Stumbling and Mumbling

Inflation and class war

Henry at Crooked Timber provides a good example of one of the more deplorable habits of the old "left"” – to oppose welfare-enhancing economic policies because of their alleged effects on income distribution. However, he's also highlighted an equally deplorable habit of the old "right" - its careless attitude towards the distributional effects of otherwise good policies.   

Unethical investing

Peter Mullen’s comments about the Church of England’s ethical investing policy appeal to my Bayesian priors (Other people have prejudices; I have Bayesian priors).

I’ve long thought that interest in ethical investing was just another example of the muddle-headed wishful thinking that lies behind so much support for New Labour – the idea that there are no trade-offs between valuable goals.

Ethical investors believe they can make good money and have a clear conscience.

But common sense says there must be a price to be paid for our moral views. We must surely sacrifice some returns by not investing in arms or tobacco companies simply because a restricted choice of shares must be inferior to an unrestricted choice.

What’s more, the capital asset pricing model tells us that the All-share index is an efficient portfolio. Any deviation from it must therefore mean we either sacrifice performance or increase risk.

Either way, ethical investing must cost us money.

So go my Bayesian priors.

But then there are the facts. This paper reports that ethical funds do no worse than conventional ones. And if you torture the data hard enough, there’s some evidence that ethical investors do better.

The likeliest explanation of this is that we’re in a second-best world. Contrary to the CAPM, the All-share index is not an efficient portfolio. A restricted choice of stocks, therefore, is not necessarily inferior to an unrestricted choice.

Does this mean the Church Commissioners are right to invest ethically? Two things suggest not.

First, ethical investing – like any non-passive strategy – is costly. The Church spends £4.8 million a year managing its investments. Is it really ethical for a charity to transfer cash to rich fund managers who can’t guarantee out-performing the market?

Secondly, the adequate performance of ethical funds might be due to just luck. There’s no theoretical reason why ethical investing should do well. As some chap well-known to the Church once wrote:

The race is not to the swift, nor the battle to the strong, neither yet bread to the wise, nor yet riches to men of understanding…but time and chance happeneth to them all.

Indeed, the performance of this fund suggests that anti-ethical investing can do even better than some ethical investors.

Intelligence and incentives

Arnold Kling has some more thoughts on the Flynn effect here. The question is: how can we reconcile this with this (worth the free registration)?

Here’s one possibility. There is an economic explanation for the Flynn effect, but not (just) the one Arnold suggests.

It’s that people are as clever as they need to be, and they respond to incentives.

A hundred years ago, there were no calculators and reference books were expensive. As a result, there was a big premium (in terms of both wages and status) on rote-learning and on being able to do long multiplication. People were therefore encouraged by schools to invest in such skills.

Today, though, the availability of calculators and reference sources mean there is no such premium on these skills. The incentive to acquire them has therefore diminished.

Instead, the premium today lies in the ability to interpret information, to tell stories and to see patterns.

The incentive to acquire these skills has therefore increased. And people have responded accordingly. The upshot is that the skills measured by IQ tests have risen, whilst the skills not measured – rote-learning and arithmetical trickery – have declined.

The Flynn effect is therefore (at least partly) the result of people reallocating their mental energies in response to changing incentives. It’s just substitution in response to relative prices.

But what evidence is there that intellectual abilities do respond to incentives? Here are three anecdotes.

First, in the film Lorenzo’s Oil, based on a true story, a man became a skilled pharmacologist in an effort to find a cure for his son’s rare illness for which there was no known cure. He found a useful therapy.

Second, a friend of mine has been threatened with a huge bill from Islington council for building works. In response, he’s become quite an expert on local government sub-contracting procedures and aspects of land law.

Third, a few years ago, I was watching TV news with the father of a friend, who was a test pilot for a civil airline. There was a report of an RAF plane crashing.

“No surprise there” said pop. “No-one in the RAF can fly properly.”

I raised an eyebrow.

“They’ve got ejector seats” he said. “No-one can fly properly with an ejector seat. Strap the fuckers in. They’ll learn to keep the plane in the air then.”

Maybe, then, intellectual energy does respond, at least partly, to incentives. Could it be that we over-estimate short-run responses to incentives (for example, to tax or exchange rate changes) but under-estimate long-run responses?

Basically right

This fiasco only strengthens the already powerful case for introducing a basic income.

I’ve long thought the fact that this would save administrative costs was one of the least of its many merits.

Maybe I was wrong.

If any political party were really serious about cutting waste, they could combine a basic income with this.

Quantifying fear

There much comment here and here about the government stoking up a fear of terrorism. Here’s a crass economist’s take on the question.

There are two rules of economics.

Rule one – talk is cheap. It's actions that matter.

Rule two – count the money.

So here goes.

First, we need to know how much a big terrorist attack would cost. This standard textbook on cost-benefit analysis puts the value of a statistical life at £2.7 million in today’s money, though there’s a wide margin of disagreement. This means a 9/11-type attack, killing 3000 people, would cost £8.2bn in human life.

To this we must add the cost of disrupted business. This study estimates that 9/11 cost Manhattanites $2.1bn in lost wages. Take this as our guide, and we’re adding another £1.1bn in costs.

And then there’s the cost of rebuilding. What matters here is not the gross cost, but the social cost. Builders employed in reconstruction would have gotten work elsewhere. The cost to society of reconstruction is that work forgone. This is much smaller than the gross cost.

Put it all together and a very rough estimate of the cost of a big terrorist attack is around £10 billion.

But the government is spending only £1.5bn a year to combat this.

This suggests it regards the odds of a major attack as roughly 15%. If it thought the odds were much higher, it would have to explain why it’s spending so little on anti-terrorism. And if it thought they were much lower, it would have to justify spending so much on so small a threat.

There are countless ways to argue around these numbers, but revealed preference suggests the government is putting the odds on a 9/11 attack at about 6 to 1 against.

Let’s extend this. Assume, for simplicity rather accuracy, that each of 8 million Londoners has an equal chance of being among the 3000. Given a terrorist attack, this gives a 0.0375% chance of being killed. As there’s a 15% chance of such an attack, we have a probability of being killed of 0.0375% x 15 = 0.0056%, or 1 in 18,000. Poker players will recognize this as roughly equal to the odds of getting a royal flush on the flop, having been dealt a suited king and ace.

Is the government stoking up a fear of terrorism? Its actions suggest not. And by their deeds shall ye judge them.

Do I want to carry an ID card in the vague hope that doing so will somehow reduce these odds? No.

Taxes and equality

Forecasts that taxes will soon have to rise should, but probably won’t, draw attention to a major reason why the old left is in such a mess. The problem is that there is a basic conflict between two of its traditional ideals – progressive taxation and big government.

The fact is that high government spending means the tax system cannot be used to redistribute income.

These figures from the Inland Revenue illustrate the point. They show that the 1.8 million people earning over £50,000 will pay £55.6bn in income tax this year. That’s 43.7 per cent of all income tax.

But it’s only 12.2 per cent of the £454.7bn the government will raise this year (table C8 here).

This means that even if the government could double income tax receipts from people earning £50,000 or more – which might not be possible - the rest of the population would still have to pay three-quarters of the money raised by government. (I’m ignoring here the fact that the rich pay more in VAT and other taxes, but this is a minor wrinkle).

Even if we define the rich as those earning above £30,000, income taxes on these account for only 18.2 per cent of all government revenues.

The bottom line here is simple. If taxes account for two-fifths of national income, they cannot redistribute income very well, because most taxes will have to fall on people who aren’t rich.

This much should be, but isn’t, well known. As Gosta Esping-Anderson wrote in Politics Against Markets in 1985:

As the incidence of taxation grows…the tax system automatically loses its potential for progressive redistribution. Under conditions of heavy expenditure, the bulk of taxes must be collected among the largest income brackets, and that happens to be workers and middle-level white collar employees.

I think this explains a lot about the demoralization of the traditional Left. They want more equality. But they cannot bring themselves to see that one way to achieve this would be to shrink the state and abolish the taxation of lower incomes. Instead, they carry on in the bone-headed notion that big government and equality must always go together.

If any political party wants my support – and they all seem determined not to get it – they would recognize that limited government and social justice are not necessarily enemies of each other.

I suspect I'll have to return to this theme....

On banning smoking

This report suggests that banning smoking in pubs could be surprisingly costly. Here, then, are three reasons why the move might be justified despite this.

First, the report overstates the aggregate long-run costs of the ban. Bear-baiters and employers of child chimney sweeps suffered when these activities were banned, but in the long-run they found other jobs, albeit slightly less remunerative.

Indeed, as loss-making pubs exit the business, the profits of the remaining ones should rise, from the lower base.

What’s more, if smokers don’t go down the pub, they’ll spend money elsewhere, thus generating profits for other businesses, like off-licenses.

Second, competition between smoking and non-smoking pubs won’t necessarily lead to an optimum outcome, because the market isn’t free.

One interesting imperfection here is that the minimum wage limits competition.

Imagine bar staff were to prefer working in smoke-free pubs. In a free market, they would accept lower wages in exchange for doing so. Smoke-free pubs would then gain a competitive advantage, which would allow them to expand at the expense of smoking pubs, as they could charge lower prices or employ more or better-looking staff.

With a minimum wage in place, though, bar staff cannot trade-off clean air for wages. Pubs offering clean air don’t therefore get the competitive edge they would in a free market, so there are fewer of them than would be efficient.

Clearly, a good solution to this would be to scrap the minimum wage. But in the presence of such a restriction, we cannot assume that the market will create sufficient smoke-free pubs. That increases the case for banning smoking, as a second-best solution, as I suggested in an earlier post.

(Libertarians will point out here – rightly – that this is yet another example of how one intervention begets another.)

Thirdly, smoking is an other-regarding action, in that it does impose costs on others.

Its advocates deny this, claiming that smokers benefit the tax-payer by paying big excise duties and dying early. But this report by ASH shows that this isn’t necessarily the case.

For one thing, excise duties on tobacco aren’t so much extra revenue as displaced revenue. If people didn’t smoke, they’d buy other things, hence generating extra taxes. Alternatively, the government would raise taxes on other things. It’s theoretically possible – though I’ll grant unlikely in practice – that these could actually have positive benefits if they internalize externalities, for example by taxing pollution or road congestion.

Also, although smokers save on pension payments, they cost the tax-payer money because they claim lots of disability benefit.

A precise quantification of this is almost impossible, partly because so many claimants of disability benefit are in fact just disguised unemployed.

All I’m saying is that there might be a case for banning smoking in pubs.

Certainly, opposing the ban should not be a priority for libertarians. Defending fox-hunting, opposing ID cards and supporting quaint old ideas like jury trials and habeas corpus are all much more important.

All that said, I should declare my prejudice here. I side with the Blue Sky Boys against Tex Williams’ biggest hit:

I don’t smoke and I don’t chew

And I don’t go with girls that do

In praise of regulation

The Daily Mail today continues to moan about the modern world. Roy Hattersley writes (not on-line apparently) that society “has gained prosperity but lost many of its core values. And the greatest loss of all is a sense of community.”

This lament leaves out two things. It misses a chance to attack New Labour. And it also misses a defence of ideas from the European Commission.

To see both omissions, begin with this paper by Stefano Bartolini of the University of Siena. He describes an orthodox economic model in which utility-maximizing households produce fast economic growth and technical progress but stagnant well-being.

This arises because people have an incentive to invest in labour-saving technical progress but not in public good-saving progress – because labour is priced whilst the public good is not. The result is technical progress but the decline of a public good; this might happen because increasing consumerism destroys our sense of community, or because growth destroys the environment. The upshot can be that our happiness at increasing wealth is offset by misery caused by the decline of social capital.

This is exactly what has happened in the western world. As Richard Easterlin – and later many others - has pointed out, economic growth is not associated with rising happiness.

In Bartolini’s model, this is the result of a missing market; the lack of a price on public goods. If the government were to put a price on these – say by taxing pollution – well-being would increase.

But economic growth would decline. This is because firms would divert resources from labour-saving technical progress to public-good saving technology. That would lead to slower labour productivity growth.

There’s a stark trade-off, therefore. We have a choice between rapid productivity growth and increasing well-being.

This is where the Mail has missed a chance to attack New Labour. In March’s Budget (p47) it wrote: “The Government’s long-term goal is for the UK to achieve a faster rate of productivity growth than its main competitors.”

If this claim is sincere, it means either that New Labour is oblivious to the trade-off, or that it is choosing productivity at the expense of well-being.

Or is it? It might be possible to reconcile the two. And this is where the Mail misses a chance to defend European regulation.

What we need is something that encourages labour-saving technical progress whilst protecting a public good.

And perhaps limits on working time, and increases in maternity and paternity leave, do just this. They increase the cost of employing people – thereby encouraging firms to save on labour – whilst also freeing people to rebuild social capital and a sense of community. The upshot could be rising productivity growth and greater social capital.

Now, I’m not sure whether the benefits of this really will outweigh the costs – that’s a tricky empirical issue.

What is clear, though, is that if you must lament the fact that community spirit has declined as wealth has progressed, you must at least consider the possibility that some government regulations might – just might – help solve the problem. 

Meritocracy versus markets

Melanie Phillips’ defence of meritocracy against New Labour omits a point that should trouble all meritocrats – that there’s a trade-off between meritocracy and a free market economy.

The fact is that the price system does not reward ability. If you want people’s earnings to reflect their ability, therefore, you can’t have a free market.

Friedrich Hayek was clear on this. In volume two of Law, Legislation and Liberty, he wrote that the function of the price system “is not so much to reward people for what they have done as to tell them what in their own as well as in the general interest they ought to do.” As a result, he says, rewards “will often have no relations to...individual merits”.

The obvious example of this comes from football. When Bobby Moore signed for Fulham in 1974, he was paid £150,000 a year in today’s money. Andy O’Brien earns much that in a month. Is Andy O’Brien 12 times the player Bobby Moore was? No. It’s just that the forces of supply and demand cause footballers to earn much more than they did 30 years ago.

Market forces also cause there to be little correlation between earnings and ability across the whole economy. The best nurse in the country probably earns no more than an average plumber.

There have been countless efforts to calculate the returns to qualifications and ability. And one result stands out – that these can account for only a fraction of earnings’ differences. For example, this paper by economists at the Institute for Fiscal Studies found that ability, qualifications and family background account for only one-third of the variation in male earnings.

If ability isn’t the only determinant of earnings in a market economy, what are the others?

Luck – the luck of having skills that happen to be rare or in demand - is the obvious one. But economists have also found that good looks (though this can’t explain Andy O’Brien’s earnings) height, and having a tidy home all increase earnings – to say nothing of obvious influences such as the size of the company you work for or your occupation.

Genuine meritocrats must object to all this. If they were logical and sincere, they would be calling for far more intervention in the labour market than they are.

The fact is, then, that you can support free markets or you can advocate meritocracy. You cannot do both – unless you’re prepared to believe Andy O’Brien is a better footballer than Bobby Moore.

The rise and fall of intelligence

From an unlikely source comes anecdotal evidence of rising intelligence. In this week’s Spectator (registration required, so no link) Matthew Parris quotes his (conservative) old man; “Young people are more intelligent these days.”

This is, of course, just what IQ tests show. It’s the Flynn effect. Jim Flynn has estimated that only 10 per cent of Britons born in 1877 had an IQ of 75 or more, whereas 95 per cent of those born in 1967 had such an IQ (“IQ Trends Over Time” in Meritocracy and Economic Inequality, edited by Ken Arrow and others).

Lest we think such enormous gains are implausible, remember how stupid people were in the 19^th century. In The Condition of the Working Class in England, written in 1844, Friedrich Engels quotes an official survey of young people in Birmingham:

A boy, 17 years old, did not know that twice two are four, nor how many farthings in two pence even when the money was placed in his hand. Several boys had never heard of London or Willenhall, though the latter was but an hour’s walk from their homes…Several had never heard the name of the Queen nor other names such as Nelson, Wellington, Bonaparte.

One reason why intelligence has risen from such levels is probably that later industrialization has increased the amount of stimuli people get, thus giving them knowledge by osmosis and forcing them to be more intelligent to cope with increasing complexity.

This, though, raises the question. If intelligence has increased massively since the 19^th century, why have the peaks of human achievement declined since then? Our politicians don’t compare to Gladstone, not our novelists to Dickens, still less our public intellectuals to John Stuart Mill. Here’s four reasons why this might be:

• There’s no increasing stratification of IQ. Flynn estimates that the IQ gap between upper and lower classes has been stable over time. Regression to the mean, it seems, exactly offsets the effect of assertive mating. This means the number of extremely high IQs doesn’t increase, except insofar as mean IQ rises.
• Intelligence is only a small part of what is required for success. Hard work and wisdom don’t necessarily increase as IQ increases.
• Politicians, novelists and intellectuals today are not selected for their intelligence. The only talents that matter are a gift for self-promotion, a capacity for tolerating idiots and an ability to articulate the tribal prejudices of some part of the middle class. For evidence of this, just look at the career of (insert name here*).
• The same vast amount of stimuli that increases basic intelligence also stops us working hard enough to cultivate intelligence. By the time I’ve finished blogging, read others’ blogs, read the papers, practiced guitar, listened to some CDs, played Civ III and watched Corrie, I’ll have no time left to do brilliant work. Well that’s my excuse…

* What was the first name you thought of? I’ll bet it was a woman.