Tuesday, 31 March 2009

The economics of economics blogging, part 1

Today: consumer perceptions of value in blog postings, and its relation to the evolution of judgment.

I have noticed recently a lot of blog posts which set out basically to shoot down other bloggers. I'm sure you share my lack of surprise at this phenomenon: it's been a staple of Internet debate for decades.

Could this be because economists (or people in general) are just disagreeable? Or is it because these postings serve a real or perceived consumer demand for conflict?

A minor tangent: Such a demand, if it exists, might arise from an evolutionary or learned response to the marginal value of information. A single new item of knowledge which acts towards confirmation of existing data is probably less valuable than one which contradicts it. This would be explained by an effect of diminishing marginal authority of data in each direction.

Let's say that Paul Krugman says the stimulus is too small. You may, for the sake of argument, infer that there's a 50% chance the stimulus is too small. If Brad DeLong agrees with Paul, that may slightly strengthen your evaluation to 70% (it would hardly increase it to 100%). On the other hand, if Greg Mankiw says the stimulus is too big, that might cancel out Paul's statement altogether, leaving you neutral as to the proper stimulus size. Thus, the degree to which your mind is changed by an agreement would be less than by a disagreement.

(This ignores the phenomenon of confirmation bias, but that applies more commonly to beliefs you have held for some time than to those formed recently from external information).

However, this is just a hypothesis about the reason that a preference for disagreement might arise. What I am interested in finding out is whether such a preference really exists.

Fortunately, we have a useful dataset with which to do so: the economics blog word cloud and the data behind it.

I wrote a program to analyse the articles and filter those which fall into the following categories:
  1. Articles whose title contains the words "is right", "agree" or "genius"
  2. Articles whose title contains the words "is wrong", "disagree" or "idiot"
  3. Articles whose content contains "is right", "agree" or "genius"
  4. Articles whose content contains "is wrong", "disagree" or "idiot"
This enables us to get a measure of how disagreeable economics bloggers are.

As I don't have access to traffic data for other people's blogs (EconDirectory.com has averages, but nothing for individual posts) I measured the number of comments on each article as a proxy for its popularity (excluding those blogs which don't accept comments).

So what results do we get?

Surprisingly (at least to me), economics bloggers are more agreeable than not. "Agree" articles (category 3) showed up more than twice as often as "disagree" (category 4). When measured by titles, the trend is not so clear, with a majority "agree" articles (category 1) when measured over the last two months but more "disagree" (category 2) when taking the last 7 days alone.

However, blog readers are not so magnanimous. On the content measure, the mean number of comments on an "is right" article (category 3) is 3.66, while there are an average of 6 comments on an "is wrong" article (category 4).

When the title filter is used, the difference is even greater: there are no comments at all on the category 1 ("genius") articles, and an average of 21.6 on category 2 ("idiot")!

(The trend for titles is less clear if we go further back, because there is a single Calculated Risk posting in the "agree" column with 166 comments. If we exclude this as an outlier, the same picture remains, but you might legitimately question why it should be excluded. If included, the average number of comments on category 1 articles jumps substantially, because there are not many in that category.)

In conclusion, bloggers can be reassured that they are quite civilised people; while blog readers are clearly baying for blood.

If you're reading this blog and you think this is incorrect, please set up a blog of your own and write an article headed "Leigh Caldwell is wrong". If enough of you do this, you may be proved right next time I run the analysis.

(Ir)rational protectionism

Paul Mason points out that world trade (more precisely exports from the developed world) is down by 40% on an annualised basis.

We can imagine rational reasons for people to trade less with each other - for example an increased desire for saving reduces the resources available to devote to the slightly risky activity of exchanging with distant parties. But what appears at first sight not to be rational is the distinction between local and foreign trade.

Trade within the UK, for example, is certainly not down by 40%. Of course the idea of "trade" within a country is not a very well-defined concept - one could perhaps look at interstate trade in the US, but I assume that such data is not collected comprehensively. But if we generalise to the idea of economic exchange in general, then GDP is essentially the measure we are looking for. And GDP, of course, has not fallen by 40% or anywhere close.

So why has international trade fallen so much more? There are several proximate reasons, and then some deeper underlying causes. The proximate reasons are rational, while the underlying ones appear not to be. But we will see that there is still some logic to them after all. The immediate causes include:
  • Flexible supply chains - allowing orders to be quickly reduced or cancelled
  • Unavailability of export credits
  • Increased risk of currency movements
All of these are straightforward business drivers which could rationally lead someone to decide either to import or export less. But each of them is in turn caused by some underlying behaviour which is arguably less rational. In particular, why would these apply to foreign relationships but not domestic ones?
  • Supply chains are flexible because buyers are unwilling to tie themselves into long-term supply contracts with foreign parties. Partly this comes from a lack of faith in being able to enforce contracts via foreign legal systems; partly from a feeling that there is less shared understanding of expectations between the two parties. There's also an effect from the relative youth of many such relationships - international trade has grown so fast recently that many supply relationships are still quite new, and therefore more tentative than local ones.
  • Export credits are less available because of a general reduction in credit availability, but also because of a fear by lenders of international economic instability. The underwriters of such credit are likely to know less about the details of the economic situation in other countries than a bank's standard credit committee will know about the local economy. There's also an effect from the length of credit terms. Local trade finance is likely to extend for 45-60 days. International trade has built-in delays, so export credits may have to finance a 90-180 day period or even longer. But this is not really a distinction between local and international trade - it is a distinction in physical distance and type of project. If the project is to build a plasticine factory or ship 10,000 tons of coal 4,000 miles, it doesn't make much difference if your customer is on the other coast of the US, or the same distance away in Brazil.
  • Foreign currency transactions are riskier than local transactions mainly because local ones benefit from sticky prices (or wages). In theory, the closure of a big factory in Detroit might lead to a collapse in the local economy, with corresponding falls in wages and prices. This would have exactly the same effects as a devaluation of the ringgit. But in reality, wages and prices would not fall very much, meaning that trade with Michigan (assuming you're in the US) is more stable than trade with Malaysia.
A few of these underlying reasons are perfectly rational, but many appear not to be. The drivers which are not in conformance with a traditionally efficient economic market include:
  • A lack of trust which differentiates between foreign and local people
  • Information barriers which are higher for foreign companies
  • High transaction costs of dealing with foreign legal systems
  • Sticky wages and prices which act differently to foreign currencies
I'm avoiding careless use of the word "irrational" here because it's a lazy way of avoiding a proper analysis. People do things for a reason, and if those reasons are not accounted for by traditional economic theory, we need to acknowledge that as a flaw in the theory, not a flaw in the people.

So what might be at the root of these apparent irrationalities?
  • Language differences create a barrier to communication and learning. There is a cost and time to absorbing information about other people, and language increases that cost.
  • People use heuristics to evaluate other people. This capability evolved to reduce the time and risk involved in trying to individually get to know every new person you met; and to overcome the inherent information barrier of not being able to read the other person's mind. But it has the dangerous effect of leading us into false assumptions about the similarity between us and people who look or speak like us.
  • There are game-theoretic reasons why foreign legal systems do not necessarily correspond with ours. This effect is mitigated now in the EU (and much earlier in the US, as interstate trade was established and deepened in the 19th century) but across other boundaries the differences are greater. Simply put, local companies do not necessarily want foreign ones to have the same protection that they do; voters don't want to change their systems or make themselves subject to someone else's rules; and even though it might be in everyone's long-term interests to make the systems compatible, the selfish incentives act like a prisoner's dilemma in retaining the differences.
  • Sticky wages and prices are the biggest one, and are caused largely by the money illusion (see this link for an explanation). If Joe's salary is cut by 10% but all prices were also cut by 10%, he wouldn't be any worse off (debts and savings would be affected but these will net out on average). But he'd probably feel that he'd been ripped off. This is a well-known and easily demonstrable psychological effect. But if his currency falls in value by 10% against all other currencies, which is exactly the same thing, he barely notices. Part of this effect comes from long-term contracts which fix prices for different reasons (though those in theory could allow for adjustments to match the general price level), but most of it is a psychological desire for apparent stability and predictability, and a cognitive resistance to the need to recalculate habitually familiar transactions.
The more we understand about these behavioural traits - which are not necessarily irrational, but are not taken into account in classical economic models - the more we'll understand and be able to combat protectionism.

Indeed this discussion has not really touched on protectionism as such, which is the erection by governments of artificial barriers to trade. But with all these psychologically natural reasons not to trade internationally, who needs artificial ones? The world trade agenda needs to give as much time to these issues as it does to the dismantling of explicit legal barriers.

Update: This also has implications for developing economies and what export industries they choose to specialise in. Stephanie Flanders points out that Canada is very well-prepared for a recession, partly because of the stability of the industries that dominate their economy. Raw materials, substantial trade with the US and no major focus on innovative or consumer-driven industries.

But then, Canada has had hundreds of years to prepare for this. A long-term, slow investment in developing industries like mining and timber does lead to a strong position. But developing economies that want to build an export position quickly will naturally choose industries with potential for faster growth (and consequently faster shrinkage in times like this).

A country which wants to build a strong and defensible export position would do well to look at the above psychological factors when choosing its export markets and the industries it invests in. Deep integration with another, richer, economy - achieved by overcoming these intrinsic barriers - provides lots of inertia and a strong position when economic turmoil arrives.

Monday, 30 March 2009

Zeitgeist analysis, 29 March 2009

Oh, you fickle economists.

Bored with AIG already? It's fallen 129 places from number 7 to number 136 in this week's word cloud.

The theme of the week? Plan is up 75 to 17 and Geithner up 218 places to 72. Asset and assets are up 106 and 53 places respectively, with toxic up 683 places and FDIC 436. Loan is up 237, bonds up 175, paper up 43 and purchase up 168 places.

At the top of the charts, one, new and financial remain in the top three places, with market up two to 4 and government and US both down one place to 5 and 6.

Banks is up 8 places to 7, banking and bank also rise substantially (also bankruptcy); currency is up 246 places and dollar and dollars both rise a few dozen positions, though money is down six places to number 14 and bill down 135 places into the 300s, with cash also falling slightly (but green jumping 477 places).

Crisis, capital, risk and investment are all up and policy, public, federal and Washington all down.

Larger movements include sales, up 230 to 61, loans, up 103 to 94, program up about 120 places to around 110, bonuses down 388 and action up 202. Oddly, house and housing are both down substantially while home and homes have jumped up.

One man at least will be happy this week: Paul Krugman becomes the first blogger (and the first economist, excluding Ben Bernanke) to feature in the list, at number 527. But there is a lot of introversion this week: economists is up 79, economics up 79 (and economic up 3 at the top of the list), and theory up 128 places.

Trillion is down 120 places, billion down 16 and million down 49. International is up 74, global up 50 and world up 5 to 31; UK up 119 and China up 113, but EU, Europe and European all down. Germany doesn't appear in the list but Texas does (George Bush's revenge?).

In a slightly hopeful sign, loss and losses both fall, while profit and profits have entered the list for the first time (though remaining less popular than losses for the time being). Recovery and recession are both down, though recession by more; depression is no longer in the list. Demand and supply are both up substantially, so perhaps the economy is starting to work again.

Look out tomorrow for some bonus analysis of conflict within the blogosphere.

Dunfermline Building Society - irrational incentives?

Robert Peston reports that Dunfermline Building Society is going to be taken over by Nationwide, and asks "why Dunfermline took such risks that ultimately cost the society its independence".

Here's an article with a bit more detail about the story and what happened.

I haven't been able to find out whether management were incentivised with highly leveraged short-term bonuses, but given that this is a Scottish building society, the obvious assumption is that they were not.

So why would they take such huge risks?

The answer surely is that they did not knowingly do so; but that they felt a pressure to chase profits and closed their eyes to the risk that usually goes with high returns. The pursuit of high profits is ingrained in the behaviour of managers even without financial incentives.

This could be seen as a social pressure to keep up with the next guy; a psychological pressure to be the alpha male; or a boundedly rational economic decision based on an inaccurate estimate of risk. All three point in the same direction: irrational corporate behaviour is not driven only by greed, but also by something inherent in human social interactions.

And don't forget that the depositors may have been influenced by high savings rates too - the management were passing on some of those risky high returns to depositors as interest, and the balance accumulated as reserves, owned by the members - who were also the depositors, as this was a mutual institution. So perhaps they were also guilty of not interpreting the risks correctly - or maybe, rationally, relying on the likelihood of being rescued in a crisis.

So this is a warning: don't expect that by regulating executive compensation, or banning bonuses, we will magically get a rational or risk-free financial system. The non-financial incentives will remain just as strong - and may be strengthened if the (potentially) corrective influence of financial rationality is removed.

Update: It has emerged that the society's 2007 accounts are highly suspect as they did not accurately explain the risks being taken. This highlights another important constraint on rational behaviour: availability of information. It's critical that appropriate information is available to regulators, depositors and shareholders to let them make the right decisions and minimise risk.

We don't know for sure whether the board itself had access to clear information to allow it to make correct decisions about risk. There are cognitive constraints on any set of individuals, which can stop a board from evaluating the portfolio of assets held by the company it runs. In the case of a large bank like Citigroup or RBS, it's a non-trivial task to design the right mechanisms to transmit risk information from the level of individual assets, up to managers and through the chain to the board.

In a small society like Dunfermline (with less than 300 people in head office) you would think this would be less of an issue. But it's quite likely that the board did not think they were running high risks, so transparency would have allowed this view to be validated or challenged externally.

Sunday, 29 March 2009

The economics zeitgeist, 29 March 2009

This is a word cloud from all economics blog postings in the last week. I generate this every Sunday 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 from the Palgrave Econolog and other sources, and uses Wordle to generate the image, the ROME RSS reader to download the RSS feeds, and Java software from Inon to process the data.

You can also see the Java version in the Wordle gallery.

If anyone would like a copy of the underlying data used to generate these clouds, or if you would like to see a version with consistent colour and typeface to make week-to-week comparison easier, please get in touch.

Economic predictions from a theory of mind

Mark Thoma reports Robert Shiller's article on the psychology of the asset bubble and bust, and asks "how to implement this forecasting technique - one based upon a theory of the mind".

I have been working in this area for some time and can suggest the following as a possible framework. I don't know if Shiller has something like this in mind - I suspect not - but I do think it will be a step in the direction that he calls for. Note that this is not yet a fully developed model, but a proposal for how such a model might look.

While standard economic theory deals with a set of goods, I propose instead that there are a set of concepts in the world. We can imagine some of these as corresponding directly to traditional goods - for example the concept of a loaf of bread or an economics PhD. These concepts are mental constructs and not physical ones; they represent the relationship of a person in this model to the ideas of bread or PhDs.

Next, let us define concepts which represent second-level, more abstract or dereferenced thoughts about goods - for instance the concept of a loaf of bread in one year or what other people think bread is worth. These can be considered contingent concepts, in that they refer to the same concept but in some kind of contingent state-of-the-world instead of the current one (with the caveat that each agent has their own private state-of-the-world made up of their own set of concepts). One of the key features of minds is that they project themselves into alternative worlds in order to make judgments about what actions to take.

These alternative worlds are why this model can be said to incorporate a theory of mind. As well as alternative worlds such as "the world tomorrow" or "the world if I buy that car" people use the same mental tools to project into "the world as seen by Tim Geithner" or "the world the car salesman thinks he's in".

A real mind of course considers many concepts which have no analogue in economic goods, such as the concept of truth or Miami or Barack Obama. But I believe we will get more tractable results with a simpler model which does not incorporate these - or at least by assuming they have no significant effect on the predictions our model gives.

Next, we allow each individual to assign each concept a number of attributes each with its own value, specific to that individual. One of these attributes is economic utility; another is confidence in their own evaluation of this judgment; others include their memories of where they have received information about this concept, and their evaluation of the risk of unanticipated changes in the attributes.

Some of these attributes will relate in turn to other concepts; for instance if I learned about what an economics PhD is worth from Greg Mankiw, I may also be interested in where I learned what Greg Mankiw is worth.

The number of attributes that a concept can have is huge, but again I believe we will develop a limited set of standard attributes about each concept that will be incorporated into the model.

The relationships between concepts - embodied in those key attributes - will be expressed in an algebra of how concepts are linked and how they are communicated between agents. This will probably be the most important aspect of the distinction between concepts in this model and goods in conventional economics.

The final step in defining the model will be to state how agents act in response to the values of certain attributes of concepts. I anticipate that this will work by defining an action as a relationship between a current and contingent state of the world, and that the actions that take place will be determined by the difference in the utility of a concept in the current state and in the contingent state. This allows agents to optimise certain concepts, meaning that they maximise the utility they can achieve from that concept.

With the model ready, we can then try out different assumptions about the cognitive constraints of agents. Key constraints may be:
  • how many concepts can an agent optimise in a given span of time (e.g. can I make a decision between the utility of buying coffee, eating a croissant, writing a blog post and listening to a song on the radio)
  • how many, or how distant, are the contingent worlds that an agent can consider in a given span of time (e.g. can I consider my coffee-utility forty years in the future or only twenty minutes?)
  • how quickly the agent receives new information about the current state-of-the-world (e.g. how do I learn a coffee is available or what attributes it has?)
  • the agent's accuracy in evaluating the attributes of contingent concepts (e.g. do I correctly predict my utility from the state-of-the-world in which I have eaten one more croissant or does my guess turn out to be wrong?)
The model as I have described it is fairly low-level but I believe it will let us derive results about the psychology of economic behaviour which will match observed behaviour. Solving without the cognitive constraints suggested above may give classical efficient-market economics; adding the constraints will give more realistic predictions of behaviours which show up in the classical model as irrationality.

This kind of model should also allow for predictions about collective behaviour which will explain "group irrationality", or the market's departures from the behaviour of its representative agent.

Once we have the basic tools from the fundamental model it should be possible to build on them to deal with higher-level predictions, and I believe this will be where Shiller's challenge is met. There is a place in the model for expectations about asset prices - individual and aggregate - and I expect that the tools developed from this model will be able to give quantitative predictions.

This proposal is based both on modelling approaches from conventional economics, and on my experience of information modelling from building software and business models, as well as some ideas from abstract algebra and epistemology. The mathematics of developing this are likely to be fairly complex, but manageable with some knowledge of abstract algebra and basic differential equations.

I intend to build a more detailed and concrete version of this model over the coming months and test the predictions that come out of it. Anyone interested in having sight of the results as they're developed, or in collaborating on this research, please contact me on leigh@intellectualbusiness.org.

[A final note: Roman Frydman and Michael Goldberg have taken a different approach to the same problem with their notion of Imperfect Knowledge Economics. I have not yet read their book but will be doing so soon. Although they have some quite different assumptions to mine - for example they take as a starting point the idea that economics cannot make sharp predictions - I suspect their modelling approach has similarities with the one I have proposed. The probabilistic aspect of their theory, in particular, may be a powerful addition to my model and might resolve some of the contradictions between the two approaches.]

Saturday, 28 March 2009

A behavioural theory of money

If you have clicked onto this article just from reading the title, then I may disappoint you slightly. I am not (yet) going to propound a behavioural theory of money, though I think there's one coming in the future.

But I will point to a couple of results which may indicate where to get one. The first is a quote from John Moore and Nobu Kiyotaki of LSE, in the beautifully titled lecture Evil Is The Root Of All Money.
"Money is the medium of exchange.

Notice that for this argument to hold together, there has to be a set of mutually-sustaining beliefs, stretching off to infinity. I was willing to hold money yesterday because I believed the dentist would accept it today. She is willing to hold money today because she believes someone else will accept it tomorrow. And so on. If there were a known end-point to history, the entire structure of beliefs would collapse back from the end."
This, as they point out, is the conventional view among microeconomists about the existence of money. However, experimental results from Vernon Smith (see references 11 and 15 on this paper, though I'll try and update later with a proper reference that's available on the web) show that it might not be true.

A laboratory experiment was set up with a number of participants. A bond-like instrument was invented, with predefined returns over a known finite period. For example, a dividend to be paid every 5 minutes over the course of an hour, with a final payment at the end of the hour. Participants were then issued with a number of shares in this instrument, and asked to trade them with each other over the course of the hour.

The participants used computers to trade with each other, and (importantly) the computers showed them the precise discounted return of the instrument at all times. Thus, this bond had a known, rational valuation at all times and all traders knew what it was. In theory, a perfectly efficient market with no external events, and thus the price should never vary from the theoretical return: it should drop by a predictable amount each time a dividend is paid, and at the end of the hour it should trade at face value and then mature. There should be no way to make money from trading it.

Despite this, the bond developed a price dynamic which was independent of this rational level. Specifically, the traders bid up the price of the instrument during the middle of the hour, and it declined back towards its rational value at the end. Thus, the optimal strategy was to buy early, sell in the middle, and (if possible) short the stock as the price declined towards the end.

This experiment clearly shows that even with a finite period and fully predictable returns, stocks still exhibit bubble behaviour.

And the monetary corollary? Money could be worth something even if history were to have a known end-point. And this indicates that there's something missing in neoclassical monetary theory. Part of the value of money (and other assets) is given by a phenomenon of self-justifying expectations about other people, which cannot be expressed in a rational model.

The Kiyotaki and Moore lecture is very well-written, very elegant and unfortunately misses a crushingly fundamental point. People do not make a rational decision to trust money. It's much more subtle than that.

Thanks to this article by Nick Rowe and numerous interesting comments on it for indirectly provoking my thoughts on this point.

Back to equilibrium?

A very reassuring sign from Barclays and the FSA (via Robert Peston) today - the FSA's evaluation that Barclays will not need to raise new capital or buy the Treasury's asset insurance (though it can voluntarily do so if it wishes).

Of course this is good news for Barclays itself and a good sign for the financial system. But it also heralds a more subtle improvement in the economic firmament: the possibility of a return to an equilibrium market in finance.

Over the last 18 months, contagion has ruled the markets. Any financial institution in danger created a concern for the viability of all others. When Lehman failed, lots of other banks (and insurers such as AIG) all suffered because they were trading with it. When there was even a sniff that Citigroup, or HBOS, or other banks might go under, everyone else suffered too.

This is not how normal markets work. If Alitalia were to collapse, Air France, British Airways and Ryanair would all benefit. If one of your local pubs closes down, the other will get a lot more business. This is a sign of a healthy economy - it has the resilience to cope with failure - and indeed a bankrupt company gives its people and resources the chance to renew themselves and find more productive uses (though with a little short-term pain).

The fact that Barclays is now likely to be able to lend profitably and may have decoupled itself from the problems of other banks is an excellent sign. If the banking market is now back in a competitive equilibrium there are a whole stream of positive consequences:
  1. Bank equity will have a meaningful and relatively stable value again
  2. Banks will therefore be able to raise private capital more easily
  3. Banks' non-equity assets will be able to find a market price
  4. The many government owned or insured financial assets acquired over the last year will achieve clearer values, helping to clarify the fiscal position of governments
  5. It will be possible to more clearly measure and predict asset prices and returns using well-understood economic theory
  6. Monetary policy may start to work more conventionally
In other words, most of the dreadful phenomena that have made the last 18 months so unpredictable and uncontrollable will move into reverse.

And the sun's coming out. What else could we need this weekend?

Friday, 27 March 2009

Waiting for a delayed plan

Paul Krugman this afternoon is, intentionally or not, "waiting for a delayed plan at O'Hare". Perhaps his flight is on Geithn Air? (sorry)

While waiting, he discusses Eichengreen and Temin's paper about the "gold mentality". I strongly agree that the gold standard, equated by some "not just with prosperity, but with morality, decency, civilization itself" is a dangerous thing; and it's a symptom of a wider illusion.

Those who fetishize the manufacturing sector and say a service-based economy is "hollowed-out"; those who say gold is the only real currency and fiat money is a fraud; those who think everything needs to be manufactured within the borders of their own country (but presumably don't take that to its logical conclusion, by operating a car factory, iron mine and arable farm inside their own house) - these people are suffering from a delusion about what reality consists of.

If they think that only physical objects are real and that perceptions, promises, knowledge, processes, contracts, laws, assumptions, relationships, language and human contact do not matter, they are really missing out on a lot. What a barren life it would be if only the material world mattered.

Search theory and business investment

I visited a networking group yesterday which brings entrepreneurs and investors together to try and matchmake them.

At the end we had a conversation about how to make the group work best. One of the persistent concerns about investment networking events is that each investor just stands there while a hundred entrepreneurs swarm over them, trying to get their money.

This is unmanageable for the investor and doesn't serve the entrepreneurs very well either. Most of them get nothing and it is so competitive that those who might get an offer, get screwed down on terms.

What's more, the facades that people (particularly entrepreneurs) erect make the search for worthwhile matches difficult. Even though investors will nearly always get to the truth before providing and money, the results of search theory mean that they will have to spend more time, and will find worse matches, than if the entrepreneurs were honest (although there may be behavioural phenomena that counter this - back to that later).

This reminded me of something: the discussion of marriage competition in Tim Harford's Logic of Life. A small reduction in the number of men relative to women results in an intense competition for husbands which hugely damages women's interests. The remaining men benefit at their expense, but probably not enough to increase total utility (let alone considerations of natural justice). Of course the same applies if there's a shortage of women, though the form that the competition takes is likely to be different. To be simplistic, if there's an excess of men they may commit more violent crime, while an excess of women may become more submissive and sexually available.

A related phenomenon is this one: given that men are biologically inclined to be promiscuous, whose idea was it to form mostly monogamous relationships? Despite the intuitive answer, it's in men's interests to run society on a monogamous basis. Wikipedia has a discussion of this. Again it's about competition - if men can have multiple wives, the high-status and rich men will have four or ten each, and lots of other men will lose out.

Now the investor-entrepreneur relationship is not the same as the dating and mating game. There are naturally more entrepreneurs than investors - it isn't trivially obvious that this should be the case, but consider that there are always some ideas that won't be fulfilled; but rarely is there any money that can't be put somewhere. This implies at least that the business plans in the market at any time are requesting more money than is available to invest. Coupled with the fact that most companies request less money than the average investor has available, there must be more entrepreneurs than investors.

Thus, without some kind of intervention, the overcompetition problem is inherent in the market for investment. Entrepreneurs will always compete with each other and drive down their returns in the fight to win money.

However, this inference is based on angel investors specifically; if you include the entirety of people with savings, it may no longer be true. Indeed one of the factors in creating the distinctive startup landscape of the late 1990s was a broadening of the range of people willing to invest in private companies. This hints at a possible way to solve the imbalance.

Another reason that this market is not like the dating market is that investors can put money into several companies; a company can also have several investors; and there is a wide range of levels of commitment available. So competition might not necessarily drive down entrepreneurs' returns across the board, but instead lead to a reduced amount of money received by each.

There is a further way out of this trap: to transcend the zero-sum game. If investors are offering something more than scarce resources - knowledge, for example - then the scarcity equation becomes very different. Entrepreneurs themselves can offer knowledge too; and thus the players in the market can benefit from each other in a way that does not diminish the resources of either party. It's not obvious how to measure this economically, except to assert that if 4 investors and 16 entrepreneurs each come into a room with three things of value to offer the others, everyone in the room can go away with something worthwhile. Whereas if they only come in either offering or seeking money, most of them will probably end up unsatisfied.

And finally on the search theory point: while investors will eventually get an accurate picture of their investees through due diligence and other information gathering, the delays in doing so mean that they cannot meet as many entrepreneurs and won't find as good a match as if they had the right information up front. In a purely rational world, this does not serve the interests of the entrepreneur any more than the investor. There is still, however, an incentive for entrepreneurs to misrepresent themselves: the anchoring effect and confirmation bias. Once an investor decides she likes you (even if it's on false information) she will evaluate future information through a filter, seeking out the facts that confirm her impression rather than those which falsify it. This will offer you some advantage in pricing or competition against other entrepreneurs. Thus entrepreneurs who do not do it will lose out to those who do. But collectively, entrepreneurs don't gain from this process; they only win at each other's expense.

So how could an investment network help to serve the interests of all its members? Two primary actions would resolve the key economic problems.
  1. Provide pre-checked information about entrepreneurs to present a more accurate picture to investors in advance
  2. Balance the amount of investment sought with the amount of money available in a given group, to control overcompetition
And two secondary actions which would support the process:
  1. Reduce search costs further by providing a more efficient filtering and selection process than the investors and entrepreneurs could manage themselves
  2. Encourage advice and other value to be generated within the group, but outside of the pure investment proposition
This is in both parties' interest because of one simple exchange: entrepreneurs get to avoid the overcompetition problem, and in return, investors get to reduce their search costs.

The entrepreneur should be willing to pay the cost of validating their information - there is a "due-diligence ready" service available from lawyers Nabarro which for a fixed price helps a company to answer all of an investor's likely questions in advance. This costs around £5000 and is possibly too much for a speculative purchase - but it would be possible to design a lower-cost version of the service that could be used to prequalify entrepreneurs for the network.

One of the distinctions between economics and the other social sciences is that it lets us not just determine that a phenomenon exists, but also measure its magnitude and cost. Search theory gives us the tools to measure the benefit of this service and thus work out if it is commercially viable to provide it.

One final note: this is exactly the justification for making the provision of home information packs mandatory. In that case, the number of houses and the number of people to live in them are about the same, so the overcompetition problem is less. Thus the seller's direct benefit from the pack is less than in the investment case - which is possibly why they have complained so much about the imposition of these rules. But since nearly every seller is also a buyer of another property, they gain from the reduced search costs when buying.

Buying and selling businesses is quite like buying and selling houses - so we could all benefit from creating a "company information pack" to streamline the process.

Update: Then again, independent ratings on debt investments have been available for ages, and we have seen what that led to.

Wednesday, 25 March 2009

The Apprentice series 5: episode 1

And finally: See you all next week (you can of course stick around and read my normal blog in between). Subscribe using the links on the right if you want to be updated with new articles every day.

Serious irrationality count this week: only 2. Surprising. I will keep a closer watch next time.

10:32 I am really not going to blog the whole of Newsnight just to wait for Raef to come on. You can watch that yourself.

10:30 The highlight of the last half hour (apart from Anita's new slimline figure): a trailer for The Wire, starting next Monday. If you've never seen it, you must watch. I can recommend the Guardian organgrinder blog (home of the infamous Anna Pickard) for lots of discussion of it. But watch the show first.

10:29 A very un-economic programme, You're Fired, relying on assertion and jokes to make most of its points with no numbers and no incentives to make the right choices. I think we need to rely on the real show for the hard-edged decisions.

10:28 Anita's little highlight sequence - at a disadvantage with very little footage to show, but they manage to nearly salvage her. Well, not really.

10:27 Anita got stuck with the 'budget' tag by Nick and all three of the panel think the wrong person was fired. Not sure if the audience agrees, but Adrian is kind to Anita by saying they do.

10:26 A moment from each of Nick and Margaret (somehow I managed to mix them up at 9:17).

10:25 Rufus nails it again. "One of his mates rang him up the night before he was due to go on. 'Wait, you're going to be on telly? But you're a right tit.'"

10:24 A little sequence on Adam Freeman, the guy who dropped out. He makes himself look slightly silly, but a lot less silly than he'd eventually look if he stayed on.

10:23 "There's no question what is the quote of the week this week. There was tough competition."

10:22 There's not much less attractive on TV than Carol Vorderman pretending to be a cat.

10:21 So is Rufus Hound, if he sticks around.

10:20 Philip is clearly going to be a hilarious turn on this series.

10:18 Anita is not playing Adrian's and Rufus's game of throwing insults at the other candidates. But then again, she now has to go back to being a professional lawyer. Good move.

10:17 In complaining about Debra's hypocrisy, Carol shows exactly why Debra was successful. She didn't take the risk of being project manager but immediately afterwards, stood up and started asserting herself from a low-risk position.

10:16 Shoe shining for 8 hours would have brought in around £500 revenue. With less than half of one team! Over £1000 if all seven did it. What were they thinking?!

10:15 I can't see any rationality in the product of the Comic Relief team. Perhaps that is the point.

10:13 A nice editing job showing the range of utter disagreements within the Ignite team. The lessons of this programme for me are twofold:
  1. Shoe shining brings in more money than car cleaning (and is easier)
  2. The teams don't understand why that makes it a better thing to do
10:10 Despite Adrian's assertion that "the customer is always right", the women on Ignite saw through the customer's claims of paying £20 a time for valeting. In price setting, you need to understand the other party's motivations for everything they say.

10:07 Rufus Hound seems to get the game theory of the Apprentice better than everyone else at the table.

10:05 A handy explanation from Carol Vorderman: profit is what you have left when you take costs away from revenue. That's why she's the cleverest woman in...well, in Carol Vorderman.

10:03 She is much better looking in the studio. Make-up perhaps, or just the six months between filming episode 1 and doing this interview.

10:02 Who are these little repeat sequences for? Who do they think is watching this that did not see the episode two minutes ago?

10:00 And, time to switch over to BBC2 for the no-tension, slightly naff debate. See you there.

9:59 Anita agrees with me about Surallan's attitude to lawyers. But then again, isn't Margaret one?

9:58 I am always bored by the little housemate shots while they wait for the survivors to come back. A couple of useless business cliches ("turnover is vanity, profit is sanity") do not lighten the mood.

9:58 She did look nice in the taxi shot as it pulled away.

9:57 And Anita is fired.

9:56 Debra nearly gets fired but he was just pretending.

9:56 Anita did not show initiative.

9:55 Mona has shown spirit; that's a good thing from Surallan.

9:53 Maybe I was slightly controversial in accusing Anita of being attractive. From some angles she is; from others, not so much.

9:51 The rational action in this situation does seem to be for two team members to create a convincing narrative in Surallan's mind about the third, but without appearing aggressive. None of them have quite managed to do this, but Anita is walking on thin ice by defending herself instead of attacking. She sends a signal to the other two candidates that she's the one to gang up on.

9:50 Debra is being called out for being dishonest - which seems to be the editors' theme for her. There's always one. Mona doesn't sound authoritative in making the accusation, though.

9:49 Mona seems a bit nervous and quivery. I don't rate her chances of staying in. I feel Anita hasn't done enough to be fired, but she's on notice.

9:47 Debra has been chosen too, as head of the second subteam. She does a clever job of pretending to support Anita while sticking the knife in her. She should survive for future snake value.

9:46 Yep, Anita is definitely going in the boardroom. Denial of responsibility for letting the costs run up.

9:43 I realise one aspect of the rules was not clear; were they allowed to go back to the van afterwards? If so, they could have kept costs low at first and retained flexibility, then gone back for new supplies when they were needed. And then they'd have known which supplies were required for whatever work there was demand for.

9:42 Debra blames the project manager for everything. But the narrative of "too much cost" is being written to get Anita in the boardroom - she was responsible for tracking the amount of money spent.

9:41 More faux confidence from the contestants: I guess it's in the contract that they have to say stuff like this about each other. "If she doesn't take me into the boardroom it's a waste of a good suit". Yeah right.

9:40 Rationality from the programme makers: non-financial rewards (the house) which have a lot more impact than the equivalent money divided between 15 people.

9:38 Shouty arguments between the women in the greasy spoon, but it is immaterial now. The only rationality issue is that this is a time to build alliances - a clever candidate would make sure they provide noticeable support to at least five or six of their teammates here - even if they had to sacrifice a scapegoat in order to do it.

9:35 Ignite profits about £160. Empire profits £239 - so the boys win. There was no need to argue after all! I am not quite as surprised as the boys' team themselves, but I don't think they deserved the win. Then again, it was a relatively stable performance given it's the first episode.

9:33 Mixed messages from the men and the women. Generally I find women to be more loyal than men on this show: that's borne out in this episode at least. Lots of fighting within Empire.

9:32 A bit of pre-emptive bitching from, or about, the project managers - not very useful because it's to camera instead of to the rest of the team or to Surallan ( (c) Anna Pickard 2007). But fun for us.

9:31 I am never sure whether the teams actually get better during the tasks or if it's the editing; but Ignite at least seemed to get a little bit more momentum towards the end.

9:30 If this were on ITV, there would be a commercial break for me to get another beer. As it is, I may have to miss 12 seconds of gormlessness to reach the fridge.

9:26 Empire: The profitable shoe cleaners have showed up to share the low-value work with the other minicab-cleaning half of the team. I am still gobsmacked by this. It's doubly ironic that it's at a taxi office - this habit is a classic failing of taxi drivers, who set a fixed financial target for the day and then stop work. Meaning that on profitable days, they stop work when there's money still out there; while on dreadful days they have to work 14-hour shifts.

9:25 Half of the girls seem to have hit on a slightly better approach - a roadside carwash. While the other half are polishing four classic cars at £20 each. In three hours they have finished four, unsatisfactorily, and don't get the rest of the job. This is described to the project manager as "a change of plan".

9:24 Numbers! £60-70 in an hour of shoe polishing; much more profitable than the cars. And the shoe polishers stop work to go and lose money on the cars! Utterly irrational. Irrationality count: 2

9:22 The boys are polishing shoes now. I wonder if anyone is going to evaluate the margins - and the time it's going to take to clean shoes versus cars. One non-customer claims that the price (£4) is far too high, but hopefully the team won't listen. He isn't representative of the likely buyers. Meanwhile, they aren't valeting the cars very well. It's going to take a lot longer than they thought.

9:19 Both teams have decided to wash cars. The girls are making the same mistake as one of the teams in the cleaning task of the last series - vastly overpricing the service. Cleaning is a hard, competitive, commodity task and the obvious customers already have a supplier they've negotiated hard with. And of course, the customer has every incentive to lie about the price they are currently charged. Not irrationality as such this time, just naivety.

9:17 Welcome to any Guardian readers popping over. Nick has complained about the girls wasting time talking over each other instead of solving the task. But this might just be the difference between individual and collective rationality. You don't need your team to win as long as you make yourself look good (though not too good).

9:11 Project manager. Is it rational to volunteer? There's been some game theory done on this in the past, and the consensus seems to be no. One of the guys does, but none of the women want to.

9:10 Team names. One of the guys wants "Strike" which, it's pointed out, reminds us of Arthur Scargill. Someone suggests "Carp Diem" [sic] but fortunately they don't make a fool of themselves by picking that. "Empire" seems to be the boys' choice and "Ignite" the girls' (hopefully BT Ignite won't be suing).

9:08 Anita Shah is a trained lawyer. Despite the quote from another candidate "I don't think there's any background that gives anyone an advantage", lawyers have traditionally not done well in this show. Usually there seems to be at least one attractive Asian woman in the show, and Anita qualifies - but I am not sure I expect her to stay in long.

9:07 First task: create and run a cleaning business. Nice simple rules for once - one of the ongoing frustrations of this series is when the candidates are subject to rules which we don't know. Without knowing the whole picture, it's hard to understand some of the decisions. But this game seems simple: sell some kind of cleaning service, buy the materials and collect the money.

9:05 As widely trailed, one of the candidates has already dropped out. Not very rational, that. Even if he thought he'd be fired, he had an option to play which is worth something. Irrationality count: 1

9:04 The usual ominous music in the background while the candidates wait to be summoned into the boardroom. It's a little artificial when we know nobody is being fired yet. But no doubt Alan will have some suitable insults.

9:03 Beekeeping.

9:02 We get some near-spoilers with shots of people in the boardroom. Fortunately we don't recognise anyone yet so it's pretty hard to remember who we're seeing in what combinations.

9:00 And it's on! The candidates are telling us how much testosterone they have. Quite rational so far: game theory and signalling.

8:58 Waterloo Road is finished and we are nearly ready to start. Hurry up. Funny to see a Friends episode before Chandler and Monica...wait, haven't you watched that bit yet? Sorry, no spoilers intended.

8:56 Ross and Rachel said 'I love you' and kissed. Meanwhile, the Guardian also has a live blog this evening.

8:45 Friends: Ross is trying to teach his son to say 'dada'. Rachel and he are disagreeing about whether or not to have children and move to Scarsdale.

8:44 Perhaps I will blog the Australian Grand Prix on Sunday. Hurry up Sir Alan, we're waiting for you.

8:43 Watching The Real Hustle in the meantime. Not very interesting. President Obama is on Channel 4 News, that's a bit better. And Spandau Ballet are reforming. Alan Sugar should remember them, though I doubt any of the contestants do.

 A couple of links to get you started: The Apprentice Forum and the official BBC1 site. Only half an hour to go...

Live blogging: The Apprentice

As regular readers know, one of the subjects of this blog is what is it to be rational: understanding how people's real behaviour departs from traditional economic notions of rationality.

And as regular viewers know, there's nowhere else you'll see the displays of irrationality that show up on The Apprentice every week (for US and other overseas readers, the British edition of the show is starting tonight).

So I'm going to give a running commentary on The Apprentice each episode, to point out where the contestants are irrational, to show where Sir Alan is, and to highlight ways in which an understanding of irrational behaviour would enhance the teams' chances of winning the tasks. And I'll try and have a bit of fun too. Nearly everyone on the programme is eminently mockable.

Come back at 9 pm and reload every few minutes to see the latest comments. Please post your own responses too or email leigh@inon.com with your input. Let me know if it's not for publication.

To list all episodes, click on The Apprentice tag.

Is bad news for the Treasury good for the private sector?

An intriguing post from Robert Peston raising the spectre of the Treasury failing to sell all the bonds it wanted to sell yesterday.

Is this, as he implies, plain bad news for the government because their funding is getting more expensive?

Or is it good news for private lenders - implying that investors are fed up with their "flight to quality" and are now considering private sector investments instead?

The answer is dependent on two further questions:
  1. is investors' money switching to foreign investments, UK private lending or UK equities?
  2. are investors actually running out of money to invest - the infamous savings trap, where people in aggregate try to increase their savings but fail to do so, because the attempt to save reduces total income in the economy and available savings are reduced too?
Hopefully we can find out. How could we figure it out?
  • by looking at total UK savings this month - this is not an exact science but we should hopefully be able to see if the trends are continuing on their previous path
  • by looking at the capital account balance to see if there is any turn in the amount of investment coming into or going out of the UK
  • by looking at the performance of equities (it has been on an upwards trend this month, so this could help answer question 1, though not definitively)
A key point is whether Mervyn King's comments yesterday have contributed to this - in other words, are investors listening to King's opinion of the government's fiscal policy and is this affecting their evaluation of government debt? This would have imply either that they are irrational, or that King's statement changed the outlook for the Bank of England's interest rate policy.

However, King's statement does not reveal any additional information about likely inflation; if only gives an indication about the Bank of England's likely response to inflation. If anything this information should reduce long-term interest rates and make these 40-year gilts more saleable, not less.

Thus, if traders are reacting to Mervyn King they are, strictly, behaving irrationally. This is exactly what happened when the QE programme was announced, though in the opposite direction.

Funny eh? There is an arbitrage opportunity here, if the traders' irrationalities can be predicted. Of course this type of behaviour will be corrected as it is noticed, so the arbitrage might not be available any more on these specific types of movements. But the opportunity is still there for those who have a good model of irrationality that can be applied in advance to future price movements.

Update: Econbrowser hints at signs that the worst (in the US housing market, and thus in the banking sector, and thus in the real economy) might be over. Too early to say, of course, but we can hope...

Lemons followup

I promised more on the lemons discussion but Sandro Brusco has gone into more depth in this posting than I could have done in the time I had available yesterday.

There's some way to go in analysing this, but Brusco has a couple of important points:

The first is that the problem will only be solved by revealing information. He suggests doing this by requiring managers to make a personal investment in the assets, so they have an incentive to get the valuation right. As an alternative, I would consider simply publishing the detail of the assets so that third parties can look at what they consist of and make their own determination of value. Depending on the level of detail, this may raise privacy concerns for the original mortgage borrowers, so it won't be possible to publish absolutely everything. But I'm sure a lot could be released.

The second is that the banking system can't function normally until this information is revealed, so it's critical to get it done soon. This is why the Geithner plan may be so powerful in the end - because it forces assets to be valued, probably quicker even than in a nationalisation scenario. Uncertainty is a big killer of economic activity - in an environment where credit and insurance is not fully available, it imposes a deadweight loss. In the current situation the loss is big.

I am still going to try and work out a mechanism for determining the different components of discount on the lemon assets:
  1. The borrowers really can't (or won't) pay them back
  2. There is not enough liquidity so the banks can't sell them
  3. There is a "lemon" discount based on asymmetric information
  4. Buyers or sellers of the assets are somehow irrational
and will get back to you later.

Monday, 23 March 2009

Lemons and toxic assets

Following up Geithner versus Darling by Robert Peston:

There are three reasons why the assets held by banks (loans to weak borrowers, packaged in whatever way) might not be worth very much:
  1. The borrowers really can't (or won't) pay them back
  2. There is not enough liquidity so the banks can't sell them
  3. There is a "lemon" discount based on asymmetric information
  4. [Updated] Buyers or sellers of the assets are somehow irrational. I don't analyse this option in the article below but will try to work out for a future article whether it is a major factor. I am trying not to suggest a bounded rationality explanation for everything in the world!
There is a huge argument going on about which of these is the real answer - because it has a bearing on which kind of bank rescue plan we should implement.

If the answer is number 1, then the banks have screwed up and we may not want to throw more good money after bad by buying the loans. If the answer is number 2, we should be happy to buy the loans as this will both offer liquidity to the banking system and a profit to the taxpayer. If it's number 3, things are a little more complicated.

In reality of course, all three reasons are contributing. We don't know the proportions but we can do some exploratory work to make a guess.

I want to go into the third point in particular, as it gives us a lot of insight into whether and how the taxpayer should contribute. I'll start with a link to Mark Thoma's very good explanation - though it outlines a simple version of the problem without going into the solution yet. Come back once you've read it and I'll continue.

Back? He outlines some of the problem quite nicely. I will put it in more concrete terms, because it illustrates a more serious problem too - the future market for credit.

Imagine you have 100 people - 50 of them are architects aged 45, employed by prestigious architecture practices, and 50 of them are lawyers aged 35, employed by prestigious law firms. In 2006 all 100 people would have had no trouble getting personal loans for, say, £15,000 each. The banks would have extended the loans on the assumption that even if a few lost their jobs, the majority would repay the loans with interest. A bit of employment insurance, some reasonable assumptions about the assets that these people have to back up the loans, and you'd make some fairly safe assumptions about getting your money back.

Now imagine that we are in a recession (not too difficult I hope), and that all 100 people have just been made redundant. How much do you expect to get back?

Here's the thing: as a society, we know with a high degree of certainty that nearly all of these people will get good jobs within the next 18 months. The recession will almost certainly have ended by then, and we know that these people have the skills to earn a decent income. Sure, the odds are a bit lower than before - perhaps 10 out of 100 or even 20 will be unemployed for a long time. Perhaps their future salaries will be a bit lower than those from their previous jobs. On average, the population's income will be about static next year and go up by 3% after that. But this is unevenly distributed - maybe 20 people lose all their income and the others get a 15% increase.

We still expect to get a high proportion of the money back. But the return is asymmetrical. On the people who have lost their income, we probably lose all our principal. However, the people whose income is up by 10% don't have to pay 10% more - they just repay what they were going to pay anyway. So if you buy this asset, you're definitely going to lose 20% of its value. This is an essential property of debt finance and is one of its flaws.

Now, a new question: are you willing to lend the same group of people more money?

If you could lend to the whole group, you would be confident of getting a good 90% of your money back. You would set the interest rate accordingly - let's say three percentage points higher than before the recession - but overall, you will still make a profit.

The problem is this: the private sector can't lend to the whole group - you can only lend to individuals. You don't know which individuals will default, but the individuals do - or at least they have a better idea than you do. So if you charge three percentage points extra, the creditworthy individuals won't borrow (or won't borrow as much). You end up with only the bad risks, and you lose most of your money.

But again, as a society we know that the group as a whole is going to have an increasing income next year and so can afford to repay.

The conclusion: the state, because it can average across a larger group and because - in this scenario - it is the only lender willing to step up, can get a more stable and more reliable return than any private sector lender.

This applies both to the purchase of old assets and the issuance of new lending. And so there are strong economic arguments for the state to buy, or guarantee, these assets.

Now let's go back to the other two reasons for asset discounts.

1. To whatever extent the debts are really not going to be repaid, the state should give the creditors a haircut. Mitigating this is the fact that the state is in a (relatively) good position both to know the answer to this question and to influence it through economic stimulus. Therefore we should worry a bit less about this than the worst-case scenario would imply. But we should still worry. This component of the asset discount is genuine.

2. The liquidity argument supports state purchases - because the state can never run out of liquidity, as it can print new currency as required. So it should use its comparative advantage in selling liquidity to the private sector in return for undervalued assets. This part of the asset discount disappears as soon as the state acquires the assets.

And the third discount, as discussed above, is much less for the state than for other actors.

So if the second and third elements of the discount are at all significant, the state can make a profit from acquiring the assets. My feeling is that they are, and so it makes perfect sense for the Treasuries in both the UK and US to pursue their respective policies.

But it is tricky to work out the balance between the three factors. Perhaps we can make a model to evaluate it. More on this tomorrow.

Links for 23 March 2009

I don't often do link lists but they seem to be quite the thing for bloggers. Here's one:
  1. Tim Harford's article in Forbes about what credit does to our brains.
  2. A clear and simple model showing one way to think about toxic bank assets from Mark Thoma
  3. The US is following the UK again: the administration has a plan to improve small business access to credit, just like Alistair Darling; a guest post on Econbrowser has some interesting microeconomic analysis of the rationale.
  4. Nick Rowe is always good value: here is a discussion of how liquidity can be factored into the value of a financial (or other) asset.
  5. A very nice summary (PDF) from Tyler Cowen of different definitions of rationality used in economics (somewhat technical, so you'll need a bit of economics vocabulary, but not much mathematics)
That will do for now. Given the results of this week's zeitgeist, perhaps I should include something about AIG. But I find it difficult to care.

State assets and the importance of being earnest

Robert Peston's column today got me thinking on a tangent.

If the state incurs liabilities (let's say while rescuing banks), there are a few ways it can pay them off.

One is by selling assets that it acquires along with the liabilities. For example, if it acquires a 70% stake in Royal Bank of Scotland, it can sell it into the private sector for (let's say) £20 billion. This might offset some or all of the liabilities it has covered.

Another is by increasing taxes. In one sense, this is exactly the same as selling assets: it takes money from the private sector into the public sector. The difference is in the distribution. When selling assets, the money comes from those people who choose to buy the assets. When taxing, the money can come from whoever you like.

A third is by walking away. After all, the state's liabilities are unenforceable except by the state itself. Thus the state can simply ignore its liabilities (as Argentina did a few years ago, and most developed economies have done at some point in history). This does reduce its ability to raise money in future, because its credibility is reduced; and it may result in confiscation of foreign assets too. In general the state loses some ability to influence future behaviour in return for current gain.

A fourth is by printing money. This is a bit like a blend between defaulting and increasing taxes. By increasing the amount of money in the economy, the value of existing money is diminished (and existing money is just another liability of the government); and the spending power of the money in savers' pockets is diminished, so this is essentially a tax on savers.

But ultimately this is a matter of how the state wants to be perceived and what the value of that perception is. If a country wants to be regarded as a low-tax economy, it is better off selling assets. If a country wants to have a strong balance sheet, maybe it should raise taxes and keep its assets. If it wants to strengthen its asset sheet and pretend to have low taxes, it can print money. And if it wants to maintain the value of its currency it should avoid printing money and reduce its debts through other means.

Ultimately though, as you might imagine if you know the Coase theorem and Modigliani-Miller, the difference between these methods don't matter much in terms of the solvency of the state. The state has ultimate control over the productive power of its population and can meet its debts in whatever way it wants.

The real issue is that some of these methods have an influence on behaviour, because they affect the distribution of resources between people. So mechanisms which provide incentives for productive behaviour are good; mechanisms which encourage the creation of public goods with a high return are good; if there is a conflict between these goals, we try to evaluate the return of each and choose the best option.

The main reasons for the state to behave in line with its own rules are: to demonstrate its adherence to the rule of law; and to make its future behaviour predictable. This both sets a good example for its citizens and enables people to maximise their welfare over a long future time period. It's all about creating credibility; being able to give its word and stand behind it. This we might call being earnest. Even though you could be laid-back about things, there is a value in having rules.

Of course you can choose what those rules are - within reason and if they appear to be logical - and governments frequently do this, when they set their central bank policy, pass a constitutional amendment relating to tax, or impose a capitalisation requirement on their country's banks. As long as you can convince people that what you are doing is a legitimate and sensible continuation of what you did before, they'll broadly continue to trust you - and accept your money.

So while it might be controversial to say that taxation, privatisation, default and printing money are all the same, they are more similar than you might think. A simple sleight of hand transforms one into the other - if you can pull it off with a trustworthy smile on your face.