Stumbling and Mumbling

Morality and markets: a paradox?

Janice Turner makes an argument that I find questionable:

Morality should enter economic decision-making, whether it is me refusing to buy flown-in American Pink Ladies in Sainsbury's during the British apple season or Total oil shareholders who should take a tiny hit to ensure that the workforce who earned them great wealth, now in a time of need gets a little back. One could, in theory, ship over Mumbai street urchins to paint one's house. But is the cheapest decision always the right one?

In one sense, yes. The lowest tenderer for a contract is the person who wants the job most - just as the highest bidder in an auction is the guy who wants the good the most. And surely it is morally acceptable - and right in utilitarian terms - to give something to the person  who most wants it.
Of course, it might not be prudent to do so - they could do a bad job or alienate your neighbours - but that’s a different thing. Or it might be that something is cheap because of an unpriced negative externality. Or someone might be desperate for a job because they are the victims of immorality or injustice in other ways, but that is a separate, though important, question.
Ceteris paribus, though, in many cases the cheapest decision can easily be a moral one.
This raises a paradox. Many people would think that an economic system which allows workers to be exploited is immoral. But given that this system exists, it might be morally justifiable for a firm to hire the individual worker it can exploit the most, as s/he most wants the job.
This paradox might justify Marx’s argument - that the problem is not that individual capitalists are immoral, but rather that the system itself is faulty.

Divide and rule

The strikes against the use of foreign labour at Lindsey oil refinery corroborate my point that recessions see a rise in racism and hostility to immigrants.
But they raise another question: why are there strikes against migrant workers when there have been no such strikes against the damage that bankers have done to the economy? The question gains force from the fact that even the most pessimistic reading of the economic research shows that immigrants have only a small adverse effect upon indigenous workers - orders of magnitude smaller than the effect the banking crisis is having.
Why then are foreign workers getting more blame than bankers?
Marxists will say that this just shows the effectiveness of the ancient principle of “divide and rule”. The capitalist class uses nationalistic antagonisms to split workers and so deflect attention away from the fact that it, rather than foreigners, is to blame for workers’ plight.
But what’s the mechanism through which they can do this? Partly, it’s simple. It’s the salience effect. British workers at Immingham can clearly see Italian and Portuguese workers doing jobs they think they can do, and infer that they are “stealing” their jobs*. By contrast, the mechanisms through which bankers destroy jobs are less obvious. And people mistake what’s obvious for what’s important.
This suggests that Marx might have been more correct than he or many of his followers made out. There are mechanisms through which workers can acquire an ideology which helps sustain injustice, which deflects their anger away from capitalists and towards fellow workers. These mechanisms don’t require workers to be the dupes of capitalist apologists. It’s just that workers - just like everyone else - are prone to cognitive biases.
* This is only part of the story. It doesn’t explain why Immingham workers are angry about Italians getting work when, I guess, they’d be quite tolerant of men from Hull or Grimsby doing the jobs.

The false public-private distinction

Are commentators making a false distinction between government and the private sector. This makes me fear so:

Asked [of Davos attendees] which policy assumption had most contributed to the global financial crisis, the most popular answer by far was the belief that markets are self-correcting…
Alan Greenspan...has said that the big mistake he made was assuming that banks' self-interest would prevent them doing anything that would threaten their own survival.

However, you could argue that banks’ failures were exactly those that free marketers attribute to government:
1. Public choice. There’s no such thing as a bank’s self interest. Only individuals have a self-interest - there’s a clue in that word “self”. And just as in government bureaucracies the self-interest of individuals differs from that of the public or policy-makers, so in banks the self-interests of individual traders differed from that of bank owners. Rational self-interest led individuals to create and hold “toxic assets” that jeopardized the interests of banks’ owners.
2. Bounded knowledge. Just as central planners lack the knowledge (or ability or incentives) to control the economy, so chief executives lack the knowledge (or ability or incentives) to control a complex sprawling bank.
What we have, then, are forms of government failure, only in the private sector.
The failure of markets lay in the fact that they did not restrain these organizational failures. Indeed, it’s arguable whether they even failed in this regard. You could read the collapse of US investment as being a very clear message from the markets - that holding so many mortgage derivatives is a really stupid idea. Why assume that markets must work gently and pre-emptively?
 Perhaps, then, we should, for some purposes, forget the public-private distinction. Maybe a better distinction lies in cultural theory. Banks’ failures lay in the fact that they relied too much upon dysfunctional forms of hierarchical and individualist paradigms.
Are more functional forms of these paradigms feasible? If so how? Or mightn’t the introduction of more egalitarian paradigms help?
I don’t know. But before leaping to answers, can we work out how to ask the questions?

Is the graduate premium falling?

The recession seems to have caused an increased scepticism about the returns to a university degree. education. I fear this is overdone in some respects, but correct in others.
Individual experience, anecdotal evidence, is worthless on this point. Economies are irreducibly heterogenous. The fact that some graduates are stacking shelves at Tesco tells us nothing about the general, average, return to education.
Indeed, some recent research suggests that, between 1994 and 2004, graduate over-employment actually declined and the average return to having a degree edged up.
However, the degree premium varies enormously by subject - and has been negative (pdf) for men with arts degrees for some time -  and it might be that more recent graduates are doing worse than older graduates.
Nor is it likely that the recession will much change this. Yes, graduating in a recession is a misfortune. But so is being unskilled, because bosses are quicker to fire workers with no qualifications. From the trough to peak unemployment rate in the last recession (1990-93), the unemployment rate for graduates rose by 2.5 percentage points, whilst that for those with no qualifications rose by 4.6 points.*
So, why do I share the scepticism about the graduate premium? Four reasons:
1. The high premium has been in part due to high graduate wages in London. But with the City now in (temporary?) decline, this contribution to the premium will fade away.
2. The government’s faith in the importance of having a degree might be based in part upon a mistaken extrapolation of past trends.
Yes, the graduate premium soared between the 1970s and 90s. But this was in part at least due to the fact that low-skilled wages were held down by growing competition from low-wage developing economies. But there’s no reason to suppose such competition will continue to affect only low-wage workers. China and India are producing tens of thousands of university graduates. It’s possible that in coming years this supply will hit UK graduate earnings, to the extent that graduate jobs can be offshored. 
3. It might be that the rising graduate premium was not a reflection of a higher marginal product of graduates, but rather of the fact that technical change has made it easier for graduates (bosses) to exploit workers (non-graduates).
4. The desire to get people into university is motivated in part by a desire to give the impression that social mobility is occurring when in fact it isn‘t - if youngsters go to university when their parents didn’t. In this sense, it might be that the expansion of higher education acts as a substitute for genuine egalitarian reform.
* Table 1.3 of this book.

Don't blame models

The Economist makes a claim which, though common, I find implausible:

Almost as damaging is the hash that banks have made of “value-at-risk” (VAR) calculations, a measure of the potential losses of a portfolio…The mistake was to turn a blind eye to what is known as “tail risk”…In markets extreme events are surprisingly common—their tails are “fat”.

I just can’t believe banks did this as an intellectual error, because it's easy to incorporate tail risk into VAR. This is because we do have a statistical description of tail risk - the power law.
To see how this affects VAR, let’s take a very simple example, starting by assuming a normal distribution.
You have a £100m equity portfolio with annualized volatility of 30%. You want to know what daily VAR is at a 1% probability.
All we do is deannualize that 30%, which gives us daily volatility of 1.86% - this is one standard deviation. We then read off from a normal distribution table that a 1% probability is a 2.32 SD event.
So we multiply 1.86 by 2.32.
This tells us that VAR is £4.32m. We can expect to lose £4.32m or more in one day every hundred.
To incorporate tail risk, we just have to tweak this.
We do so by recognizing that losses of more than two standard deviations are distributed as a cubic power law. This means that, to find the probability of a rare event - with SD of x - we simply divide x by two and then raise to the power 3. This tells us how much less likely the event is than a two standard deviation event. So, for example, a 10 standard deviation loss is five to the power  three = 125 times less likely than a two standard deviation event.
Now, we are interested in 1% probabilities, which are 2.28 times less likely than a two SD event. Our cubic power law tells us these are 2.63 SD events. So, we just multiply 2.63 by 1.86. This gives us £4.89m.
So VAR is 13% greater than under a normal distribution.
This doesn’t seem much of a difference. But this is because 1% events are quite common. It’s when we go further down the extreme of the distribution that tail risk matters. For example, for one day in 1000 losses, a normal distribution gives us a VAR of £5.75m, but our cubic power law gives us a VAR of £10.55m.
And here’s my problem. Any idiot can tweak VAR models to incorporate fat tails - hey, an idiot just did. I just can’t believe that banks’ risk managers have been so stupid as to be unable to do this. It’s certainly not the case that fat tails are something new; we’ve known about them since at least October 1987.
Instead, I suspect that banks’ failure lay elsewhere. One difficulty was that their portfolios were much more complex than mere equities, so it was harder to calculate the distribution of extreme returns. But I would have thought that, given that these portfolios were vulnerable to default risk, liquidity risk and correlation risk, it would have been reasonable to assume an equity-like cubic power law, or an even higher exponent.
Another difficulty, though, was internal politics. Risk managers might have wanted to assume fat tails and a high VAR, but traders, anxious for a freer rein, would have resisted.
Which comes down to an important point. Banks’ failures are more likely to have been due to organizational failures - the difficulty of measuring their portfolio and reconciling competing internal interests - than to the inability to use mathematical models. Which in turn suggests they need more radical reform than merely better risk models. 

KIlling bankers

Should we kill bankers? I don’t mean as vengeance for their past misdeeds. Instead, I mean that, if banks are to remain in the private sector, the death penalty should be part of the new regulatory regime.
The problem with any regulation is that regulators are always at an informational disadvantage; outsiders know less than insiders.  There is therefore a danger that breaches of the new regulatory code - excessive risk-taking - will not be identified quickly; as Warren Buffett said, it’s only after the tide’s gone out that you can see who’s been swimming naked.
This means that if the penalties for breaches are low, bank bosses might have an incentive to ignore regulations - as they discount punishments by the probability of getting away with their crimes. To prevent this, punishments must be huge.
What I’m advocating here is a system of perfect deterrence, as discussed by Saul Smilansky in 10 Moral Paradoxes; if the punishment is high enough, no crime will occur.
What’s more, the death penalty will focus bosses’ minds. As Chesley Sullenberger showed us, when a man faces the likelihood of death, he finds a way to do a great job. The notion that bank bosses require big bonuses to incentivize them rather than the threat of punishments was always a self-serving fiction, not a realistic psychological proposition.
You might object here that threatening bank bosses with death would deter good men from taking the job.
I’m not convinced. For one thing, the threat of death doesn’t stop good people from applying to become airline pilots or army officers. And for another, having duffers run banks wouldn’t be a catastrophe. A return to the old 3-5-4 business model (borrow at 3%, lend at 5%, be on the golf course at 4 o’clock), whilst being sub-optimal, would at least save us from disasters.
Another objection you might have is that banks are so complex that no chief executive or board of directors can possibly control them adequately - hence the number of rogue traders. If this is so, then we risk killing men for things over which they have no control.
This, though, just raises the questions. If this is so, why have we attributed such importance to chief executives? And should banks remain such ungovernable structures?

The BBC: a proposal

How can the BBC be, at the same time, so moronic and so brilliant? On the one hand, it’s refusing to  broadcast an appeal for aid to Gaza, whilst on the other hand, BBC4’s programmes on Friday were just fantastic.
Which brings me to my proposal. David Hare is right. The BBC is “incredibly stupid” to devote so much resources to news-gathering. It should instead close down its radio and TV news operations for the UK, confining news to its website. I say this for six reasons:
1. TV especially is not the right medium for news. Stories are rarely illuminated by egomaniacs waving their arms. News is better suited to the web, which has the virtues of immediacy and flexibility; if pictures or sounds improve a story, the web can carry them, and if not, it can bin them. The web also better allows reporters to explain what’s going on, as Mark Easton’s and Robert Peston’s blogs demonstrate.
2. Reducing expensive news-gathering would release resources for better programming. News could be replaced by quality documentaries; an understanding of the Israeli-Gaza conflict would surely be better promoted by historical documentaries than necessarily partial reports of who’s lobbing bombs at whom.
3. The 24-hour news cycle has had a wholly pernicious effect upon politics, encouraging soundbites, spin and news management over the content of policy-making. Abolishing news-gathering would force political change.
4. In withdrawing from news, demand for newspapers might revive., which might encourage a greater diversity of news and analysis.
5. News can be provided by the private sector; there's no market failure which justifies it being done by a public sector organization. It is, however, possible that there is a market failure which causes the under-provision of BBC4-type programmes.
6. Reducing news would de-politicize the BBC, taking a huge step towards the (false) idea of impartiality. There’s a danger of the BBC becoming a political football, kicked around by loud-mouths who verge upon the mentally ill; I suspect a lot of the manufactured fuss about the Ross-Brand business was a sublimation of anger at the BBC‘s political reporting. In withdrawing from news-gathering, and moving up-market, the BBC would not have to worry so much about appeasing such mobs.
Now, I grant that my proposal is wholly unrealistic; almost all policy ideas are “unrealistic” unless they become inevitable. And I grant that there’s much else to be done with the BBC, not least a cull of managers and massive expansion of BBC4‘s budget.
But if the BBC were genuinely public spirited and committed to Reithian ideals, would it at least consider this?

On fiscal policy

One objection to the use of fiscal policy is simply that governments get the timing of it wrong. Today‘s figures (pdf) seem to bear this out. As I point out in my day job, these show - amazingly - that the output of government services actually fell in the fourth quarter by as much as the output of the business services and finance sector.
In this sense, the government has contributed to the recession, not relieved it.
But don’t make too much of this. For one thing, this is only a partial measure of government activity; it ignores social security payments. And for another, it would be odd for the government’s critics to complain about a shrinking in the size of the state.
Whilst I’m on the subject, I suspect popular discussion of fiscal policy is coloured by the homoerotic undertone in Keynes’ idea that we should pay men to dig holes and fill them in again*. A latter-day  heterosexual Keynes might suggest instead a different metaphor  - paying Carol Vorderman (a victim of the credit crunch) to lightly oil herself.
Ricardian equivalence suddenly becomes less persuasive, doesn’t it?
Which shows the importance to political discourse of choosing the right metaphor.
* In fairness, this undertone exists more in what Keynes is supposed to have said informally. The relevant passages in the General Theory have no such connotation. They are:

If the Treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coalmines which are then filled up to the surface with town rubbish, and leave it to private enterprise on well-tried principles of laissez-faire to dig the notes up again (the right to do so being obtained, of course, by tendering for leases of the note-bearing territory), there need be no more unemployment (chapter 10, page 129 in my copy)

And:

To dig holes in the ground,” paid for out of savings, will increase, not only employment, but the real national dividend of useful goods and services (chapter 16, p220).

Lotteries and irrationality

Does money help people avoid going bankrupt? You’d think so. But you’d be wrong.
This new paper studied what happened to winners of the Florida state lottery between 1993 and 2002. And it found:

Although recipients of $50,000 to $150,000 are 50 percent less likely to file for bankruptcy in the two years after winning than are recipients of less than $10,000, they experience a statistically significant increase in bankruptcy rates of similar magnitude three to five years after winning. This suggests that winning the lottery only postpones bankruptcy rather than reducing it.

Kerry Katona’s troubles are, it seems, not atypical.
This is a kick in the teeth for the notion that consumers are rational. The permanent income hypothesis predicts that the rational consumer will spend only the annuity value of a windfall*.
So why don’t people do this? It could be that lottery players are just feckless and will fritter away their fortune. Or it might be that they acquire expensive tastes which they find hard to drop when the money runs out. Or maybe they engage in mental accounting, and regard a lottery win as “fun money” rather than something with which to pay down debt.
Whatever, this is evidence for the paternalists. Which I find sad.
* Not all data on windfalls contradicts the PIH, however. This paper (pdf) shows that Czechs who received windfalls during the 1990s privatizations did behave in accordance with the PIH. Which raises the intriguing possibility that people brought up under communism act more like rational economic agents than those (such as these Floridans) raised under capitalism.
** My picture proves that smoking is not necessarily bad for your chest.

When stupid is smart

Niall Ferguson says (via):

Our ability to evaluate risk is hedged by all sorts of cognitive biases. It's a miracle that we get anything right.

It’s no miracle at all. Cognitive biases persist because in many cases they are useful. What looks like a bias can in fact be what Gerd Gigerenzer has called a simple heuristic that makes us smart.
Here are a few examples.
1. What are the chances of Manyoo beating S***s on Saturday? We could try to remember Manyoo’s defeats and S***s defeats. The latter come to mind more readily than the former, so we infer than S***s have little chance. The bookies agree. But we’ve just used the availability heuristic.
2. Over-confidence, wishful thinking and the self-serving bias can give us the impetus to undertake risky projects. As a result, people start new businesses, write books and go into the music business in more numbers than rationality dictates.
But the result of this is that society is better off; we get new businesses and products, and more books and music than we would in a rational world. And it’s quite possible that the benefits to the successful outweigh the losses of the unsuccessful.
3. Bandwagon effects can work. There’s lots of evidence that momentum investing works in stock markets. So you can, on average, make money at least if you are early onto the bandwagon.
And when there is wisdom in crowds, the bandwagon is right. If you’re looking for somewhere to eat in a strange town, it might be a good idea to prefer the crowded restaurant to the empty one.
4. The focussing effect - looking at one piece of data and under-rating others - can be a way of identifying what’s important. This new paper  shows that some value investors can beat professional fund managers, because they focus on selected data, rather than look fruitlessly at everything.
5. The status quo bias and the “not invented here” bias can be ways of combating our bounded rationality. They help us recognize that the risks of new schemes cannot always be fully measured, and that things that have stood the test of time have done do because they have hidden advantages.
If banks had displayed more of these biases a few years ago, they’d have been more sceptical about new credit derivatives, and we wouldn’t be in the mess we are in.
And in other cases, biases can even out. The gambler’s fallacy (“we’ve had a run of reds, so black must be due”) can cancel out the hot hand fallacy; “red’s on a roll tonight.” Similarly, the base rate fallacy - ignoring prior probabilities - offsets the conservatism bias, our tendency to underweight new evidence.
It is, therefore, no surprise that biased thinking can lead to good results. Which is precisely why biases are so persistent and ubiquitous.