Sunday, 28 February 2010

The economics zeitgeist, 28 February 2010

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, 27 February 2010

The price of ideas: competing incentives for innovation

[I intended my next post to be a followup to yesterday's, but I need a bit more time to work on that. So you can have this one instead - it's quite good too]

Only someone with Nathan Myhrvold's Microsoft money - and reputation as a mad genius - could get away with starting Intellectual Ventures and still being taken seriously. But since he can, it makes it an interesting concept.

This article by Ryan McClafferty raises some tricky questions about whether the company's attempts to create a marketplace in ideas will encourage, or instead stifle, innovation.

Normally if we deepen the market for a commodity, more of it will be produced. It gives producers more chances to sell, consumers more places to buy and lets price discovery be more accurate. As a side-effect it will usually improve the quality of the good - imagine that instead of a competitive dealer network for buying and selling cars, the government simply issued one to every family. It's very unlikely we'd have the quality of cars that we do now (and let's not go too far with that Toyota example).

This is Myhrvold's argument for Intellectual Ventures - by putting a price on ideas, it will correct a market failure which currently leads to them being under-produced. This is a respectable and mainstream economic argument: if a good has unpriced positive externalities, the economy will not produce as much of it as people would like to consume.

But some people think ideas are different. Simple production of new ideas is not enough to make them useful - they must also be used as widely as possible. And despite the Coase theorem, which says that assigning property rights to a good will let it be allocated with maximum efficiency, that might not be true of so-called non-rival goods like ideas or inventions.

The biggest reason is transaction costs. The main problem with software patents - from my point of view as owner of a software company - is not the fact that we might need to pay a licence fee. We already pay a licence if we resell someone else's database software or other components alongside our products. The problem is the search cost. We have no effective way of knowing whether our software infringes any of the millions of patents out there. If we had to go through them all and find out, we would swiftly run out of money before ever creating a useful product.

I guess it wouldn't be so bad if we could just go out there and make something, then worry about paying the licence fee afterwards if someone proves their patent claim to a court's satisfaction. But that wouldn't really work either - because we might have sold products for $100 which the patent owner wants to charge a $10,000 licence on. The court might just say no, the patent holder can never have more than a 20% share of revenue - but that makes it too easy for us to exploit the patent by simply setting a very low price.

A theoretical fix for this is to contractually construct a claim over buyers of our software saying that patent owners could come after them for retrospective payment. But guess how many we'd sell on that basis? The level of uncertainty for buyers would kill the market.

And that leads us to another problem with this market: uncertainty. Those who use one idea to build another - the potential customers in this new market - often have huge uncertainty about whether their work will lead to anything. And even if there is a price on ideas, they're also uncertain about whether they'll be able to capture the benefits of the invention for themselves. Who knows what competing products will emerge in the five years it takes me to bring a new invention to market? Who knows if anyone will even want it? This uncertainty also causes under-production (and under-use) of ideas, and stricter enforcement of patents could increase the cost of that uncertainty, resulting in less production and use of inventions.

I don't know which of those effects is greater - the underpricing or the uncertainty - but I do know that transaction costs are likely to dominate either of them, at least until there are better methods of searching for inventions and using them. Maybe IV can produce a search engine which will let me describe my potential invention in an abstract way and present me with a list of available ideas that I can use. That would both save me a lot of time in redeveloping the same thing twice, and take away the major transaction cost - search - which stops this market working properly.

To do that, they would need to be less of a patent owner and more of a patent exchange. Is that in their gameplan?

Is there an alternative mechanism that would work better? Open source adherents propose a mechanism which I used to think would never work - but having tried it out in the last couple of years, I'm coming round to it.

That is the idea of rewarding one non-rival good with another. In return for generating and publishing my ideas, I get acknowledgment, admiration, fame or social status. I used to think this was all very well for Linus Torvalds who has become world-famous for creating Linux - and as a result is paid quite well to advise companies, speak, write books and so on. But for people in niche markets, I didn't think it could work.

I don't quite agree any more. Even the little recognition, in small niches, that I've had from writing this blog, is both gratifying and profitable. A couple of comments on the BBC, articles in trade magazines and a few speeches have led to contracts for my business and a raising of my profile and status in some communities. It doesn't yet rationally justify the thousands of hours I've put in, but that will no doubt come.

If I had to try to earn money directly by selling my ideas, it would have been a lot harder to get a return - and certainly much harder to get the useful feedback I've had from many well-informed readers - than it is when I give them away for free.

A related aspect of this market is that I get to read the ideas of Tyler Cowen, Scott Sumner and Rajiv Sethi in return for contributing mine; and my readers get to see my ideas in return for writing comments or sending me emails occasionally.

Because these knowledge goods are non-rival, thousands of people can benefit from a piece of writing that only one person has to produce. I get much more benefit from reading the thoughts of other economists than the effort of writing my own stuff. In a naive sense my net benefit would be even greater if I just read theirs and didn't bother with my own, but actually the cognitive benefits I get from reading are greatly magnified by the effort of writing my own pieces.

Maybe innovators' preferences for recognition, status and feedback are far stronger than their preference for excludable rival goods like, say, hamburgers. Maybe the structure of production is such that recognition and feedback actually allow people to buy more hamburgers than if they sell the ideas directly. If so, eliminating intellectual property rights and reducing the transaction costs which put a brake on the free exchange of ideas would result in more production and use of ideas, not less.

I'm afraid I don't have a clear answer to this question - if only economists could be so decisive - but economics does at least provide us with the tools to analyse the issue.

So to resolve this debate, we'd need to measure the strengths of those competing incentives and understand the production function in a lot more detail. Anyone have any ideas how to do that? If you do, name your price and maybe I'll buy it from you. Or you could just publish it and get famous.

Friday, 26 February 2010

RBS, Lloyds, lending and taxpayer value

Robert Peston has been working hard reporting on results from RBS and Lloyds the last couple of days.

A couple of points.

He claims that taxpayer's money has gone down the drain at RBS, because:
we as taxpayers put in £25.5bn of new equity into this bank last autumn...but...the equity of this bank has increased by less than £16bn to £80bn.
So almost £10bn of the £25.5bn we've only just put into RBS has already been wiped out by losses.
Well, that's half true. £10 billion has indeed been wiped out by losses. But it's not £10 billion of our money, it's £10 billion of the former shareholders' money.

Our £45.5 billion has bought 84% of that £80 billion in equity, a £67.2 billion asset.

The reason we're not in profit yet is because the market is still applying a discount due to uncertainty over future losses. We don't know if those losses will happen yet - it depends mainly on economic recovery - but on the book value of the bank, we got a good asset at a discount, and the writeoffs are still coming out of that discount.

So let's not be too worried about whether our tax money is going down the drain yet...the old shareholders (who, after all, got some nice dividends when the going was good) are the ones who lost their equity when their gamble failed.

My second point - and much more important than whether we make a £10 billion profit or loss on the taxpayer's bank shares - is how quickly the economy is going to recover. Every 1% of growth that comes a year earlier is worth £14 billion per year to the country, a cashflow with a net present value of several hundred billion (depending on your unit root assumptions). So getting back to growth as soon as possible is absolutely critical. Here the news is less certain:
What we're not getting is oodles of credit funnelled to businesses vital to the UK's economic recovery.
By its own admission, Royal Bank has flunked the government-set target of providing £16bn of additional loans to "credit-worthy" businesses...In fact, there has been a £12.2bn reduction to £151bn during the course of the year in the total volume of loans provided by Royal Bank to companies.
And Lloyds:
...has a contractual arrangement with the Treasury to increase lending to UK businesses by £11bn and to home-owners by £3bn both in 2009 and 2010.
Is that in fact what happened? Has it met those lending commitments?
Well, Lloyds' published numbers do not tell that story.
In every segment of Lloyds operations, loans and advances to customers fell: by £6bn in its retail bank, by £43bn in its wholesale bank (which deals with businesses) and by £1bn in its wealth and international division.
Breaking that down further, mortgages on its balance sheet decreased by more than £10bn, credit for transport, distribution and hotels was almost £4bn down and loans to manufacturers dropped by £4bn.
So - at least from these two banks - we don't have an increase in lending. But do businesses want to borrow?

Well, there's lots of anecdotal evidence suggesting they do. You only need to go round the room at any small business event to find plenty of people who want to borrow from the bank and have been turned down. But many of these businesses just want to borrow to paper over a fall in cashflow and are not genuine investment opportunities.

The main reason these people are being turned down - as far as I can see - is because their cashflow is not enough to service the loan. This usually means that they are a small firm, seeking a loan to make a risky long-term investment, instead of for safe capital expansion such as buying another machine in a successful factory. This is the kind of investment that's often thought to be more appropriate for equity investors than lenders, because equity investors can capture some of the high upside while lenders can't.

Then, is equity investment rising or falling? We don't know - but it isn't really core business for the banks (though they used to lend lots to private equity houses which would invest on their behalf). However, there's a reason why equity investment might not be the right answer here.

First let me take a step back to the fundamentals: are there appropriate opportunities to invest? Not according to one view. Adam P, commenting on Worthwhile Canadian Initiative, has said:
[In a recession] investment falls immediately too, but this does not raise the marginal product of capital because the marginal product of capital depends on the level of the capital stock. The marginal product of capital rises only slowly as depreciation reduces the capital stock. Thus investment falls further than consumption and stays depressed longer.
In the absence of a monetary response to bring the real rate down the recession won't end until the capital stock falls to the point that the marginal product of capital, and hence the natural interest rate, again equals the real rate, at which point full-employment is restored.
This is a technical way of saying: there are no good investment opportunities because the factories we built in 2007 can still produce more than enough to meet today's shrunken consumer demand. Until demand rises, or can be clearly predicted to rise strongly in the next few years - or until the old factories break down - it won't be worth building new ones.

The most likely way out of this, as Martin Wolf hints in a pessimistic but good article in the FT and Paul Krugman agrees, is for some foresighted people to be able to foresee good investment opportunities in some new area. We might be helped in the short term by a rise in consumption in China or Germany, but the more hopeful scenario is that there are opportunities to invest in some new technology area or a gap in capital stock somewhere in the world.

Apparently nobody is spotting these opportunities. Robert Peston says:
Royal Bank says the money is there to be lent, but that bankable businesses don't want to borrow - or, at least they don't want to borrow enough.
...shocking official statistics...on investment by British business... showed that in the last three months of 2009 business investment fell almost 6 per cent to a level not seen since 1992.
It looks as though - as per Japan in the 1990s - unconfident British companies are choosing to pay down their debts rather than invest for the future.
A simple view of capital markets theory says that this doesn't matter: if company debts are repaid this makes more capital available for venture capitalists or savers to invest in other ways. And this is the argument I referred to above, which says that equity investors such as venture capital firms should be stepping in now.

But this neglects George Akerlof's theory of "the market for lemons". There's a severe asymmetry of information in the investment market. VCs have to be conservative when they invest, because they don't have access to the same market information that the managers of firms do. Plenty of firms will come along asking for VC money and, essentially, gambling on an idea that may or may not work. If it does, they get a share of the winnings. If it doesn't, it's the VC's money that's gone up in smoke, not their own. The VC can't really tell - unless, like the Silicon Valley VC community, they are themselves market experts - whether the managers are pitching a really solid idea or just taking a punt. And thus, standards for VC investment need to be higher than they would optimally be.

This is why internal investment within the firm is such an important mechanism. Because someone who runs a companies and also controls capital can see an opportunity and make their own judgement about investing in it. And that kind of investment is financed not by VCs, but (indirectly) by banks. Managers who see an opportunity and believe in it, can put their own and their shareholders' money on the line by not paying out profits in dividends, but instead mortgaging the existing cashflow of the company to borrow and invest in that new opportunity.

What this means:

  1. Small businesses aren't necessarily the answer to growth. They are good for bringing new ideas to the economy, which has a spillover effect that justifies government subsidy in the small firms loan market. But they don't bring together two essential elements: the cashflow on which to secure borrowing, and the market knowledge on which to be confident that borrowing to invest is worthwhile.
  2. Large firms are able to get cheap finance in the equity and corporate bond markets, if the opportunities are there.
  3. Medium-sized firms can get bank finance if their cashflows are safe enough - though they probably are regarded as a poor risk by banks at present. Some government intervention might be justified here, on the basis of nudging the economy from a low-investment equilibrium to a higher one.
  4. But there's no obvious answer to the real challenge, which is: how can we demonstrate to managers of medium and larger firms that there will be more demand in the future and they should invest now. If we can't show this, investment won't happen and the low demand will be a self-fulfilling prophesy. If we can, the investment that does happen will stimulate aggregate demand and the investment will turn out to be justified.
On this last point, I do have one idea which I will lay out in my next article. Until then, do continue to fiddle with the institutional details of the banking system, play with capital requirements and support aggregate demand with fiscal and monetary stimulus. It's all fine, but it papers over a fundamental fragility in our economy; and that fragility is what I'll propose a real solution for.

I'll give you a clue. It's all based on one word, and it begins with D. Place your bets, please.

Thursday, 25 February 2010

Cheryl Cole and the liquidity paradox

This may be the first time I've linked to a story in The Sun, but it illustrates a striking economic puzzle, so here goes:
"[Cheryl Cole] will not be fighting for a huge settlement. She just wants to get out fast so she can press on with life and move on.
"The initial advice is that it speeds up the process if there is no claim for money"...Cheryl hopes to keep the couple's £6million home.
So wait...this transaction will be more liquid with lower transaction costs if it takes place in property instead of cash?

This goes against all standard microeconomic theory, which strongly implies that cash transactions should be more efficient than barter. Cash is a fungible asset, highly granular, and any transaction involving other assets will be an imperfect match for the agent's preferences, reducing the available consumer surplus.

What could be the explanation for this?

  1. Cheryl could be rationally giving up a potential material gain simply to reduce likely negotiation and transaction costs. This might result in a net benefit if the legal fees, time and stress would be greater than the share of Ashley's money that she might get. However, he's supposed to be worth £14 million (plus £4 million a year in salary) and he appears to be (or is painted as being) unequivocally at fault - meaning she'd probably make a big profit by fighting - unless she assigns an unrealistically high cost to the emotional stress of the contest.
  2. The endowment effect might increase her subjective valuation of the house, making it (strictly speaking, his half of it) more valuable to her than £7 million of cash. Supporting this, I ran a test of the endowment effect last week with the result that the subjects valued their own asset an average of five times higher than an identical object owned by another person.
  3. The benefit of the transaction might be primarily social rather than material - symbolising Cheryl's victory over Ashley in the public eye - meaning that the iconic value of the marital home more than outweighs any dimunition in utility from the good. At first it seems intuitively appealing that her fame and public image would be worth more than the cash. But then again, this is a woman who, according to Facebook, is barely more popular than a sausage roll.
  4. Or there could be a cognitive explanation based on uncertainty over preferences. Cheryl presumably has a good idea of the value she gets from the house, as she lives in it. She may also have a clear idea of her current marginal utility from wealth - how much happier will one more pound make her? But she has no way of knowing what utility she'll gain from wealth once she has £7 million more in the bank. Perhaps after another half million her utility from wealth will drop off a cliff and the next £6.5 million will hardly make her happier at all. In which case she'd be better off just taking the house. While it's hard to make an informed case for believing in that kind of utility curve, it's quite plausible for a person to have such a lack of visibility of their own preferences.

Whatever the right answer (and it's probably a combination), this apparent paradox of liquidity illuminates some interesting features of real markets which rarely find their way into the microeconomics discipline.

[article continues below this slightly disturbing yet appealing picture]

image from daily mail

The article goes on to criticise Ashley:
"as more shabby revelations emerged about his links with five girls."
which is all very well, but a bit rich given that Cheryl has her own widely reported "links with five girls" (see the link for photographic evidence).

Finally it appears that Cheryl, who plans to revert to her maiden name, Tweedy:
may return to America to have the "Mrs C" tattoo on the back of her neck removed.
Note, however, her foresight in having included just Ashley's initial in the tattoo. This opens up the opportunity for her to reduce pain and trouble by hooking up with another partner whose last name also begins with C. Not that I'm suggesting anyone in particular - just saying...

Tuesday, 23 February 2010

Dodgy arithmetic - but if it proves the point, who cares?

I don't have time to write a detailed post today so let me do something slightly unfair by picking holes in somebody else's.

Stephanie Flanders writes about (among other things) the risk to UK exports posed by the slowing eurozone economy.
Germany seems to have had no growth at all, the Italian economy shrank by another 0.2%, and Spain by 0.1%. Between them, those three countries accounted for 15% of UK exports in 2008.
Sounds terrible. But wait, there is a little bit of good news to partly make up for it:
British exports to China were 53% higher last month than in January 2009. But they start from a very, very low base: just 2% of our exports went to China in 2008.
In total, about 12% went to the Brics - with about 75% going to advanced economies, primarily the the US and the EU.
Solid growth in Europe is a necessary condition for a healthy recovery in the UK. So the latest weak numbers from across the channel have given the MPC one more reason to keep the door to further quantitative easing wide open.
So from reading the conclusion you can clearly infer that British exports will continue to decline until Europe revives, right? China might slow the process down but can't make any real difference. Not so fast.

A drop of arithmetic shows this to be incorrect. If exports decline in line with GDP*, the 0.08% fall in total GDP of the three EU countries mentioned, multiplied by the 15% share of exports that they represent, means a decline in British exports of around 0.012%. That's about one in ten thousand, or a £120 decline for each million pounds of exports.

On the other hand, exports to China have increased 53% - yes, from a small base of only 2%, but still - that change is a whole 1.06% of British exports.

That is, the increase in exports to China is ninety times greater than the likely fall in exports to the three shrinking EU economies.

So while I certainly support the call for more quantitative easing, let's not pretend that the reason is to make up for a lack of growth in exports to the EU. There are much more important things to worry about.

* it's true that trade tends to decline faster than GDP. But even if it shrinks three times as fast, the Chinese growth is still thirty times greater than the reduction from the countries Stephanie names.

Monday, 22 February 2010

Free lunches (wrapped in vine leaves)

This quite clever proposal from Cavallo and Cottani sounds plausible at first but my immediate reaction is: how can it work?

The idea is to eliminate payroll taxes in Greece and instead raise VAT to 25%. This is meant to increase competitiveness while reducing distortions in the economy.

It feels like a magic solution - which naturally makes me suspicious. If the economy really needs a devaluation, then how can they miraculously solve the problems without one?

But then I realise that magic really can happen.

A devaluation is only a nominal change - it simply breaks people's money illusion and affects relative prices. In fact, a devaluation requires no real actions at all, although it does change the pattern of of future real demand. All the benefits of a devaluation can, in principle, be achieved through the coordinated individual choices of all the agents in the economy.

Of course such coordinated choices are highly implausible, which is why devaluation is a good shortcut to achieve them. But then why shouldn't other shortcuts work too?

The effect of the proposed tax changes is really just a general cut in wages and an increase in prices; and the price increase (for non-tradable goods at least) will not last long if people can't afford to buy stuff.

The lesson: nominal changes, by countering our cognitive biases, really can produce a free lunch.

Could you name five female CIOs?

This article bemoans the fact that a 13-year-old girl:
was able to name five favorite female authors but couldn’t name five female CIOs.
A terrible indictment of the perception of science among young female students? Well...could you name five female CIOs? Never mind that - could you name five CIOs?

OK, maybe that's not quite fair. Let's make it easier.

Could you name one CIO?

Sunday, 21 February 2010

Agreements and disputes: Tim H and Chris D

Tim Harford's on a couple of rants this weekend: a light-hearted bitch about non-mathematical economists alongside a more serious argument against the "Robin Hood tax" (a much catchier, or perhaps I should say Orwellian, name for the Tobin tax).

I'm with Tim on this one. There's a typically Curtisian video on the front page of the campaign's website (about as blatantly manipulative as the director's better-known work, Love Actually, and with about the same amount of factual content). It attempts to put across the idea that the tax is simultaneously tiny and huge - small enough to have no impact on financial efficiency while being large enough to solve all the world's problems at home and abroad.

Tim makes the case against it pretty well - here's a key example:
For instance, I might buy car insurance which could – if I knocked somebody down and permanently disabled them – trigger a payment of £1m. My insurance company might want to reinsure that million-pound risk, a perfectly sensible, socially useful and non-speculative transaction. But at a “tiny” tax rate of 0.05 per cent, that’s a £500 tax on a face value of £1m. It’s hard to imagine such a tax wouldn’t somehow affect my premium.
The basic point here is that a transaction with a value of £1 million doesn't necessarily mean anyone makes a £1 million profit. It doesn't necessarily mean that some plutocrat is trading £1 million of platinum futures in order to buy themselves a new yacht; the economic value of the transaction may only be a few pounds. You might ask why the markets are so leveraged that a nominal instrument priced at £1 million is only worth £10, but this is to misunderstand the nature of financial markets.

Finance aggregates the risks, liabilities, assets and profits of hundreds of millions of people, each of whom has only a tiny stake in the whole. This is the only reason we can even get an insurance policy to protect us against such risks. It's the reason that small shareholders can finance huge infrastructure projects; and it's the reason that specialised companies can exist which serve just a few hundred customers out of a worldwide market of billions.

Now you could always make an exception in the tax for transactions like the one Tim described. But then, the insurance company could also restructure its transactions to have a lower face value. One possibility - instead of trading a security with a £1m face value, simply sign a letter saying that if certain conditions are met, then you'll trade that security. Another option - insurance companies are priced out of the market and only huge reinsurance companies can afford to provide car insurance. Even though the same transaction is happening, because it's done internally within the company, with no money changing hands, they don't have to pay the tax.

The nominal value of a transaction is arbitrary - it depends entirely on how the deal is structured and there is no doubt that people would immediately find ways to reduce nominal deal size without affecting the reality of what's going on. Any of these routes would make the market less efficient, but would avoid or reduce the tax take.

The essential principle is that taxes should only be levied on the economic profit from a transaction and not its nominal value. If the Robin Hood campaigners want to simply argue for a tax on banks' profits to support poverty reduction, I'll sign their petition. But if they continue to pretend that this magic tax will somehow come for free, without harming our economy or the growth that saves jobs and increases incomes, they won't get any support from me or most of the economics discipline.

And I was quite amused by this little effect - Google obviously hasn't quite caught up with Bill Nighy yet:

Someone else with whom I normally agree has surprised me this weekend with two postings that I don't get at all. Chris Dillow says first that:
The only way the taxpayer can gain by selling bank shares is if they are sold at an over-inflated price, such that subsequent returns on them are lower than the returns to gilts.
So, let’s be clear. What Osborne is proposing here is nothing other than a Russian-style privatisation* - the plundering of public assets for the benefit of friends of the government.
This is a rather simplistic view of the capital markets. Like any form of ownership, owning shares is not a neutral portfolio matter, but can change people's behaviour. The reason that governments subsidised home ownership in the old days was not some foolish fallacy of composition - some people choose to own a home, therefore it's good for everyone to own homes - but because ownership gives people a stake in their community, encourages investment and increases social cohesion.

Of course home ownership is not an unalloyed good, and the subsidy in that case was probably overdone. But you can hardly argue that it made no difference to anybody's behaviour.

The same with share ownership. Rightly or wrongly, the intention - just as with the big privatisations in the 1980s - is to change culture and behaviour by altering how people relate to their savings and to public companies. The attempt might not be successful, but it isn't by any means a pure money transfer.

More bizarrely, he extrapolates from his personal claim never to have met anyone interesting in a cafe, to an assertion that cities are no good for innovation, knowledge spillovers or growth. I am astonished by this. I spend about a third of my work time in meetings, workshops, conferences and other conversations that would never happen if I were based outside of London; and perhaps the same proportion of my leisure time meeting and talking to people that I'd similarly never have met. The knowledge and ideas that are exchanged and created in these interactions are manifold.

Of course it's no more valid for me to base this argument on my own personal experience than it is for Chris; but it isn't controversial to claim that these kind of conversations are happening all over London and other big cities, all the time. There is a reason people come to the cities to work, and there's a reason GDP per head is far higher in central London than anywhere else in the UK. This seems to be one case in which the conventional wisdom is exactly right, and the contrarian view is just contrary.

The economics zeitgeist, 21 February 2010

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, 20 February 2010

The appeal of the sweatshop

This beautifully shot photostory isn't strictly about sweatshops, but it might as well be. The women who work as porters in Ghana's city markets must endure:

  • Long hours
  • Backbreaking physical labour
  • Low pay
  • Living in cramped slum conditions
  • Moving from a village where there's food to share, to the city where you starve if you have no money
Sounds terrible, right?

And yet:

  • People are doing it voluntarily
  • It lets them build up savings
  • They can reinvest those savings in a business, or in going home to start a family
  • It is being used to finance their own or their children's education, so the next generation won't have to do the same
Nobody is idealising this lifestyle. It's hard work, I wouldn't want to do it, and at least one of the women in the story who has left the job is glad to be out of it. There is an element of randomness, and if you have no money one day, nobody is going to feed you.

But it's more dangerous to idealise the alternative. Subsistence farming is even harder work, you're at the mercy of the elements, and it provides no route to improve your life.

People are choosing to move from the farm to the city, as they have throughout history, because they correctly recognise that this is the first step in making their lives - and the future lives of their families - much better.

Friday, 19 February 2010

Economics live!

Sports fans will mostly be familiar with the idea of live text commentary. If you can't watch the game, you can often find a live text stream on the BBC or Guardian websites giving you a minute-by-minute description of events. It's a good idea - it's much easier to multitask with the text stream in a window than while watching TV, while still retaining the dramatic tension of the game.

Today, for some reason, the Guardian has come up with the hilarious idea of running a live commentary on the economics news. And yet - there is nothing to comment on!

Here is the link - it started out at some think tank conference but I think they've swiftly given up on anything good happening there. So they've started pasting in press releases from economics consultancies and updating us on the dollar-pound exchange rate.

They did find one interesting piece of news, from the US inflation data. Mirroring the UK's experience last week, an announcement of monetary tightening by the central bank has been followed by weak economic statistics. In this case the Fed raised its emergency lending rate last night, and today the inflation figures show a fall in prices from December to January.

This may be a whimsical one-day experiment, but I think we should have a live economics commentary permanently running on the web. In fact, if you were to watch the blogroll in my right-hand column and just refresh every 5-10 minutes, that's what you would have. I encourage any interested readers to do just that, and thanks in advance for the boost to my traffic figures!

Athens in Wonderland

Have a look at the following very odd statement from Laurence Kotlikoff in the Economists' Forum. He is suggesting that Greece does not need to devalue, because its prices and wages will quickly adjust regardless:
In the US...the past two years has seen essentially zero inflation leaving prices today substantially lower than where they’d be today had there been no recession.
This is hardly evidence of sticky prices.
I find it difficult to interpret "zero inflation", and prices exactly where they were two years ago, as anything other than evidence for sticky prices.

He then goes on to address the important question of sticky wages in exactly the same way:
Nor is there strong evidence that wages don’t adjust to market pressures. In the US, median real wages have hardly moved for decades

I haven't seen the new Alice in Wonderland film, but I have the feeling this must be what it's like. Syllogisms whose premises and conclusions point precisely in opposite directions.

The best thing about Alice in Wonderland is its surreal sense of humour. Kotlikoff has mastered this too - here is his proposal for what Greece should do about its problems:
Specifically, the Greek government would decree that all firms must lower their nominal wages and prices by 30 per cent, effective immediately, and not change them for three months. After three months, everyone would be free to put prices and wages back up.
Beautiful! He tops it all off by asserting that this is all based on what "as economists, we know" to be true.

But one solemn moment of self-awareness upsets the illusion:
Like many quick ideas, this one may have serious flaws
Oh, Laurence. Don't talk yourself down. Flaws are not what this idea has. What this idea has, is on another level entirely. Just think of yourself as a Robin Hanson for macroeconomics. In true Hansonian style, this is a thought experiment designed specifically to expose its own absurdity.

Thursday, 18 February 2010

Were we wrong about the minimum wage?

Stephanie Flanders points out some huge discrepancies in the labour market between older and younger workers, and between the current recession and that of the early 90s.
But of the 16-17-year-olds not in full-time education, nearly 41% were economically inactive during the last quarter of 2009. Back in 1992, the figure was less than 15%.
...consider the following astonishing fact.
In the second quarter of 1992, two-thirds - 65% - of 16-17-year-olds who were not in full-time education were reported to have a job. Now the figure is 35%.
These figures are startling and, especially having got used to economic statistics measured in increments (unemployment 2% higher, inflation 1% lower), really worrying.

What's more - though Stephanie surprisingly does not point this out - there is a very clear suspect here: the minimum wage.

Like all card-carrying bleeding-hearted liberals, I was in favour of the UK's minimum wage when it was introduced in 1997.

I did have some minor reservations, as the standard economic argument against minimum wages is clear and well-known. However, I took heart from a body of research indicating that minimum wages do not clearly cause a rise in unemployment; and from the social justice benefits of the minimum wage - having had friends who felt obliged to work for £1.30 an hour in the early 1990s, I wasn't very sympathetic to the positive effects of deregulation on employers' welfare. Under strong economic conditions, a minimum wage is a transfer program from shareholders to low-skilled workers; it helps to stop workers being played off against one another to reach a market-clearing wage. There are respectable arguments for why we should support this, based on bounded rationality and hyperbolic discounting.

And for the first twelve years of the minimum wage policy it, indeed, didn't seem so bad. Younger people, though still suffering higher unemployment than older, had plenty of opportunities and if there was a challenge, it was how to persuade 17-year-olds to stay in education rather than how to get them a job.

Now it appears that is no longer the case. The higher education system is oversubscribed (nothing wrong with that intrinsically, but it's a sign), and according to the figures above, young people can't - or don't want to - get jobs.

If the cause is that they don't want to work, that's a different thing. There could be cultural shifts which reduce the willingness of young people to work - maybe their parents are better-off on average, or maybe they have watched too much BBC Three [if this were a Chris Dillow post, the point would be illustrated with a picture of one of the girls from Coming of Age]. If that's the case, the minimum wage would help to increase employment among young people, because it would force employers to offer higher wages.

But if employers are not hiring - as, crudely speaking, they currently aren't - then the minimum wage forces them to hire more skilled people than they might otherwise do. Someone who might have employed three people at £3 an hour may instead choose to hire one or two more experienced people at £6 an hour. And young, low-skilled workers are the most likely to lose out from this. Long-run, this provides an extra incentive for people to stay in education and gain more skills. But that's a tough sell in this economy.

This point was no mystery when the legislation was written, which is why the minimum is lower for 16-17 year olds and 18-21 year olds than for older workers. But it inevitably has some effect - the size of which we cannot be sure about.

I'm not ready to write off the minimum wage yet, but we need to acknowledge that it has costs as well as benefits. Let's hope there are enough automatic stabilisers in the benefits system to avoid the worst hardship.

Talking of Chris Dillow, he has some slightly different thoughts on the same subject.

Update: Chris responds with two good points - first noting that the rate of employment among young people was already declining before 1997, and second that there is probably a strong selection effect affecting the characteristics of 16-17 year olds not in full-time education.

Wednesday, 17 February 2010

CDS spreads on spreads

In defence of Greece, I pointed out to a colleague the other day that the cost of a Greek CDS is only 4% for a five year period - meaning that you only need a 0.8% interest premium to make a Greek bond worthwhile, or that the market only gives Greece a 1/125 chance of defaulting each year.

He responded with the valid observation that this is all very well, but who's offering this insurance policy and will they be around to pay it if Greece does default? After all, AIG wasn't.

In fact, the 4% is not the spread between the chances of Greece defaulting and a risk-free bond, as it's commonly presented. It is actually the spread between the chances of a Greek default and an insurance company default.

It's a lot easier for an insurance company to go bust than it was two years ago. Not only have risk conditions deteriorated, but after AIG, Citi and the rest, it would be immensely tough politically to bail out another big insurance company or bank which had issued CDS it could not pay out on. So keep this in mind if you are tempted to buy any CDS coverage [er...this is not investment advice!].

Related: chat from the FT.

Also related (though non-Alphaville members may not have access): who are Greece's CDS counterparties? The rumour is that these are being sold not by international insurance companies, but by GREEK BANKS! How much do you think that insurance policy is worth?

The FT's thoughts on my pricing post

I had a nice email from the FT today in response to this previous item (posted with permission):
Hi Leigh
Sorry to hear about your recent subscription problems. I thought I might try and explain a couple of the oddities you encountered in your renewal process.
When we moved to a 'metered' access model for in November 2007, we upgraded all of our long-standing customers, like yourself, to the newly-created 'Premium' service level. We did this so that you wouldn't lose access to parts of the site, like Lex, that had been included in your old subscription package. Naturally, we kept you on the same 'old' rate.
By the time your subscription fell due for renewal, your 'old' rate had fallen considerably behind the £25.99 a month we charge new 'Premium' subscribers, and even behind the £17.50 we charge new 'Standard' subscribers. Fortunately, you have a long history as a customer of the Financial Times and therefore qualify for special treatment - hence the £12.98 offer, or 50%-ish discount. I appreciate that a price increase is rarely welcome and I'm sorry that you have had a bad experience, but some legacy subscription offers are simply not sustainable given our commitment to invest in the product.
Since 2007 we've been working hard to upgrade the site and add new features such as the interactive portfolio, Lexicon glossary of financial terms, Editor's newsletter and the FT Newsmine email service. At the same time we've attempted to charge a fair price, which reflects the high quality content and services we try to deliver.
Our editorial team is over 500 strong and it includes some of the world's leading commentators on finance and business. It's an expensive resource to maintain and it's important that our prices reflect the costs we incur. Even after your recent rate increase, it will still cost you less than 50 pence per day to access some of the world's finest journalism. We feel strongly that this is excellent value for money - I hope you agree.
Please be assured that we do not upgrade customer's subscriptions by default at renewal, and that we scrutinise all our marketing efforts for even the perception of a 'bait-and-switch'. If you think any of our offers are misleading, I would like to hear about it and remedy it.
My reply:
Thanks - those are all fair comments.
I hope my blog post didn't come across as implying anything unfair on your part, though I guess I may have unduly emphasised my surprise at noticing the increase! I do agree that 12.98 is a perfectly reasonable price and was happy to renew at that rate.
It would be interesting to know the reaction of new subscribers to the £26 monthly price, though I appreciate that's probably commercially sensitive information. It sounds a little expensive to me but that's partly because I got used to the older £6.25 rate.
Could I post a copy of your email on my blog as a followup to the original article?
And the response:
by all means post, leigh
i only wish we had access to your kind of constructive engagement from more of our users
on new subscriber acquisition: i can tell you that we're attracting a lot more new customers than we were this time last year - but a raft of marketing and product development initiatives are influencing that, not just price.
So no discounts! But as you can see, I wasn't really asking for one. Congratulations to the FT (or at least to this particular individual, but I do think he is representative of the culture there) for listening, and for a constructive and informative response.

Tuesday, 16 February 2010

My BBC interview on inflation

I'll be on the BBC News channel at about 6.40pm today talking about the newly released UK inflation figures.

Inflation has risen to 3.5% in January, driven by VAT, oil prices and lower retail discounting. It's interesting to see some analysts comment that the VAT rise has not been fully passed on, and yet consumer prices show a less-than usual level of discounting in the January sales. I am not sure how these two are meant to be disaggregated (or if they even can be).

Overall, higher inflation is a good thing for the economy and will help us to get out of recession faster. While it will have a short-term impact on savers, if it helps to work out some of the inflexibilities in the economy, they will benefit in the long term along with borrowers and wage-earners.

What is interesting is the Bank of England's pause to the QE programme - I suspect the inflation rise is the main reason for this (after all their job is to target inflation at 2%). I hope they will signal a willingness to restart QE when inflation falls in the spring.

Monday, 15 February 2010

Beliefs not motivations

Anthony Evans at The Filter makes a suggestion I agree with:
...I recollect a conversation I had with Russ in class once, where I cast doubt on the "follow the money" implications of public choice. He suggested that if you look hard enough it's usually the case that poor policy stems from vested interests. At the time I was unable to articulate my feeling that often it's simply mistaken beliefs.
Yes indeed. In fact, many economic phenomena - micro and macro - stem from mistaken or incomplete beliefs. I am developing a model which will shed some light on this, but it may take some time.

In the meantime, a simple question. The world is complicated; and there are millions of things I could do that might very well be in my interest. How would I know about all of them?

Private ownership, public services - a depressing theory

Robert Peston highlights the Conservatives' idea (I originally wrote 'plan', but it's too vague and too early to be convinced they will actually do it) of moving public service provision into employee-owned, profit-making companies.

He points out a few political constraints, in particular:
If a John Lewis style primary school were a floperoo, would all the teacher-shareholders be sacked, or only the head? A resolution procedure for failing co-ops that didn't harm pupils - or patients of community nursing teams - would plainly be essential.
In fact, this is probably a constraint on all private provision of public services. The co-op structure is not really an issue either way, except that it sounds nicer and less cut-throat than straight privatisation.

I'm a fan of market solutions and have generally been well-disposed towards the idea of private companies bidding to do public work - why shouldn't a company be able to offer medical treatment or training if it can do a good job for less than the public sector?

But what if the inefficiencies of the public sector do not actually originate in the incentives of staff, or the lack of innovation in civil service bureaucracy? What if the high costs of public provision are all down to the need to cover every citizen and every eventuality?

One of the main ways in which private firms make money is by picking the most profitable customers or the most attractive markets. This is why we have universal provision rules in the telecoms, postal and water industries, all of which make much less money as a result. It's relatively easy to cover the first 95%, but covering that last 5% of any market gets really difficult and expensive. Look up 'increasing marginal cost' in your economics textbook - there's a reason the supply curve slopes upwards.

Inevitably any public service will suffer political pressure to cover everyone - including the hard-to-reach, hard-to-service individuals - and to provide enough spare capacity to step in if a particular institution (school, hospital) fails. Perhaps there is no solution - public or private - to provide the level of universality that we demand in our public services without the high costs and low average productivity that we see in the public sector.

How depressing that would be.

Update: Chris Dillow has found some completely different reasons to be cynical about this idea.

Sunday, 14 February 2010

The economics zeitgeist, 14 February 2010

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.

Is the euro doomed?

There's a meme around which says that the euro is destined to break up because countries like Greece are fundamentally less productive than countries like Germany. A strategist at Societe Generale has put his name to this idea, as has the director of the Open Europe (anti-EU) think tank.

This argument supposes that the only way to become competitive is to devalue one's currency.

But surely this applies within countries too? The southern half of Italy is much less productive than the north, while the reverse is true in Britain. But there are no calls for a London currency and when the lira existed, it was never under the threat of an Italian breakup. Different states in the US are just the same - with widely varying fiscal problems as well as the same diversity of competitiveness.

At the individual company scale, Yahoo is less competitive than Google, but does Yahoo need its own currency to devalue? And 22-year-old new college graduate Travis is less productive than his experienced 38-year-old colleague Kate, but they still spend the same dollar bills. Kate simply has more of them.

So there's no fundamental argument why devaluation must be necessary at a country level.

But as a practical matter, devaluations are a useful coordination mechanism. They instantly enforce a price and wage cut across a region, making everybody more internationally competitive at the cost of reducing their ability to buy things from other countries. They serve the same coordination role as inflation. The drawback is that people or firms who are internationally competitive get penalised for the benefit of everyone else (just as with inflation, people who have more wealth in cash or other currency-denominated assets are penalised). This provides a disincentive to invest in becoming competitive, just as inflation is a disincentive to save.

If there were other mechanisms for making these cuts (say, agreements between government, labour unions and large employers) then devaluations would not be necessary. Conversely, if devaluations and inflation are not available, people will be forced to find those other mechanisms - though there may be a lot of pain in the meantime.

The Daily Mail (which does have an agenda on this subject) says:
Countries that are highly uncompetitive are normally able to slash interest rates and devalue their currencies to prop up their economies.
But this is not possible within the euro, given its one-size-fits-all economic governance.
The implication is that weak, peripheral eurozone members will have to suffer years of painful deflation and tumbling living standards, as well as draconian budget cuts, in order to adjust.
Of course with a devaluation, they'd still have the deflation, tumbling living standards and budget cuts - but all at once instead of gradually.

The "one-size-fits-all" argument is a revealing one, because of course there has to be one-size-fits-all economic coordination at some level. The question is whether it's at the level of Europe, of an 80-million person region like Germany, a 12-million person region like Greece, a one-million person region like Amsterdam or a one-person region like my apartment.

As Paul Krugman points out, there's a theory of optimal currency areas which gives some clues as to the right level for this coordination to operate. I used to be convinced that a bigger area was always better - and in the very long run, I still suspect that's true. The effects of currency flexibility are essentially monetary ones, and in the very long run the real performance of the economy is neutral with respect to money. But we all live in the short run and I'm no longer certain that the euro is the right level.

However, a stable currency does strengthen the incentives for less competitive regions to save and to invest in productivity, both of which are prerequisites for long-term growth. Perhaps the unusual circumstances of the last ten years have allowed Spain, Greece and Portugal to get away with less productive investment than they would have if the euro had started at a different time.

Or perhaps they have been investing - in long-term projects such as education and infrastructure, rather than capital equipment - and the returns just haven't started to come yet. If so, it would be a tragedy to throw all that away, destroying the returns for those who have chosen to invest, and condemning the Mediterranean population to decades more of second-class economic status in Europe. So my instinct is: stick with it. A few more years and the results will start to show.

p.s. A good way to achieve many of the same goals as a devaluation, with less of an investment penalty, is the IMF's proposal to have a higher, but still stable, inflation target. This gives much more room for relative wages to adjust in different countries, but also across different industries or even different people. Paul Krugman has a good explanation.

Update: Bluematter has a good post on the same topic which comes to a less equivocal pro-Euro position than mine.

Saturday, 13 February 2010

Markets in nothing: El Bulli

Economics appears to have failed today.

El Bulli ("the world's best restaurant") is permanently closing in December 2011. According to owner Ferran Adria, it's because they are losing half a million euros per year. This poses two problems for economic theory.

First - why is it losing so much money when demand is so high? The 48-seat restaurant has a six-month season with about 8,000 covers a year. It receives 300,000 applications for those seats [though this article says a million and this one two million], selling out the whole year's reservations on the same day that bookings open for the season. Why wouldn't they bump up the price from 230 to 330 euros, to simultaneously manage demand and eliminate the losses? Price elasticity can't be that high.

Second - why is there no resale market in the small number of reservations available? Neither the US nor UK Ebay site has any results for El Bulli, except a few copies of the cookbook. Normally, when a venue imposes an artificial price ceiling, it creates a thriving market for scalpers. Now I'm sure the restaurant does not approve of reselling its reservations, but if "John Smith" books a table for six - even if he decides to use his own name and turn up himself, it wouldn't be so hard to sell the other five seats for a couple of thousand dollars each.

Of course there are many theories for why concerts, sport events and so on are sold below market price. Often the argument rests on the sale of ancillary products, and Adria does sell consultancy, books and other products which cover the restaurant's losses. But this doesn't answer the question: an extra €100 on the bills surely would not damage his culinary reputation at all, and if he closes the restaurant, sales of the other services will be hurt too.

Possible explanations?

  1. The 300,000/one million/two million applications every year are fictional. In fact, just 8,000 people apply, prices are already at the revenue-maximising level and the business model simply isn't viable.
  2. Adria was right the first time, when he said he was stopping not because of money, but because of the 15-hour days. His utility from leisure is greater than the attainable revenue from the restaurant.
  3. Irrespective of the current pricing policy, the marginal product of training new chefs (Adria plans to replace the restaurant with a culinary academy) is greater than that of cooking new meals.
  4. The endowment effect means that those who have a reservation value it much more highly than potential bidders who do not have one.
What are your theories?

Updates: According to some other blogs, it isn't closing permanently at all!

But despite that, I've already started getting Google hits for "El Bulli reservations for sale".

Britain and US shouldn't criticise Greece - ECB

Great interview of Jürgen Stark (chief economist of the ECB) by Spiegel Online. He's a very funny guy for a central banker (maybe I'm revealing too much about my sense of humour).
SPIEGEL: You are maneuvering yourself around an answer to the main question: What happens if Greece doesn't make it?
Stark: I do not think that is the most important question, but I will answer it with a clear statement: The country must and will make it.
More importantly, he is very clear that Federal Reserve-style monetary expansion is not on the cards for the ECB, and that he thinks eurozone governments should be cutting deficits faster. Also:
Stark: ...I would like to point to one aspect in this context: Great Britain has a budget deficit of the same magnitude as Greece's. The US budget deficit is also more than 10 percent of GDP. All advanced economies are currently having problems. In fact, it is astonishing to see where most of the criticism of the euro is coming from at the moment.
SPIEGEL: It sounds as if you suspect that the Anglo-American media is behind the attacks.
Stark: At any rate, much of what they are printing reads as if they were trying to deflect attention away from problems in their own backyard.
Oooh, well that's us told!

Correction: the action is at the margin

Barbara Kiviat at Time writes about the jobs bill Harry Reid is trying to pass:
The bill would temporarily exempt employers from paying Social Security payroll taxes for new hires, and give a $1,000 tax credit for new workers kept at least a year. This type of move isn't really about creating jobs, but about accelerating those that would have been created anyway. (I've yet to find a businessperson yet who has said he or she would create a job out of thin air just to grab a tax break.)
Not right.

The point of tax breaks is to move the margin. Indeed, nobody will create a whole job just to get a $1000 tax break (let's say $3000 including the payroll taxes). But the case that matters is where the employer's gain from employing someone would have been $29,000 and the cost $30,000. A net loss, meaning no job. The subsidy changes the equation; the cost goes down to $27,000 - and suddenly it's worthwhile for the hire to take place.

What's more, the government will more than get its money back in new income taxes, meaning everyone wins. (Although there is a genuine cost to the government, which is the unnecessary subsidy it gives to other people who would have got jobs anyway).

Naturally most employers don't calculate things quite as clearly as that - there are error bounds and heuristics, and attitudes differ between one employer and another - but on balance, a job subsidy does enable people to be hired who would not otherwise be.

So while Barbara is correct that the policy might accelerate some hires (which is a good thing) it will also give jobs to some people who would never have got them. How strong the effect will be is an empirical question, but I'm sure there is data out there to indicate the likely impact.

Friday, 12 February 2010

Behavioural economics, industry specials

I'm on a deadline for a magazine article today so I'm not going to write much.

But a heads up on some articles coming up in the near future. I plan to write a series of analyses of individual industries from a cognitive/behavioural point of view and would welcome suggestions on which sectors to pick.

Current plans are:

  • Market research
  • PR
  • Accounting & auditing
All of these are industries which, in a neoclassical world of pure rational preferences and perfect information, would have no reason to exist. But because the world is not like that, they do.

For each one I'll be exploring which aspects of bounded rationality give the industry a reason to exist, and what this means for practitioners in the field and the way they do business.

Suggestions for other sectors or disciplines you'd like me to cover? Email me or post a comment here.

Thursday, 11 February 2010

Rolling in Wonga(tm)

[Update: Someone from Wonga has responded in the comments - please read their clarifications]

This won't be new to some of you, but it deserves highlighting.

Yesterday I saw a TV ad for a company called "Wonga" (a British slang term for money). This is what's called in America a payday lender.

The character in the ad needed to borrow £70 for five days. Wonga proudly announced that they can help him out - for a fee of only £9.22.

Let's look at that for just a second.

£9.22/£70 = 13.17%. For five days.

Imagine you lose your job and don't have the money to repay at the end of the five days. Maybe you'll borrow another £79.22 from Wonga (or a different lender). In another five days you still haven't found work so you roll it over again. You keep this up for a year before finally getting an inheritance from your dear great-aunt Mildred. How much would you have to inherit to pay off the bill?

Take a guess, off the top of your head, before you read further.


OK, you need to compound five days at 13.17% up to a whole year. You'll end up turning over the loan 73 times in 365 days. Total compounded annual interest...wait for it...

Eight hundred and thirty-seven...

(no, not £837. Not even 837%)

Eight hundred and thirty-seven THOUSAND percent.

And how much cash do you need - to repay your £70 payday loan?

Well, let's hope Aunt Mildred had a big house. You are now in for the flabbergasting sum of £585,982.03.

Can this possibly be correct? Remember - this number didn't come from some investigative expose of a council-estate loan shark. This is the figure the company themselves puts in their TV advert (you'll get the same figure if you go to their website and enter the figures directly).

Presumably, therefore, that's either the low end of the range of interest rates - or at least an average figure, representative of all the company's borrowers. Which would imply that there are people paying more than this. Even a single percentage point increase from 13.17% to 14.17% will almost double the cost after a year, to over £1.1 million.

So this can't be right. I found the company's website and things started to be a bit clearer. It's not quite as dreadful as it first seems, but that's not much comfort.

First, two caveats:
  • Clearly a part of the £9.22 is classified as a fixed transaction fee rather than an interest payment. It doesn't make any difference to the consumer on the first loan - if they roll over the loan at a different lender, their total debt still goes up by 13% no matter how the fee is described. However, what it does mean is that the effective interest rate on a larger loan is less than on a small loan. Thus, if you have accumulated £200 of debt the interest amount on a five-day loan goes to £5.50 + (£205.50*4.92%) = £15.61 or 7.8%. A bit better, but that's still only for a FIVE DAY period.
  • Clearly these loans are not designed to be rolled over (and Wonga are explicit about that on their FAQ page). But many people using payday services have little choice in the matter, and it's likely that many of them will have to roll over their loans at least once. Maybe Wonga won't allow them to roll it over directly (actually they do, but with restrictions), but I don't see that they can stop somebody borrowing from a different lender to repay their loan...and then five days later, switching back to Wonga again, £18.88 poorer.
The company is quite ballsy about this whole issue - see the following slightly Orwellian explanation of the astronomical rates. The APR figures they quote are a bit lower than the numbers above because they subtract the £5.50 fixed fee before calculating the interest rate - despite the following phrase:
Yep, we know. It’s huge. But there’s a simple reason for this and we’re more than happy to explain... Much like traditional lenders, we could use fixed fees, long term products and small print to dramatically shrink our annual percentage rate (APR). Yet the beauty of our short term service is its unique flexibility and complete transparency - and that's something we won't compromise... [my emphasis]
But...but...that's exactly what they have done. By charging a £5.50 fee before they apply the interest rate, they are artificially reducing the component of the fee which has to be compounded under the APR regulations.

So let's look again at the amount Mildred has to leave you to get you out of this mess.

Instead of simply compounding 13.17%, we need to work through the following steps:

  1. Take the amount borrowed (£70)
  2. Add £5.50 (£75.50)
  3. Take 4.927% of the total (£3.72)
  4. Add that on (£79.22)
  5. Take the total as the starting amount for the next loan.
  6. Repeat as above, 72 more times
This is what Excel was invented for - a moment's work and we get to see the total amount outstanding in a year. Ready?

After a year, you'll have to repay £6,148.29.

Mildred's inheritance is relatively intact after all - but only relatively. You have paid back nearly ninety times your original loan, an APR of 8783%.

I am sure that Wonga has a very careful compliance department and is obeying the letter of the law in publishing those APR figures. But let's just say that I would not have used their calculation method myself.

I was surprised to see that Wonga is backed by some quite respectable names in venture capital. That gives me hope that they will be somewhat responsible in stopping people from running up large debts. But the very existence of a service this expensive seems to indicate either a serious market failure in the credit world, or some big gaps in financial education.

Perhaps Grameen Bank needs to set up in the UK?

Wednesday, 10 February 2010

Make your mind up, Mervyn

Mervyn King said today that the UK economy might go back into recession and that the recovery is weaker than hoped.

So, Mervyn, what possessed you to stop quantitative easing less than a week ago? Scott must be so disappointed. Unless you can come up with a solid rationale for why QE can't work, this is bizarre and inexplicable.

p.s. to be fair, he has also said today it's 'far too soon' to assume there will be no more QE. David Wighton in The Times points out that this behaviour looks 'downright peculiar'.

Murders in London hit a new record...a record LOW

As a footnote to a sad story in the Evening Standard today:
The killing is the first suspected homicide in London since 15 January and ends one of the longest periods of time in the city without a murder.
Surprising (on the face of it) but very good news. A reminder that, consistently over long periods of time, society becomes safer and more civilised as it becomes richer and better educated. Progress is the default state in modern life; fear and decay is not.

Tuesday, 9 February 2010

Oddities in the media

I'm stretching a point to make an economic connection on this post, but Nick Rowe has had a couple of items recently relating to infinity.

This news item, on the other hand, evokes a much more potent image:
He said his design means patients can have their modesty covered but still allow medics immediate access through clever "entrance points" in the gown.
"It's infinitely dignified, yet practical. And Velcro doesn't enter into the equation."

While we're on the BBC news website, take a look at the new regulatory powers now available to soap opera actors:

Finally while researching a previous posting, I came across this gem:
Senior sources at the FT have confirmed that the group is in discussions with a number of payment processor companies to establish a simple "one-lick" procedure that would enable consumers to pay a small fee for single articles that would otherwise be available only to subscribers.
I can't wait for that micropayments system to be available. Is the lick my payment or part of what I'm buying?

Hector Sants as a prediction market?

The interpretation of Hector Sants' resignation announcement seems to be that it's a protest against the Tories' plans to gut the FSA if they are elected.

But the Tories haven't been elected. So it's a little odd to make a protest gesture like this.

Thus, despite Robert Peston's speculation that this might be bad for the Tories, it actually suggests the converse: that Sants is very confident they will win. And he's putting his money - as it were - where his mouth is.

Although this isn't exactly a prediction market, it has some of the same incentive characteristics as one. And looking at a real prediction market (Betfair) the Tories have decimal odds of about 1.5 to win an overall majority (indicating about a probability of about 66%). Not sure I'd leave my job on those odds, but his contract does expire in the summer so it's decent of him to allow some time to find a successor.


Nothing to do with economics, but...

The FT's pricing department are cunning devils

I finally got fed up of not being able to read FT articles after my debit card expired, so I went in to update the details. I'm not a huge fan of paying for content online - actually I'm not a huge fan of paying for anything, as both a Scot and an economist - and if I have to, I would prefer to pay per article. But the FT is both high quality, and its content is sufficiently important to this blog, that it's worth the subscription.

My recollection of the price was around £6.99 a month [I have now checked this - it was £6.25, dropping to £6.12 with the VAT cut last December], so I was a little surprised to see this:

They've upgraded me to a premium subscription by default, I thought - sneaky. I don't think I need a premium account - from memory it gives access to stock data or something else that I don't use. Easy, I thought - I'll go and change it back to a regular sub again.

So click on 'Change or upgrade access level' and this is what you see:

I'm sure £4.99 per week isn't the same as £12.98 per month - but maybe there's a difference between monthly and weekly prices (the clever "per week" bit distracted me, so I hadn't quite registered that this is the annual price, and therefore likely to be less than the monthly version. These people are good).

I occasionally read a Lex item but it isn't worth paying £1.70 a week for it - if anything it's a distraction from more interesting things, and I have enough distractions already what with Facebook, twitter and working for a living.

So I select Monthly instead, and this is what I get:


This more-than-fourfold price jump in less than a year had exactly the intended effect: making me think the £12.98 deal I'm currently on is a pretty good one. I checked some old emails and it turns out I was paying that since March 2009 - at least until the card expired.

So I have reluctantly renewed at £12.98, with a grudging admiration for the FT's pricing department. I guess they are in an internal contest with the Economist inside Pearson plc. Maybe Dan Ariely will have to update the first chapter in the next edition of Predictably Irrational.

But am I on a grandfathered deal because I'm an existing subscriber? Is it a mistake on their part because I hadn't yet updated my card when this year's price rise came in? Or is it behavioural pricing - designed to encourage me to renew when I otherwise might be inclined not to?

If I get an email after this posting explaining that my charges are going up to £25.99, I'll be sure to let you know.

Update: Turns out the FT is considering a pay-per-article model. Although according to the Independent, the medium of payment is going to be somewhat unconventional:
Senior sources at the FT have confirmed that the group is in discussions with a number of payment processor companies to establish a simple "one-lick" procedure that would enable consumers to pay a small fee for single articles that would otherwise be available only to subscribers.
I think I need to know more about the mechanism before I know if I prefer the 26 quid...

Update 2: I have now received a nice email about this from the FT - details here.

Monday, 8 February 2010

Snow and demand

The snow in America seems to be pushing consumers out to the right-hand end of the demand curve. So how should retailers respond?

First Marginal Revolution (Alex for once) points to this Bryan Caplan article:
A blizzard is about to hit DC...people unsurprisingly rushed to grocery stores to stock up....For any given type of product, the most popular brand always sold out first. There were no Eggo waffles, but plenty of Wegmans brand waffles. All the national brands of hot dogs and sausages were gone, but there were plenty of obscure sausages still on the shelves.
Can you guess my explanation? Click through to the MR link to see my answer in the comments, or look at the comment from Eric on Bryan's page for a similar idea.

Then Pricing for Profit asks the question: how should hardware stores optimise their profits when everyone wants a snow shovel? By now of course the answer is clear - at least if they have any foresight.

Simply get a bunch of cheap shovels with an unusual brand into the storeroom; put them on the shelves for $95 in the expectation that nobody will ever buy one. Until, that is, the snowstorm comes and all your regular shovels sell out.

And back to that MR item: a completely different, quirky but plausible theory from another commenter:
"This is exactly the reason LTCM failed: under time pressure, people flock to the name brand vs the equivalent non-name brand product (e.g. on the run vs off the run treasuries.) The spread widens in the short-term. In the bond markets, people fight for a fraction of a basis point most days, yet happily pay a bit more in an emergency for the reduced cognitive effort to ensure safety.
Posted by: gorobei at Feb 7, 2010 1:49:08 PM"

Sunday, 7 February 2010

The economics zeitgeist, 7 February 2010

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.