Stumbling and Mumbling

Luck, & helpful illusions

Here are four pieces of recent research:

- children whose fathers lost their jobs in the 1980s recession did worse (pdf) in school and went on to earn less than otherwise similar children whose fathers kept their jobs.

- good-looking men earn more than ugly ones at any level of earnings.

- children who are bullied at school before the age of 12 go on to get worse grades and are more likely to take drugs or get pregnant in their teens.

- children who are taught in small classes between ages 10 and 13 go on to earn more in middle age than those taught in larger classes.

These apparently different findings have one thing in common. They all show that our fate in life depends upon luck. It's a matter of luck whether your dad kept his job or not; whether you are ugly or not (make-up doesn't get you far (pdf)); whether you're bullied or not; and how big your school classes were.

Granted, the average effects in these papers are smallish. But they are only a tiny subset of the ways in which luck affects us. Whether we get teacher and mentors who inspire us or not, whether we enter (pdf) the labour market in a recession or boom, whether we're members of the lucky sperm club or not and - most importantly - whether we are born in England or Ethiopia are all matters of dumb luck.

Ed Smith is surely right. Our success, or not, in life is surely a matter largely of luck. I can easily imagine that slight tweaks in my fortunes would have made me either a multi-millionaire or a convict - and I suspect the same is true for most folk.

In saying this, I am not taking a purely leftist position. In Law, Legislation and Liberty (ch 8), Hayek said that income inequalities between people "will often have no relations to their individual merits"and decried it as a "misfortune" that people defended free market on the erroneous grounds that they rewarded the deserving.

I fear, though, that mine, Smith's and Hayek's position is a minority one.Far more common is the belief that the successful have earned their rewards whilst the poor should work harder. Why do people belief such nonsense?

The obvious answers lie in cognitive biases. The just world fallacy causes us to find justifications, even spurious ones, for injustice. And self-serving biases cause the successful to believe that success and failure are due to individual effort - and, of course, the opinions of the rich carry far more weight in politics than those of the poor.

But how costly are these illusions? Hayek pointed out that they can have big benefits. The belief that our well-being depends upon our own efforts will spur us to study and work harder than we would if we thought our well-being merely a matter of fate. And this greater effort can make us all in aggregate better off.

There is, then, a trade-off between truth and utility.

Unemployment: a brief history

My chart below puts today's unemployment data into long-term historical perspective. Using Bank of England data, it shows the unemployment rate since 1855.

What stands out here is that a highish rate of joblessness is quite normal. It is the 1945-73 period of full employment (for men!) that is historically odd, not today's joblessness. In fact, between 1855 and 1939 the unemployment rate averaged 5.1% - higher than the claimant count rate is now.

I reckon there are several important messages here:

1. Marxists are right. From the point of view of workers, capitalism tends to stagnation, in the sense of being unable to provide work for all. Michal Kalecki was spot on: "unemployment is an integral part of the 'normal' capitalist system."

2. The idea that free market policies can generate sustained full employment lacks any historical foundation, unless you want to argue that there were severe labour market regulations that caused mass unemployment in the 19th century; "Damn those Factory Acts!"

3.Claims that the welfare state has created a culture of dependency in which folk don't want to work look silly. High unemployment was the norm in the pre-welfare state era.

4. Unemployment is not merely a cyclical problem remediable merely by counter-cyclical macroeconomic policies. It is more permanent than that.

5. If we want full employment - and we should - we need something like the post-war settlement. Which poses the question of whether this is feasible. Personally, I fear it's not; the post-war reconstruction and Fordist manufacturing which created ample jobs for the unskilled are gone for good.

6. If full employment is impossible under capitalism, the question arises: how can we mitigate the misery it causes? I'd suggest active labour market policies that do not stigmatize job-seekers, and a more generous welfare system (clue - basic income.) But I don't expect such suggestions to be heeded.

Help for right-wingers: the data are consistent with the idea that there are lots of people who are unemployable, but that this has always been so, except when demand for the unskilled was very high in the post-war era.  

When organizations fail

The G4S fiasco has led some to question - not necessarily consistently - whether the private sector is any more efficient than the public.

For me, the question makes little sense as an ideological one. Hierarchical organizations are prone to failures arising from adverse incentives, limited knowledge and bounded rationality (planning fallacy, anyone?).What matters is how organizations mitigate these dangers; whether they are in the public or private sector is not often the issue.

There is, however, a common claim - one I think I've made myself - I want to challenge. It's the idea that market forces mean that the failure of private sector organizations is less catastrophic than public sector ones.

Now, in many cases, this is true. When Woolworths collapsed, there was no generalized crisis; people simply bought their pic 'n' mix elsewhere. By contrast, when the "Border Force" screws up, people cannot use other means to get through immigration checks quickly.

What interests me, though, is that there are cases where private sector failure does have costs - and I don't just mean the fleeting political embarrassment that arises from G4S's failure.

The biggest and most obvious example of this was, of course, the banking crisis. It showed us that the collapse of a handful of organizations can have colossal macroeconomic effects.

I'd suggest three general ways in which private sector failures can have macroeconomic effects:

1, Common failures. If every organization is pursuing the same strategy, then any change which causes the strategy to lose money might kill off all organizations in an industry. Markets are like ecosystems (pdf).If there's insufficient biodiversity, environmental change will wipe out entire ecosystems.This is the story of banks.

2. Market blockages.Ashwin says: "When the incumbent fails, there must be a sufficient diversity of small and new entrants who are in a position to take advantage." But this is not assured.For it to be true we need (among other things) an entrepreneurial culture, a lack of barriers to entry and expansion and finance for entry and expansion. None of these are assured.

3. Being big enough to matter.As Xavier Gabaix has pointed out, some firms are sufficiently large that they matter for aggregate growth. The failure of one or two mega firms might then generate the sort of adverse productivity shock that RBC theorists fret about.

I reckon there are (at least) two implications here.

First, the standard macro-micro division of labour in economics can be dangerous, as it can blind us to the fact that micro failures can have macro effects.

Secondly, the question of whether private sector firms are well or badly managed cannot be left to the market, and nor can they be rectified by macroeconomic policies. The question of how private sector firms are managed is a legitimate political one. And this raises issues which the non-Marxist left has tended to ignore for too long.

When were we Keynesian?

The government has announced a big  investment in infrastructure - to start in 2014. If you believe the OBR's forecast for economic recovery, this means the investment will come just after the economy most needs a boost.So much for Keynesianism.

This set me pondering. Just how counter-cyclical has public investment in infrastructure been in the past?

My chart suggests: not much. If spending were counter-cyclical, you'd expect to see a negative correlation between gross public investment as a share of GDP and the output gap, with recessions causing high spending and booms lower spending. But in fact, there's no such relationship. According to Treasury/OBR data, the correlation was zero between 1963 and 2010*.

You might find this surprising, because you don't need to be a Keynesian to believe that infrastructure spending should be countercyclical. If real interest rates fall in recessions, you only have to think it's a good idea to borrow more when interest rates are low to want a negative correlation between the output gap and infrastructure spending.

So, why haven't we had one? Anti-Keynesians could argue that it's just impossible for governments to behave in a Keynesian way.The time lags involved in finding and planning big investments mean they cannot be started when the economy is weak. Alternatively, perhaps investment decision have been driven more by politicians'vanity - a desire for grand projects such as Concorde - than by economic logic.

Good points. But they run into a problem. If we split our data sample into three periods, we find different, and negative,  correlations: -0.1 for 1963-79;-0.56 1979-97;and -0.85 for 1997-2010.

What we have here is an example of Simpson's paradox.

In other words, both the Thatcher/Major governments and New Labour behaved Keynesianly, having higher investment in booms and slumps. For example, Thatcher cut infrastructure spending as the economy moved from recession in 1981-82 to boom in 1988-89.

If anything, it was the pre-1979 governments that were not so Keynesian, having only a weak correlation between the output gap and investment. The golden age of Keynesianism was no such thing.

In this sense, Cameron's announcement of rail investment represents a return to pre-Thatcherism. 

* In theory, this could be because governments have seen recessions coming and increased investment in anticipation of them with the result that recessions haven't materialized, and so there's been no correlation between spending and the output gap. But I don't think anyone thinks this has been the case in practice.

Trust cycles

I've suggested that potentially the biggest cost of the Libor fiddle is that it might depress trust in the economy and hence long-run economic activity. Coincidentally, a new paper half-corroborates my fear. It says we can be "locked into cycles in which trust and trustworthiness emerge and collapse again and again."

Think of a trust game. In this, one person - the investor - decides whether to give money to another, the trustee. If he does give money, the experimenter triples the sum. The trustee then chooses whether to give any money back.

Experiments show that investors often do hand money over, and trustees hand some back. This contradicts the ideas that people are rational selfish maximizers, as this predicts that the trustee will keep all the money for himself.

But what if the game is repeated, with investors choosing trustees?

Imagine that some trustees then behave badly and don't return money. Investors who trust will then lose money. In evolutionary terms, they'll be selected against and will die out. Trust will then decline. And it might not be rebuilt merely by state regulation (pdf) of trustees. If it declines to zero, no investor will hand anything over to trustees, so trustees will end up with zero return as well.

But when trust is low, the trustee who can somehow signal his trustworthiness will attract more investors than his untrustworthy competitors. As an example, think of those 19th century food manufacturers such as Bird's, Colman's or Cadbury's who invested in brand reputation to signal that their products were less adulterated than their rivals'.

Trustworthiness will then be selected for, and so will spread. And as this happens, investors who trust will earn bigger returns, and so selection instead of favouring the untrusting will now favour the trusting. Both trust and trustworthiness will then rise. But when trust is very high and investors are handing over big money, trustees will have stronger incentives to run off with the money.

So, we get cycles of rising and falling trust and trustworthiness.

There are several implications here:

1. Homo economicus - the selfish rational maximizer - does not necessarily create a prosperous society. This is because homo economicus might have an incentive to run off with the money. A society of such people might therefore be a low trust one - and therefore poor.

2. Both trust and trustworthiness have positive externalities; they benefit others, not merely ourselves. This suggests they might be under-supplied by homo economicus.

3. There need not be stable equilibria of high or low trust. When trust is low, trustees have an incentive to be trustworthy. And when it is high, they have an incentive to defect. This gives us cycles.

4. Matthew's contention that "everything is leveraged" - small changes can have big and longlasting effects - is valid. A smallish loss of trustworthiness or trust can set us on the downward leg of a cycle. Which is why banks' misbehaviour is worrying.

Crony capitalism - the only capitalism

Supporters of free markets seem to be increasingly vocal in their opposition to corporatism or crony capitalism. Whilst I wholly welcome this, I fear that the demand for a proper free market economy without cronyism or special favours is as unachievably utopian as the wildest leftist fantasy.

I say this because of the first premise of free market economics - that incentives matter. Politicians want money, business wants influence and favours. Both sides therefore have powerful incentives to trade - to give us cronyism.

Of course, this wouldn't be a problem if there were, as Sandel and Walzer have argued, moral limits upon markets - an agreement that there should be some things, such as political power, that money shouldn't buy.But this ethical demand runs into the fact pointed out by Marx - that the logic of capitalism is commodification, the extension of the cash nexus:

The bourgeoisie...has left remaining no other nexus between man and man than naked self-interest, than callous “cash payment”...It has resolved personal worth into exchange value, and in place of the numberless indefeasible chartered freedoms, has set up that single, unconscionable freedom — Free Trade.

There's another reason why crony capitalism will always exist. As Arnold Kling says, there will always seem to be a good argument for regulation. And thanks to regulatory capture, an inevitable by-product of this will be that regulation will favour big business; this fact is now so obvious that it even Liberal Conspiracy and a Very British Dude agree upon it. The only way to avoid cronyism is to avoid regulation - and nobody wants this.

There's a third point, which I think is under-appreciated. To survive - let alone thrive - in a proper market economy requires great entrepreneurial skill, to be flexible, efficient and genuinely "customer-focused". But these skills are very scarce. In a true market economy, therefore, not only would entire industries such as banks and arms companies not exist in their current forms, but nor would many firms, such as G4S, A4E or Atos. State support for business is necessary to sustain demand for the vast supply of incompetents and fraudsters.A free market economy would be one in which many people are unemployable.

Crony capitalism, then, is the only feasible form of capitalism.

What are politicians for?

What is the function of politicians? I ask because the coalition is making pitifully slow progress in reforming the provision of social care.

The thing is, this is the sort of straightforwardish job that government should do. We have a ready-made solution to a genuine problem. But it seems the Dilnot report is being as ignored as the Mirrlees review, which vindicates of Alan Blinder's saying that "economists have the least influence on policy where they know the most and are most agreed."

We see here two features of this government. One is a failure to be guided by good advice. The other is an inability to perform a core function of the state - to rectify a market failure. And this is all the social care problem is; there's a missing market in insurance against the small danger of incurring a large expense.

And here's my problem. There are two classes of issues:

1. Those that governments, in principle, can address by being able to marshall collective action and informed opinion, but are not addressing: these include reform of social care and the tax system, for example.

2. Those problems that are irremediable. I'd put increasing long-term GDP growth and eliminating troubled families in this class.

My question is: what issues fall outside of these two classes? Which are in the set of problems that governments can solve (or ameliorate) and is solving?

The Lib Dems think the answer includes reform of the House of Lords. But only a minority of cranks think this is an important issue.

Put this another way: how many social or economic problems of, say, the last 20 years have been solved by politicians, as distinct from by the passage of time or by economic growth?

My problem here is not a UK one. Indeed, the two biggest current obstacles to western economic growth are both the result of politicians' failure: the US "fiscal cliff" and the failure to resolve or patch up the euro area crisis.

Now, one might argue that I'm looking too much through a technocratic prism. Perhaps it's the function of politicians to embody particular values.

There might have been a time when this was true - when, for example, Tories favoured negative liberty and Labour equality. But such conflicts of values are rare now. And even were they not, in a Macintyrean world, few people are capable of making coherent arguments about values. Politicians have a base in neither expertise nor moral authority.

Now, I am not arguing here for a "strong man" dictator. All I'm doing is posing the question: what are politicians for? Unless they can answer this - and they show little appetite for doing so - then mainstream politics will look like no more than a circlejerk. 

Equality vs big government

Imagine a tax system in which the first £10,000 of income is tax-free, the next £40,000 is taxed at 20%, and incomes above £50,000 are taxed at 50%.

Imagine then that the income distribution moves from A to B in my table. B is a poorer society and, by most measures, a more unequal one. Such a move could happen if the financial sector, which has a few mega-incomes, increases in size whilst it imposes a negative externality onto the rest of the economy. Or it could happen because bosses increase the rate of exploitation of workers by engaging in rent-seeking which impoverishes society as a whole.

What happens to tax revenues when we move from A to B?

The answer is that they rise significantly, from 77 to 107. This is despite the fact that B is poorer.
The message here is awkward. Given a reasonable tax system, a government which wants to maximize tax revenue will welcome a rise in inequality - even if that inequality is associated with lower GDP.

This, it is alleged, is what New Labour did. Nick writes:

In the bubble, Labour let the City rip and used the taxes to fund handouts to the poor and social improvements.

And the Spectator's leader says:

Brown's greed for tax was just as pernicious as the bankers' greed for profits. Every bonus paid in the City was split 60/40 with HMRC; it was a joint venture with the banks.

These complaints hint at a genuine trade-off - that, under a progressive tax system, the Left faces a choice between increasing equality and increasing tax and thus public spending.

Now, you might object that this trade-off isn't as acute as I've pretended:

1. "To the extent that higher tax revenues really do help the poor, the social wage rises and so inequality doesn't increase as much as I've painted." But what if the revenues are spent on corporate welfare, or are lost through stagnant public sector productivity?

2. "Given high indirect taxes, the overall tax system is not terribly progressive." True. But I'm not sure this is something the left will welcome.

3. "A clampdown on tax-dodging would allow a leftist government to increase both equality and tax revenue, thus overcoming the trade-off." However, if such activity is as widespread as claimed, it is evidence that the state lacks either the will or ability to eliminate it, which raises another awkward problem.

If there is the sort of trade-off I've described, then Labour has a problem. On the one hand, the case for reducing inequality is very strong - either as a direct goal of policy or as a by-product of putting the financial sector in its rightful place. But on the other hand, doing so would jeopardize tax revenues and thus make it harder to reverse the Tories' squeeze on spending - especially if Labour is committed to fiscal conservatism.

Rational overconfidence

It is a truth universally acknowledged that the best lack all conviction whilst the worst are full of passionate intensity. Which is another way of describing the Dunning-Kruger effect - incompetent people don't know they are incompetent. They are overconfident.

However, a new paper by Peter Schanbacher suggests that, in many cases, what looks like overconfidence might in fact be quite rational.

To see his point, take a different case. Imagine a coin is biased to land on heads 80% of the time and tails 20%. Predict the next 10 tosses.

A good answer to this question would simply be 10 heads. This will be more likely to be right than any random-looking sequence of eight heads and two tails. But this answer is biased - it overpredicts heads.

The lesson here is that there can be a trade-off between bias and variance. The "10 heads" answer is biased, but it has less variance (is less likely to be wrong) than (say) HHHTHHHTHH.

A similar problem faces the ignorant individual when asked about his chances of solving a problem correctly. The same lack of expertise that makes someone ignorant can also mean there is large variance around his estimate of his competence. One rational solution to this, says, Schanbacher, is for him to give a biased answer - to over-estimate his competence - just as a biased answer to our coin-toss question is reasonable.

In this sense, overconfidence might be a good answer to a bias-variance trade-off.

This is not the only way in which overconfidence might be rational:

- Overconfidence might be the only way of steeling oneself to take risky decisions, such as to start one's own business.

- Overconfidence can be mistaken for genuine skill. Being overconfident, then, is a good career strategy.

All this raises a distinction which is often overlooked.

I suspect that the large majority of people who are overconfident have not solved a bias-variance trade-off or chosen a career-enhancing strategy. They are just mistaken. In this sense they are irrational, in the sense of having a belief for which they do not have evidence. However, they act as if they are rational, in the sense of doing something which maximizes their chances of success.

In other words, rational behaviour is more common than rational thinking.

Some feminist economics

Here are some new economic research findings of interest to feminists:

1. Access to abortion led to a significant drop in teenage motherhood - more so than access to the pill. Given that teen motherhood is associated with adverse social and economic effects, this provides a consequentialist argument for abortion.

2. The daughters of women who had feminist opinions in 1975 are more likely to have been to university and to work longer hours than the daughters of women with more traditional gender attitudes. In this sense, feminism is good for human capital accumulation and hence economic growth. However, this finding challenges Judith Rich Harris's claim that parents are less important than supposed. 

3. "Over recent decades, countries with higher shares of women in parliament have had faster growing economies." This might be because a society which encourages women to become MPs is likely to be a society which tries to make more of its citizens' talents than societies hostile to womens' advancement.

4.Women do worse in wage negotiations than men.This suggests that some of the gender pay gap reflects gender differences in the ability to extract rents - a point which gets lost in the neoclassical fairy tale which assumes that people are paid their marginal product.

It's rather sad that it takes a sexist old dinosaur like me to point out things like this. But then, when feminists confine themselves to complaining about people being mentally ill, or whining about the frustrations of careerist egomaniacs, someone has to point to proper social science.