Tim Harford's Blog, page 107

Betting against London is tempting but no sure thing

There is far more to the British capital than hot money and hot air, writes Tim Harford

Shanghai’s Pudong district soared out of a swamp in a few short years; Dubai bloomed in a desert. London is too venerable for such sudden efflorescence, but the City is trying its best to sprout skyscrapers. The infrequent visitor cannot fail to be struck by the line of new buildings striding north from the Shard at London Bridge: the Walkie-Talkie, the Cheese-Grater, the Heron Tower, Broadgate Tower. The City’s first skyscraper, then the National Westminster Tower, was completed in 1980; it took a generation to add a second, the Gherkin. Now both are lost amid a fairground of new stunt architecture. There is more to come.

Meanwhile, the only thing Londoners themselves can discuss is the rapidly inflating price of the houses they have bought – or cannot afford to buy. The joke used to be that the typical London house was earning more than the typical London household. Today it is no longer a comic exaggeration.

To add to the air of insanity, there is talk of “lights-out London”. Rich foreigners are snapping up prime property for tens of millions of pounds, digging out multistorey basements that would shame Tolkien’s Mines of Moria, and then leaving them empty while they sail around in gigantic yachts.

It is all rather unnerving. So when Cory Doctorow, an author and blogger, recently posted the question, “How would you short London?” he seemed to be raising something vital. Shorting London property is not too hard – betting against the shares of Capital and Counties or Great Portland Estates should do the trick. (I have not yet figured out how to bet against luxury hair removal salons or overpriced steak houses.) But the deeper point is not how to short London but whether it has set such a hubristic course that nemesis is inevitable. There seems to be something feverish and surreal about London these days. The contrarian in me whispers that it will all end in tears. Will it?

It is worth teasing apart different parts of the madness. The idea of lights-out London can be dispelled by five minutes walking down Oxford Street, or a single attempt to make a tube journey between the hours of 8am and 9am. London is heaving: the shops are full, the pavements are spilling over, the streets are clogged with traffic and the public transport system is crammed. Some foreigners are buying second homes in central London but the numbers seem to be very low. Soho is in little danger of becoming a ghost town.

The skyscrapers are a separate facet of the London craze. One can quibble with the selfish, attention-grabbing architecture. Even if the Walkie-Talkie with its heat-focusing curved sides has stopped destroying nearby property, it is a bully of a building that will do London no favours.

Yet the scale of the building effort itself is less insane than it might seem. London is making up for lost time. New Yorkers would chuckle at the idea that the Heron Tower alone was plenty big enough for one decade’s worth of growth. The housing bubble looks more serious. One measure of that is the gross rental yield, which – reckons property search engine Home.co.uk – is below 3 per cent in the prime west London postcodes, and below 5 per cent in much of the rest of the capital. Those yields look like a recipe for trouble when interest rates rise – which they will.

But what do I know? I have been convinced that London’s housing is overvalued for at least a decade. The longer the boom continues, the more I doubt myself – even if the evidence of unsustainability just gets stronger.

Robert Shiller, one of this year’s Nobel memorial prizewinning economists, has long been my guide to bubble spotting. Perhaps in the hope of teasing fellow economists he has taken to treating a bubble as a condition best diagnosed with a psychiatrist’s checklist: “Sharp increases in the price of an asset like real estate or dotcom shares; great public excitement about said increases; an accompanying media frenzy …” Tick, tick, tick.

The most interesting question is the hardest to answer: is London’s innovative and cultural dynamo in danger of slowing down? Perhaps rich Russians and Saudis will live in Chelsea, their needs taken care of by armies of Poles commuting in from Bromley and Walthamstow, while French and American bankers will sleep four-hour nights in luxury flats in Canary Wharf and work flat-out the rest of the time. The entire mega-city, in this scenario, would contribute to the UK only in the way that an oilfield in the Thames Estuary would. The capital would be a plug-and-play, could-be-anywhere financial hub grafted on to a London experience theme park for visiting billionaires.

Perhaps. I am struck by how heavily this dystopian vision leans on the idea that foreigners are to blame – an idea that always seems to engender panic and shut down the critical faculties. “It’s foreign investment, buy-to-lets,” one estate agent recently told a worried Guardian columnist. But that does not mean Brits cannot live in London. They can – but often as tenants of a foreign landlord who may well have overpaid.

It is possible for a neighbourhood to become a victim of its own success. Low rents attract artists, new businesses, experimenters and risk-takers. The neighbourhood becomes cool; rents rise. Eventually only middle-aged, middle-class squares live there. (Or – gasp! – rich foreigners.) But it is hard to see this applying across an entire city. Some fret that Manhattan is becoming a bore. It still seems passably diverting to this tourist, and even if Manhattan is tedious, Brooklyn is picking up the slack. As in New York, so in London: if Shoreditch becomes too pricey for bearded hipsters making artisanal pickles, there’s always Bow or Clapton Pond.

London is too economically diverse and too socially cosmopolitan to turn into a high-rent economic desert. As Europe’s only English-speaking world city – apologies to Amsterdam, Birmingham, Dublin, Manchester and Glasgow – it is a magnet for English-learners and English-speakers from across the EU. It is a centre not only for finance and tourism but education, media, technology, food, design and the arts. It is a hub for the British and a gateway to Europe for the rest of the world. The housing bubble looks likely to burst. But there is more to London than hot money and hot air.

Also published at ft.com.

How did space become junk’s final frontier?

‘Space hasn’t been made impassable by debris just yet. There’s quite a lot of room, after all’

I don’t think I’m spoiling too many surprises when I reveal that the plot of the film Gravity, a low-orbit spectacular starring Sandra Bullock and George Clooney, involves spacecraft getting hit by space debris. It’s a less fanciful premise than it might seem: in 2009, two unmanned satellites hit each other without warning, nearly 800km above Siberia.

That collision heralded a serious problem, first flagged in 1978 by Donald Kessler, then an astrophysicist at Nasa. The concern isn’t that space debris will rain down on us here on Earth: it’s that it will stay up there in space.

The two satellites that collided, Cosmos-2251 and Iridium-33, weighed almost a ton and a half altogether. The result was at least a thousand fist-sized chunks of metal, any one of which could destroy a further satellite, and produce hundreds of further chunks. It takes time for these chunks to fall out of orbit.

What worried Kessler – and still does – was the prospect of a chain reaction. Too much debris in orbit would make it impossible to launch the satellites that have become an indispensable part of life back on Earth.

Nasa is tracking 21,000 pieces of junk 10cm across or bigger – like small cannonballs. In low Earth orbits, they are travelling at about 7km a second (25,200km/h). But space hasn’t been made impassable by debris just yet. There’s quite a lot of room up there, after all. Low Earth orbits are common but include a variety of altitudes, so objects have plenty of ways to fail to hit each other. Geosynchronous orbits, popular with communications satellites, must be exactly 42,164km from the centre of the Earth. But satellites that far out share more than 22bn sq km of space.

Still, some orbits are more crowded than others; more collisions are surely just a matter of time. That was the opinion of a 2011 report from the National Academy of Sciences, “Limiting Future Collision Risk to Spacecraft”, which argued that there is already enough junk crashing into other junk that the problem will worsen even if there are no further launches.

Deliberately moving the debris somewhere safer seems possible, but pricey. It’s expensive to tidy up a satellite – or to design one that tidies itself up – and while the benefits of doing so are widely shared, the costs are not. So the clean-up doesn’t happen.

The regulation of satellites is no simple matter: Cosmos-2251 was launched by the Russian military; Iridium-33 by a US corporation. The single largest space-junk incident was in 2007, when the Chinese military blew up a satellite just to show that it could. The regulatory authority capable of dictating to all three of those parties does not exist. (The United Nations did issue voluntary guidelines in 2010.)

Economists such as Molly Macauley of Resources for the Future, a think-tank, have been pondering this problem for some time. The obvious economic solution, recently revived by three researchers, Nodir Adilov, Peter Alexander and Brendan Cunningham, is a tax on new satellite launches. Macauley has proposed linking the level of this tax to the design of the satellite – safer designs would attract a lower charge. Another possibility is that satellite operators would put down a deposit, to be refunded once the obsolete satellite had been pushed into a safer orbit.

This is one of those all-too-common situations when it is easier for economists to announce the optimal policy than it is for politicians to implement it. As with climate change, there’s a burden to be shared here, a threat of uncertain magnitude, and plenty of opportunity for free riding.

Yet this is a far cheaper problem than climate change, with a smaller number of decision makers. It should be easier to reach an agreement on space junk than on greenhouse gases. Alas, that is a not a very encouraging comparison.

Also published at ft.com.

Swallow your contempt – Wonga is the symptom, not the problem

Disdain is no guide to regulating a socially useful sector, writes Tim Harford

I believe it was December 1980 when my father sat down with me and warned me gravely that the central heating had broken down. It would cost money to repair, money that simply could not be summoned out of thin air. I should not count on getting the toy I wanted (a Lego Space Cruiser, in case you were wondering). I considered myself duly warned.

Such a conversation is hard to imagine today. Why empty such a big bag of sadness over the head of a seven-year-old Lego fanatic? Why not, instead, log on to Wonga.com and borrow a cheeky £150, just until payday at the end of December? Wonga would charge £27.99 interest, plus a £5.50 fee – is £33.49 really too big a price to pay for the happiness of a young boy?

But the story will not end there, will it? The total repayment of £183.49 after 18 days might not sound such a lot, but it is an effective annual interest rate of almost 6,000 per cent. At 6,000 per cent a year, the money to buy a pricey toy one Christmas will balloon into a debt that could have paid for a small car by the year after – and a large house the year after that.

That would seem usury enough. But there are more serious dangers lurking for an unwitting borrower. Wonga charges £30 for late payment, substantially increasing the cost of the loan for the most vulnerable. At that point, the hapless borrower’s credit rating will start to slide, and he will find himself unable to tap into more conventional sources of credit.

It is a minor tragedy: the journey that begins by buying the toy for the much-loved child ends not long afterwards with a treacherous plunge into financial ruination.

Wonga has found itself surrounded by critics, naturally enough. Justin Welby, the Archbishop of Canterbury, announced this year that he would compete them out of existence. (That’s a tough proposition: you don’t compete with Wonga on price but by offering faster access to more convenient, less-scrutinised loans.)

A parliamentary select committee toasted representatives of the payday loan industry this week. When Ed Miliband, the Labour leader, sought a phrase to summarise all that is wrong with life in Britain under his political opponents, he settled on “the Wonga economy”. But there was worse: financial guru Martin Lewis, a man with a knack for attracting the spotlight, condemned payday loan companies for “grooming” young people with catchy advertisements on children’s television channels. When your critics borrow language that is normally reserved for sexual abusers of children, you have an image problem.

This conversation has turned into the country’s favourite pastime: a witch hunt. Little good will come of it.

Start with Wonga in particular. It is suffering the fate of many industry leaders: precisely because it is a familiar brand, critics attack it for what it symbolises more than for what it does.

In the 1990s, Nike found itself shouldering the blame for sweatshops everywhere; in the 2000s, Starbucks came to represent the oppression of coffee growers; more recently, when activists wanted to raise concerns about Chinese labour conditions, they went for Apple. This is understandable as a campaigning strategy but makes for poor policy.

Some of the specific allegations against Wonga look hysterical. Wonga is not trying to sell loans to five-year-olds. The company advertises on children’s TV, one surmises, because parents of young children are prime candidates for emergency loans. That is not pretty, but let’s call a spade a spade rather than calling it a cluster bomb.

Nor could Wonga be accused of lacking transparency. The fees, the four-figure interest rates, the late payment charges, the impact on credit ratings: everything is laid out on the website in the simplest and clearest terms imaginable.

No high-street bank comes close to this clarity, and an unauthorised overdraft may cost far more than the loan that prevents that overdraft. Outcompeted on convenience, on comprehensibility and perhaps even on price by the likes of Wonga, Britain’s banks should hang their heads in shame.

But while critics of payday lending may content themselves with attacking Wonga, its defenders cannot merely protest that it is the best of a bad lot. The real question is what to do about payday lending in general. The focus on “grooming” or deceptive terms and conditions allows us to look away from the real problem – which is that an adult can be presented with unambiguous facts about a payday loan but still do something she comes to regret.

The twist is that a payday loan can do real good, as a cash injection that helps avoid far more serious financial consequences, such as the loss of a job because the car broke down or penalty charges for failing to pay a bill on time. A randomised trial conducted in South Africa showed that this was not just a theoretical possibility. The experiment randomly approved or rejected applications for loans at an annual percentage rate of 200 per cent. Those who received one ended up better off than those rejected.

This is the problem. One person uses a payday loan to buy the suit he needs for the job interview, and gets the job; another person uses a payday loan to buy lottery tickets. I know of no law that can allow one case and forbid the other. Transparency and fair dealing is no guarantee of happy outcomes. A cap on interest rates will do no good, because for small short-term loans the interest rate is not a meaningful measure of what the loan costs.

I view the payday loan industry with disdain. I cannot imagine using it myself and would be horrified if I knew that a close friend felt the need to turn to Wonga for help. But my personal contempt for the industry, from my position of privilege, is not much of a guide to how we should regulate it.

The world is full of products that people demand yet seem harmful, from cigarettes to lottery tickets. That is not capitalism gone mad: it is simple evidence of human frailty. I sympathise with Mr Miliband’s discomfort at living in the “Wonga economy”.

But Wonga did not create modern Britain; modern Britain created Wonga.

Also published at ft.com.

What’s so scary about insider trading?

‘The awkward truth about the practice is that it’s far from clear that it should be illegal’

It was Halloween on Thursday, so let’s meet a frightening ghoul who haunts our financial markets: the insider trader. The Halloween metaphor is not mine but that of economist Donald Boudreaux, who asks if the insider trader is a genuinely dangerous monster or a comical apparition in a fright mask, fit only for the scaring of children.

Attacking insider trading has a singular advantage for regulators and journalists alike: short of swiping money from the cash register, it is the simplest financial crime to understand. The frauds perpetrated at Enron or, a generation earlier, the Equity Funding Corporation, defy any simple explanation. Insider trading – making money by trading on confidential information – is an easy sin to attack. Yet the awkward truth about the practice is that it’s far from clear that it should be illegal.

A school of thought on the libertarian wing of economics has long argued that insider trading is at worst harmless and perhaps even beneficial. The most famous proponent was the late Milton Friedman; more recently the likes of Boudreaux, a professor at George Mason University, have called for its legalisation.

The case for legalisation has several pillars; let’s consider three. First, despite intensive monitoring, it’s hard to detect and even harder to prove. Much insider trading clearly occurs without detection – why else does the share price of acquisition targets tend to rise sharply before the acquisition is announced? And people with inside information can often profit simply by not taking action when the uninformed take actions they later regret.

The second point in favour of legalised insider trading is that market prices are supposed to reflect all available information, the better to allocate capital. Insider trades simply hasten that process. This argument is not hugely persuasive on a day-to-day basis but there’s certainly a case that insiders at Enron or the Equity Funding Corporation might have exposed misdeeds sooner if they had felt able to profit by short selling the stock. (A footnote: Ray Dirks, the analyst who did a great deal to expose the Equity Funding scandal, was pursued for insider trading of Equity Funding stock before being acquitted by the US Supreme Court.)

The final defence of insider trading is that it’s a victimless crime: if you want to sell your shares in Tim Harford Corporation, and I know that record profits are about to be announced, then my swooping in to buy your shares does you no harm: you would have sold them anyway, and you received a better price because I was willing to buy.

The common sense reason to ban insider trading – that it just doesn’t seem fair – is flimsy. So is the argument that small investors won’t play the game if they feel it’s rigged: small investors are at a disadvantage, anyway, and should see that disadvantage with clear eyes.

But there are two reasons to ban insider trading that seem compelling, neither of which receive enough attention in this debate. The first is that insider trades raise the cost of being a market-maker. When secret good news is in the air, insiders will snap up stock. Market-makers will be left holding none, just as the price is rising. Conversely, insiders will dump shares on market-makers just before disaster is about to be revealed. The spreads that market-makers offer must be wide enough to reflect this risk; consequently, we all pay more because of insider trades.

The second worry is that if managers can trade easily on inside information, they have an incentive to take big risks. If you could place bets after the roulette wheel had stopped spinning, you’d spend your days down at the casino. Even if insider trading might make financial markets more efficient, it might also encourage reckless decisions in the rest of the economy. That possibility alone is enough to give me nightmares.

Also published at ft.com.

Why can’t banking be more like baking?

The last time a bread maker laid waste to the City was 1666, writes Tim Harford

“It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest.” Adam Smith, The Wealth of Nations

A tender medallion of steak, a foaming pint of bitter and a crusty roll still hot from the oven – no wonder that Adam Smith chose an alliterative trio of artisanal food providers to make his point about the benefits of capitalism. If he had chosen a junk bond salesman, a fund manager, and a quantitative analyst, wielding a Gaussian copula in an effort to price a synthetic credit derivative, his defence of the market mechanism might not have resonated down the centuries in quite the same way.

Smith’s point was a good one. We are unlikely to give our custom to butchers who poison us, brewers who serve foul beer or bakers who overcharge; food sellers find it profitable to serve decent food at reasonable prices. The system needs some oversight – hygiene inspectors, trading standards officers, the Competition Commission – but the main engine of quality is the market mechanism. People prefer cheap and delicious food to food that is pricey and tastes horrid – and that fact alone delivers more than regulators ever could.

For some reason, that does not seem to be true of financial services. No food regulator has ever described bakers as engaged in “socially useless” activity, a term Lord Turner levelled at the industry in 2009, when he was chairman of the UK’s Financial Services Authority. Mark Carney, the governor of the Bank of England, recently looked forward to the UK banking sector becoming even larger and more “vibrant”. He added that some would “recoil in horror” at the prospect, which some already have.

Surely nobody has ever recoiled in horror when a French technocrat expressed the hope that France would produce and sell lots of wine. Or when a Japanese minister wished the Japanese car industry well. There is something different – something sinister – about the financial services industry these days. So what is the difference between the baker and the banker?

The first difference is competition. This is partly about pluralism: there are lots of places to buy bread, but not so many to get a mortgage, or for that matter to underwrite an initial public offering. It is a devil of a job to set up a bank – and even harder to attract stuck-in-the-mud customers.

More fundamentally, many consumers of financial services cannot tell a good product from a bad one. The spectrum runs from payday loan customers unable to grasp quite what the loan is going to cost them, to people saving for a pension amid a fog of confusing charges, to clients of Goldman Sachs who bought into a subprime mortgage deal called Abacus 2007-AC1. (They did not realise that Abacus had been constructed with input from the Paulson & Co hedge fund, which was betting that the entire thing would implode.) It seems nobody is safe.

In a speech about the UK’s asset management industry this week, Clive Adamson of the Financial Conduct Authority quoted economist and Nobel laureate George Akerlof: “In a market plagued by asymmetries of information, the quality of goods will decrease and the market will come to be dominated by crooked sellers and gullible or desperate buyers.” Mr Adamson added that he did not mean to apply this description to UK asset managers; however it is hard to see why else he said it.

At the same event, Mr Adamson’s boss, Martin Wheatley, fired a shot across the UK asset management industry’s bows – although even trying to understand quite what Mr Wheatley is worried about will have the ordinary punter’s brain bleeding out of his ears. In a nutshell, some of the people who buy, sell and analyse shares are paying some of the people who run companies to meet up with some of the people who pick the stocks that go into the investment funds that your pension fund is buying. Mr Wheatley thinks that is OK, but the price tag for all this needs to be more transparent. (No, I don’t understand either.)

It is a safe bet that when the regulator cannot even clearly explain the commercial activities that are worrying him, the market has become too complex and opaque to deliver happy results.

If all that was wrong with finance was that customers at every level were repeatedly being ripped off, that would be one thing. But it gets worse. Income from banking is highly concentrated. When an economy – such as the UK’s – becomes highly dependent on financial services the effect can be a little like the phenomenon of “Dutch disease”, which afflicts oil-producing countries.

If a nation exports a lot of hydrocarbons, their exchange rates may appreciate, which means that it is difficult for those petro-states to compete doing anything except selling oil. As a result their manufacturing and industries decline. Similarly, it is difficult for bank-led economies to compete doing anything except selling financial services. And this matters if the employment in these sectors is slim. It would be going too far to suggest that either the City of London or Britain’s North Sea oilfields are a curse – but they are not an unadulterated economic blessing, either.

Then there is the fact that banking has a tendency to blow up, causing tremendous collateral damage. The last time a baker laid waste to the City was 1666, when one accidentally triggered the Great Fire of London; bankers seem to be able to perform the trick more frequently.

Mr Carney, and other financial regulators across the world, are forced to deal with a sector that combines the most unattractive features of the oil industry (well-paid jobs inflate the currency), the nuclear industry (occasional blow-ups and meltdowns) and the second-hand car industry (enough said).

What can be done? A wise course of action is to look for structural reforms that will make banking function a little more like baking. But there seems to be something irreducibly problematic about finance. I wonder if even Mr Carney will be able to make the market for pensions work like the market for croissants.

Also published at ft.com.

How to make money from a Nobel cause

‘It’s hard to beat the market, and you should probably be suspicious of people who claim to be able to pull off the trick’

At last, they’ve given out a Nobel memorial prize in economics for something that could make money for you and me. Eugene Fama and Robert Shiller have, between them, saved me many thousands of pounds. (Lars Peter Hansen, who shared this year’s prize with Fama and Shiller, developed statistical techniques that, I’m sad to report, have never made me a penny.)

There have been practical prizes before, of course. Only last year, Al Roth shared in the prize, in part for his work designing ways in which possible kidney donors and recipients could be matched with each other for maximum advantage. Ronald Coase, who won in 1991 and died this September, inspired markets to control pollution. And Thomas Schelling, a winner in 2005 for his wily and practical take on game theory, arguably helped prevent the cold war turning into something more catastrophic.

But hard cash in my pocket is something else. And the odd thing is, Fama and Shiller disagree with each other.

Fama’s most famous contributions have been in refining and testing the idea of efficient financial markets. The efficient markets hypothesis, or EMH, is much maligned, so let me state it in the form that has spared me anxiety and saved me money over the years: it’s hard to beat the market, and you should probably be suspicious of people who claim to be able to pull off the trick. As Fama himself told me in a rare interview for the BBC last week: “People spend lots of money … trying to hire managers that can pick stocks although the evidence says quite conclusively that that is probably impossible to do.”

But let’s consider two reasons why we should treat the EMH with scepticism. The first is that it may have led regulators astray by encouraging them to leave markets alone when they should have intervened. Maybe the EMH is a better guide for investors than it is for regulators – although I feel allowing excessive leverage was the ultimate regulatory sin before the crisis, and one not closely connected with the EMH.

But a second reason to disbelieve the EMH is the experience of the dotcom and subprime bubbles. “I don’t even like the word,” says Fama. “If your meaning of the word bubble is that prices went up and then went down, that’s fine. But if your meaning of the word is that prices went up and then it was predictable that they would go down, then I don’t think there’s any evidence to support that.”

Shiller would disagree. He is the pioneer of “behavioural finance” – putting psychological factors back into a study of market behaviour. And a single graph drawn by him saved me from being swept up in the dotcom mania.

Shiller simply plotted a standard measure of stock market valuation – the price/earnings ratio – but rather than looking at a single year’s earnings he looked at average earnings over a decade. The resulting graph showed a huge peak in 1929 – just before the Wall Street crash – that is unique in market experience between 1880 and 1995. Then in the late 1990s, a far larger peak built. In 2000, I showed this graph to many people – and stayed out of the market. It saved me a lot of money.

Of course, it is hard to reconcile Shiller’s conclusions with Fama’s. But when I spoke to Shiller last week, he summed up the tension rather well: “It’s a little bit like religion, you know. There’s all these different sects and, when you look at them in the whole, it doesn’t seem to make any sense, they contradict each other so fundamentally. But maybe there’s some wisdom about living that comes out of all of them.”

That may sound a little far out but in my experience it has proved absolutely true.

Also published at ft.com.

Teachers could predict exam grades better – but not much

Teachers forecast the right results nearly half the time. Few professions can boast such a record

“Half of A-level grade predictions prove to be wrong, figures show, raising questions about the use of predicted grades in university applications. Just 48.29 per cent of the grades forecast by teachers last year were accurate, according to statistics published by OCR, one of England’s biggest exam boards.” – The Guardian, October 22

That’s bad.

Is it? There are seven grades available, including the U grade (fail, to you and me) and the new A*, so the chance that a dart-throwing bonobo would pick the right grade is about 14 per cent. Cambridge Assessment, the group that analysed OCR’s exam statistics, reckons teachers are accurate almost 50 per cent of the time. Some 92 per cent of forecasts were within one grade of the result. Better than any bonobo could achieve.

Am I supposed to be impressed that teachers are better forecasters than dart-throwing bonobos?

It impresses me. Few other professions can boast such a record. The psychologist Philip Tetlock, in a landmark study of expert forecasting, once gathered 27,450 quantifiable forecasts from about 300 experts. Over two decades he was able to observe how good those forecasts were. In each case he grouped the range of possible outcomes into three roughly equal ranges chosen based on historical outcomes.

You’re going to tell me that the experts fared poorly against the bonobos.

I am. And Professor Tetlock wasn’t focused on “random-walk” processes such as the movement of stock prices; he was asking for predictions on political and economic outcomes that were, in principle, predictable. The experts, whether journalists, diplomats or academics, fell short. No doubt forecasting exam grades is a simpler matter than making political forecasts, but picking the right grade almost half the time is no bad performance.

But could it be better? I note that grammar and independent schools managed to deliver more accurate forecasts.

Fractionally more accurate. But they had an easier job. The top grades were more likely to be forecast correctly, and I’m afraid top grades are disproportionately the preserve of independent and grammar schools. Teachers at these schools were also less likely to be optimistic. One imagines darling Felix and Felicity drifting into Oxbridge on a wave of effusive fluff from their teachers, but students from independent schools are almost three times as likely to get at least three A grades as those from state schools, at which point it becomes hard to deliver over-optimistic predictions.

But there is a general tendency for teachers to deliver rose-tinted grade forecasts, isn’t there?

Yes. Erroneous forecasts were three times as likely to be too high as too low. That might not be a problem – students whose exam results fail to live up to teachers’ promises are often turned away from the first-choice university to find a place somewhere less competitive. Far rarer is the process of “adjustment”, where a student’s final grades are better than predicted and he or she manages to win acceptance to a more prestigious course than originally admitted for. So teachers may be right to err on the side of optimism.

Sounds like cronyism.

Well, teachers’ predictions can’t match Wall Street analysts’ earnings forecasts for optimism. In the past 25 years, analysts have on average been too optimistic 22 times and too pessimistic three times.

Nobody takes Wall Street seriously any more. But exam forecasts are important: universities use them when making offers.

Universities do take other factors into consideration, but you are right. The situation is hardly reassuring. There is one consolation, though: the results being predicted here aren’t flawless measures of student ability. They’re just a snapshot of how a student coped on the day with hay fever, menstrual cramps or just an unfortunate choice of questions. Teachers may not forecast the vicissitudes of exam season correctly – but who’s to say their predictions may not be just as good, or better, indications of how talented students really are?

So all is well.

Perhaps. A final note of caution. These forecasts were submitted to OCR as late as May, four months after forecasts made for university admissions. For all I know, the forecasts that really matter – those made for university admissions – are optimistic beyond the dreams of Wall Street.

Also published at ft.com.

Unemployment stats aren’t working

‘The unemployment rate is the result of millions of individual stories of finding and losing jobs’

The unemployment rate seems a thoroughly straightforward economic statistic. It’s currently 7.7 per cent in the UK – which means that for every 12 lucky souls with a job, there’s an unlucky 13th looking for one.

The reality of the labour market is a little more complex. There are, for example, three times as many “economically inactive” people of working age (defined archaically as 16-64) as there are unemployed people. These are people who do not have jobs and, in principle, do not want them. If you’d like to understand the distinction between them and the unemployed, the unemployed are both available for work and actively looking for it; the economically inactive are not. It is not a distinction that can easily be observed by a government statistician.

Consider a 20-year-old undergraduate en route to a solid engineering degree. She’s actively looking for part-time work in a bar or restaurant to help keep her debt under control; she can’t find that kind of work, so is relying on student loans to pay the bills. Meanwhile the 50-year-old former coal miner with health problems is on incapacity benefit: he wants a job but with little optimism that he will find one, he has stopped pretending to look. Common sense suggests that the middle-aged man is unemployed, and the young woman is not. The Office for National Statistics would reach the opposite conclusion.

Perhaps the strangest thing about the unemployment rate is the impression it gives of stability. Over the course of the recent severe recession and subsequent doldrums, the number of unemployed people rose by more than a million. But the number of jobs that have been lost is approaching 20 million – not far off the size of the entire British labour force.

What’s going on? Churn. In a typical three-month period in the UK, about one employed person in 80 leaves or loses his or her job. (That is an understatement: it does not include people who immediately step into new jobs.) Over the same period, one in three or four unemployed people finds a job. Even a severe recession only has a modest effect on these numbers: the quarterly job-loss rate briefly hit one in 50 at the depth of the 2009 recession; during the years of flatlining that followed, it was one in 70. The job-finding rate has sunk somewhat, but gently.

The odd truth is that almost all of the people who lost jobs during any particular quarter of the recession would have lost them anyway. Michael Blastland and David Spiegelhalter, in their recent book about risk, The Norm Chronicles, put the additional risk of unemployment every three months during the no-growth years as one extra person in 500.

The recession is no illusion, of course – if the chances of losing a job rise a little and the chances of finding a new one fall a little, over time the ranks of the unemployed will swell alarmingly. What is an illusion is the idea that economic booms provide substantially greater job security than recessions. They do not.

The unemployment rate is the result of millions of individual stories of finding and losing jobs. There is more than one way, then, to get the unemployment rate down: reduce the rate at which old jobs disappear, or increase the rate at which new ones are created. It isn’t hard to see which of these two options is likely to go hand in hand with a more dynamic, creative and higher-growth economy. Nor is it hard to see why so many workers naturally value protecting the job they already have, rather than some abstract promise of a new job in the future.

Creating jobs is not the same thing as making people feel secure in their jobs – not the same thing at all.

Also published af ft.com.

Patience pays off for long-game investors

Stockpickers who persevere with their ‘pets’ are rewarded when they perform impressive profits

“Neil Woodford, one of the colossi of British fund management, is leaving Invesco Perpetual after a quarter of a century to pursue his conviction that modern investment has become too short-term.”, Financial Times, October 15

One of the colossi?

I know, I know. I’d have plumped for one of the colossoi myself. Or one of the colossuses. Or maybe one of the giants.

I wasn’t being pedantic. I was wondering whether there really are any colossi in stockpicking. Wasn’t the Nobel Prize in economics given this week to Eugene Fama, who showed you can’t beat the market?

Speaking of pedantry, it’s not a Nobel Prize. It’s best described as the Nobel Memorial Prize. And, yes, Professor Fama did show you can’t beat the market. But whether or not he’s correct, investors believe in star stockpickers, from Benjamin Graham and Warren Buffett to Anthony Bolton and Mr Woodford. So there’s likely to be a stampede for the exit at Invesco Perpetual, which could be hard to manage.

Do you think Mr Woodford is merely the beneficiary of a lucky streak, then?

It’s devilishly hard to know. His record is excellent – over the past 25 years, the market as a whole would have turned £100 into £1,000; Mr Woodford would have turned it into £2,300. A modest degree of outperformance, delivered with reasonable consistency over a quarter of a century, will do that to your portfolio. Maybe those results are a matter of luck – there are, after all, many fund managers in the world, and somebody has to be the best. But maybe it’s real skill. Quite possibly both. One of Prof Fama’s findings was that smaller companies, with low market value relative to book value, have tended to outperform the market as a whole. This may be because such companies are riskier and the high expected return is compensation for taking that risk. It turns out that such companies have played a significant part in Mr Woodford’s success.

It might also be that he takes an interest in the companies he invests in.

He’s certainly had substantial shares in some of them for a very long time. This is similar to Warren Buffett’s approach, and is reminiscent of John Maynard Keynes’ behaviour while investing on behalf of King’s College, Cambridge. Keynes invested for the long term in a few favoured companies, which he called his “pets”. These were extremely profitable – in contrast to the investments he made earlier in his career, when he tried to deploy his knowledge of the business cycle to time his trades.

Timing the market didn’t work out for him?

No. Buffett-style value investing did very well, though.

But this long-term vision isn’t just an investment strategy, is it? There’s a sense that stock markets are insanely short-termist these days, and Mr Woodford’s activist approach and “buy-and-hold” tactics are good for capitalism as a whole.

It’s curious. One of the points of an equity market is that, by making shares easy to trade, it allows investors to take a long-term view of profits. As a shareholder in a non-traded company, you care about when it makes its money because it directly affects your own cash flow. But if you hold shares in a publicly traded company then you don’t need to worry about the precise timing of profits: you can cash out at any time by selling to someone who is able to wait.

I understand the theory but things are different in practice, aren’t they?

It seems so. John Kay, an FT columnist who chaired a government-commissioned review into equity markets, felt many British companies were too focused on short-term returns. The reason for that was the behaviour of Mr Woodford’s competitors and all the other intermediaries that stand between company managers on one side and savers and pensioners on the other.

But Mr Woodford has directly benefited from a long-term perspective – as did Mr Buffett and Keynes. Why don’t other investment managers acquire a few “pets”, if it’s so good for business?

That’s a good question. We are unwittingly rewarding investment managers for sticking with the crowd and following some particular benchmark. More independent-minded managers are taking a big risk – if their decisions don’t pay off at first, they are unlikely to get another chance. Even Mr Woodford has had bad years: if they had come early in his career, I wouldn’t now be talking about him.

Also published at ft.com.

Dr Osborne’s bitter medicine is no cure

The chancellor’s claim that Britain’s slow recovery vindicates his policies is drivel

‘The International Monetary Fund has dropped its criticism of George Osborne’s austerity drive after revising up the UK’s growth forecast by more than any other leading economy.’ Financial Times, October 8

Good news for the chancellor, then.

He’s had a pleasant week. The independent Office for Budget Responsibility also said this week that his austerity policies were “not the most obvious reason” that economic growth had been so weak until recently.

Pretty embarrassing for his Keynesian critics, eh?



That depends on whether his Keynesian critics are embarrassed by the sneers of cloth-eared nincompoops or not. I don’t see how any thoughtful, open-minded person can believe that Mr Osborne’s critics have been proved wrong by events.

How so? Growth is back! Isn’t that an endorsement of government policy?



OK. I’ll use small words to explain this. Let’s say that a man gets sick. He picks up some pills from the chemist.

What sort of pills?

Antibiotics.

That isn’t a small word.

Oh, shut up. So our man begins taking the antibiotics, but almost immediately gets an appointment with Dr Osborne, who declares the antibiotics a quack treatment. Dr Osborne confiscates them and instead prescribes prolonged bed rest. Our friend is sick for a long, long time. But recently, he’s been feeling better. He’s out of bed, pottering around and thinking about taking a shower, getting dressed and heading out for a walk. Dr Osborne claims vindication. He says the quacks who suggested antibiotics were wrong because the man’s getting better. But this is the argument of a fraud or a fool – or, of course, a politician. Sick people usually get better. Sick economies usually get better, too. That fact, enormously welcome though it is, proves nothing.

Mr Osborne has said that the opposition couldn’t explain why the economy was recovering despite continued austerity.



That’s drivel. No sane person would claim that austerity – a catch-all term for higher taxes and lower government spending – is the sole cause of economic performance. A simple textbook model would suggest short-run economic performance is determined by demand while long-run economic performance is determined by supply: of the British people, their skills, the buildings, infrastructure, equipment and institutions that surround them. We’d expect austerity to dent demand in the short run – two or three years. In the long run, as Keynes reminded us, we are all dead. This simple model says that Mr Osborne’s economic vandalism can hold the economy back for a long time, but not forever.

I’m sure there are kinder ways to characterise the chancellor’s policies.

It’s simple logic. Austerity doesn’t explain everything about the recession, but that doesn’t mean it explains nothing. Let’s be clear: the UK economy is suffering the slowest recovery of gross domestic product since credible records began by a colossal margin. Sixty-six months after each began, in the awful recessions of the 1920s, 1930s, early 1970s and early 1980s, GDP had recovered to 5-8 per cent above the pre-recession peak. This time, we are still about 2-3 per cent below it. We are looking back – I hope – at an unprecedented economic catastrophe. The OBR says Mr Osborne’s austerity wasn’t the only cause – or indeed the largest cause. He didn’t cause the financial crisis any more than Dr Osborne infected our patient. Our sick man had many things wrong with him and the antibiotics would have cured only one of the conditions. But it’s cheeky of the chancellor to claim the limpest recovery in British history vindicates him.



We don’t know that for sure – not like we know that antibiotics kill germs.

True. But we’re reasonably confident austerity damages economies in recessions.

You’re talking as though Mr Osborne had a choice. Our deficit was vast and it’s still big; he couldn’t have risked a debt crisis.

Markets – aided by the Bank of England, with unlimited ability to print sterling – have been happy to buy UK government debt. They might not have been so sanguine if the 2010 election had delivered a lame-duck minority government. But with a solid coalition Mr Osborne could have taken credible steps to encourage spending during the slump while charting a course to long-term fiscal rectitude.

Why didn’t he do that?

Political timing. Mr Osborne’s economic mismanagement has cost a lot of people their jobs. It may well keep his own secure.

Also published at ft.com.