Monday, 30 November 2009

The economics zeitgeist, 29 November 2009


This week's word cloud from the economics blogs. I generate a new cloud every Sunday, so please subscribe using the RSS or email box on the right and you'll get a message every week with the new cloud.

The words moving up and down the chart are listed here. Key words this week: Dubai, gold and percent (for some reason).

I summarise around four hundred blogs through their RSS feeds. Thanks in particular to the Palgrave Econolog who have an excellent database of economics blogs; I have also added a number of blogs that are not on their list. Contact me if you'd like to make sure yours is included too.

I use 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.

Sunday, 29 November 2009

What's the difference between short-term and long-term?

[Fairly long post: scroll to the bottom for a one-paragraph summary]

I've been interested in this debate for many years. It takes several different forms, but the simplest statement is: stockmarket investors are too focused on short-term returns at the expense of the long-term investment that builds real economic capital.

I first heard this argument deployed against "asset strippers" such as Hanson, a UK conglomerate prominent in the 1980s. Since then it's been used to describe stockmarket traders, company shareholders in general, financial institutions of all kinds, and US and UK companies who supposedly focus greedily on quarterly earnings, unlike the more virtuous French, German and Japanese firms who are willing to take the long view.

The first problem with the argument is this: long-term returns are just a string of several short-term returns in a row. For example, £1,000 invested over 20 years to return £5,000 is equivalent to an annual return of 8.3%. But at any point during that 20 years, the asset is worth more than the original £1,000. In theory, it can be sold at any time for a (short-term) profit. And the fact that someone sells it for a one-year return of 8% does not stop the 20-year investment from happening.

Of course some markets are not liquid. If I invest £100,000 in a high-speed die stamping machine on a 10-year business plan, I probably won't be able to sell the machine itself for £108,000 a year later. But that's why we wrap those assets up as shares in public companies, which can be bought and sold on any timescale.

Pharmaceutical research is an excellent place to see this process in action. It takes five to ten years, or longer, to develop a new drug. Sometimes large firms will do it internally, in which case the progress of drugs through the pipeline is reflected in the value of the company and investors can buy and sell as they wish. More commonly, a biotech startup kicks off the process, in which case you can clearly see the increase in value as the process occurs.

First, they raise venture capital to finance the initial development - at a valuation of a few million dollars. If they succeed, they enter a research or marketing joint venture with a big company at a valuation of $10-30 million after the initial results are proved. Eventually, they will usually sell out to one of the multinational firms for anywhere from $100 million-$1 billion. Finally, the accrued benefit to Glaxo's shareholders, through dividends or capital value, might be $5 billion or more.

This is a long-term investment, but financed by a series of short-term bets by different investors. Even within the two to three-year turnaround of a single stage in this pipeline, investors can buy or sell their stake according to their estimate of the likely success of the product. There is, in fact, no conflict between short- and long-term investment horizons in terms of how they are financed.

In other words, the financial markets are precisely how short-term investors can finance long-term investments. Conversely, a long-term investor can participate in a series of short-term investments made by the management of the companies whose shares they hold.

But moving away from the finance markets, there might be something behind this argument. A company does have a genuine choice between taking risky long-term bets on major new products, or making smaller innovations which will complete within a few months or years. And sometimes they choose not to make those long-term investments. But this isn't just risk aversion. There are some real facts about the world which could lead firms, rationally, not to make long-term bets.

  • Uncertainty. It is very hard to know what kind of products will be demanded in twenty years. The economy will change beyond all recognition. Could Apple have possibly known enough to start investing in the iPhone in 1989? Of course not. But could it invest in the Mac Classic, a more consumer-friendly and cheaper version of its then-mainstream product? Yes. And from there, the iMac, a brief diversion via the failed Newton, back on track with the Powerbook, the Macbook and finally the iPhone when they could see that people would actually use it. Most revolutionary new inventions fail.
  • Incrementality. Perhaps it's actually better strategy to invest in a series of small improvements rather than trying to achieve one big one. Cars now are much better than cars thirty years ago, but not because BMW set out on a huge long-term investment programme to invent "the car of the future". Instead, they carried out a series of small improvements - each of which was very likely to be successful on its own terms, and their product kept getting better. (On the other hand, we don't have those flying cars yet. You could argue that if they had started on that in the 1980s, it might be done by now.)
  • Compounding. Maybe the iPhone is five times better than whatever we had in the 80s. But does that mean Apple should have built it, even if you could predict that it was going to be successful? Perhaps not. If you can instead make your current products 10% better every year - and I'd argue that Apple has done exactly that - then in twenty years the outcome will be that your products are seven times better. Major new developments might look spectacular, but they are not the only way to make big changes in how we live.
In short, it is often more effective in the long run to make lots of small improvements than to try to create a revolution with a big-bang invention.

[Update: in the comments, codemonkey_uk points out the challenge of local maxima. It is certainly possible that a short-term improvement can lead to a 'dead end' because it optimises for something that is true now, but might not still be true in ten years. This is one of the disadvantages of incremental development. But as he also points out, it's effectively impossible to see ten years ahead - so, like evolution, we are better off accepting this cost and pursuing short-term improvements anyway.]

Think of the intelligent designers' argument about the human eye. Evolution couldn't have produced this, they say, because it is too complex to have occurred in a random mutation. The individual components alone could not have evolved, because a retina provides no advantage without a lens, a cornea or the delicate muscles of the iris; and none of them in turn are any good without the retina.

However, it turns out that the eye could have, and did, evolve incrementally. In just the same way, most of our advanced and innovative technologies - the Internet, the car, the steam engine, the mobile phone - come from a long series of small improvements rather than a revolutionary fifteen-year plan.

The more basic fact is that technology (and investment) exist within a social context. Any technology is useless without the right context to enable it; Facebook would be pointless without widespread Internet access and a social desire to communicate, just as the spinning jenny is now useless in a world of electrically-powered machines. Since the social context is changing all the time, the best possible technology to make people's lives better is changing too.

This also means that a new application of an existing technology can be as useful as a new technology itself. Would anyone really claim that flying cars would make a bigger improvement to our lives than the Internet? If so, why aren't more people buying helicopters?

The fact is that many people have a romantic attachment to high-profile new inventions. The invention of the aeroplane is more important, they say, than the telephone's gradual eighty-year evolution from post-office or corner-shop speciality to one-in-every-home to one-in-every-pocket. But on most imaginable metrics - frequency of use, size of market, or impact on daily life - that simply isn't true. New inventions are more macho, and more visible in the historical record, than evolutionary improvements, but they are simply less significant on average.

Of course there is a role for both, but if we had to pick one, increments are better than revolutions.

So in the financial markets, short-term and long-term investment are exactly the same. But in the real world of decisions on how to create products, a gamble on a specific long-term goal is usually less effective than a series of short-term results that build on each other and, in the long run, change the world.

Friday, 27 November 2009

Tories: Are you sure you understand that word "elected"?

There's a cute article in the Evening Standard today about the Conservative plans to bring in US-style elected police chiefs.

Whatever the merits of the idea, there's a very odd statement from shadow home secretary Chris Grayling.
"We envisage the Mayor of London being the elected police commissioner."
Now this could mean that they expect the current Mayor of London (Boris Johnson) to also run for the post of police commissioner, and just happen to win. But it doesn't mean that.

It might even mean that they expect the Mayor of London to be the temporary holder of the police commissioner role until an election can be held - though it would be a very strange way to say it. But it doesn't mean that, either.

What it means is that the Mayor of London has at some point in the past been elected; and that he will become police commissioner by virtue of his position.

I don't really think that is what anyone thinks they meant by "elected police commissioner". Do you?

Tuesday, 24 November 2009

The economics zeitgeist, 22 November 2009


This week's word cloud from the economics blogs. I generate a new cloud every Sunday, so please subscribe using the RSS or email box on the right and you'll get a message every week with the new cloud.


I summarise around four hundred blogs through their RSS feeds. Thanks in particular to the Palgrave Econolog who have an excellent database of economics blogs; I have also added a number of blogs that are not on their list. Contact me if you'd like to make sure yours is included too.

[For some reason, Dean Baker's blog this week crashed my code, so I've taken it out of the feed temporarily. Proposals as to why this might be are very welcome.]

I use 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.

Holding out for a hero - Microsoft?

Media owners are salivating over the idea that Microsoft is going to save them in a hugely expensive attempt to compete with Google. "Microsoft makes move to cut out Google" in the FT:
"Microsoft are doing exactly the right thing and asking exactly the right questions," Richard Titus, chief executive of Associated Northcliffe Digital.

"Any competition to Google is a good thing," one UK publisher said.

Tom Curley, chief executive of the Associated Press, said last month that Microsoft was willing to accept “principles” such as favouring AP stories in search results over others that regurgitate its news, or helping it track its content. “We are only going to work with those who use our principles,” he added. “We stand at an enviable moment where Microsoft and Google have decided to go to war,” he said.
You can smell the desperation of people whose business model has been overthrown - not by any underhand behaviour or cheating from Google, but by a world where information flows freely and the barriers to finding it are low. There simply is no way to turn back the clock. In the old model, we couldn't easily find out what was happening in the world and newspapers were the obvious way to lower information costs.

Media is a special category because it has immense economies of scale - you can make a fortune if you achieve high distribution, as most of your costs stay fixed while your revenues scale up with the number of readers. But it's also special because it relies on barriers to knowledge. In some places knowledge is unavailable by the nature of the environment; in others, media owners try to impose controls on it themselves.

The more that knowledge is freely available, the weaker the traditional business model becomes. Technology moves on, and the need for traditional media as a provider or facilitator of information is far less than it was. Knowledge can flow more easily in other ways - such as, of course, Google. Many people have their livelihood invested in those old, profitable economies of scale and it's natural that they would try to defend their position. And when white knight Microsoft appears to ride to the rescue - as they tried to do with the Zune in the music industry - it's immensely appealing to hang onto their stirrups. But it can't work.

All the wishful thinking is cut through by the one sensible comment, from industry analyst Alan Mutter:
"The problem with this bargaining tactic is that it appears newspapers need Google more than Google needs them."
Update: Paul Mason has another nice addition, in a longer and interesting article:
"Excluding your content from searchability AND at the same time erecting a paywall sounds a bit like taking yourself out of the phone directory and for good measure having your landline disconnected."

Friday, 20 November 2009

Practical applications of behavioural economics

I'm starting a series on how to use the principles of behavioural economics in the real world of business.

It will be structured around a series of individual cognitive biases, and for each bias I will outline:
  1. Examples and stories to demonstrate how it works
  2. The cognitive theory of why it works
  3. A toolkit showing how to implement it in practice
First up, this weekend, will be anchoring. Come back tomorrow to see some examples of this from our clients and other companies.

And if you'd like to be featured in this series - and in a forthcoming book on the same subject - please email me to share your stories of cognitive bias or behavioural economics in the business world. If you are writing about a specific business, please mention whether you're happy for their name to be used in this blog and/or in the book.

Wednesday, 18 November 2009

Does QE cause deflation?

In the leader column of City AM today, Allister Heath argues that quantitative easing should be stopped because it will lead to inflation. Set aside for a moment the fact that this is the whole point of it. Is he right that it will actually succeed in causing inflation?

Scott Sumner (consistent with mainstream monetary theory) points out that an increase in the money supply is only inflationary if it is expected to be permanent.

And is QE a permanent increase? Not necessarily. On the contrary: QE in isolation makes the money supply smaller.

Under QE, the Bank of England has issued £200 billion of new currency and used it to buy bonds (mostly gilts) in the private market. (The Federal Reserve has done something similar, with a higher proportion of corporate and mortgage-backed bonds.)

So there's now £200 billion more sterling than there used to be - it's fair to say the money supply is bigger. What will happen next year - or in five years time, or thirty years when all the bonds have matured?

As those bonds come due, their issuers will have to pay the face value, plus interest, to the holder of the bond - the Bank of England. A £1 billion 10-year gilt maturing in 2010, which the Bank of England may have purchased for £1.35 billion, will require the government to pay £1.4 billion to the Bank next year (one more year of interest having accrued).

What will the Bank do with the money that comes back into its vaults? Nothing, unless they explicitly decide otherwise. The money is an asset of the Bank and as soon as it's paid back to them, it will disappear.

Thus, the money supply will be reduced by £1.4 billion - cancelling the £1.35 billion increase and a further net reduction of £50 million.

The Bank is buying gilts which mature in between 5 and 25 years. If the average is 15 years, and the size of the programme is £200 billion, then around £100 billion will be drained from the money supply as a result of QE. This needs to be discounted either by the predicted Bank policy rate or by expected inflation, so the exact size of the effect is hard to predict. But a reasonable estimate is £50 billion or about 30% of the UK's monetary base.

So, unless the Bank says otherwise, far from being a permanent increase, QE is actually a permanent net reduction in the money supply. Orthodox monetary theory says this should cause not inflation but deflation.

If this logic is correct, then either:
  1. QE is not causing inflation
  2. QE is causing inflation because the Bank is expected to make the money supply increase permanent
  3. QE is causing inflation because the theory of permanent increase is wrong
If case 1: it's a clever way of boosting short-term activity without (apparently) an inflationary impact. Nice idea, but completely counter to the goals of QE.

If case 2: The Bank can do whatever it wants in future years, including increasing the money supply to counter the effects of maturing bonds. If markets are assuming they will do this, it provides another explanation for why long-term interest rates are falling: the long-term path of policy rates will be lower than it would otherwise be. The other reason for falling rates is that QE provides extra demand and keeps the prices of bonds higher, but the interest rate path is probably a stronger effect.

If case 3, there's a behavioural explanation: the extra money in the economy boosts immediate spending even though people should rationally expect a reduction in the future money supply. Clarity on this may need to await a theory of expectations.

So which is it? Is QE a mistaken policy? Is orthodox theory wrong? Or are the policy and theory both right, and markets are revealing an expectation of future policy? If so, are their expectations right? Time for the central banks to clear this up.

(This argument is strengthened by the fact that the expansion of the monetary base does not seem to be going into general circulation, but that is a distinct problem).

Monday, 16 November 2009

The economics zeitgeist, 15 November 2009


This week's word cloud from the economics blogs. I generate a new cloud every Sunday, so please subscribe using the RSS or email box on the right and you'll get a message every week with the new cloud.


I summarise around four hundred blogs through their RSS feeds. Thanks in particular to the Palgrave Econolog who have an excellent database of economics blogs; I have also added a number of blogs that are not on their list. Contact me if you'd like to make sure yours is included too.

I use 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.

Sunday, 15 November 2009

Can we build a theory of expectations?

If Scott Sumner and Paul Krugman agree on something, it must be true. I think most of us would accept that as an axiom of economic sociology.

Accordingly (see here and here), we can take as read the idea that expectations of inflation and aggregate demand strongly influence actual inflation and aggregate demand.

There's nothing really controversial about this: the idea of multiple equilibria is well established. If people expect deflation and recession, they will try to save more, spend little and invest less - and deflation and recession will result. If people expect inflation or growth, they will spend more quickly and invest in the hope of protecting their assets and capturing a share of that growth; and as a result, the expectation will be fulfilled.

Or as it's caricatured by a self-help motto you've probably seen: if you think you can, or if you think you can't, you're right.

Presumably we want to have more growth rather than less, and (mild) inflation rather than deflation. So we'd want people to expect growth and inflation respectively. Can we, then, influence people to change their expectations? Certainly.

There are two separate expectations here: inflation, and growth. They are linked, but I'll start with inflation as it's a little simpler.

One way to change expectations, on which Scott and Paul agree, is for the central bank to announce a policy of higher inflation. Paul's view, which is more mainstream, is that the Federal Reserve should simply have an explicit inflation target - perhaps 4%. If people believe that the Fed has the power to achieve this, then they will act accordingly and the target will become self-fulfilling.

Imagine a bus driver announces that he'll drive on the left-hand side of the road. It's quite credible that he can implement this policy, because his bus is big and heavy. Therefore it becomes self-fulfilling, because everyone coming the other way drives on their left, and the bus driver doesn't have to work very hard to achieve his goal.

However, many people might not believe the Fed has the power to achieve this - perhaps they think it can't get money into circulation fast enough, or maybe that its tools are not precise enough, that it is at risk of overshooting and therefore may undershoot to avoid this risk.

Thus, the Fed announcing a target of 4% inflation might not be enough to get people to expect 4% inflation. Could we build a model of how individuals form their expectations? If so, we might get some idea of how to communicate, what actions to take, and what incentives to put in place to affect expectations just right.

Scott has a solution. His policy proposal cleverly bypasses the need to understand the mechanisms of expectation forming by using the price mechanism instead. It says that the Fed should not target inflation but should target the market's expectations of inflation. The Fed would measure market expectations by buying and selling futures contracts on next year's price level. By looking at the prices of those contracts they would know exactly what the average expectation is, and therefore could take exactly enough action to raise or lower expectations (i.e. the prices of those futures) by the right amount.

An ingenious scheme indeed. However, it still relies on the Fed having enough power (through monetary policy) to be able to adjust the prices of those futures contracts. Does it have this power? As a counterfactual, imagine the Fed decided to target the market price of a 12-month future contract on barrels of oil - it is not at all obvious that it would be able to do so.

And when we consider expectations of real growth instead of inflation (or nominal growth, which is Scott's preferred target) everything gets a bit more complex. Monetary policy can probably help us to get out of recessions (because negative growth is a perverse state for the economy to be in); but it surely can't increase the productivity of firms across the economy - which is what is needed to sustain real growth.

Expectations of growth, on the other hand, probably do influence productivity: my experience of firm behaviour is that they invest more in, and care more about, their output when they have an external benchmark. I would love to see some data on this if there is any. Perhaps monetary policy is still the best solution, because nominal growth may be just as relevant as real growth for setting expectations.

Let me touch briefly on the theory of rational expectations. This is the idea that any time expectations are out of line with market prices, market prices will immediately change to reflect expectations. For example if oil is currently $70 a barrel and everyone expects it to be $100 by Christmas, it will jump up to $100 right now (with a small discount for interest rates). Thus, expectations will always be the same as market prices, and market expectations by definition will be fulfilled. That is, whatever people expect is true, and whatever happens was already expected.

Another clever idea, but it begs two questions:
  1. Markets are composed of many people with different expectations - does it matter that the price level reflects a weighted average of a range, instead of a single opinion held by the whole market?
  2. Do expectations and prices really move instantly, or do illiquidity, imperfect information and bounded rationality mean that they take some time to change? If so, what if expectations change again before the price catches up? Will the arbitrage opportunity implied by the rational expectations ideal ever really exist?
Neither of these questions are well-understood; the first is glossed over by the idea of a representative agent, the second by doubtful assumptions about efficient markets. Attractive as Scott's idea is, I suspect it too is at risk from these same questions.

So let's get busy understanding - and learning how to change - some psychology. What factors determine the amount of growth, and inflation, people expect?

This knowledge will help us build an economy that achieves its potential, keeps growing and suffers from fewer and milder recessions.

Update: Scott has an excellent posting here summarising the relevant bits of macroeconomic theory and some interesting cultural points; Nick Rowe has another good (though technical) article here. Meanwhile, I realised after posting that I spent so much time summarising the background to the expectations debate that I didn't make any actual proposals on how to model them. I'll come back to that tomorrow.

Friday, 13 November 2009

Psychology of sticky prices

Do we implicitly extrapolate, unconsciously, from how we make a single trade to how we behave in markets generally?

We have a basic need to fix the price of a transaction for long enough for the trade to complete. If I agree to buy this beer from you for £3.40, and by the time it's finished pouring, the price might be £3.75 (or indeed £2.90) neither of us is likely to buy or sell much beer. For a transaction of this kind to work, the terms should be known in advance to both parties and remain the same for the duration of the trade.

And with our minds' amazing capacity to extrapolate, it's not such a big leap from there to the expectation that prices will remain stable over a slightly longer period of time (an hour, a day, a month, a year?)

Whatever learning mechanism creates this stability of expectations over the duration of a single transaction can surely be fooled into expecting the same thing for a bit longer.

This is reinforced by the tentative and exploratory nature of psychological valuation. We 'learn' the correct value for a transaction by deciding whether the object is worth what is being asked, and once we have made the decision it becomes available as a cognitive shortcut. That is, the learning is persistent - once we have made the decision once, we rely on it in future transactions. So if prices were to change, we'd resist the extra work of unlearning it in order to reconsider whether to buy the good at the new price. Price setters, in turn, instinctively know this and keep their prices stable where they can (apart from Amazon, it seems - but there are special circumstances there).

This effect strongly encourages price stability - and, in turn, has a powerful effect on market illiquidity. The sad consequence of this sticky prices phenomenon is: recession.

Most of our policy cures for recessions - monetary expansion, fiscal stimulus - are a workaround for this simple psychological fact. Maybe if we could change our minds a bit faster - or if some other cognitive assistance became available - the world economy would run a little more smoothly.

Thursday, 12 November 2009

Amazon's behavioural pricing

I'm studying behavioural pricing as part of my response to the forthcoming OFT market study, and Amazon has an interesting history of this.

Whether or not they still offer personalised prices to different customers for the same product (probably not, as they were shot down for it last time), their pricing strategy is still fascinating. Take a look at this screenshot:


Because I have a ton of books in my 'Saved for later' list, I get a message like this nearly every time I visit the Amazon checkout. Often the same book moves up or down by £1 or 50p several times over the course of a few weeks.

The only plausible explanations for this are that Amazon either:
  1. has an incredibly sophisticated demand management process and knows exactly when people will pay more or less for a book
  2. or, is testing different prices to measure the overall demand curve (or my personal one, which is even more interesting).
Either way, it's fascinating to watch one of the most sophisticated behavioural marketers in the world optimise their revenue before our eyes. Even though Jeff Bezos said "We've never tested and we never will test prices based on consumer demographics", there are much more subtle ways to make personalised offers to customers which are in the mutual interest of both buyer and seller - and I expect Amazon is at the forefront of researching them.

These pricing mechanisms, the recommendation engine and related techniques are likely to be responsible for up to 40% of Amazon's revenue. If you happen to know someone who'd like to get that extra revenue in their business too, do put them in touch...

And I'm not even getting onto the Amazon Mastercard promotion at the top of every checkout page...hyperbolic discounting FTW.

Update: Another example about three days later:



Sunday, 8 November 2009

The economics zeitgeist, 8 November 2009


This week's word cloud from the economics blogs. I generate a new cloud every Sunday, so please subscribe using the RSS or email box on the right and you'll get a message every week with the new cloud.


I summarise around four hundred blogs through their RSS feeds. Thanks in particular to the Palgrave Econolog who have an excellent database of economics blogs; I have also added a number of blogs that are not on their list. Contact me if you'd like to make sure yours is included too.

I use 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.

Saturday, 7 November 2009

An unanticipated surge of lending?

I've had this article in draft for about three weeks. Paul Krugman's latest item seemed an opportune moment to finish it.

Intriguing article by Sheng and Pomerleano in the Economists' Forum about zero interest rate policy. I don't think I agree with what they are saying (insofar as I can even tell what they're saying) but it stimulates a few thoughts along Scott Sumnerish lines.

One bit (from Kevin Warsh, quoted approvingly by the authors) jumped out at me:
A complication is the large volume of banking system reserves created by the non-traditional policy responses. There is a risk, of much debated magnitude, that the unusually high level of reserves, along with substantial liquid assets of the banking system, could fuel an unanticipated, excessive surge in lending.
Now surely a surge in lending is exactly what we want? Isn't all this monetary activism meant to increase the effective money supply (or counter a fall in velocity) therefore sustaining nominal GDP? After all, this year's collapse in new loans is meant to be one of the main causes of the recession.

The problem, according to Scott, is that the Fed has created a trillion dollars or so of extra money which banks are hoarding because they are earning interest on it. I am also unsure about this argument - would the small difference between +0.25% and -0.25% really make the difference between whether or not banks lending into a market they see as having a high risk of default?

Surely the issue is, instead, that banks don't think there are enough creditworthy borrowers; in effect, their expected return on the marginal loan is negative. While that half-percent makes a marginal difference, it is likely that the banks' expected average return on capital has fallen much more than that - and only a -5% or -10% rate would be enough to make lending attractive.

Despite Scott's heated response to Paul today, I actually think they agree on many points:
  • Falling real GDP is a problem
  • Falling nominal GDP is a problem
  • Nominal GDP is directly affected by tight money (and money is tight now)
  • Sticky prices are the reason real GDP falls in consequence
  • Real GDP is path-dependent, so monetary policy does matter for the real economy
  • If the Fed were willing to target inflation, nominal GDP could be increased and this would help with real GDP
Scott doesn't acknowledge the importance of real GDP very much - because it's hard to observe or even estimate realistically. Paul on the other hand overemphasises the binding constraint of the zero interest rate bound. But if they could just get past that, they'd be pretty close.

After these cosmetic issues, the disagreement is about how to get out of the zero interest rate trap and expand the amount of money circulating in the economy. Scott's view is that if the central bank targeted an NGDP forecast, this would stimulate appropriate behaviour in the private sector to achieve its target. Paul's view is that - in today's institutional and political climate - fiscal stimulus is the right way out of the trap.

To resolve this argument, we need to understand behaviour at a lower level.

We need to understand the behavioural relationship between base money, broad money supply and velocity. In particular, given that MV = PY, what other factors apart from the size of M affect Y (and P)? That is, what are the determinants of velocity?

We don't know what those behavioural stimuli are in any detail. We do know that the government can directly manipulate some of them by spending money and employing people (Paul's approach); and we know that expectations of future economic performance affect them too (Scott's approach).

Some more careful analysis - or even some experimentation - would give us a better theory of monetary behaviour which would help us be sure of how to restore economic growth.

Friday, 6 November 2009

How can rising productivity mean more staff?

This BBC article asserts that...
Productivity, as measured by output per hour of work, rose at an annual rate of 9.5% between July and September.

The data suggests that firms, which have cut jobs in the downturn, are now increasing their output, which may in turn lead to them needing more staff.
This is truly a paradox. Greater productivity normally means firms need fewer staff - until, eventually, rising income increases aggregate demand, and then the laid-off people are employed in other sectors.

The article seems to be another example of the equilibrium fallacy*, where a reversion to equilibrium is mistaken for a first-order effect.

That is, firms cut staff because they had insufficient demand for their products - naturally, getting rid of the least productive staff. The remaining workers are more productive on average, and the reduction in output is less than the reduction in staff. This doesn't imply at all that either demand or output is increasing. If productivity had increased without any staff cuts, then output would have risen too. But that's not the case.

The viewpoint is slightly refined later in the article, where a Barclays economist says:
"...businesses will have to start to increase hours worked and payrolls around the turn of the year since they cannot expect their current work force to sustain such rapid productivity growth."
Maybe so. But it's pretty odd to suggest that productivity growth is the cause of an employment increase.

* This page has a different interpretation of "equilibrium fallacy" but the phrase doesn't seem to be in common use - anyone want to suggest an alternative?

Thursday, 5 November 2009

No, really?

A good friend sent me a link to this unintentionally hilarious article about pricing on the iPhone App Store.

I burst out laughing at the writer's tone of utter outrage. App developers are charging the price the market will bear, and it is lower than his moral intuition tells him it should be?

The list of "complaints" in this article is hilarious:
  1. People used to sell apps for $50/year on Windows. When they moved to the iPhone, the optimal strategy was to sell it for $10/year. Therefore they sell it for $10/year. NO, REALLY?
  2. "Not all of the people investing time and money in their products are reaping the returns they expected." NO, REALLY?
  3. Someone had to price his app not on the basis of how much work he put in, but on the basis of what people would pay for it. NO, REALLY?
  4. The top ten apps list (which is based on the number of items sold, like every other top ten list in the world) is dominated by cheap applications and not by expensive ones. NO, REALLY?
  5. As there are more developers and more apps doing the same thing, prices are falling. NO, REALLY?
  6. Someone submitted an app, and Apple recommended they cut the price in order to get more sales. They did cut it, and they got more sales. NO, REALLY?
  7. If someone writes an app for the 50 million Apple users and is considering a port to Palm's 500,000 users, they'll think twice about it. NO, REALLY?
Extensive guffawing ensued at the entitlement mentality of this guy. What is the conspiracy here? What is Apple supposed to have done differently? What sort of world does he want us to live in?

Wednesday, 4 November 2009

The economics zeitgeist, 1 November 2009


This week's word cloud from the economics blogs. I generate a new cloud every Sunday, so please subscribe using the RSS or email box on the right and you'll get a message every week with the new cloud.


I summarise around four hundred blogs through their RSS feeds. Thanks in particular to the Palgrave Econolog who have an excellent database of economics blogs; I have also added a number of blogs that are not on their list. Contact me if you'd like to make sure yours is included too.

I use 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.

Tuesday, 3 November 2009

Lisbon treaty ratified

Vaclav Klaus has become the final European leader to sign the Lisbon treaty into law, enabling it to take effect across all 27 countries.

This is good news from a purely practical point of view - it streamlines decision making and enables the EU to work more effectively with a growing number of member states.

From a symbolic point of view things are more controversial. It is a declaration that the European institutions intend to move forward rather than fading into irrelevance, and there are a number of important symbols which will reinforce this in the public view. In ten years it is possible to foresee a European president coordinating and powerfully representing European interests in the world. Possibly even the beginning of a European economic or fiscal presence. And most importantly, a more powerful, legitimate and meaningful democratic process in Brussels and Strasbourg.

Most people would regard most of these things - in isolation - as positive moves. But they will inevitably take power and attention - is there a difference? - away from national governments. This is the main reason why people whose power base is local, or who have a strong emotional attachment to national cultures, object to greater European democracy and streamlined institutions. Nobody can dispute democracy and streamlining on their own merits, so opponents must either make a complex case about limited public attention, or a simple (and misleading) case about loss of sovereignty.

The treaty will remain divisive for few months, but I suspect that long before the next British election it will have faded as an issue. Tory divisions mean that David Cameron will be no more keen than Gordon Brown to raise its profile. UKIP will try to run against it but I don't see them making much headway in a parliamentary election.

Overall: a good thing, and the only logical next step in the European story. Let's take this opportunity to hold European institutions accountable and ensure that they serve us and not themselves.

Monday, 2 November 2009

Superfreakonomics - wrong by a factor of nine

So tomorrow is the big day: the result of the Superfreakonomics counting contest!

My logarithmically scaled maximal-gap estimate, as you'll recall, was 88,782. This number was my carefully calibrated guess for the number of Google results shown for "Superfreakonomics".

At first I was worried that my number might be too high. But in fact I was stunningly inaccurate in the other direction. The current figure, one day before the authors will calculate the final result, is 737,000. It has been increasing at tens of thousands per day and will likely creep up a bit more before the search is carried out at 6am Eastern time tomorrow.

Two scenarios are possible:

Either, one of the other contestants has gamed the Google search in order to bring the results up to their guess - probably not worth it, as such skills are highly marketable in the search engine manipulation, I mean optimisation, industry. Then again, I've wasted a couple of hours writing about it by now so we can't rule this out.

Or, a stunningly successful PR campaign about global warming and geoengineering has triggered intense debate and insults all over the blogosphere, spilling into the "real" media. It's worked on me anyway - I have given up on any chance of winning the book and ordered one from Amazon.

Everyone else seems to have assumed that this publicity was orchestrated by Levitt and Dubner themselves. But they claim that they never expected the global cooling chapter to provoke this kind of response. Thus I suspect that "Nick", whose contest entry was 787,316 Google hits, might just be the responsible party.

Stand up and take credit, "Nick" - a new career in book marketing beckons...