Stumbling and Mumbling

Goodwin's pension: Labour's failure

The fuss over Fred Goodwin’s pension misses a point - that his payout highlights a failure of New Labour ideology.
The link is obvious once we realize why Goodwin is getting such a pension despite running RBS into insolvency. The problem is not that he was reckless and greedy; we’d all like a £693,000 a year pension. It’s that his greed and reckless was unrestrained. Neither shareholders, nor fellow executives, nor the remuneration committee checked his plundering egomania.
But this idea that there should be no restraints placed upon the powerful is part of New Labour’s mindset. We see this in their proposals to harass people who photograph the police - the point being to remove one check upon the police’s maltreatment of the public. We see it too in Straw’s refusal to publish minutes of the Cabinet meetings about the Iraq war - denying the disciplining effect upon policy-makers of publicity.
The common thread here is that the powerful don’t need restraining because they have our best interests in mind. If only leaders are given enough power, they can guide and protect we mere mortals.
Straw gives us a glimpse into this mindset in this astoundingly fatuous article. He says:

As James Madison said, if people were angels, there would be no need for government. But sadly people are not all angels.

What he omits to point out, of course, is that rulers are not angels either, and that they therefore need checks and balances. Instead, to Straw, it is only the hoi polloi who fall short of angelhood, who need restraining.
Underpinning this is a faith in “leadership.” Common to both Blair and Brown was a belief in the  power of “strong leaders“ to improve schools, hospitals or communities, and - at least before the crisis broke - Brown rarely missed a chance to praise the “leadership“ of businessmen.  But of course, if you believe leaders have such power, you must pay to attract the best of them, and not put any obstacles in the way of their ability to lead.
In this sense, Goodwin’s pension is not about greed at all. It’s about the failure of Labour’s faith in the untrammelled power of leadership. Not, of course, that they are capable of seeing this.  

Animal Spirits: A review

Alex Curran, Stevie Gerrard's missus, has said that the recession is causing her to cut her spending. To orthodox economics with its rational maximizing people, this makes no sense. The downturn isn’t hitting Stevie G’s earning power or permanent income, so why should it reduce her spending?
It’s in this context that George Akerlof and Robert Shiller’s new book, Animal Spirits, comes to the rescue.
We cannot, they say, understand major economic events without paying attention to “the thought patterns that animate people’s ideas and feelings, their animal spirits.”
These spirits, they say, comprise five different aspects: confidence, fairness, corruption, money illusion, and stories. These aspects can generate booms and slumps. I suspect three of these lie behind Ms Curran’s cutbacks. Though the recession is not materially hitting her, it’s sapping her confidence; she’s telling a story in which the recession means that people are becoming more frugal; and she might think it unfair to go on spending sprees when others cannot. Through these routes, the recession is bigger than it would otherwise be, because Ms Curran - and millions like her - cut their spending too.
Akerlof and Shiller explain how the other two fit into booms and slumps. In booms, confidence is high. People trust each other and get greedy for high returns. So Madoff and Stanford thrive. Money illusion matters too. It causes people to over-estimate  long-run returns on house prices - thus contributing to the boom in them. And as it causes workers to resist nominal pay cuts, downturns in demand lead to big falls in employment.
All of this is overlooked by orthodox economics with its rational utility maximizes. Akerlof and Shiller are too polite to say so, but I suspect the emphasis put upon the max U story in universities is in part due not to its factual accuracy - though as Akerlof and Shiller concede this is not wholly lacking - but to the fact that it generates nice mathematical exam questions.
So, how well does their story fill the gap?
No doubt, you can’t understand the housing market or capital spending decisions without animal spirits. In this sense, they score big hits. But I fear they are stretching a little in trying to apply their story to minority poverty. And I’m not sure animal spirits - in the sense of pure irrationality - is the whole story behind stock market volatility; I’d have welcomed a discussion of Patrick Minford’s idea that small changes in the probability of disaster or boom can rationally generate high volatility.
I’d also have welcomed more on how exactly the “confidence multiplier” works. Yes, confidence raises asset prices which in turn raise investment. But how is it that sometimes confidence leaps from one person to another - causing big booms - and sometimes it doesn’t, with the result that we get economic stability? There’s a single line of how stories can spread like epidemics, but no discussion of, for example, Christopher Carroll’s work on the epidemiology of expectations.
There are a couple of other gaps that might have strengthened their argument. There’s no mention of work in neuroeconomics (survey pdfs here and here) by the likes of Drazen Prelec or Colin Camerer, even though this is perhaps undermining the notion of a single, united rational self.
An even bigger gap is the lack of any discussion of Austrian economics.  As it stands, Animal Spirits contrasts rational homo economicus with skittish irrational Alex Currans. But the Austrians give us a third way. The facts necessary for rational calculation are often missing or unknowable; as G.L.S Shackle said, knowledge of the future is a contradiction in terms, and - I‘d add - bosses rarely know workers‘ marginal products. In conditions of such unavoidable ignorance, animal spirits are all we have to motivate economic actions. It’s not that people are irrational - it’s that they just haven’t the tools to be rational with.
Which leads me to another issue; is the ubiquity of animal spirits really a bad thing? Maybe not. Daniel Gross has shown that bubbles leave a benign legacy; those condos in Miami may be worth only a fraction of what they cost, but they put roofs over folks’ heads. And Robert Lucas has shown (pdf) that the average costs of economic fluctuations are small and can in principle in shared by using better markets in risk - which Shiller’s own superb work has helped demonstrate.
What’s more, given that the private benefits of innovation are low, and the probabilities of success in many arts and industry small, it might be only animal spirits that give us artists and entrepreneurs. As Richard Nisbett and Less Ross wrote years ago:

We probably would have few novelists, actors or scientists if all potential aspirants to these careers took action based on a normatively justifiable probability of success. We might also have few new products, new medical procedures, new political movements or new scientific theories.

Perhaps, then, it’s not just that animal spirits are ubiquitous - but they are necessary too.

Politics, science and ego

Two different blog arguments remind us how rare it is to find an empirical, scientific attitude in political debate.
Take first Dave Osler’s contrast between Jade Goody and my fellow Corpuscle Gail Trimble. He says that “basic family details alone would be sufficient for most of us to have no difficulty in predicting” their very different academic attainments. But his first commenter points out that many people from poor backgrounds are academic achievers.
The commenter misses the point. Dave is claiming a correlation between background and academic achievement. Pointing to one or two instances where the link doesn’t hold does not refute Dave’s claim. It merely shows that the correlation is less than 1.0 - but no-one is claiming that it is.
What neither side does, however, is refer to empirical evidence. But this exists. For example, this recent paper seems to support Dave’s point. It shows that there is a positive correlation between parents’ and childrens’ reading and maths abilities even at age 7. Bright parents have bright children. But the correlation, whilst positive and significant, is sufficiently far from one for there to be many bright children from less bright parents*.
My second example is this rather vitriolic dispute about home schooling between David Semple and Bishop Hill.
But surely, the question about the merits or not of home schooling is largely (not entirely) an empirical one; do home-educated people do better than school-educated ones? Neither David nor Bishop provide evidence (Bish’s link is broken) - not even a link to this fine blog. But there is some. This US research shows that test scores of the home schooled are “exceptionally high”. Of course, this might be because they come from the sort of families that would ensure they did well even if they went to school. Or it could be that this achievement comes at the expense of other things - for example, worse “soft skills” as a result of not mixing so much with others.
But these are empirical matters, which require research. So why the abuse?
I say all this not to condemn the individuals concerned, but rather to draw a contrast between two approaches to political issues.
One approach assumes that the resources of one’s own ego - prejudice and anecdote - are sufficient to settle a question. You know that home schooling is good (or bad),  that there are no barriers to social mobility, that single parents are scroungers, that Israel (or Hamas) is right. And so on. So you just abuse the other side and wallow in your self-righteousness.
The other approach, though, is to ask: what exactly is the evidence? What would count as good evidence?
This latter approach, though, is a minority one. I suspect that we live not in an age of science and empiricism, but rather in an age of ego.
* The data doesn’t wholly vindicate Dave, though. He claims that “human beings are born with more or less equal potential.” But there seems to be a big genetic component in maths ability.

House prices & biases

Polly Toynbee wants us to come off the house price drug. She says:

Property speculation is hardwired in the British brain after decades of a one-way bet - with only a few small blips.

This statement is both true and false. It’s true in the sense that the Brits have traditionally seen housing as an investment. But it’s false, in the sense that this investment has not yielded spectacular long-run gains. My chart shows this. It shows the ratio of real house prices (from the Nationwide) to real GDP. You can see that over some long periods this ratio has barely risen at all. Since the end of 1955, house prices have risen 2.7% a year in real terms, whilst GDP has grown 2.4%.
Over the long-run, house prices rise more or less in line with GDP.
Granted, this is better than shares, which have risen 1.2% a year (ex dividends). But it’s not a fantastic gain. Which raises the question. Why, then, have people thought that house prices are a good investment?
One reason, stressed by Akerlof and Shiller in Animal Spirits (which I’ll be reviewing soon), is money illusion. If you’d bought an average £20,000 house in late 1974, you’d now have an asset priced at just over £300,000. A great gain? Not really. Prices have fallen relative to money GDP. Most of the gain is just inflation.
A second reason is the availability heuristic. My chart shows that prices have soared since the mid-90s. It’s natural to weight this evidence more heavily than evidence from the 70s showing that prices can fall relative to national income. But it’s wrong to do so.
Thirdly, house price gains come for free. I don’t mean they are free of tax - so are stock market gains within pension funds. I mean they come on top of the consumption benefits of housing.  I can invite laydeez round to my house, but not to my Scottish Widows tracker fund.
Fourthly, there’s a self-serving bias. If we hear news of a neighbour’s house selling for a given sum, we assume our house is worth more because we have such good taste that  our home improvements are so much better than theirs.
Finally, there’s an “out-of-sight” bias towards risk. Every night, Robert Peston tells us how much share prices have fallen. But he doesn’t say every night: “you’ve lost another £300 today on your house” - even though this is the average daily loss someone would have suffered on a £400,000 abode over the last six months. The result is that we regard shares as much riskier than our own home; remember - individual house prices are much riskier than house price indices.
There are, therefore, a number of biases leading people to overweight the gains from property speculation.
But should policy-makers do anything to combat this, as Polly asks?
Maybe not. I suspect that house prices will fall further, and for some time. Perhaps, then, the passage of time alone might wean people off the property drug - for a while.

Should lone parents work?

Laurie Penny is keeping up her attack on James Purnell’s Welfare Reform Bill, and in particular the plan to get single mothers back into work.
She has a point. If we look at the DWP’s own figures (big pdf), the returns to work for low-skilled lone parents are small. Table 1.2f suggests that a mother of one child who works 30 hours a week on the minimum wage is £56.87 better off in work than out.
This is an effective wage of just £1.90 an hour. And this ignores the cost of travelling to work and childcare costs - though 80% of the latter are subsidized through tax credits.
For a woman with two children (table 1.3f), the effective wage is just £1.65 an hour - before costs.
Purnell’s claim that work is the route out of poverty is true in the sense that work raises a lone parent’s income. But it doesn’t raise it much.
Herein, though, lies a quirk. Getting mothers into work might not be good for the mothers - I doubt if £1.90 an hour is much recompense for the disutility of working - but it could be good for children. This paper estimates that the children of lone mothers score better on some cognitive tests if their mothers go out to work early - though the results are not statistically significant. This could be because the extra income, small as it is, helps child development (say, if it’s spent on books or educational toys), or because paid childcare is better than the mothers’ care.
Whether these results are robust enough to justify Purnell’s harassment of lone mothers is, however, doubtful. I suspect instead that they are just a small, unintended by-product of a campaign motivated - as Laurie says - by much baser motives.

Nationalize the banks

The case for a fuller nationalization of UK banks looks a little stronger this morning.
 The government is using Northern Rock to expand mortgage lending. This demonstrates the old saying, that when your tool is a hammer, everything looks like a nail.
The thing is, the slump in mortgage lending is not the cause of our recession; we know this because falling house prices have not led to a drop in retail sales, volumes of which have risen 3.6% in the last 12 months. It’s not even obvious that a lack of supply of loans is the major reason for falling house prices; over-valuations a year ago and now job insecurity might be bigger reasons.
Instead, our big problem is a lack of supply of loans to companies. This is behind the lack of job creation which is a big reason for rising unemployment, and the destocking that’s caused a collapse in manufacturing output.
So, why doesn’t the government increase the supply of corporate lending, as it has mortgage lending?
Because it’s got no tool. Yes, it’s got loads of policies aimed at boosting corporate lending. But these work - if they will at all - only indirectly, by restimulating credit markets or the banking system.
And they’re not working yet.
The result is that demand for loans - as we see with LDV’s call for state aid - is becoming politicized. Which is a recipe for a horrible misallocation of capital, as tax-payer money will go to larger, more powerful firms who are best able to wave their festering stumps like Indian beggars - “we need to save hundreds of jobs.”
Yes, this misallocation is a second-order problem - it takes lots of Harberger triangles to fill an Okun gap. But whilst corporate lending depends upon the ad hoc decisions of ministers, we’ll have the worst of both worlds - Harberger triangles and an Okun gap.
The solution here is obvious. We need a state-owned corporate lender which can increase loans to companies, as Northern Rock has to home-buyers. But this requires (some) banks to be fully nationalized.
As I said, nationalization, far from being the enemy of a free market, might be a precondition for it.

Stalinist companies vs market forces

One of my favourite claims, which I made in my book,  is that if centrally planned economies are a bad idea, how come centrally planed companies are a good one?
Well, it turns out that RBS was just like a centrally planned economy, complete with the suppression of dissent and cult of personality. And look what happened. I’m vindicated.
Or am I? Don Boudreaux challenged my analogy:

Unlike with government central planning, the size and scope of each firm on the market is itself constantly tested by competition.

Obviously, he was right on this. The market’s verdict on Fred Goodwin’s Stalinism was - ultimately - decisively damning.
But does it follow that his more general point was right, that market forces greatly ameliorate the damage done by Stalinist bosses? I’m not sure.
1. The market’s verdict is subject to the Duhem-Quine problem, that hypotheses can only be tested jointly, not singly. RBS’s demise is consistent with my thesis that centrally planned companies are a bad idea, but it doesn’t prove it. Another possible reaction to RBS’s failure is that it just shows that the wrong man was in charge, and that hierarchy would be optimal if RBS had the right boss.
This means the market doesn’t necessarily select out hierarchy as a bad organizational form - a problem exacerbated by the fact that other market failures (huge barriers to entry in the case of banking) prevent co-operative ventures from growing.
2. The market mechanism was very messy. In theory, RBS could have suffered an orderly run-down, as talented people took their expertise to other firms and the share price sagged until it was taken over by a cleverer bank. This didn’t happen. Instead, RBS’s collapse imposed negative externalities onto the rest of the economy: adverse wealth effects as the stock market fell, and a reduction in bank lending.
3. RBS’s demise costs the tax-payer money. Even if it hadn’t been nationalized and had instead just failed, we’d still have a bill for deposit insurance. (And if we didn't have deposit insurance, would things really have been better?)
This suggests the market is a very imperfect check upon Stalinist companies. Which in turn leads me to suspect that government intervention to promote more co-operative forms of company aren’t necessarily a bad idea.

Public borrowing & the credit crunch

Today’s public finance numbers confirm what we all knew - that government borrowing is exploding. It’s quite possible that Darling’s forecasts made in November will be too optimistic. And ConservativeHome are talking about “bankrupt Britain.”
What’s not sufficiently appreciated, however, is that this is in large part just an inevitable effect of the credit crunch.
This follows from a basic national accounts identity - that across the whole economy, savings must equal investment.
Now, the credit crunch means that private sector savings are rising, relative to investment. This is not just because folk are paying down debt. It’s also because credit constraints mean that people who would like to borrow cannot do so.
If private sector savings rise relative to their investment - that is, they run a big financial surplus - someone else must run a deficit. There are only two candidates - foreigners or the government. But foreigners, especially those in Asia, are net savers.
As a matter of arithmetic, therefore, the government deficit must increase.
My chart shows this. It shows that for the last 20 years there’s been an inverse relationship between the government’s financial balance and the corporate sector’s. When companies save more than they invest, government runs a deficit. With companies now running the biggest surplus they ever have - partly because those who would like to borrow to invest cannot do so - it’s no surprise that the government is running a big deficit. 
This has four implications:
1. Britain’s red ink is not just due to New Labour’s profligacy. The OECD expects government borrowing to rise in most developed economies (though granted, more in the UK and US than elsewhere). This is because the rise in the private sector’s financial balance is a worldwide fact, albeit more so in the UK and US than elsewhere.
2. It explains why gilt yields have stayed low. The same credit crunch that is, by simple arithmetic, responsible for government borrowing is also causing a “flight to quality” and low gilt yields.
3. Your view on how big government borrowing becomes should depend very much upon your view of the credit crunch. If you’re pessimistic about the latter, you should expect big borrowing.
4. It’s possible that the public finances might improve more than expected. If or when the credit crunch does end, companies might have a big backlog of unfilled capital expenditure plans. As these become realizable, the corporate surplus could swing into deficit, causing the public finances to improve quickly.
Seems unlikely? Maybe. But I remember being told both in 1989 and 2000 - when the government was in surplus -  that we faced years of surplus. And I remember being told in the mid-90s that we faced years of deficits. It was all bull.
Experience, then, teaches me that long-term forecasts of the public finances aren’t worth a wet fart.

In defence of bonuses

Everyone’s moaning about “bonus culture.” So I will too. You know what the problem with “bonus culture” is? There ain’t enough of it.
Now, I’m not defending bankers’ multi-million bonuses - they were just legalized extortion. What I mean is that a bonus should be a larger part of ordinary workers’ salaries. I say so for four reasons:
1. The problem with fixed wages is that they generate unemployment in bad times. If a firm pays a fixed wage and suffers a fall in demand, the marginal product of some workers fall below the wage, and so the firm has to sack them. If, however, wages comprised a more variable element, demand shocks would lead to varying wages, but with more people keeping their jobs.
This point was made forcefully by Martin Weitzman and James Meade in the 1980s, though for some reason it never caught on. However, now we know that the psychological costs of unemployment are large (pdf), it’s time to revive interest in the idea.
2. Bonuses would allow firms to hire otherwise discriminated-against workers. Imagine two equally qualified 20-somethings, a man and a woman, apply for a job. The employer, fearing the woman will take maternity leave, hires the man. But what if the job comprises a lowish wage and variable bonus? Then, the risk of hiring her is partly shared with her - in the form of a lower wage. So our employer might be tempted to hire the woman, and if she doesn’t take maternity leave he can pay her a decent bonus.
3. There’s good evidence (pdf) that some forms (pdf) of profit-related pay can improve (pdf) productivity quite significantly. Bonuses can be effective incentives.
4. Bonuses can be a paternalistic way of encouraging savings. If people regard their base pay as normal, and bonuses as windfalls, they are likely to save at least some of the latter. This is what I did when I had a job with a big(ish) bonus element.
Now, there are two obvious objections here, both of which have easy solutions.
You might object that a mix of lower pay plus a bonus would merely be a way for employers to screw workers’ pay down.
But this can be solved by giving workers greater control of their workplace.
Or you might object that variable pay exposes more people to economic risks. This problem can be overcome by ensuring that people have an out-of-work income that helps smooth such fluctuations a little - such as a citizens’ income.

GIlts and QE: some questions

Following his speech (pdf) last night in which he talked about quantitative easing, Alice Cook has some questions for Charles Bean. Here’s how I would answer them if I were he:

The UK government will have to issue £120 billion of new debt [next year]. What will the Bank of England do if the government can not sell this debt without long term government yields beginning to rise?

Nothing. The Bank has no more of a target for gilt yields than it does for share or house prices. What’s more, there’s probably nothing it could do. Gilt yields are, to a very large extent, determined globally; since January 2000 the correlation between UK and US 10 year yields has been 0.78 (R-squared = 60.6%). The likeliest way in which gilts would sell-off significantly would be if government bonds around the world did so. The Bank could do little about this.

Suppose the government, in its desperate desire to run this huge deficit, allows rates to increase. As Mr. Bean knows, this will put upward pressure on all interest rates. In turn, this will crowd out private expenditure in favour of public consumption. Will the Bank of England accelerate money creation on order to keep government yields down?

No. The premise here is mistaken. The likeliest scenario in which yields rise is if global investors ' appetite for risk returns, and if they anticipate an economic recovery. But these would be circumstances in which bank lending resumes and credit spreads fall. So, far from private expenditure being crowded out, it’ll be crowded in.

What will the Bank of England do, if as is likely, investors begin to sell UK gilts as long term inflationary expectations begin to rise?

Simple. We’ll stop quantitative easing and raise interest rates. That’s what inflation targeting means.

Assuming that the Bank of England want to prevent gilt yields rising, will it begin to buy government paper in order to put a floor under bond prices via quantitative easing?

But we don’t want to stop yields rising. The assumption is wrong.

If private sector investors starts to seriously dump UK gilts, is the Bank of England prepared to become the buyer of last resort for government paper?

No. Remember here that there are two distinct reasons why investors might dump gilts - because of worries about the governments’ creditworthiness, or because of fears of inflation. The former is a remote prospect. Indeed, it’s possible that creditworthiness fears would actually be good for gilts, if investors dump Irish or Italian bonds in favour of safer UK ones.
And if the market starts worrying seriously about inflation - despite the Bank’s target - they'll pile into index-linked gilts as well as dump conventionals.  Government could address this simply by issuing more linkers and fewer conventionals.

If the UK bond market collapses completely, is the Bank of England ready to become the primary source of funding the government deficit?

The contingency is too remote to bother with. There’ll be a demand for gilts. The only question is: at what yield? Why should it worry the Bank if that yield is high, except insofar as a high yield is a signal of high inflation expectations?

When will the BoE tell the government that it wants to stop buying government paper in order to prevent the UK from drifting into a hyper-inflation?

We can tell them any time we like, and a very long time before we get anywhere close to hyper-inflation. The extent of quantitative easing is for the MPC to decide. As Mervyn King told last week's press conference (pdf):

Decisions on those operations would be as now made entirely by the Bank of England and it would be just as independent as it is now.

Of course, it is perfectly possible that the Bank will misjudge the degree of QE required, with the result that inflation overshoots its target. But this is the sort of error that happens all the time even under conventional monetary policy. Talk about hyper-inflation or a collapse of the gilt market is just hyperbole.