of investment in each national economy as a target for the future. If actual investment is substantially below that, we can seek mechanisms to increase it. If it's at its normal level, then perhaps consumption should be boosted instead.

To help choose a mechanism, consider two reasons that the stimulus should work.

The main rational purpose of the fiscal stimulus is to directly bring unused resources into production, so that we avoid the deadweight loss of people and capital sitting idle for a year or two. But an important psychological argument for it is to give people and companies confidence that there will be future demand for their services, discouraging them from retrenching. In this way, agents choosing to buy things will create additional demand in the economy on top of the direct stimulus.

(Note that this argument has nothing to do with debt and savings rates. These are purely monetary effects which have no direct impact on resource usage or total production in the economy. Of course the existence and structure of debt and saving is one mechanism which affects how resources are used via signals and incentives; so it is important to understand it. But the amount of debt (public or private) is not relevant to the balance between investment and consumption - not least because every debt is an asset, so the total amount of debt in the world is zero.)

So an ideal mechanism for the US and UK (where investment does appear to be depressed below long-run levels) would do the following:
  • Identify underemployed resources
  • Identify investment opportunities with the greatest net present value
  • Incentivise capital, or directly provide capital, to bring the chosen resources into use to implement the chosen opportunities.
Naturally, a free market is usually best at doing the above jobs. But if resources are underemployed (which is clearly true) and investment is not happening (which is probably true), then is the market doing its job?

There are two answers to this:
  1. There are no profitable investment opportunities at present. Therefore the market is acting rationally in not investing.
  2. There are profitable investment opportunities, but something is preventing them from being exploited by the market.
Answer 1 seems illogical. If the resources are unemployed, surely there should be a market price they can take, at which investment becomes viable. Sticky prices and minimum wages may possibly stop this from happening, but this would only be true if there had been so much overinvestment in the recent past that all profitable opportunities have been used up. But does anyone think we have had a splurge of overinvestment in either the US and UK this decade? On top of this, interest rates are so low that some investments which were not viable last year should have become profitable now.

Answer 2 is more convincing. Here are some factors that may stop the market from taking effect successfully:
  1. Lemon projects. Famously, due to asymmetric information, the used car market can never achieve its potential. Buyers fear they will get a lemon and will only pay a discounted price; the seller knows the quality of the car much better than the buyer, so there is an adverse selection problem and only low-quality cars will be offered on the market, requiring a further discount. The same effect may be at play with potential investment projects. Although it is clear that some investments must be profitable, there is much uncertainty about which ones, and therefore investors are staying away altogether.
  2. Uncertainty in capital markets. Although the total amount of money available in the market is bigger than ever, due to quantitative relaxation by central banks, nobody knows how long it will stick around. Banks are not renewing credit lines or extending new long-term loans because they can't know whether their own finance will be renewable. They must know that some money will be available somewhere; but nobody knows if they will have access to it, and so everybody reduces lending.
  3. Transaction cost of reallocating resources. It could be that the underemployed resources are not the ones needed to implement the most profitable investments. Retraining takes a long time and is risky; resources may be in the wrong location or be otherwise unsuitable.
Probably all three of these factors contribute to the problem. So, once again, what mechanisms would help address them? Our candidates need to meet some or all of the following criteria:

  1. Any solution that provides long-term predictability of new demand, either aggregate demand or demand for specific goods and services, should assist in resolving problem 1.
  2. A solution providing guaranteed availability of long-term capital should help with problem 2.
  3. Choosing the character of demand (under criterion 1) to be compatible with the underemployed resources in the economy will help with problem 3.
And, conveniently, there is a mechanism which can achieve precisely this, under certain conditions. The Obama "green stimulus" package.

However, I believe it needs to be backed up with certain complementary actions. Therefore, I propose the following structure for that package:
  • Guaranteeing long-term demand by legislating for a future carbon tax at a known rate. This will provide incentives for the private sector by guaranteeing profitability of well-designed environmental investments. Joining the Pigou club, as Greg has it.
  • Committing future carbon tax revenues to provide long-term investment finance. In the current environment, only government, central bank and a limited range of long-term private savings schemes (primarily annuities) can guarantee long-term finance. The central bank will prefer not to do so due to inflation risks, while private savings are already being mopped up largely by Treasuries. Government's ability to issue long-term debt may be constrained by its growing deficits, unless it credibly commits to future tax increases - the carbon tax could provide that commitment.
  • Providing limited micro interventions to assist the incubation of the new sector. These need not be substantial, but there are certain public goods - such as education, or management and pricing of public commons - which can be most efficiently done by the state. Anecdotally, it seems that many resources which were employed in residential investment over the last seven years are among those which are now underused and would be ideal candidates to participate in this program.
  • Direct some of the fiscal stimulus towards tax cuts and spending which directly supports this sector. A tax break for relevant investments is one option; spending directly on environmental goods is another. Note the balance between the stimulus, which is necessarily short term, and the carbon tax, which provides its long-term counterpart.
Undoubtedly there are other suitable mechanisms too. But this one - provided the carbon tax is credibly instituted - seems to meet the criteria so well as to be irresistible. And the logic of this package may provide the only politically credible chance to get the carbon tax in place for the next decade.

Update: Useful data from the Atlanta Fed about investment levels, with a somewhat similar analysis of the reasons investment might be falling.

Lottery rollover - fewer players, bigger prizes? Bad maths

I was sceptical of a claim on Free Exchange today:
"...if there is no winner the prize is carried over to the following week. A smaller participant pool can then result in infrequent, higher jackpots."
This struck me intuitively as unlikely. So I thought I would work it out.

Probability theory has been unpopular among economists this year - everyone quotes Nicholas Taleb and slowly, loudly explains to us how the financial markets don't behave like a normal distribution after all, and we don't have enough historical data to give us a predictable distribution for the future. Insufferable.

Fortunately lottery draws do obey standard probabilities and we do have enough data (and enough theory) to predict how they will behave. So we can use some standard results.

Assume that a lottery has 10 million participants each paying $1, with a 50% payback. The prize fund in a typical week is $5 million. Let's say the odds of getting the right numbers are 1 in 14 million; then the chances of a rollover are around 49% (see this page on Poisson distributions to work out why, or post a comment if you want an explanation).

So starting from a week with no rollover, there's a 51% chance of a $5 million prize, a 25% chance that it builds up and $10 million is won the next week, 12% of $15 million the week after, 6% of $20 million, 3% of $25 million... 0.2% of $45 million... and so on.

Now imagine the number of players falls by half. 5 million participants, $2.5 million expected prize. Chances of no winner in a given week are now about 70%. So again starting with an empty prize fund, we have a 30% chance of $2.5 million, 21% chance of $5 million, 15% chance of $7.5 million, 10% chance of $10 million, 7% of $12.5 million, 5% of $15 million... 1% of $25 million... 0.07% of $45 million.

The probability of reaching a given size of prize fund never exceeds the probability with a higher number of players. You can tweak the numbers to check this - it's easy to build a model in Excel - or I may revisit this shortly with an analytical rather than numerical demonstration. But I'm afraid the Economist, for once, has made a mistake.


Comment from "AAPrescott" on Justin Webb's blog:

"From a political point of view I like many of Tom Daschle's policies, but he does talk about 'evidence based medicine'.... As a practitioner of Chinese Medicine I have some unease about this"

I hope this says more about the commenter than it does about Chinese medicine.

Monday, 5 January 2009

More wrong science

The Telegraph thinks America produces enough electricity to power one lightbulb for every 30 citizens. Huh?

This article (about a powerful laser) says it produces " equivalent to 1,000 times the amount produced by America's national grid, or more than 10 billion times more than an ordinary household lightbulb."

A bit of simple arithmetic indicates that the national grid can power 10 million light bulbs. Which, with 300 million people, means it must be pretty dark most nights.

Actually, the laser has a power of 500 trillion watts - which means nearly 10 trillion 60-watt lightbulbs. But if you let loose on science stories journalists with no instinct for arithmetic...

The crucial question that goes unanswered by the article is, of course: will it create a black hole that could destroy the Earth? I say we should shut down all scientific research until we are sure.

As Brad DeLong might say: "Why, oh why, oh why..."

The "Buy American" clause

Greg Mankiw is not in favour of a "Buy American" clause in the expected US fiscal stimulus package.

I don't like protectionist rules myself, and normally you wouldn't find many economists arguing for them. But I have a feeling now that we might see support among some economists for variations of this "Buy American" rule. For example, a condition that spending can go only to countries that have also passed a major fiscal stimulus package.

This might just come from people feeling peeved at Germany. It might come from instinctive protectionists finding a respectable way to get their point across. It might come from strong Keynesians who are worried about the damage to the fiscal multiplier from propensity-to-import.

It may be unfair to him, but I predict that Paul Krugman may be a flagbearer for this argument. He has just won a Nobel Prize for his New Trade Theory work, which argued (among other things) that some protectionist policies might be justified if they encourage local network effects which stimulate increasing returns to scale. It's easy to extrapolate from there to the generalised "network effect" of the Keynesian multiplier.

Krugman also strikes me as one who would support a fairly interventionist fiscal policy - highly targeted government spending, aimed at maximising the multiplier, as opposed to a hands-off tax reduction. This is another variant of that targeting.

My own feelings? My general position, though still Neo-Keynesian, is closer to moderates such as Mark Thoma than to Krugman. I believe that:
  1. This is a world problem. Therefore we shouldn't try to solve it locally. There is lots of theory and some clear empirical data behind this.
  2. US gross exports are strong (even though there's still a trade deficit) and will be boosted anyway if other economies successfully emerge from recession.
  3. Well over 50% of the world is likely to engage in fiscal stimulus (the EU, possibly apart from Germany and Italy, is mostly committed to it; China has announced an even bigger package than the US, though it is unclear whether they can follow through; Japan is still running deficits) so any potential leakage of multiplier into the non-stimulating countries may be outweighed by the loss of efficiency from protection.
And I am tempted to say that there are some principles more important even than getting out of this recession quickly. International trade and equal treatment probably qualifies as one.

Update: Paul Krugman has posted his opinion on this. My prediction wasn't exactly right, but have a read and see what you think.

Sunday, 4 January 2009

Innovation, investment and patents

One of my long-term themes on this blog is knowledge work - how we measure the productivity or capital value of knowledge, and how it is converted into valuable outputs. And a recurring recent point has been investment, what it is and how we encourage it.

Combining these two is a posting from VoxEU from a few months ago: "Efficiency in the 'market for innovation'" by Alberto Galasso and Mark Schankerman. They claim that

"The 'market for innovation' - the licensing and sale of patents - is, for example, one of the principal incentives for firms to invest in R&D."

My instinct is that this is not true at all. Lots of companies that I work with invest in R&D, and virtually none have any patents. Admittedly I do not work with any large biotech or electronics manufacturers, so my anecdotal evidence is not necessarily representative. But I do believe that a lot of innovation goes on in the marketplace which is not captured in patent statistics.

Economists often deal with information which is hard to measure and even harder to run controlled experiments with. In research on innovation, patents are a useful proxy for both innovation or R&D, because they are hard to measure directly (cf. Nick Rowe's point 2 in my previous posting). But are they a good enough proxy? I think not.

Here are some important factors which argue against patents being a good measure of innovation:
  1. They are biased towards larger firms. The fixed overheads of registering and defending patents means that a firm needs to be able to amortise their innovation over a minimum level of revenue before it becomes worth patenting. However, lots of innovation does go on in small firms - particularly in the high-tech sector, but also in many others.
  2. They are biased towards formal, laboratory-based research work. Of course this work is important, but not the only - and probably not the major - source of innovation in the economy. Market-based innovations - a new way of packaging a product, a new way of reaching potential buyers, or a new pricing structure - create economic value just as developing a new type of microchip. Of course most individual market-based innovations have a smaller effect than a newly invented pharmaceutical, but there are many more of them.
  3. They are biased towards work which is known in advance to be innovative and patentable. Many of the new services that arise in the economy (think of Twitter, Facebook, Walmart, Pret a Manger) arise through trial and error, and the innovative components may only be visible in retrospect. Most services have been through many iterations and discarded 90% of the new ideas they tried, keeping only those that worked in market testing. It's not only impractical, but sometimes legally impossible, to patent a new concept developed in this way.
  4. They are biased towards long-lasting (and therefore perhaps slow-moving) innovations. Because patents take a couple of years to acquire and last for 17 or 20 years, they are best suited towards big inventions with large investment and high, slow-burn returns. However, a vast number of useful ideas only take a short time to develop and may only bring a return for a few months until they are obsoleted or copied by competitors. Many of these are certainly worth doing, and certainly not worth patenting.
  5. Patents act as a disincentive to some kinds of investment, as well as an incentive to others. Software patents are the most-cited example: they discourage the development of some new kinds of software because the developers may not be able to afford to licence a known patent, or may fear the risk of infringing an unknown patent. On the other hand they do offer an increased return to the developer who gets the patent. Which of these effects dominates? It is not known, but there are definitely two sides to the question.
So I would like to pose four questions:
  1. Can we measure, or estimate, the amount of this kind of innovation which takes place, compared to the amount of formal, patentable invention?
  2. Can we therefore estimate the amount that is invested in these innovations, and the return made on it?
  3. Does this shed any light on the total amount of investment in the economy?
  4. Is there an alternative, more economically efficient, system to use instead of patents?
None of these questions has an obvious answer, or one that's clear after ten minutes' thought, so I will post this as it stands and await further inspiration.

Nick Rowe's response

Nick Rowe responds with some feedback on my posting:

Three thoughts on your variant of the proposal:
  1. Remember the classical dichotomy, between nominal (measured in $) and real (measured in physical, or inflation-adjusted units), and the (long-run) neutrality of money. Monetary policy cannot determine any real variable in the long run. The attempt to do so would cause accelerating inflation or deflation. (The attempt to peg employment with a vertical LR Phillips Curve was one example of this). So REAL investment won't work as a target, but NOMINAL investment might.
  2. It is VERY hard to measure investment (even gross investment, let alone net investment). Where do you draw the line between consumption and investment; current expenses and business investment? Human capital? Home improvements? Cars? It's also noisy, on a monthly basis. Somebody buys a big order of airplanes, and up it goes. (Depends on size of country, but a guy at the bank of Canada once told me that US is a big enough country that this noise gets smoothed out, but Canada isn't, so never believe Canadian monthly GDP figures). And data comes in with a long lag.
  3. Some fluctuations in (real) investment are good, and you don't want to try to smooth them out, or to tighten monetary policy whenever investment increases. In Canada, I think of the oil sands investment, big enough to show up in national figures. Maybe a housing boom as well, if baby-boomers suddenly all reach the age of wanting houses.
I think that 2 above is the biggest reason why targeting investment could never work on a practical basis. The data is just too noisy, lagged, arbitrary, inaccurate.
Thanks to Nick for giving this some thought. These are good arguments to, at the very least, rethink the suggestion. My responses are:
  1. True. This would imply that this scheme should only be used to correct money-related reasons for a shortage or excess of investment, and not to try to change the underlying dynamic of the economy. For example, if underinvestment is due to an imbalance between the availability of long-term debt and the demand for long-term investment; or due to uncertainty that short-term debt can be rolled over in the future. Arguably the central bank has a role in reassuring markets that debt of various maturities will always be accessible.
  2. I had not appreciated this factor to the extent that Nick makes clear. Although I would specifically exclude residential investment from the target, this only addresses a small part of the point. As someone who runs a business myself, I am well aware of the inadequacies of standard accounting measures of capital investment (for example software is usually considered a revenue expense even though nobody would buy software on that basis). So we might need to invent some kind of proxy to understand the actual levels of productive investment. I would think that in the current economy it's clear that investment is below optimal levels, but without further evidence I would be hard pressed to defend that point.
  3. Again true, though this is also true of inflation targeting which tends to be targeted on a 2-year horizon. As Nick says, point 2 is probably the main issue.
I welcome further input on this proposal in the comments or by email, and hope it will all be as incisive and thoughtful as Nick's.

Saturday, 3 January 2009

Robert Solow's Nobel speech

It's hardly news - he got the prize in 1987 - but I was searching for something recently and came across this. It makes a pleasant read, and those interested in the economics of growth may enjoy reminding themselves of some of Solow's work in a lucid, nicely-written piece.

Friday, 2 January 2009

Private investment by central banks

Roger Farmer has taken up my suggestion that central banks should make equity investments. OK, chances are he didn't get it from me - but his proposal is somewhat similar to mine. I explain my suggestion in more detail below.

Farmer's article has provoked much comment on economics blogs – as befits an unorthodox proposal. Although there are understandable objections to it, it is at heart a sound idea.

Most of the responses which argue against the idea use one of two grounds. First, that equity price targeting is not the government’s job. Second, that market indices are not a good way to pick the equities to be purchased (Farmer’s suggestion of the S&P 500 index would privilege those 500 companies at the expense of smaller firms outside the index). For these reasons I would also argue against the proposal in the form that Farmer makes it, but recognise the fundamental reasoning behind it. With a slightly different emphasis, the logic becomes much more compelling.

The reason for central banks to make equity investments is not in order to target an asset price. Asset price targeting is not a well-understood discipline and it seems risky for the Fed to gamble tens of billions of dollars learning about it.

Instead, the reason to do this is because the tools of monetary policy have lost effectiveness – not just because they have reached the zero interest rate boundary, but because of decision-making behaviour in the private sector.

The primary goal of monetary easing is to boost investment and consumption by reducing the cost of money. Ignoring for now the effect on consumption, private investment is meant to increase when interest rates are cut. If money costs 1% instead of 6%, many more investment projects should become viable. However, private actors are behaving as if their investments will not make any positive return at all, and therefore are not worth making.

Clearly this cannot be true across the whole economy; there are always productive investments to be made. However, investors fear that they may require short-term access to capital, which they will not have if it is invested in machinery or intellectual capital that cannot be easily liquidated.

This is a concern which central banks do not have; they can always issue additional currency if needed to meet a short-term call. The credibility of money is not – at least in theory – affected by the holding of illiquid assets, as long as they are likely to provide a return eventually.

Thus central banks should seek ways to directly stimulate productive investment in the economy. This is more likely to be achieved through private equity investments than purchases on the public markets.

A proposal has been made by Lucian Bebchuk and Itay Goldstein to set up state-backed loan funds (to be run by private fund managers). My proposal substitutes for this; it could more quickly and perhaps less controversially be financed by central banks than by taxpayers; and in either case, long-term investment is more naturally financed through equity than through debt.
Measurements of the amount of private investment in the economy are readily available (though on a less timely basis than consumer price indices) so an optimal level of investment could certainly be targeted by central banks.

If this means private companies must accept equity investment instead of loan finance, so be it; this will result in a less leveraged private sector in the short term, though companies can gear up again when the confidence of lenders revives. At this point the central bank may reduce net investment either by selling its equity stakes into the private sector or simply by ceasing to provide new funds or to reinvest its returns.

To make any such scheme more effective, we should also seek ways in which central bank funding can by multiplied – for example by co-investing with private investors, or being offered in conjunction with private lending to reduce gearing and risk.

As Farmer argues, the fundamental productive capacity of the economy is still sound and so there is no reason why equity investments should not make a good return. As long as the central bank only acts to correct clear market failure, these actions should not have a distortive effect on normal private investment.

Update: Nick Rowe of Carleton, who wrote a paper about this in the early 90s, has responded by email with a critique of this proposal - I have posted his comments here.

Update (29/1/2009): The Japanese government has proposed buying equity stakes in small to medium sized companies. Not via the central bank, but the (state-owned) Development Bank of Japan. The plan will be considered by the cabinet next month.