Stumbling and Mumbling

Reinventing the wheel

In both the UK and US, wage inflation has stayed low despite apparently low unemployment – to the puzzlement of believers in the Philips curve. Felix Martin in the FT says there's a reason for this. The “dirty secret of economics,” he says, is “the central importance of power.” Inflation, he says, is “society’s default method of reconciling, at least for a while, irreconcilable demands.” And because workers don't have the power to make big demands, we haven’t got serious inflation.

What's depressing about this isn’t just that it’s right, but that it needs saying at all.

Economists of my age were raised to see that inflation was a matter of power. The very idea of the Nairu arose from a paper (pdf) written by Bob Rowthorn in 1977 (He didn’t actually coin the phrase “Nairu”, but the idea is there). “Conflict over the distribution of income affects the general level of prices in advanced capitalist economies” he wrote. “Power plays a central role in the determination of wages and prices.”

His insight was taken up. In a textbook that grew from some of the few lectures I actually attended in the mid-80s, Wendy Carlin and David Soskice wrote:

In an economy in which both workers and firms have market power…each group will attempt to get hold of particular share of the economy’s product…Suppose that the competing claims are inconsistent ie that the claims of workers to real wages and firms to real profits sum to more than is available in output per head. The each side will attempt to secure its claim by using its market power – workers will secure higher money wages and firms will put their prices up. The result is rising inflation. (Macroeconomics and the Wage Bargain, p6)

In this view, the Nairu is the unemployment rate necessary to secure peace in “the battle of the mark-ups*”.

Anyone who knows anything about the genealogy of the Nairu would therefore know that insofar as it is a useful idea at all, power is indeed central to it.

And yet Felix has a point; this fact has been glossed over by later fancier theories. This is yet another example of something I’ve said before – that technocrats have a blindspot about power.

But there’s another point here. This shows why the history of economic thought matters. It’s because the creators of economic thought sometimes had ideas which subsequent thinkers ignored. Intellectual progress is not guaranteed.

The tendency of some new Keynesians to ignore the role of power in determining inflation is just one example of this.

Another example is the IS-LM model. Among its faults, this contrived to efface what was perhaps Keynes most important point – that our knowledge of the future “is usually very slight and often negligible.”

A recent paper (pdf) by Oscar Valdes Viera gives another example. Neoclassical economists who tried to “construct economic laws that would validate the existing capitalist order as universal, natural, and harmonious” led us away from Adam Smith’s insights that people are social beings motivated by more than mere egotistic self-interest. If economists had more accurately followed Smith rather than be misled by ideological motivations or mathematical elegance, they wouldn’t have needed to rediscover the importance of institutions and complex (pdf) motivations (pdf).

I don’t write all this to decry mathematical economics: I think it has a (limited) role. Instead, I’m appealing for economists to be a little more aware of the history of their discipline. Doing so can save us from having to reinvent the wheel.

* I'm not sure who coined this phrase: it might have been Richard Layard and Steve Nickell.

Brexit: an interminable debate?

David Aaronovitch has a nice piece in the Times on the stories that Trumpites and Brexiters can tell themselves to avoid admitting being wrong*. I’d add another problem – that the ratio of noise to signal is so high that firm evidence is hard to find.

Let’s take GDP per head. Remainers claim that this will be lower under Brexit. NIESR estimates that Brexit will cut GDP by up to 7.8% by 2030, and CEP economists (pdf) by up to 9.5 per cent.

But trend growth is noisy, even over longish periods. For example, in the last ten years the standard deviation of annual growth has been 2.3 percentage points. This implies that even over ten years the standard error of annualized growth has been 0.7 percentage points.

The intuition here is simple. If we take any time period, it’s possible that it contains a disproportionate number of good years. It would be wrong to infer from this that trend growth is high: what’s really happened is that we got lucky. Conversely, if our sample contains some bad years, trend growth will look low when in fact we’ve been unlucky.

Even over periods as long as ten years, luck by no means cancels out.

My chart shows the point. It shows that it’s possible that trend growth didn’t change much from around 2% from the 70s through to the late 90s.

And here’s the problem. Even the worst-case costs of Brexit aren’t much bigger than one standard error. CEP’s estimate of a 9.5% hit is equivalent to 0.9% lower average growth over the 11 years from 2019 to 2030. That’s only 1.3 standard errors. Which is the sort of thing we could get through bad luck.

Or it might be cancelled out by good luck. It’s possible that growth will be higher in the 2020s simply because Brexit is one of only many influences upon growth. Maybe the scarring effect on animal spirits of the financial crisis fade. Maybe we'll get more sensible macroeconomic policies. Maybe the slowdown in world trade will be reversed. Or perhaps some new innovations will boost investment. There are many possibilities.

If this happens then even if the CEP’s worst case scenario is bang right, Brexiters will be able to say in (say) 2030: “you said Brexit would hurt growth, but in fact the economy’s done as well in the last 10 years as it did in the previous 10. You were wrong.” Remainers will reply that things would have been even better had we stayed in the EU. Ex hypothesi, they’d be wholly correct. But this won’t be clear from the facts.

My point here is that it’s quite possible that the economic impact of Brexit won’t be proven, at least sufficiently clearly to persuade Brexiters. This isn’t just because of our reluctance to admit we were wrong. It’s also because a combination of the Duhem-Quine problem and a high noise-signal ratio means that the debate might, in practice. be intractable. I find this a depressing prospect.   

* Scoffers have pointed out that Aaronovitch has himself used such epistemic defence mechanisms in his continued support of the Iraq war. I think that just shows we are all much better at spotting cognitive biases in others than we are in ourselves.

Trade deal? Yawn.

One of the most elementary distinctions in economics (and in life) is that between instruments and objectives. Interest rates, for example, are only an instrument whereas the objectives are price and output stability. I fear, though, that this distinction is being overlooked by those Brexiters aroused by what Trump calls a “big and exciting” trade deal between the UK and US. Trade deals are only a means of achieving what really matters – prosperity. And they might be a weak one at that.

Liam Fox claims that bilateral US-UK trade could rise from £167bn a year to about £207bn by 2030 “if we’re able to remove the barriers to trade that we have”. This isn’t as impressive as it seems.

The UK currently exports £100.3bn of goods and services to the US. Let’s assume this rises as much as Fox claims. Over the 11 years from 2019 to 2030 that’s a rise of £24bn. Which is 1.2% of GDP. Or 0.1% per year. And in fact, the rise would be much less than this simply because exports have a high import content*.

Granted, this might understate the benefit. Perhaps a trade deal would boost GDP not so much by raising exports but by giving us access to cheaper imports, thus raising real incomes. However, cheaper US imports would threaten to drive some UK producers out of the market – a fact they would of course resist. One reason why trade deals take such an infernally long time is simply that every goddamn lobbyist in the country sticks their neck in.

All this, though, assumes something that mightn’t be the case – that Fox is right that a trade deal would raise exports a lot: that word “if” in his statement is doing a lot of work.

Research by Monique Ebell and Silvia Nenci shows that this mightn’t be the case. Nenci, for example, shows that cutting tariffs has been of only “small significance” in boosting trade. A big reason for this is that trade deals often leave in place non-tariff barriers to trade such as differences in regulations. These are the sort of things removed not by trade deals but by a single market across nations. If only somebody had ever thought of such a thing.

What’s more, there are countless non-governmental obstacles (pdf) to trade such as exchange rate volatility, consumers’ preferences (pdf) for home-produced goods and services, uncertainty, credit constraints, a lack of entrepreneurial nous and of course distance. Two big facts tell us that these are important. One is that world trade has slowed in recent years without significant increases in legal obstacles. The other is that Germany exports much more than the UK does to non-EU countries – a fact which tells us that the barriers to UK exports are not primarily regulatory.

Herein lies my gripe with Brexit. It steals cognitive bandwidth. Instead of considering the countless possible ways** in which we might improve our economic performance without the omniuncertainty of Brexit, we’re discussing how to clean a fucking chicken.  

Why, then, are Brexiters making such a big thing of a UK-US trade deal? One reason lies in the old cliché that if your only tool is a hammer, everything looks like a nail. They’re making the mistake the right has made for years – of assuming that dynamism and flexibility will be unleashed if only the state gets out of the way.

Also, there’s the confusion of instruments and objectives. Those who regard Brexit as a good thing in itself are making a fetish of trade deals: they're saying “look at what we can achieve outside the EU” without asking what the payoff to that will be. 

In this sense, Brexiters are like the worst sort of amateur DIYers who refuse to hire proper tradesmen. Their unwarranted belief in their competence and self-reliance is causing them to wreck the house.

* This is a specific example of the general policy made by Dietz Vollrath – that “you can’t reform your way to rapid growth.”

** There is of course a tension between this claim and Vollrath’s scepticism about supply-side reform. My point is that economic stagnation requires a broad-spectrum response; we should throw as many sensible policies at it as possible, in the hope that one or two will work.  

Marriage & wages

Actor Tom Chambers has caused a row by claiming that “many men's salaries aren't just for them, it's for their wife and children, too." As a justification for the gender pay gap, this is lousy. But there’s a core of truth in what he says.

It’s a lousy justification because if employers paid higher wages to people with dependents we’d expect to see women with children earn more than childless ones. But the opposite is the case. TUC research (pdf) has found that full-time working mothers aged 42 earn 7% less than otherwise similar but childless women. That might be because mothers take time off work to care for their babies and so accumulate less experience. But it also seems to be the case that single mothers earn less than married ones – which is inconsistent with Chambers’ “breadwinner hypothesis.”

However, he’s got a point in another sense. Fathers and married men do, on average, earn far more than single men or those without children. The TUC has estimated that fathers earn more than 20% more than otherwise similar men without children. And Elena Bardasi and Mark Taylor have found (pdf) that married men on average earn 46% more than the never-married.

These are massive differences. The question is: why?

One reason is selection effects: some men only get married or have children if they can afford to do so.

Another big explanation is simply that married men are different from single ones, and so would get higher pay any way. The things that make men good marriage prospects also make them attractive to employers – such as good education or dependability. Bardasi and Taylor write:

A large proportion of the marriage premium is due to unobservable characteristics that are valued both by wives and by employers, such as motivation, loyalty, dependability and determination.

We should add to this list appearances. Handsome men earn more than munters (pdf) on average (though there are of course exceptions: Piers Morgan, for example, earns a fortune).

However, these things don't explain all of the married men’s wage premium. Bardasi and Taylor say that married men earn more than singletons because marriage increases their productivity. They point out that the wage premium is higher for men whose wives do more household chores. Maybe, therefore, married men earn more simply because they’re not as worn out as us singletons from having to do the housework.

The problem with this, though, is that it doesn’t observe productivity directly. Naomi Feldman and Francesca Cornaglia address (pdf) this problem by studying professional baseball players, whose productivity can be measured directly. They find that married players on average aren’t individually better than single ones, but they do earn more. One reason for this, they say, is that married players are more consistent, and this enhances team performance. Also, they say, married players are less exploited; wives help players to drive harder bargains (perhaps in part by reminding them of their team-mates pay).

For me, this chimes true. I would have thought that marriage and children would increase men’s earnings by making them more dependable: married men are less likely to spend their evenings drinking and gambling and so are more likely to be fresh in the morning. As baseball manager Casey Stengel said, “Being with a woman all night never hurt no professional baseball player. It's staying up all night looking for a woman that does him in."

There is, though, another potential effect of marriage which I would expect to be important in some cases.  I suspect that if I’d ever been married I would have earned more because I would have changed jobs. I’d have chosen higher-paid but riskier or less interesting jobs than the one I’ve had. I’d have chosen a bundle of compensating advantages in which money featured more highly. This, however, doesn’t seem to be a significant factor in the research, which surprises me.

There are two points to all this. One is that, if we strip away the moralizing, Chambers has an empirical point. The other is that there are countless things that determine wages, as a classic paper (pdf) by Bowles Gintis and Osborne pointed out. One of these things is bargaining power.

In defence of the state pension

“Should we pension off the state pension?” asks Robert Colville. The answer is: emphatically no. Quite the opposite. There’s a case for increasing it.

Robert is right that the cost of the state pension will rise over time. The OBR expects it to rise from 5.3% of GDP now to 7.3% in 2060 if the triple lock continues.

But this is irrelevant. Unless we euthanize people in their 60s, we’ll have to pay pensioners an income. The question is whether this comes from taxes in the case of a state pension or from dividends in the case of a private pension financed by stock market investment. Whichever it is, there’s a burden upon future working people.

And I reckon there’s a good case for pension provision to be done by the state more than via individual private pensions.

I don’t say this merely because some people are too short-sighted or poor to save, important though this is. It’s because even the most prudent saver will struggle to provide a private pension for herself.

One reason for this is that the costs of private pensions are eye-wateringly high. It’s common for fund managers to charge £1500 a year on a £100,000 pension pot -  which is a fortune for what should be a simple administrative job.

But there’s a bigger reason. It’s impossible to know how much we should save. This isn’t just because we don’t know how long we’ll live or because stock market returns are volatile. It’s also because we don’t even know what long-run equity returns should be.

Of course, we know they’ve been high in the past: 5.7 per cent per year in real terms since 1900. But we can’t be at all sure this is relevant. For much of the 20^th century, investors feared there was a chance of something really nasty happening: military defeat, nuclear annihilation, revolution or severe depression. For the most part, these risks didn’t materialize and so returns were good, at least in the US and UK. But we can’t be sure that our luck will continue, and it’s not obvious that stock markets now are so under-priced as to offer decent long-run returns.

In fact, if we add the equity premium (pdf) estimated by Mehra and Prescott to current real bond yields, we get negative prospective real returns on equities.

I suspect this is too pessimistic. But that’s not my point. The point is that we cannot know how much we can save for a pension. And remember – the costs of misjudging savings cut both ways. Under-saving gives us an impoverished retirement. But over-saving means we deprive ourselves of nice experiences in our youth, and so have a depleted stock of happy memories in our old age.

A good state pension is the solution here. The state is better able to bear risk than private citizens.

This isn’t just because tax revenue is more predictable than equity returns. It’s also because the state can better pool some risks. For example, whilst individuals face longevity risk (the danger of outliving our assets) this is not so troubling for the state; aggregate life expectancy isn’t so uncertain as individual life expectancy.

And there are some types of equity risk the state can bear. Retired savers face distribution risk: the danger that profits and dividends will fall as wages rise. This isn’t a problem for governments which can tax labour as well as capital. Equity investors also face creative destruction risk – the danger that future growth will come from as-yet unlisted companies rather than from listed ones (as happened in the 70s (pdf)): insuring against this risk by holding private equity funds is difficult, as these expose us to considerable fund manager risk. But again, this needn’t trouble the state as it can tax profitable firms whether they are listed or not.

You might question how much fiscal space governments have. But they have a damned sight more than individuals do.

For me, all this argues for the state undertaking the job of pension provision far more than it does. This isn’t to say there’s no place for private provision: insofar as doing so involves investing overseas, we can get future pension incomes from foreign workers not just UK ones, which is sensible risk-pooling.

I suspect there are simple reasons why this case is rarely made.  One is that people tend to fetishize the public finances, and forget that some jobs need to be done and the question is only how to pay for them. Another, of course, is that low state pensions suit the parasitical fund management industry very well – and it has considerable influence over politicians and journalists.

There is, though, another point here. Given that future pensions must be paid by future workers, it is imperative that they produce a pie big enough to feed future oldsters as well as themselves. This means that policies to increase productivity are essential not least as a way of better providing future pensions.

The ideology of "the market"

One curiosity of the row over top BBC pay has been the attempts of past and present BBC bosses to defend high pay by invoking “the market”. “There is a market for Jeremy Vines, there is a market for John Humphrys” says James Purnell. “We operate in a market place.” Pay is based on a “market-based calculation” say Mark Damazer (9” in). “The BBC does not exist in a market on its own where it can set the market rates.If we are to give the public what they want, then we have to pay for those great presenters and stars" says Lord Hall.

However, the “market” here is a queer one. There aren’t many firms who want to hire someone to read the ten o’clock news, and there aren’t many who can supply the proven skills to do so. It’s a thin market. In such a market, we should understand pay as being set by a bargaining process in which power is exercised on both sides.

Talk of the “market” is therefore what Georg Lukacs called reification – the process whereby “a relation between people takes on the character of a thing and thus acquires a ‘phantom objectivity.’” It obfuscates the fact that wages are set by the power of one person over another. Such obfuscation serves a profoundly ideological function; it effaces the fact that the capitalist economy is based upon power relationships.

Of course, BBC presenters aren’t unusual here. It’s generally the case that the labour “market” is in fact a power relationship.

For example, (many) capitalists have bargaining power and (many) workers do not. This means that, generally speaking, capitalists exploit labour.

And the “market” has given us a relative decline in low-skilled pay since the 1980s. This isn’t wholly due to technical developments but to changes in power, such as the decline of trades-unions and welfare state and adoptions of surveillance technologies that have reduced the efficiency wage element of their pay.

Similarly, “market forces” have given us stagnating real wages over the last ten years. But again talk of the “market” disguises what are in fact dysfunctional emergent features of capitalism – the stagnant labour productivity that has arisen from, among other things, low innovation and capital spending.

What’s more, “demand” is in part an ideological construct. Bosses are well-paid in part because of an ideological belief in the transformative power of leadership – a belief that isn’t wholly backed by facts. And carers and cleaners are poorly paid because of an ideology which devalues their work.

Talk of “the market” is often question-begging; it begs the question of how, exactly, prices and wages are determined in the market. The answer usually involves some element of power.

Now, Hall, Damazer and Purnell are not stupid men and they probably fancy themselves – not perhaps wholly without justification - as among the more liberal and humane members of the ruling cadre. And yet they guilty of an unreflecting inability to see that market relationships are also power relationships. In this of course, they are not unusual. I’ve long complained that centrists and “liberals” have a blindspot about power; we saw just this in this week’s Taylor report for example.

This blindspot, of course, serves the interests of the rich well. The BBC is not impartial.

Cronyism, & the demand for redistribution

Is actually-existing capitalism a fair or a rigged game? The answer matters a lot for attitudes towards redistribution, as some recent experiments by Matthias Sutter and colleagues show.

They got people to choose between a safe investment and a risky one. After the pay-off to the risky investment was seen, they asked third parties whether they wanted to redistribute.

When the pay-off to the risky asset was determined fairly – by the toss of a coin – few people were complete egalitarians. However, they then tweaked the experiment so that subjects who chose the risky asset could toss the coin themselves and report the result without anybody checking it. In this experiment, the number of third parties who were egalitarians tripled.  

Even the suspicion of cheating – let alone the reality – creates a big increase in demand for equality.

It’s in this context that we should read three things I’ve seen recently:

 - A survey of CEO pay by Alex Edmans, Xavier Gabaix and Dirk Jenter finds that high pay cannot be entirely explained by maximizing of shareholder value, and that rent-seeking plays a part.

 - Luigi Zingales argues (pdf) that corporate and political power are becoming increasingly intertwined, and this is a threat to the free market, prosperity and democracy.

 - Graeme Archer calls on the government to fight the “crony corporatism” which has seen bosses’ pay soar without any increase in economic efficiency.

What we have here are mainstream and rightist writers acknowledging that the game is rigged, at least partly. Rhetoric about capitalism is changing. Even outside the left, the rich are no longer seen (only) as talented public beneficiaries whose rewards are the product of free markets, but also as thieves who exploit power for their own ends.

Sutter’s experiments suggest this should cause a big rise in demand for redistribution. We don’t need to prove that theft and rent-seeking are widespread; the mere suspicion of it creates many more egalitarians.

But there’s a quirk here. Sutter’s experiments also found that even where there is that suspicion of cheating, many people remain libertarians who refuse any redistribution. This isn’t wholly unreasonable. They might judge that the danger of stealing money from the honest risk-taker outweighs the desire to punish cheats. Or – to translate Sutter’s results into the real world – they might not want to deter beneficial risk-seeking entrepreneurship.

Professor Sutter and colleagues infer from this that the suspicion of cheating creates political polarization.

I draw another inference. It’s that we need much more than redistributive taxation to tackle cronyism. We need to change institutions to prevent rent-seeking. Whether Archer’s relatively mild suggestions – more transparency and shareholder power – are sufficient is something I very much doubt.

Asymmetric policies

“We’ve got to reverse QE and do so quickly” says Tim Worstall. I don’t want to take a view on that. What interests me instead is that reverse QE might be a misnomer, because central banks selling bonds doesn’t have the same effects as them buying bonds. “Reverse QE” is not simply QE with the opposite sign.

What I mean is that the first round of QE in particular worked (pdf) through two mechanisms. One was a portfolio rebalancing effect. The Bank’s buying of gilts forced yields down, and this helped reduced yields on equities and corporate bonds as investors rebalanced their portfolios towards those assets. The other was a signalling effect. QE signalled to everybody that the Bank intended for interest rates to stay low for a long time. This reduced gilt yields simply by reducing the expected path of short rates.

With QE, these two effects worked together. With reverse QE, however, they’ll work in opposite directions. Yes, central bank selling of bonds will tend to depress their prices and raise yields. But the signalling effect will work against this. Investors might interpret reverse QE as an alternative to rate rises – because if policy is being tightened via the portfolio rebalancing effect, it won’t need to be tightened so much via higher short rates.

The net impact of reverse QE is therefore unclear.

What we have here is an asymmetry. Policy works differently in one direction than it does in the other.

Which brings me to a more interesting question. How large is this set of asymmetric policies? I suspect it Is quite big.

Fiscal policy at the zero bound might be another example. If policy tightens, multipliers (pdf) might be large because there might be little reliable monetary offset; how true this is depends upon your view of the reliability of QE*. But if policy loosens, multipliers might be smaller because there is a monetary offset: rates can rise.

Brexit is another example. Having left the EU, we might not be able to rejoin it on the terms we currently enjoy: we might, for example, have to join the euro.

Another set of examples concern hysteresis effects. Simon says that austerity might have reduced trend growth by creating an innovations gap. Reversing austerity might not close this gap. It’s possible that memories of years of slow growth post-2008 will continue to depress animal spirits even under more sensible fiscal policy.

The Lawson boom of the late 80s might be an example of this. It led to higher inflation in part perhaps because the Thatcher recession had destroyed skills and industrial capacity. Reversing tight policy did not therefore undo the damage of that policy.

Other examples centre on cultural effects. To take a long-term historical example, freeing slaves did not fully reverse the damage of slavery, as its adverse effects are still with us.

I fear that inequality falls into this category. The IFS said this week that inequality has fallen. This might not, however, swiftly reverse the damage done by increased inequality in the 80s and 90s – for example, the reduction in trust and in productivity.

Perhaps top tax rates are another example. The cut in these in the 80s led to (or at least was associated with) a sense among the rich that they are entitled to their pre-tax incomes. It reduced tax morale – the rich’s willingness to comply with tax laws. And this in turn means that raising tax rates would lead to more tax-dodging, emigration or retirement than would otherwise have been the case. Reversing tax cuts might not therefore raise very much revenue.

Maybe you can think of other, better, examples from other fields.

My point here is that we shouldn’t assume that policy-making is a simple hydraulic process of pulling and pushing levers. Pulling a lever doesn’t always simply reverse the effect of pushing it. Bill Phillips Moniac model is perhaps sometimes a bad analogy. Instead, I prefer the wisdom which I associate with Joseph Schumpeter (although I can’t track down the source): “If a man has been hit by a truck, you do not restore him to health simply by reversing the truck.”

* I think reliability is a key issue. Maybe there was a particular amount of QE the Bank of England might have done to offset fiscal austerity. But given the Bank’s inability to know this quantity precisely in 2010-11, a full offset was very difficult.

The economics of BBC pay

The BBC’s publication of a list of its best-paid talent has triggered many subjective views on who’s overpaid. But there’s another issue here, namely: how can we understand what’s going on?

The natural framework for doing so is a bargaining model. This says that pay depends upon just a handful of factors*:

 - Fall-back options. For the BBC**, this is what it would get if it employed the next-best alternative to (say) Naga Munchetty rather than Ms M herself. For Ms M, it’s what she’d get if she worked elsewhere. Obviously, the better your fall-back option, the better you'll be paid, other things equal. 

 - The joint surplus.  The is the pay-off to both parties of the match between the BBC and Ms Munchetty, relative to their fall-back positions. This pay-off isn’t necessarily wholly monetary. For the BBC, it might be the prestige of a quality programme, or the job security commissioning editors get from high viewing figures. And for the talent it can be the platform it gets; being on BBC Breakfast can be a springboard to getting onto Strictly, for example.

 - Bargaining power. How much of this surplus can one extract for oneself?

Take, for example, Peter Capaldi, who earned less than £250,000. This doesn’t seem much, given that the joint surplus is huge – Doctor Who is a worldwide hit – and Capaldi’s ability so great as to give him lots of outside options. But it’s more understandable, once we recognise two things. One is that the BBC’s fall-back position is strong: Doctors are replaceable and the format’s success doesn’t depend upon the actor – and that being the Doctor gives Capaldi a fantastic basis for negotiating his next job; it's wroth being temporarily underpaid for that.

Or take Alan Shearer. His £400k+ wedge looks like he’s having a laugh. But it’s the result of his having a strong fall-back position. He could get big money from Sky or BT Sports; given the rubbish the latter employ, this is a credible threat. Or given his wealth, he could simply walk away: this is another example of a Matthew effect. This gives him a high wage. You might think this is offset by the BBC’s strong fall-back position: anybody can talk shit about football. This is not so. Few have the credibility as a pundit that comes from being the Premier League’s top scorer; BBC bosses evidently value that highly, and so have a poor fall-back position.

Or consider Helen Castor (as I often do). Based on talent, she should be high on the list. But she’s not. One reason for this is that highbrow history shows on BBC4 have a small joint surplus. Another is that she lacks a good fall-back; there are few good history programmes on other channels and Suzannah Lipscomb has bagged them.

I reckon the bargaining framework helps illuminate what’s going on. But there are (at least) four wrinkles:

 - In many cases, the BBC’s fall-back position is weak, or at least it believes it to be so. The reason for this was pointed out by Marko Tervio. What’s scarce, he says, is not so much talent as proven talent. You might think you could do a good job of interviewing a politician live on air. But unless you’ve done so, you can’t prove it. And few people have done so. This means BBC bosses are scared to replace Andrew Neil or Eddie Mair – hence their big money. Similarly, some radio presenters are well-paid, because bosses doubt whether their replacements will get so many millions of listeners.

 - Compensating advantages. As Adam Smith pointed out, differences in wages are often just compensation for other advantages. Breakfast presenters, for example, must be well-paid to compensate for having to get up so early.

 - Comparisons matter. Our well-being depends not just upon our income but upon how much we get relative to others (pdf). This means that unless the BBC wants some of its presenters to look and sound miserable, it must pay them something like their colleagues, even if their objective talents don’t necessarily merit such rewards. Having decided to pay Alex Jones a good wedge, the BBC thus gives Matt Baker a fortune. (This doesn’t, however, seem to have worked in John Humphrys’ case).

 - There’s an idiosyncratic element to bargaining power. Anybody who’s worked in investment banking knows that similar talents and circumstances co-exist with huge differences in pay. In particular, we know that – in least in some circumstances – women get worse (pdf) deals than men (pdf).

It is, therefore, a little odd that the BBC should refer to the list as payments for on-air talent – because talent is only one factor that determines pay.

* I'm drawing here on Ch 5 of Sam Bowles Microeconomics, one of the best economics textbooks

** I’m speaking loosely here. By BBC, I mean the specific BBC bosses who hire the talent, and their interests mightn’t be aligned with the corporation’s or the viewers’.  

Facts, frictions & "mainstream" economics

John Rapley’s claim that economics has become a religion has kicked off another debate about the state of economics.

For me, there seems to be a presumption here which both sides seem to share but which I don’t – or at least that I don’t care about. It’s that economics is a canon of work which is taught to students and the outside world. However, I think of economics differently – as a box of theories, evidence and mechanisms which help me make sense of the world. What I care about is: what are the facts? And: how do we explain them? I don't much care what's orthodox or heterodox. 

I’ll take an example from financial economics. We have a theory here – the capital asset pricing model – which predicts that riskier shares will on average out-perform safer ones, where risk is defined by a share’s covariance with the market (or beta). I used to believe this.

But there’s a problem with it. It’s false. We know this not because of methodological diversity but because of the facts. We have a body of evidence which shows (pdf) that less risky stocks out-perform riskier ones – in flat contradiction to the CAPM*. I stress here that it’s the body of evidence that matters. Single studies are prone to not being replicated, but the defensive anomaly has been found in different data and with different measures**. And the CAPM’s failure is now accepted even by mainstream economists: Eugene Fama and Ken French have written that it “has never been an empirical success”.

Now, maybe the CAPM is still taught uncritically in some business schools and universities. To the extent that it is, Rapley is right. But I don’t really care. The purpose of university is to acquire credentials and a grounding for later learning rather than to get a complete education.

What I do care about is why the CAPM is wrong. A big part of the story lies in market imperfections.

Researchers at AQR Capital Management point out (pdf) that many investors cannot borrow and lend freely as the CAPM assumes. They express their bullishness not by borrowing to buy the market portfolio but by buying high-beta stocks – those which are in effect a geared play on the market. This causes such stocks to be over-priced on average, because most investors are usually bullish; they know about the equity premium. The counterpart to this is that defensives are under-priced.

A second imperfection is that short-selling is a damned sight harder in practice than in theory. Even if you’re right in the long-term (a few weeks) that a stock is over-priced, margin calls can wipe you out in the near-term. This is especially true for volatile stocks.

Such frictions mean that mispricings persist. Again, we know this not because of abstract theorizing but because economists have done the hard yards of seeking the facts. David McLean and Jeffrey Pontiff show that only around half (pdf) of mispricings in the US are eliminated after they’ve been discovered. The proportion is even smaller in Europe.

What does all this tell us? In part, it leads me to side with some “heterodox” economists***. Market frictions such as borrowing and short-sales constraints (pdf) are not minor quirks that can be ignored until later in one’s studies. They are instead part of the essential nature of the beast which generate the most important thing in economics – facts.

But I also sympathize with the “orthodoxy”. Flaws with “mainstream” theory are to be found – in the first instance - not by armchair theorizing but by gathering facts.

Now, you might object that financial economics is a minor tributary of economics that nobody much cares about. For me, this is its appeal. Macroeconomics is, for many people, so tied up with their political passions that progress is more difficult.

* This isn’t the only evidence against the CAPM: there’s also momentum, among other things.

** In the day job, I’ve ran my own real-time test. I’ve simply taken an equal-weighted basket of the 20 lowest-beta stocks in the FTSE 350 and measured their performance. My chart shows that they have hugely beaten the FTSE 350.  

*** The scare quotes are because I don’t care about the distinction between heterodox and orthodox. What matters is what explains the facts.