Tuesday, 30 June 2009

Paul Krugman versus the stimulus

Many of you will have noticed Paul Krugman's continuing demands for a bigger fiscal stimulus - he thinks it should be around double the size proposed by the administration. If nothing else, we have to give him credit for being consistent, right?

Well...maybe not. You see, I came across an old article where he was, as usual, insisting that the stimulus should be doubled...but only to $600 billion! A double-take. Could it ever be true that the administration was proposing only a $300 billion stimulus? Yes it could - in fact in the early days of the election campaign Obama's proposal was for a stimulus of $60 billion. No wonder Paul originally supported Hillary.

I thought it would be interesting to run a comparison of Paul Krugman's desired stimulus versus the stimulus proposed (and eventually passed) by the Obama administration. Here it is (click on the graph for a larger version). The red line is the administration's efforts and the blue is what Paul wants:

The red line fluctuates as the administration floats a few different figures to test out media reaction - presumably not including the reaction on Paul's blog.

Meanwhile Paul doesn't always give a figure - sometimes a call for a "huge", "big" or "strong" stimulus suffices. At one point he admitted that the administration's package was "not bad" but soon realised it was, in fact, "too small".

Now I heard somewhere that correlation does not equal causation. There could be a common cause for both of these increasing lines - a worsening recession. But I well remember all the cries of apocalypse throughout last year, and so far I don't think we have seen anything much worse than predicted at the height of the financial crisis in August and September. Perhaps it just takes a while for these things to sink in.

Or could it be that whatever level the administration picked, Krugman would insist on more? Some have speculated that he wants to offer political cover to the Democrats by making it look like they have stayed well within the bounds of what their left wing wants.

I like Paul Krugman and prefer to ascribe him only the noblest of motives. But it might be worth his while to explain what has changed over the last six months to nearly triple the size of his ideal stimulus package.

Should governments manage their finances like households?

Generally it's a fallacy to suggest that governments should act like ordinary people in managing their debts. Governments have a responsibility to consider the effects on the rest of the economy - whether in economic stimulus, or the effect on long-term interest rates of an increased debt burden, or the fact that they create a destination for excess desired savings.

So does this apply to the financing of aircraft carriers which Robert Peston reports today?

As Peston says, the government appears to be acting like a cash-constrained household - deferring payments now and accepting that they'll have to pay more in the future. This may be perfectly logical for households - if they need to buy a car that they can't afford, the value to them of having access to the car may exceed the extra payments, especially if it helps people get to work and earn more money.

But for governments there are different ways of borrowing money. The way Peston presents this it looks like vendor financing - where you pay the supplier of the goods an interest rate in order to not have to pay cash up front - normally an expensive way of achieving the goal because the vendor can't borrow money as cheaply as the government. The UK Treasury can borrow at present at rates of about 3.75% so shouldn't it borrow the money on the market and then just pay the contractors in the normal way? Wouldn't this also contribute to a greater fiscal stimulus?

I thought I'd investigate roughly what effective interest rate they are paying for extending the term. According to defence procurement minister Quentin Davies, the extension is two years (from an original delivery in 2014 and 2016 to new dates in 2016 and 2018). So on average an extension from 2015 to 2017.

Assuming the annual payments under the contract are equal, we were expecting to pay (from 2008) approximately £490m per annum, and we will now pay £500m. So that can't be right. The payments must be back-loaded. Let's say that (as a rough estimate) annual payments would have been £200m per year for eight years with a £2.3 billion payment on delivery (£3.9 billion total), and they'll now be £150m per year for ten years with a £3.5 billion payment on delivery (£5 billion total).

Taking out £300 million of the increase to represent changes in specifications, we are left with a relatively simple NPV calculation. And it turns out (figures available if you want them) that the government would be paying an interest rate of around 10.5% for this extension.

Admittedly that does include inflation, so the real interest rate might be more like 7.5% - but then the 3.75% rate they pay at the moment also includes inflation. So this doesn't look like a good deal.

Why are they doing it then? I believe the overriding factor is that debt is politically toxic. Any extra debt is harshly criticised - as I've written before, there's an anti-debt culture - and particularly at the end of 2008 before the government had announced its future debt path, borrowing extra money would have looked irresponsible.

We have seen this before - the desire to reduce balance sheet debt at the cost of increasing future payments was also the unfortunate driver of some PFI deals in the past, rather than the increased value that the private sector should be incentivised to deliver.

Aside from the fear of debt there may be a credibility factor. If the government can stop its departmental expenditure rising above budget, it's more likely to have credibility in sticking to future spending plans - which might help keep overall interest rates low. And it's definitely important to keep down the interest rates on the £150 billion or so of borrowing that needs to happen next year; every tenth of a percent increase in interest rates on that debt over 20 years costs £3 billion.

So it is possible to make a valid case for why this deal is in the country's financial interest - but it relies on a couple of assumptions which are politically dangerous for the government to admit. If they talk about the political dangers of debt they sound like they're making excuses for further borrowing; and if they talk about the need for financial credibility they risk damaging that very credibility by making it a political token. A tough place to be.

Monday, 29 June 2009

Should contracts be allowed to overrun their budget?

I was curious to notice that the UK's aircraft carrier contracts have been allowed to overrun their budget by around 25%. This seems to be a common phenomenon in public sector contracts - but should it be? Why aren't the contracts signed at a fixed cost with the private sector allowed to take the risk?

This is a common question in my own field of software development. There are traditionally two ways you can approach a contract - with a third variation now emerging which might solve some of the traditional conflicts between client and supplier.

The old-fashioned approach - which I believe is still used in many military contracts - is that the supplier bills on a time and materials basis. This reduces the risk for the supplier and places it all on the client. This may well be appropriate if the client is responsible for specification and design - if that is the case, the supplier might not be able to estimate the timescale accurately enough, and many overruns are caused either by incomplete specifications or faulty designs.

The appeal of this approach is that you can get started quickly, and - politically - that nobody in the client organisation has to take responsibility for signing off a definitive specification in advance.

However, it does not incentivise the supplier to deliver quickly or accurately - indeed they have an incentive to spin the project out for as long as possible. Only professional ethics prevent them from padding out the project, and even if they do, they have a valid defense that they just wanted to ensure the highest possible quality and safest outcome.

The second approach, which is the one that Inon has traditionally followed, is to agree a specification up front and then offer a fixed price and timescale for the work. This gives the supplier an incentive to complete the work as quickly as possible - but the client's and supplier's interests are still not completely in line. The client now has an incentive to interpret the specification as broadly as possible, to try to include more and more functionality. Often this becomes a contest between the two parties - the supplier trying to restrict the scope of the product and the client trying to expand it.

It is rarely possible to define the specification tightly enough in advance to avoid these battles - and even if you can, then you end up with an ossified specification that never evolves in line with new business opportunities or constraints.

What happens then? The client realises six months later that they actually want something extra, they raise a change order and the supplier has to charge extra. This is likely to be what has happened with the aircraft carriers Robert Peston mentions in today's news item. Sometimes the client will refuse to pay extra if they think the specification has not changed after all.

We sometimes try to allow for this by including a contingency element in the price, but the drawbacks are:
  • if you separately itemise the contingency fee, the client rarely accepts that it is needed - they usually want to cut costs and ask you to remove it, believing that the specification covers everything they could possibly want
  • if you do not itemise it, your prices may be uncompetitive compared with a supplier who does not include the contingency. Whether your competitor genuinely believes it won't be needed, or is gaming the system by underbidding and expecting to make up the difference on change orders, does not matter. They are more likely to win the contract and the contingency element will not be accounted for up front.
Still, these methods are sometimes appropriate - especially when the requirements and the business environment are reasonably stable, and the project can be delivered quickly enough that the spec is not out of date. If the supplier has much more expertise in understanding and delivering projects than the client does, then fixed price is also likely to be a viable approach. If the supplier is able and willing to take the risk of overruns, their profit margins should be better and the client is generally happy because they are partly protected from unexpected spend. However it is impossible under fixed price to fully eliminate the conflict in interests between supplier and client.

What is the alternative? A contract method which aligns the interests of client and supplier such as structured pricing. This sets out business objectives for the client and pays the supplier for achieving them.

In a business environment this is usually a goal such as winning more customers or increasing staff productivity. We therefore tend to agree a fee per new client (or a percentage revenue share) or else a value per hour saved, which means if we achieve more then the client is happy to pay more.

There are challenges in such contracts: we need to agree how to measure whether the new clients or the extra productivity actually result from our software or not; but we can usually work out a reasonable way to determine that. We also need to have enough capital to finance the project delivery before the results have some in - often this will be done by an advance payment from the client. And finally we need to have enough understanding of the client's business to produce flexible and creative ways to achieve to their goals.

When we do, the rewards for both parties can be immense. Instead of delivering a project and walking away, we stick around to keep improving it and we are rewarded automatically for every improvement we make. There is no need to negotiate in advance before making changes: we describe our idea and if the client agrees it will be beneficial, we implement it.

Usually we would expect to achieve at least 50% better results for a client, and because the client is protected from the risk of failure they are willing to pay more per unit achieved - resulting in perhaps double the revenue for us with only a third more effort; and higher profits for the client because the increased results more than outweigh the extra money they pay.

Now could this be applied in the military environment? The business objectives are not so obvious - I would hope that nothing so crude as "number of enemies killed" would be adopted, but instead an externally judged measure of security goals achieved, number of square miles protected or average response times to incidents. Client and supplier both benefit and costs are only increased if performance is improved.

Incidentally, will this kind of contract stimulate the economy? President Obama has been criticised for commenting approvingly on cost savings in the stimulus spending; because less spending of course means less stimulus. On the other hand, getting the same output for cheaper leaves more money to spend on other things, and if the amount of money spent is fixed then we should try to get as much as possible in return for it. Generally a structured pricing approach is fine for the economy if the total amount of spend is fixed, and even better if spending is allowed to rise when more output is achieved.

Oddly enough, UK governments (both Labour and Conservative) have tried something quite like a structured pricing approach before. Once in pay-for-services market reforms in the health service, and once in the construction of PFI contracts. Both times they were excoriated for it. Some of this criticism was fair - where contracts have been structured to keep all of the risk in the public sector and not to encourage the delivery of better results. But some criticism was purely based on the fact that these policies might cost the government more money. This is the whole point, though - it does cost more money but only if more results are delivered. We want more results to be delivered and we should be willing to pay for them.

The economics zeitgeist, 28 June 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. The millionth Wordle is coming up in about a week, so look out for that.

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.

Special this week: Guest appearance from Virgilio Anderson.

A viable Post Office...ViaPost?

The Royal Mail is caught in the middle of a collision between its past and its future.

Decisions made in the past have led to a £10 billion pension fund deficit. Other decisions - whether by the board or by the Post Office's regulators - have held its business model back from evolving in a world where communications technology is changing faster than any other.

I don't know about you, but I send barely any letters nowadays; the occasional Mother's Day card and VAT return is about it. I pay bills online, send invoices by email and even our direct marketing is mostly by email.

On the other hand, I probably receive more than I used to: Amazon and other online stores have enabled a combination of online ordering and delivery service to compete very powerfully with retailers. And the margins on these deliveries must, I suspect, be better than on ordinary letters - though there is much more competition.

So the Royal Mail has two problems. Its past has created huge obligations, incurred in conjunction with assets which are not worth as much as they were. Its future is uncertain and it needs to invest in order to shift its business model to a new and more profitable basis.

Addressing either of these problems on its own will simply not work. Either the government takes over the pension liabilities and leaves Royal Mail to run up even more losses until it needs bailed out again; or a new business model is constructed which is then crushed under the burden of £1 billion a year in financing costs for its debts.

So Peter Mandelson is correct to insist that they be resolved together. The political will is unlikely to exist for two independent rescues; and the equity market will want to see both challenges addressed simultaneously in order to create a predictable business they're willing to invest in.

How might they create that new business model? A merger with a delivery company (TNT for example) may not be a bad idea. But that doesn't really have the boldness that is needed to give a postal organisation a life in the Internet era. So why not consider buying a company like ViaPost?* Services like theirs - which accept documents from their clients electronically, print and deliver them physically - may be the perfect interface between the physical and networked world, and surely represent a more realistic vision of future than requiring physical contact at both ends of the chain.

If the Post Office were able to switch 30% of its mail to a ViaPost-like service, they'd eliminate at least 15% of their cost base - £1.3 billion a year - and transform their viability. Realistically, making that many staff redundant would require a political deal - but if it isn't done now, it will gradually happen anyway over the next fifteen years while the taxpayer wastes another £10 or £20 billion in propping up the organisation.

A revolution in business model is the only way to solve the Royal Mail's problems - bringing both the liabilities and the strengths of its past and its future together.

* Disclaimer: Simon Campbell, CEO of ViaPost is someone I know as a business contact but I have no relationship with ViaPost itself and have not consulted him on this posting.

Sunday, 28 June 2009

How much is the future worth?

As promised, a more detailed to Chris Dillow's posting Is behavioural economics wrong? Analysed in comparison with Age and time discounting from the Geary behavioural blog.

The key factor to note in the research Chris posts (by Laurie Pounder) is that it is based on a very different age cohort from most behavioural experiments. The subjects were aged between 53 and 73 because the author wanted to better understand the behaviour of those who contribute the majority of savings in the US economy - which happens to be that age group.

As Chris mentions, the results show that people over-save compared to the theoretical prediction of the permanent income hypothesis (PIH). This hypothesis predicts that rational people will smooth their consumption over time according to their expected lifetime income - borrowing if their income is lower than the lifetime average, or saving if it's higher. The results, however, indicate that people save more and consume less than the theory predicts, and therefore end up with more savings than they need.

Most previous behavioural research, on the other hand, indicates the reverse. It shows that people save less on average than theory predicts. Chris wonders therefore whether the basic data behind behavioural economics may be wrong.

My responses to this are:
  1. Behavioural economics covers a lot more than savings behaviour, but I'm sure Chris was just being a little bit provocative with the title of his article. I will focus in this response only on the savings-related aspects of the field.
  2. It's possible for people to behave irrationally in different ways at different times. My interpretation of the results of this research is that even if they have saved too little early in life, people in their 50s and 60s not only save enough to make up for it, but actually over-compensate. This is "irrational" according to the PIH, but plausible in a psychological model where people are driven by availability heuristics and not just by analytic calculation. If I know I don't have enough saved up, then in conditions of uncertainty I may well save more than I really need to, in some kind of emotional compensation mechanism.
  3. One of the key insights of (say) Thaler and Benartzi's work on saving is not that people do not know how much to save, but that they have a self-control problem in getting started. A lot of behavioural research is in areas like this. In this view, people can be thought of as having a rational 'core' - their underlying utility functions do look like those of rational agents - but their short-run behaviour systematically departs from what is predicted by those utility functions.

    Possibly the major debate between behavioural and traditional economists is about how much this matters. Classical economists tend to say that the errors* will average out or correct themselves, and that they don't matter much for economic theory. Behavioural economists tend to believe that the errors do make a real difference - for example in creating asset bubbles, or reducing average saving over a lifetime to below the utility-maximising level - or in the case of these results, increasing average saving beyond the optimal level. Of course, over a whole lifetime, it can't be both! But it is entirely plausible for savings behaviour to depart from optimality in two different directions at different times, reducing total utility in both cases.
Interesting to compare this study with Time discounting over the lifespan (Daniel Read and N.L. Read - public version available at the link given) via Kevin Denny at the Geary blog, which examines time discounting at different ages. In other words, how much do people privilege present gains over future gains? The results find that:
older people discount more than younger ones, and that middle aged people discount less than either group
This would support the idea that young people do not save enough, the middle aged save more, and the old least of all. Unfortunately the age groups (mean ages 25, 44 and 75) are not compatible with the 53-73 range tested by Pounder, so it's hard to compare the results. But it is intuitively reasonable to imagine a model of under-saving up to 40, over-saving from 40 to 65, and drawing down of savings after retirement - which would fit both results.

Denny suggests a reasonable explanation for greater discounting by old people - that they are less likely to be around later and therefore it is rational to spend more money now. This doesn't however explain the difference between young and middle-aged people - though Read and Read's paper does suggest some possible rationales, among which are:
  • evolutionary fitness creates a preference to consume resources in youth when fertility is highest
  • it takes time to learn that the future exists and to accurately estimate the likelihood of being able to draw on saved resources, therefore young people are more biased towards immediate gratification
Read & Read's paper is an exemplar of good behavioural economics - it does not just throw out random departures from classical rationality, but measures those departures and proposes different explanations for them, allowing room for those be extended into a richer decision making model. One could certainly argue that it is in fact rational to make decisions in these richer ways, and I think ultimately the gap between behavioural and "normal" economists will be closed in this way. The idea of plain "irrationality" makes good journalism but bad economics.

Most of the popular books on behavioural economics do not take this step of rationalising the behaviour they describe - which may be why they are popular, of course. Looking at the world with an economic mindset can be a harsh experience, and offering an escape valve from this worldview is probably a good way to make people feel better. But it is not very helpful in understanding society better.

* By errors I refer to errors in the theory's prediction of human behaviour; I do not mean to suggest that individuals are making errors when they depart from the rules given by economists.

Friday, 26 June 2009

Technorati - top 100,000

Even though this blog's Technorati authority has gone down from 52 to 44 (I assume because some of our incoming links went past the six month limit), we have improved in the rankings - now into the top 100,000 blogs for the first time.

Although thoroughly anecdotal, this fact might support Charles Arthur's theory that the long tail of blogging is dying. If there are fewer active blogs, the remaining ones will inevitably rise up the list.

Have any other blog-owning readers noticed less competition out there?

Selling in a recession - the idea trap

There's lots of Bryan Caplan I don't agree with, but I can't deny he has some interesting ideas and a good way of thinking about them.
The connection between growth and ideas is not so much logical as psychological. It is not logical for people to embrace counter-productive ideas just because conditions are getting worse, but they seem to do it anyway.
This is from a paper on idea traps which is the concept that a society can get stuck in a sub-optimal equilibrium where the economic ideas that it runs on are flawed, but do not self-correct.

My own experience of this is a paradox based in the economic situation in the UK right now.

Logically, when there is low demand in an economy companies with a fixed cost base should spend more on sales and marketing.

(This might not apply to firms which can easily scale down their costs - you can argue that the marginal return on sales spending is lower and therefore the optimal spend is less. But most companies are retaining most of their staff in the hope of riding out the recession. In this case, to maintain profits, or at least to reduce your losses, you should increase your spending on sales and marketing tools or activities.)

However that's not what we see. Most companies use the recession as an excuse not to invest in sales. Why would this be?

I think there are two combined reasons:
  1. Recessions increase fear. When fearful, people put a greater weight on uncertainty and their loss aversion increases. Spending on new sales and marketing activities feels risky (indeed, it really is risky) and so there's a psychological reluctance to do it.
  2. Most small to medium business owners do not see sales and marketing expenditure as an investment. They regard it as an obligation, something they know they are meant to do (all the business books say so), but they only do it when they can afford to. This is counterproductive - like the taxi drivers who go home each day as soon as they make £200 - but it feels like a natural way to manage your resources.
Because my company's CVM software is a sales and marketing tool, we suffer from this psychology. Our solution? To turn the lion's share of our price into a success fee. Clients only pay a small amount for Inon CVM software itself but if it successfully generates sales, they pay a commission.

In this way we not only reduce the risk for the client, but signal our confidence in the effectiveness of the software. Both of these effects increase our customers' willingness to buy from us, and in this way we overcome the paradox. The phenomenon certainly doesn't disappear altogether - architects in particular are very reluctant to spend anything at the moment - but it helps a lot.

Thursday, 25 June 2009

Finally - a consensus on economic recovery

Too many people in recent weeks have concentrated on the differences between professional economists' thoughts about the recession and recovery. Are there green shoots? Is the economy still shrinking? Is it shrinking slower than it did? Is the rate of slowing of shrinkage increasing or decreasing? What does the historical record show, in contrast with the economic models of Keynes, Lucas or Krugman? Too much information!

I think it's time for a survey of non-professionals. These are people out in the real world, after all - none of your ivory tower theorising from them. I'm going to start with the comments on today's Robert Peston blog, which give some real insight into the political and economic factors behind where we are today.

  • Why do you think this great country is in this awful mess:-
    1. Labour Government
    2. Gordon Brown
    3. Prime minister Peter Mandleson

    The only way we can start to even think about recovery is by getting rid of the above.
    The banks are waiting, business is waiting, commerce is waiting, and no one trusts the current government hence they are holding on.
  • I tend to think that this restocking process is a natural reaction when stocks have been so run down, You either have to restock or you go out of business altogether. It's hardly a sign that the recession is over until sales stop falling.
  • The only way we are going to dig ourselves out of this Labour hole, is to get down to making stuff and selling it overseas. As "picking winners" does not have the best of track records by government, current OR previous, any tax breaks on R&D is vital especially at the moment.
  • The only way out of a recession is a revival of consumer led demand and we're not going to get that for some time. We all know that taxes will have to rise, and public expenditure will have to be curtailed
  • All I here from Peston is I, Me and My! Instead of thinking about building your own image, did you ever stop to think that your Gloom, doom and despondency helped to feed the recession and panic?? ...If you and other so-called Economic 'experts' got off your butts and did something constructive perhaps we'd all be better off.
  • This was an ideal time for the government to build the affordable housing that this country is crying out for. But they are home owners too and more houses would bring the value of their properties down. Can't have that can we ! Now the steel and building supply industries seem to be in dire straights. Well, if we could have built the affordable housing we are in dire need of...... and on it goes.....
  • Writing about green shoots is a waste of ink. Green shoots appear on the apple tree, then comes the blossom. And if the coddling moth get into the blossom there's your apple crop down the chute. [I especially liked this one, though I am poetically baffled by it]
  • Why isn't the weak pound helping more? Is it simply global lack of demand or creeping protectionism/foreign ownership closing the doors to UK manufacturing?
  • Recovery from recession is partly a function of time i.e. Consumption and profits come back as inventories fall to below demand levels, but there also needs to be 'confidence' that things will improve and this is dependent on there being a 'plan' at the macro level to prevent the recurrence of circumstances that caused the recession in the first place!
  • some measures implemented to mitigate the recession are begining to work; but we have to accept that these are palliatives and not actual economic recovery. This has still to come and there are many perils still out there that could reverse these measures and return us all to a further more deadly recession.

    We are at a time when we need to change our political behaviour. It is no longer a case of knockabout fun on expenses. This is now grown-up stuff about getting good people back to work, reducing costs and increasing value. The political class must step up to the plate or be condemned.
  • The weather system is Capitalism - once we understand that - we understand why it keeps crashing on to the rocks every 20 years or so...
  • Manufacturing again suffers, wake up! It's the one of the only sectors of the economy that adds value to an economy. Rocks into steel, steel into tools, tools allow you to make well, everything- Geddit?
As you can see, all we need to do to get out of the recession is to get the prime minister to resign, sales to stop falling, start making stuff and selling it to foreigners, consumers to start spending, experts to get off their butts, the government to build affordable housing, protectionism to end, to have a macro plan and wait, to (I guess) replace capitalism, and turn rocks into tools.

I am grateful to all blog commenters for the insights - and entertainment - they provide, and I do hope that the government is reading and will act accordingly. If only the real economists could get their act together and provide such a sensible and straightforward analysis, wouldn't we be better off?

Next in the series: an analysis of quantitative easing and its effects on the M2 money supply by the users of Youtube.

Wednesday, 24 June 2009

Newspaper pricing, health, calculus and confidence

The Economist's underrated Free Exchange blog asks: Can behavioural economics save newspapers? Of course the Economist itself is famous for designing a multi-product framing approach (see the first chapter of Dan Ariely's Predictably Irrational for details) which successfully biases customers to switch to a higher priced subscription. The phenomenon they describe is either a good example of price discrimination (a commenter suggests environmental benefits), or a clear instance of cognitive bias. Perhaps it's both.

While you're visiting Free Exchange, they also link to Alex Tabarrok discussing QALYs. I went to a lecture by Tony Atkinson at the RSA last week which discussed this issue. The conversation there was about how to value health outcomes as a component of GDP (and by extension, government services in general - which in the US are valued at cost, but in Europe are valued by an output measure which is meant to estimate their value). One approach is to attempt to measure consumers' willingness-to-pay for health services and value the output of a public health system accordingly. Appealing in theory, but difficult to measure accurately what people would really pay for a treatment. Another is to calculate the notional value of QALYs, combined with some measure of customer experience of the health service process itself.

An audience member asked the following interesting question. Does it really make sense to give any significant weight to the consumer experience during the treatment when this is likely to be vastly outweighed by the long-term outcomes? No matter how terrible or painful that two-week stay in the cancer ward...if it gives you six months more of high-quality life, surely that's what matters?

And yet, imagine we offer people a choice between the following two treatments:
  1. a special high-tech "keyhole" treatment in a BUPA hospital, including luxury accommodation in a private ward, a painless operation and release in five days: which is statistically expected to result in eleven years of survival;
  2. an NHS treatment in a dirty, noisy shared ward, with a painful operation requiring a two-week stay, and a two-month waiting list; but statistically likely to permit twelve years of survival.
I bet that people would be willing to pay more for the first option. Does this mean it's worth more? Who can say apart from the consumer? Yet the second would almost certainly be more highly valued in the GDP figures, and I expect that most clinical decision making procedures would favour the second.

This is just plain funny (and very geeky).

Finally, going back a few months, here is a nice Lucy Kellaway column about economic confidence and the Internet. And on the same topic more recently, James Hamilton at Econbrowser casts a little doubt on the idea that we can be confident because we are confident. But that idea is more valid than it might seem - there can clearly be multiple equilibria in an economy, and it's a major open question how far apart and how stable these equilibria can be.

I am going to revisit this topic in the context of debt and economic restructuring - as I'm seeing more and more the idea that the economy cannot recover until there is a fundamental shift away from finance and business services, and towards "productive activity". This assertion definitely needs more analysis - my instinct is to reject it but it deserves a fair trial. I will be back to it soon.

Micro and macro-prudential

Robert Peston has an interesting insight into the financial regulation debate today:
In other words, what's known as micro-prudential issues dovetail with macro-prudential issues. And if that's the case, it would make sense to put the central bank, the Bank of England, in charge of both. Or so the shadow chancellor believes.
Intriguing. Indeed, it's true that there is a direct causal link between micro and macro behaviour in the financial markets. There are two reasons for this. First, the trivial one that all macro outcomes are ultimately caused by individual decisions.

Second and more interestingly, one of the key influences on credit and asset markets is the appetite of individuals for risk. And a key factor in the stability of markets is whether these risk appetites are governed by rational preference theory and therefore have the ability to self-correct. In the long run everything (more or less) does correct itself, but an asset bubble and a financial crisis can easily erupt while we're waiting for the long run to come (I won't mention that old cliched Keynes quote - oops, I just did).

Both risk appetite and adherence to rational preferences are measurable at the individual level through techniques developed in behavioural economics. My proposal (here at VoxEU) is that the financial regulator designs an index to measure this, and samples it on a monthly basis as an input to macro-prudential decision making.

And this is where the substantive point arises in the current debate: whose job is it to do that? As Peston points out, micro regulation is currently the domain of the FSA - they are the ones dealing with banks' interactions with individual customers, and this is where the risk and rationality measurements would be made. But it is the macro-prudential regulator - the Bank of England, backed by the Treasury - who needs to make decisions based on the measurements.

Those decisions may have both macro consequences - interest rates or fiscal policy - and micro consequences - changes in how financial institutions communicate to their customers. The macro changes mainly affect risk appetite, while the micro changes can influence the customer's adherence to rational preferences. How do these regulators talk to each other and coordinate these changes? Who implements the decisions once they're made?

The Tories have one view of how this relationship should work; the FSA has another; Mervyn King a third; and the Treasury will be publishing its own version soon.

But the point is that a restructuring of the regulatory environment cannot work if it is just a shuffling of job titles. It must be accompanied by a new theoretical understanding of behavioural macroeconomics. Hints of this are emerging in the economics profession and in the regulation debate, but they are taking their time.

Update: For a different but very interesting view, look at comment #15 on Robert's article - written by David Chassels of Procession, it's a good summary from an auditor's point of view of how the financial crisis came about.

Tuesday, 23 June 2009

Greg Mankiw's jury duty

Greg Mankiw wonders why he was kicked off a jury by one of the lawyers in a medical malpractice lawsuit. "Why does being a professor of economics at Harvard make one an undesirable juror in such a case?" he asks.

I have another theory. Perhaps it was this quote from 2005:
Greg Mankiw, the administration's chief economist, noted in early December: "The president's economic agenda involves removing obstacles to growth. One such obstacle is the considerable burden placed on everyone by excessive lawsuits."
The President's economic policies are precisely aimed at encouraging businesses to expand and create jobs in the United States. In addition to the tax cuts, he wants to reduce the burden of frivolous lawsuits, contain the growth of health costs...
Lawyers have Google too, you know.

More behavioural and other links

  1. Tyler Cowen's thought-provoking analysis of national income accounting.
  2. From Cheap Talk (also via Tyler), Is behavioural economics doomed? Linking to Cheap Talk rather than the original David Levine paper because there are a few interesting comments on that version.
  3. A piece by Christopher Caldwell (no relation) in the FT on addiction and Gene Heyman's book Addiction: A Disorder of Choice. I don't think I fully agree with his political/moral point but he has a couple of interesting notes on intertemporal optimisation and the serial nature of choice.

Monday, 22 June 2009

Stephen Hester's pay package

The BBC has reported that the chief executive of RBS, Stephen Hester, is about to be offered a new pay deal by the board. If one thing is predictable in life, it's the howls of outrage that will accompany the headline figure: £9.6 million.

But the real figure is not £9.6 million - it's £1.2 million. Still a big salary, but on nothing like the same scale. The biggest chunk of the rest will be payable only if the share price of the bank hits 70p - double its current level and 40% up from the 50p at which the government originally invested - meaning that the taxpayer will have made an £8 billion profit on its RBS investment.

So why is it being presented as a £9.6 million deal? Of course this might just be the BBC's spin. Perhaps they put together all the figures themselves and picked the highest figure, a natural thing for any reporter to do.

But in fact it may be the bank who has decided to lead on this figure. If so, why would they do that? Surely they have an interest in keeping the core figure as low as possible, keeping their heads down and avoiding the media where possible?

First question: are the newspapers always going to calculate the maximum possible figure and run with that? Well, it can't be beyond the wit of the remuneration consultant to design a logarithmic share scale. This would keep an effective cap on rewards while ensuring that there is no fixed maximum amount to act as an anchor point. If they haven't done so, there must be a reason for that.

I think that the core reason is this: outrage is a non-proportional effect, and most people can't relate well to numbers outside of their realm of experience. If they said that Hester were getting £1.2 million, the public response would be almost identical to the announcement of £9.6 million. Both figures are well outside of the salary experience of 99% of the population.

But by leading on the top figure, they can follow up with: "but nearly 90 percent of it will only be paid if he makes a profit for the taxpayer". Once people are psychologically anchored on the £9.6 million figure, the £1.2 million of guaranteed salary sounds much more reasonable.

If on the other hand they started by announcing the £1.2 million, journalistic outrage would only be further fuelled by "and what's more, he can get another EIGHT million by just getting the bank's shares back to where they were a year ago".

Really, the initial figure is almost irrelevant - £9.6 million is more than what 99.9% of the population earns, but then so is £960,000. Even £96,000 is more than about 98% of other people, so no matter if the package is reduced to completely commercially unviable levels - the likely public reaction would not be much diluted.

Whether the package is seen as fair is more important than the number that's attached to it. And with this structure, the bank at least has a chance of pulling that off.

Thus: by an alert use of the technique of anchoring, the board is able to pay Hester a viable market rate which will keep him in the job for a few years - while keeping at least some kind of control over the damage to its public image.

Update: Robert Peston has been told that UKFI - the arm of government which holds its stakes in listed companies, and thus the majority shareholder in RBS - insisted that the headline number in the package be kept less than £10 million. Even given the anchoring argument I've made, I think this is still a very sensible decision. There is definitely some kind of perception effect from adding another digit to the number, though I don't know if this has ever been measured experimentally.

Sunday, 21 June 2009

Should China invest rather than consume?

...increased government spending on high enough return investments (and there are plenty) can be maintained indefinitely even without tax increases (in rate) because the high returns over the long run allow the payoff of the government debt and much more
While I'm certainly sympathetic to this argument in principle, it isn't proven by simple assertion.

Serlin links to one of his previous articles via Mark Thoma, and outlines the argument:
...high social return projects that the free market won't undertake due to market imperfections that are well established and proven in economics...like externalities, asymmetric information, impracticalities of patenting, large economies of scale and monopoly issues, the zero marginal cost of information and ideas, the inability to price discriminate well, and many more.
Again, this is the basis of a valid argument but in itself it is not one. Why not?

Simply because there are negatives as well as positives to government investment - agency problems, diminishing returns - and a full analysis needs to demonstrate not just that there are benefits, but that the benefits outweigh the costs.

I know Serlin knows this - he's an economist after all - and he does mention in the original article that he'll post again later with more analysis and data. Fair enough. So what would such an analysis need to consider?

  1. The balance between investing and consuming. Investment is not a good in itself - it is valuable because it enables future consumption. Consumption now is generally regarded as better than consumption in the future - for various reasons such as the risk you won't be around later, the risk that consumption opportunities will disappear, and the simple human desire for instant gratification. So even an investment which enables lots of future consumption might not be good if present consumption needs to be suppressed to enable it. This can be modelled by maximising intertemporal utility - with consumption smoothing over a lifetime being the typical outcome.

    A key point in this debate is that China already invests a lot (40-50% of GDP on some figures). So it could be that it has already found right level of investment to achieve maximum utility. The argument in fact would seem to be better applied to the developed economies (or to developing countries with a different investment profile) than to China.

  2. Are good investment opportunities available? Serlin seems sure that there are projects available that the government can invest in, with a positive net present value. That may well be true, but it ain't necessarily so. It is possible for all of the available profitable investment opportunities to be used up. Some would argue that this is exactly what has happened in the private sector - another debatable point, but certainly possible. So we need to show that there are still profitable places for the government to put its money. This could perhaps be done by looking at projected returns on existing discretionary government projects. If they are higher than the government's cost of capital, then we can reasonably assume that there are still opportunities out there with a return lower than existing projects, but still exceeding their financing cost.

  3. Does the government have the ability to pick good investments? I (and Serlin) believe it does, but the point could use some support. Principal-agency conflicts and the knowledge problem argue that the government does not make good decisions; externalities, economies of scale, and the other arguments that Serlin gives, argue that it can and should. There are market-based mechanisms available to solve most of the collective action problems that Serlin mentions, but there are also circumstances in which they are less effective than direct government action.

    I haven't seen a model which attempts to quantify these arguments and compare them. It should be possible to create one, however. We could examine historical data on returns (including externalised social goods) from public investments, compared with total social return on private investments. Both are difficult to measure but I am sure some clever economist could do it. Or we could develop a theoretical model, but I'm certain that such a model could be calibrated to support either point of view, and we would need to make a judgment call about which parameters best fit the real world. At least the model would probably help us identify some success factors for government decision making, and perhaps help design democratic mechanisms to encourage good decisions.
On balance, I would like Serlin to be correct in his point - but I know that others will disagree with him strongly (not least from the comments on Mark Thoma's post). So I post this article to develop the debate a little further and point the way to a more detailed demonstration.

The economics zeitgeist, 21 June 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. The millionth Wordle is coming up in about two weeks, so look out for that.

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.

Sorry: Last week's analysis never happened. I will include a summary in this week's analysis of the moves and trends coming soon. For now, I'll simply mention the following:


However please note that this week's results were provided to us by the Iranian Interior Ministry and Mousavi may be ahead if we are allowed a recount.

Friday, 19 June 2009

Create your own Tyler Cowen

I am looking forward to Tyler Cowen's new book, Create Your Own Economy, which sounds like a thought-provoking and very unusual approach to economics. But I didn't really want to pay US shipping fees or wait several days, so I clicked over to the UK version of Amazon to see its entry there.

I was surprised to see that on the UK edition, he has acquired a new editor and illustrator...with very strange names:

But I guess people have all sorts of odd names nowadays.

So I thought I'd scroll down and find out a bit more about what the book covers. I'm afraid, however, that it may be a little too avant-garde for me. The product description is in some rather odd style of free verse. I am sure the book will be exciting but it's going to be tough going if this is any guide:

Krugman and macroeconomics: an explanation

I'm on a continuous quest to apply behavioural modelling to macroeconomics, and I have some way to go before I complete a model that is credible, tractable and predictive.

But what I can do is use behavioural finance research to explain a trait that Paul Krugman discusses in his blog posting today.

Put simply, people feel losses much more keenly than they imagine gains.

Ask a hundred people whether they'd work an hour to earn £10 and most of them will say no. But overcharge them £10 on their mobile phone bill and watch them sit on hold, fill out forms and argue with shop assistants for as long as it takes to get their money back.

And there is something about fiscal deficits that just feels like a loss. Carrying billions of pounds of debt and knowing that your income tax will go up to pay for it is a very concrete concern. But the idea that without it, you will lose 10% of potential growth in your income, is much harder to get worked up about.

You could make a legitimate argument that the debts are (relatively) certain while the benefits are not guaranteed. But to counter that, there are ways to reduce the effective costs of a stimulus - Krugman has pointed out that about 40% of it comes straight back in tax anyway, and there's always inflation (at least, there was always inflation, and will be again). The overall consensus of economists is that the risk-weighted benefits exceed the costs.

But a reasoned argument like that has much less impact on the gut than the idea that politicians are gambling with your money, running up a £20,000 debt which you will have to pay off, paycheque by painful paycheque, with the sweat off your back.

Psychologically I ascribe this to the following cognitive process: we have a stronger visualisation of situations that we're familiar with than those we haven't seen before. Thus, when you have suffered a loss, you are in one state-of-the-world comparing it with a state you are already familliar with - the one before the loss - and you can easily compare the two and feel the difference. But when contemplating a potential gain, you are comparing the current state-of-the-world with a provisional one you have never experienced. This is much more difficult.

Or look at it this way: most of us can remember what it was like to be poorer - but few of us have been richer than we are now. And so it's painful to imagine going back, but not equally powerful to imagine going forward.

So losses - and by association, debt and higher taxes - have a powerful hold over us. That's why it's only by evoking the Great Depression that economists and politicians have pushed through the stimulus packages that have happened so far.

The cultural expression of this is that those who play safe, consume little, don't borrow, and save for the future tend to be admired over those who take risks and borrow to consume or invest. But as I said in a previous post, for one person to save, another has to borrow; for one to sell, another has to buy. Economics is fundamentally about trade-offs, and different preferences giving rise to mutually beneficial situations. And similarly, a preference for saving and accumulation is appropriate at some times, and a preference for borrowing and running down the reserves is appropriate at others. Now is the time for borrowing.

Thursday, 18 June 2009

In praise of Fred Goodwin

As I start this posting, I have no idea what I'm going to write about. But surely there must be something? The guy has been so pilloried that his real attributes must surely be better than his public image.

Goodwin has just agreed to give back a chunk of his pension, helping the government achieve its political objective, RBS get rid of a distraction, and Goodwin himself look at least a little better than before. But looking further back, surely there were people who thought he was good at his job in 2007? With so many executives hagiographed in the business press, he must have had his turn.

So what can we dig up?

Start with a Google search for "Fred Goodwin achieved". Amazingly, there is only one link: someone defending him on the grounds that the cost of his pension was only a small fraction of RBS's losses, and that by performance-related pay standards he does better than the Bank of England.

Similarly, "Fred Goodwin succeeded" returns nothing, and "admire Fred Goodwin" just one - which is someone admiring his not backing down over the pension - guess that one's out the window now. "Fred Goodwin is great" - nothing. "Fred Goodwin is good" - one hit, which reads "anything that could possibly adversely effect Sir Fred Goodwin is good from my perspective".

Perhaps he never did anything worthwhile at all? Let's try and figure out what he did do.

Wikipedia has a summary of his career. I remember seeing his name when he was chief executive of the Clydesdale Bank - which was my bank at the time - after its takeover by National Australia Group. I wasn't especially impressed which is why they aren't my bank any more.

After that he joined RBS and led its growth by acquisition into "the largest company in the world" (by assets, though like all banks it had liabilities almost as big). He was accused of "megalomania" but one could argue that he was just playing the game encouraged at least by the business media, if not the stockmarket (which has rarely rewarded size as well as it rewards growth, paradoxically indicating that it might be nearly rational after all).

Fortunately, Wikipedia provides us with some ammunition for our campaign to restore Fred's reputation. Forbes voted him Businessman of the Year in 2002. Between 2003 and 2006 he was at the top of the Scotland on Sunday "Power 100" list - and forgive me for cynicism about my country of birth, but that's not as impressive as it might sound. He was knighted in 2004 for services to banking.

But what's intriguing about that little list of external recognitions is its last entry. He was awarded a fellowship of London Business School as late as July 2008 - while he was admittedly still chief executive, but RBS had failed in a £12 billion rights issue in April and the writing was on the wall. Still, these things are probably in the works for a while. A search for "Fred Goodwin awarded" finds him also a fellow of the International Concrete Repair Institute, though if that's the same guy he has been living a very successful double life in chemicals for the last 30 years.

Outside of his professional life, he has chaired the Prince's Trust for about six years and was rumoured to be an option to replace Max Mosley at the head of Formula One governing body the FIA. Really, if the FIA chucks Max Mosley and the best option they can think of for restoring their own public image is Fred Goodwin...well, they deserve him.

But I digress. We are here to find the positive things that Fred has done...not his bad losses but his good wins, one might say.

Maybe it's not so bad that he built RBS into a vast, risk-taking behemoth. It did pay a lot of corporation tax over the years, and played its part in making London the financial centre of the world. Does this outweigh the net cost to the public of rescuing it? Actually, it might. But our old friend loss aversion means people focus much more on the losses than the gains.

One particular little note in that Wikipedia article is very interesting: while working for Touche Ross accountants, he headed up the liquidation of one of the last big failed banks, BCCI [update: according to a commenter, he was involved in the project but did not head it]. Do you remember the outrage about that, and the attempts to reclaim money from the people who had supposedly spirited it away under the noses of the regulators? So I guess he has some experience of how to play that game. In the end he managed to get half of the money back, which is a bit better than RBS has done with Fred's pension (for clarity let me emphasise that unlike BCCI, there is nothing fraudulent about Fred Goodwin's pension award!)

The Daily Telegraph has told us that "his grasp of finance is in the Alpha class" whatever that means. I think it's meant to be a good thing.

And to burnish Fred's reputation a little further, I have finally found some Google searches with positive results. "Fred Goodwin's achievements" returns two genuinely positive comments about his achievements and "Fred Goodwin created" gives an article suggesting he be congratulated for building what was, after all, one of the world's most successful companies for a time - as well as yet another not-that-Fred-Goodwin who works as a government psychiatrist.

Ultimately though, Fred leaves the Web uninterested and unmoved. Some of you may be familiar with the well-known mechanism for determining how good a programming language is: the sucks/rocks index. For example "Java sucks" finds 11,500 results while "Java rocks" finds 10,800 - a net suck of 700 or 6.5%. Perl does much worse on this measure (net suck of 107%) while Python does a lot better (a net rock of 184%).

Fred Goodwin, on the other hand, gives the following somewhat forlorn results:
I guess in the final calculation, nobody really cares.

Behavioural economics links

A very good article from Matt Grist, countering the argument that all choices arise from a priori objective preferences, pointing out that choice in itself can shape behavioural capabilities.

Chris Dillow asks: Is behavioural economics wrong? (the answer is no but that's a subject for another posting)

A funny post from missmarketcrash about gambling, gold, smoking and rats.

And the odd link out: Justin Fox's article summarising his new book The Myth Of The Rational Market discusses the history of the idea of market (ir)rationality without once mentioning behavioural economics. Still, the following line made me think:
"Joseph Stiglitz showed that a perfectly efficient market was impossible, because in such a market, nobody would have any incentive to gather the information needed to make markets efficient"
While that's true in principle, it should not be hard to incorporate the cost of information gathering into a market model: then those who have a comparative advantage at gathering information will still have an incentive to do it, and those who do not have that advantage will pay for it through small mispricings of stocks. So while information costs are clearly a reason why markets are not perfectly efficient, I suspect there is more to it than that.

Wednesday, 17 June 2009

The Virgilio Anderson Project

28th July 2009: Happy birthday to Virgilio Anderson. We hope that your serene Facebook nature will be restored to us soon.

: Virgilio Anderson has disappeared from Facebook. We are urgently investigating - more news later...

Fans of Robert LePage and Richard Herring (there must be one of you out there) may enjoy The Virgilio Anderson Project, in which Herring attempts to steal Virgilio Anderson's identity in return for Anderson having taken his.

His name on Facebook, that is.

The real Richard Herring explains all on the page linked above. Please do not get the wrong idea from the imagery of the page - the moustache thing is an experiment...well, just read it, that is all explained too.

Update 1: Thanks to Virgilio I have had a good couple of hundred thousand people come to this page this week. So I think it's worth adding a little more content. Why don't you answer some of the questions posed by Richard in his column:
  1. Is Paul Sheppard the new Virgilio Anderson?
  2. When is Virgilio Anderson going to paint the rest of his house? Has he left just one pink bit after doing the rest brown, or is it vice versa?
  3. If that house is as abandoned as it claims to be, who took that picture?
Since Wikipedia isn't allowing Virgilio his own page yet, you can use the comments section of this one to accumulate information about him. Facts or non-falsifiable assertions only, please - unless they're especially funny.

Update 2: More light on the Virgilio Anderson secret may be shed by this picture. If you're on twitter, please retweet "Who is #virgilioanderson" and see if the tag can become a trending topic. And if you think Virgilio Anderson should be forced to reveal his identity, his second home expenses and the reasons behind his decision to go to war, please sign the petition at http://www.ipetitions.com/petition/VirgilioAnderson/

Update 3: I and a number of others including the Acting Head of Virgilian Research Paul Sheppard, are now Virgilio's Facebook friends and you can see some of the discoveries in the comments below. Thanks to the other intrepid commenters on this post: new research being conducted on Loot (you might need to visit another page on the Loot site then go back to that one). Also some intriguing pictures spotted around the place: here, here and my favourite here.

I think the Macedonia, Ohio hometown is a red herring (to coin a phrase) - probably because Facebook didn't have the correct Macedonian town in its database. Virgilio is a member of the group "The Former Turkish Republic Of Greece" which I think is quite a good joke against the politics of country naming - see here for a bit more history. In any case it seems a good indication that he really is Macedonian. Or North Macedonian. Or something. I don't want to get into trouble with my many Greek readers.

There are 37 people in the United States Census called Virgilio Anderson.

Update 4: Richard has returned to the theme in today's Warming Up entry. In other news, Paul Sheppard and I intended to register virgilioanderson.com but we missed the boat by a few minutes. We do have virgilioanderson.net and co.uk and a website will be up soon. Unless you're the owner of virgilioanderson.com and would like to work together with us - we would be happy to join forces. I say that blithely, as if I have authority to speak for Paul Sheppard as well as myself. But after all I do have his username on facebook...(not really)

Update 5: Thanks to Adam in the comments for his offer - I'll be in touch.

Meanwhile I have been investigating from a different direction. I had the idea that Richard Herring might be a real person in Macedonia - which might make a little more sense than Virgilio stealing our Richard's name. A Google for "Richard Herring" and Macedonia produces tons of results but none seem to be quite right. There is an Richard Herring, economics professor, who wrote an analysis of international banking systems - possibly including Macedonia's - but that was 25 years ago. However while searching, I came across this very odd little story [also with prequel - by ZombieSlayer54 from here]...

Update 6: Virgilio Anderson websites sprouting up as we speak...currently waiting for DNS servers to update and will publish the addresses here soon. In the meantime have a listen to http://www.youtube.com/watch?v=BiOP04R3nZg

Update 7: http://en.wikipedia.org/wiki/List_of_architects

Update 8: Who is Anderson Virgilio? http://www.importgenius.com/importers/ariane-soung-anderson-virgilio.html

Update 9: The websites are up: http://www.virgilioanderson.co.uk/, http://www.virgilioanderson.com/ and an excellent posting at the Virgilio blog.

Update 10: Order your Virgilio Anderson t-shirts at Go Faster Stripe [no longer available - 90 shirts were ordered including seven small men (no Snow White jokes please), one small woman and two extra large women - and are being printed as a limited edition.]

Update 11: Find out if you are Virgilio Anderson at the Virgilio Anderson Quiz.

Update 12: The zenith of Virgiliism so far: http://www.youtube.com/watch?v=6Cw9go_qW48

Update 13: The question "Who is Virgilio Anderson?" is answered - accurately or not, you must judge for yourself - here.

Update 14: Super Detective Paul Sheppard has discovered that Virgilio has vanished from Facebook. A memorial service is to be held next week. Please buy all his records this week.

Tuesday, 16 June 2009

Funding multiple broadcasters

Stephen Carter's Digital Britain report, published this afternoon, will propose that the licence fee be shared out among other broadcasters as well as the BBC. I guess the idea is to ensure a diversity of voices and that there is some competition within the public-funded media.

But the BBC is already providing that on its own.

perhaps the prime minister over-egged it this morning (surely not) when he wrote in the Times that "a fast internet connection is now seen by most of the public as an essential service, as indispensable as electricity, gas and water".

And yet, what did one of his colleagues at the BBC write last week but:
The Communications Consumer Panel, which advises Ofcom on broadband issues, recently conducted research among 2,000 people, both on and offline.

It found that 73% described broadband as essential a utility as water or electricity.
Now maybe Robert Peston does think that part of his role is to conduct a robust internal debate with his colleagues, and that other people in the BBC sometimes over-egg the news. Fortunately nobody could accuse him of that crime...

Sunday, 14 June 2009

The economics zeitgeist, 14 June 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.

Update: Analysis of this week's moves later today.

Friday, 12 June 2009

Modigliani-Miller and West Brom

West Bromwich Building Society has raised £185m of new capital using an innovative new shareholding structure. They were previously a mutual building society but the new move makes the company into a hybrid between mutual and private company.

Does it matter? Economics would say not. The Modigliani-Miller theorem states that (given some assumptions) all forms of capital are equivalent to a company. But in this case, the following questions arise:
  1. There appear to be at least some costs to the firm in raising capital in this new way - at the very least, there will be political and possibly legal costs. The management needs to be able to defend its decision against some of its mutual owners who will object to the fact they now have private shareholders who will share in some of the profits. So why do these costs arise?
  2. Because there are costs, there must therefore be benefits to the new source of capital (otherwise the firm would not pursue it). What are these benefits?
The answer to both questions must be a violation of the Modigliani-Miller theorem. Assuming the proof of the theorem is correct (which is a reasonable assumption as there has been plenty of time to challenge it) some of the conditions must be violated? Which ones, and how? See the wikipedia link above for details of what the conditions are.

Your answers in the comments please.

Thursday, 11 June 2009

Why are banks not like ordinary businesses?

A commenter on Robert Peston's latest article asks: why can't we just treat banks and building societies like normal businesses?

And Mark Thoma also links to a similar question from Joseph Stiglitz: are the banks too big to restructure?

First an answer to Robert's commenter:

The most obvious difference between a bank or building society and a normal business is that the government guarantees the deposits of a bank. If this didn't happen, the depositors would be creditors like any other. But the other distinction, which I'll come to in a few paragraphs, is that banks are much more closely embedded in the operation of the rest of the economy than most other companies.

If they were to be treated as a normal business, then the liquidators would come in and start to sell off their mortgage book (probably at a discount) and the creditors (bondholders, depositors and suppliers) would have to queue up to get back whatever they could from the proceeds. If there was anything left the shareholders would get it - unlikely since the current illiquidity of the market for mortgages means there would probably be nothing left.

But because banks are regulated and the government insures the deposits, they reserve the right to step in and immediately eliminate the shareholders. They pay depositors back immediately and then make a decision about how gradually to sell off the mortgages. In theory they might decide not to sell them off at all, but to hold onto them until the homeowners pay them back over 25 years as normal (some mortgages of course will be partly paid already and will finish paying off sooner than that).

So the question then becomes: how are the bondholders treated? In a normal liquidation, they would not get their money back: instead they would take control of the assets and try to get whatever they could for them. But in a complex bank liquidation this may end up costing so much in legal and accountancy fees that they'd end up getting very little back. Plus, the government - having paid off the depositors - is first in line. So what then (this is where we get onto the Mark Thoma/Joseph Stiglitz link too)?

In fact, the government has mostly provided enough money to the big banks to stop them from going into liquidation and to ensure that the bondholders don't lose out.

Why have we been so scared of making bondholders take losses? They lent to banks knowing there was a risk (even if they didn't bother to evaluate the size of that risk) and got a decent return, and then it went wrong.

Two reasons: fear that losses will stop them from lending to the banking sector again; and fear of the transition costs of forcing the sector to restructure.

In a rational market, making bondholders absorb a share of losses - instead of the taxpayer filling the gap - would not affect future lending by a single cent. Everyone would dust themselves off, write off the old losses and start lending again (at least those who still have anything to lend).

However, there is a clear perception around Washington and London that this rational market does not exist. Somehow, the idea seems to be that if bondholders take a writeoff, they will not want to lend to banks ever again. If true, this implies that bondholders are highly loss-averse - once burned, they will refuse to lend even at high interest rates.

Or maybe the problem will not be a refusal to lend, but simply that they'll demand interest rates which make the business models of banks unworkable. And simultaneously, that they'll enmesh the banks in vast lawsuits which would make them unmanageable.

Which brings us to the other half of the rationale: unlike most firms, banks are so critical to the operation of the economy that if their business model were to disappear, the rest of the economy would be thrown into chaos while restructuring takes place and the financial sector finds a new way to operate.

So we agree to keep them going for now - perhaps while a new business model is sought, or perhaps forever. It does amount to a public subsidy, but maybe the banks have such huge externalities that the subsidy is economically justified.

An effective financial sector (and despite popular belief, we do have one that's effective in most ways) does vastly reduce transaction costs for the non-financial parts of the economy. With the economy operating as it now does, those transaction costs could easily represent 5-10% of GDP without a banking sector, and the economy would immediately become highly distorted as people tried to work around them. To prevent an instant depression, the banks are worth preserving.

It's right that shareholders at least are mostly wiped out, as they have been - because they're the easiest class of asset to deal with.

But on both counts, government should be thinking very carefully. Are the bondholders as irrationally loss-averse as the current policy implies? Even if they are, then lending might still continue if the finance sector can find new ways to route money from wherever it ends up after a restructuring, back into the bond markets again.

So the argument for rescuing banks actually depends on both arguments together: are bondholders loss averse, and is the finance sector too inefficient to quickly restructure and find new sources of capital to lend? If both are true, then government or central bank rescues are justified.

And if the rescues result in restricting the activities or leverage of the financial sector, then this will prevent it from having exactly that flexibility. Perhaps this is justified for other reasons, but it does run the risk of making the rescues self-fulfilling. Because of the bailouts, the bailouts are proven to be necessary. On the other hand, bailouts prevent the money supply from contracting as much as it otherwise would, meaning that the central banks need to print less money than they otherwise would. Perhaps that's why all the money the Fed is printing is sitting on its balance sheet as undrawn bank reserves. It's enough to make your head spin.

Wednesday, 10 June 2009

Paul Krugman in London 2 - the future of economics

Maybe this should be titled part 3, but I combined the first two out of three lectures into part 1.

Although billed as a plan to reform finance and redesign the teaching of economics, most of tonight's lecture was an entertaining survey of the last 70 years of economics, and a story about how we got into the "dark age" Krugman says we're in. A few mild digs at freshwater economists, but mainly an explanation of the differences between the two schools and a rubbishing of the idea that the "civil war" is over - in fact, he says, the difference between freshwater and saltwater economists is that saltwater economists know the difference between freshwater and saltwater economists. But he believes the current recession is definitive proof that the real business cycle model is wrong.

There wasn't much specific on finance: increased capital requirements, more transparency (though with the wry comment that everyone wants more of that and nobody knows what it means), and a much reduced amount of financial activity. Which incidentally would have more serious consequences for the UK than the US economy.

At the end he touched on what the future should hold for the economics profession.

His first recommendation is that Keynesian models need to be studied. The teaching of Keynes should be revived, if nothing else so that people can stop believing in Say's Law. And Minsky, after whom tonight's lecture was titled, has some insights too - though with some utter tosh mixed in.

Another suggestion was to do less rigorous model-building (though I guess illustrative toy models are still OK) and more examination of empirical data. He praised Reinhardt and Rogoff's work in analysing business cycles and crises by looking for common patterns in neutral historical data, rather than by building models and trying to find data that fits them.

And he discussed behavioural economics. Can it provide ways of predicting and responding to recessions? Not yet, Krugman feels. It's still a bit too focused on explaining anomalies, and it isn't ready to be used as the basis of macroeconomics.

Here's where I am right on the line between agreement and dissent. What he says is exactly true of most past behavioural research. But the "not yet" that he identifies is not a problem with the field: it's precisely the next step that behavioural theory needs to take.

Now, I would say that, wouldn't I. My own research programme is about finding a model of decision-making which both predicts real choices better than the rational preference model, and is tractable to scaling up. First into an intermediate level of aggregation, the equivalent of demand and supply curves, and then up to macro conclusions. So I have an interest in this being the next big step for the economics world. But it's clear that this work has a long way to go.

So Krugman's "not yet" is literally true - because that model doesn't exist yet - but I do think it will be an important field for economics in the next ten years, whether I or others manage successfully to produce such models. In the meantime, I'm broadly sympathetic to Krugman's thesis, and as a scientist, certainly support empirical work as the basis for developing theoretical models.

A couple of non-technical points.

He is clearly an absolute superstar among economics students (and faculty for that matter). On all three nights there were queues of at least a hundred to get books signed, ask questions and generally hang around near the great man. I should have got a picture of the crowd of 20 people desperately holding the elevator doors open for last-minute autographs, photos and handshakes while he attempted to leave. He was pretty gracious about it and left it to the LSE staff to bundle everyone out and let the doors close.

And the other clear message is the power of good communication, even in a technical field. Like Richard Feynman in physics or Richard Dawkins in biology - or indeed, as Krugman pointed out, Keynes in economics - Krugman will undoubtedly create thousands of followers of his ideas and programme within the economics profession, because he's a great communicator in all the media he works in. Not that his ideas aren't good anyway. But there are undoubtedly many theorists producing equally insightful work who will continue to labour in obscurity, whose ideas may not have the same opportunity to shape the world, and who certainly won't be getting any Nobel prizes, just because they don't step up and train themselves to put ideas across in the way Paul Krugman can. Just like there are no great companies without great marketing, communication is not an optional extra.