Tim Harford's Blog, page 132

Screening: It's all in the numbers

Bayesian analysis questions how we understand the notion of 'probability' and how we update our beliefs in light of new information

You're a woman in her early fifties. You're invited to a breast cancer screening unit, and you go along hoping for the all-clear. After all, 99 per cent of women your age do not have breast cancer. But … the scan is positive. The screening process catches 85 per cent of cancers. There is a chance of a false alarm, though: for 10 per cent of healthy women, the screening process wrongly points to cancer. What are the chances that you have breast cancer?

Over 50,000 British women face this awful question each year. I first encountered it – in a less alarming context – as an undergraduate economist. And I was in the audience recently when David Spiegelhalter used it as an example in his Simonyi Lecture, "Working Out the Odds (With the Help of the Reverend Bayes)". The numbers approximately reflect the odds faced by women who go for breast cancer screening. And the answer – courtesy of the Reverend Bayes in question, who died 250 years ago – is surprising.

Bayes was concerned with how we should understand the notion of "probability", and how we should update our beliefs in light of new information.

A Bayesian perspective on the apparently grim screening result tells us that things are not as bad as they seem. The two key pieces of information point in different directions. On the one hand, the positive scan substantially worsens the odds that you have cancer. But on the other, the odds are worsening from an extremely favourable starting point: 99 to 1 against. Even after the positive scan, you still probably don't have cancer.

Imagine 1,000 women in your situation: 990 do not have cancer, which means we can expect 99 false positives, far more than the 10 women who do have cancer. This is why any apparent sign of cancer should be followed up with further tests in the hope of avoiding unnecessary treatments. The chance that you have cancer is 9 per cent – up dramatically from 1 per cent, but with plenty of room for optimism.

None of this proves screening is pointless. It can save lives, but it raises dilemmas. The UK's breast cancer screening programme is currently under review. A systematic analysis published by the Cochrane Collaboration found that for every woman who had her life extended by early detection and treatment, there would be 10 courses of unnecessary treatment in healthy women, and more than 200 women would experience distress as the result of a false positive.

Bayesian reasoning has implications far beyond cancer screening, and we are not natural Bayesians. Daniel Kahneman, a psychologist who won the Nobel memorial prize in economics, discusses the issue in a new book, Thinking, Fast and Slow. I recently had the opportunity to quiz him in front of an audience at the Royal Institution in London. Kahneman argues that we often ignore baseline information unless it can somehow be made emotionally salient. New information – "possible cancer" – tends to monopolise our attention.

Another example: if somebody reads the Financial Times, should you conclude that they are more likely to be a quantitative analyst in an investment bank, or a public sector worker? Before you leap to conclusions, remember that there are six million public sector workers in the country. Base rates matter.

Sometimes there is no objective base rate and we must use our own judgment instead. I think homeopathy is absurd on theoretical grounds; others find it intrinsically plausible. Bayesian analysis tells us how to combine those prior beliefs – or prejudices – with whatever new evidence may come along.

Whenever you receive a piece of news that challenges your expectations, it's tempting either to conclude that everything has changed – or that nothing has. Bayes taught us that there's a rational path between those two extremes.

Also published at ft.com.

You're wrong – we are all wealth creators

"We will set public sector pay awards at an average of 1 per cent for each of the two years after the pay freeze ends . . . while I accept that a 1 per cent average rise is tough, it is also fair to those who work to pay the taxes that will fund it."

The chancellor's autumn statement

"Did you hear about that 1 per cent pay rise?"

"I did. Tough but fair, if you ask me."



"Why's that?"

"Well, we in the private sector have to work to pay for you in the public sector. It's only fair that you show some restraint."

"Well, 'show some restraint' is not quite the phrase, is it? It's not as if I'm choosing my own pay. You must be confusing me with the chief executive of a major PLC. No need for me to show any restraint; George Osborne is quite capable of showing restraint on my behalf, thank you very much."

"Good job he is, too. I'm paying for your salary."

"Is this the 'hard-working private sector funds the bloated public sector' line?"

"Funny you should mention that, I guess it is."

"I've never understood that. I'll admit that you pay for my salary, but I pay for your salary too."

"How's that?"

"You work in sales for a mobile phone company. I work as a teacher."

"Yes, my taxes pay for your salary."

"But my mobile phone bill pays for your salary. If the government nationalised Vodafone – stranger things have happened – and privatised the school system, my taxes would be paying for your salary while my employer would be sending you a bill for my teaching of your children. But we'd still be paying each other. This is a modern economy. Everybody pays for everybody else's salary, except the subsistence farmers and survivalists, who look after themselves."

"But…"

"Look, communism didn't collapse because there wasn't any private sector to pay for the public sector. It collapsed because the incentives were thoroughly screwed up. There's no logical reason why an economy couldn't be 100 per cent public sector. You're making it sound like that's impossible as a matter of simple arithmetic."

"Still, communism is hardly an advertisement for the public sector, is it? The private sector creates wealth."

"No, individual technologists, managers, scientists and entrepreneurs create wealth. Their natural home might well be the private sector but there's no logical reason why they can't be employed in the public sector. Tim Berners-Lee invented the World Wide Web while he was working in the public sector."

"He's not exactly representative of the public sector."

"Sure, but Steve Jobs isn't exactly representative of the private sector either. There are remarkable individuals who do remarkable things, and I'm happy to acknowledge that the private sector is usually the place where those remarkable things have space to grow. But the private sector as a whole is doing something more pedestrian: it's providing goods and services. And so is the public sector. To suggest that some of these goods and services count as 'creating wealth' and others don't, purely because some are paid for out of taxes and others are paid for in the marketplace, doesn't make any sense."

"Still, Osborne was right: we need to make savings. Public sector workers have to do their bit."

"That's a fallacious line of reasoning: it assumes that the public sector workers of yesterday are going to be the same people as the public sector workers of tomorrow, after several years of chipping away at their real incomes. They might not be. I might decide to become a mobile phone salesman instead of an economics teacher."

"The way this conversation is going I wish you'd made that choice a while ago."

"The question is where you want the best people. Trimming public sector wages might harm current public sector workers, or it might just persuade them to seek new pastures, to be replaced by over-promoted junior staff – or mobile phone salesmen who were sacked because of a sudden influx of better-qualified people who could do their job. It may well be reasonable for Osborne to squeeze public sector pay, but if he does, private sector workers will suffer consequences too. Sometimes when he says that we're all in this together, he's right – if only by accident."

Also published at ft.com.

'Tis not the season to be shopping

Christmas Day should be the beginning rather than the end of the festive celebrations. But commercial logic points in a different direction

I'm one of those old-fashioned types who reckons the Christmas season should begin late. I like to put the Christmas decorations up the Sunday before Christmas at the very latest, and I even enjoy working on the morning of Christmas Eve – there's something more magically Dickensian about taking just that afternoon off and heading home with beribboned parcel, rather than taking up residence on the sofa a week beforehand. Christmas Day should be the beginning rather than the end of the festive celebrations.

Commercial logic points in a different direction. There is little profit for Selfridges or Dixons or Hamleys trying to get people in a Christmassy mood at the very last minute. Indeed, the economist Emek Basker has found that in the US, where the Christmas shopping season varies between 26 and 32 days depending on the date of Thanksgiving, longer seasons mean more overall spending (about $8 per person per extra day). Daily spending rises in November after Thanksgiving, but is just as high in December even during the most protracted shopping seasons.

The economist Joel Waldfogel, author of Scroogenomics, estimates that the extra spending on Christmas and Hanukkah in the US in 2007 was $66bn – a substantial sum, and relative to the size of the economy it is even larger in the UK.

No wonder that at this time of year, everyone hurries to publish articles about how the Christmas spending rush is good for retailers. But this is odd. Imagine how much easier life would be for retailers if that extra $66bn was spread evenly across the year.

For a hint at the inconvenience, I spoke to Derek Hayes, of Oxfordshire-based Skyline Promotions. Hayes runs the ultimate seasonal business: a British company producing firework displays. This year was particularly challenging because Bonfire Night fell at the weekend. (Wednesdays are easiest, because they spread the workload across two weekends and midweek.)

Skyline employed 42 people to run 16 firework displays on Saturday, November 5. Because most of Hayes' staff have unrelated day jobs, the 14 displays on Friday the 4th were even more challenging. But contrast that peak of 42 workers with much of the rest of the year, when Hayes works alone. To cope this year, he called in favours from old associates who travelled from Cornwall and Leeds. He even organised a post-fireworks reunion party.

Firework displays are, of course, particularly challenging: they are extraordinarily seasonal, cannot be stored, and require skilled staff. But other businesses must cope with versions of the same challenge.

Does this matter? The economist Jeffrey Miron pointed out in The Economics of Seasonal Cycles, published more than two decades ago, that a perfectly efficient market will cope just fine: prices, wages and rents will rise at peak times to cover the very real costs of seasonal booms. Customers will either willingly pay extra, because they value the convenience of the timing, or will instead buy Christmas presents in the January sales, order cocktails during happy hour, and organise weddings on Wednesdays in October.

In practice, Miron argued, things are not quite so simple. For various reasons – some cultural, some legal – there are limits to how flexible prices and wages tend to be, and how responsive people can be in return. Some office Christmas parties are successfully moved to January, but few family Christmases are. And most schools will not applaud parents who seek a cheaper holiday by pulling their children out of class. As a result, shops will remain congested and staff harassed during Christmas, and managing inventory will be a logistical nightmare.

My Christmas decorations may be going up late in the season, but I did most of my Christmas shopping early. It was the least I could do.

Also published at ft.com.

When the Christmas stocking shrank in the wash

In an act of last-minute desperation, the prime minister decides to replace his chancellor George Osborne with a figure judged to have broader political appeal: Santa Claus. (The decision was approved by a committee of Liberal Democrats.) The FT can now present a transcript of the conversation the night before the chancellor's autumn statement:

David Cameron: OK, Santa. It's time to start slipping some goodies under the Christmas tree for the great British public. What can you do for us?

Santa Claus: Well, young David, the trouble is that nobody put aside any funds for this kind of thing. A Christmas savings account is traditional, don't you know?

DC: Nobody set aside any money. This was the position we inherited from the last government, Santa.

SC: I understand, David, but the blame game doesn't get us very far in this season of goodwill to all mankind, does it? Try "Santa didn't visit because Daddy lost his job at the UK Border Agency" and see how far that gets you on Christmas morning.

DC: Fine, fine. And that's why we need to give people something. Anything cheap and cheerful? Any stocking fillers?

SC: Stocking fillers? It's not as easy as that, young fellow. Have you seen the report from the Office for Budget Responsibility?

DC: I know, I know. Even if the eurozone gets its act together, our growth rate is way down.

SC: No, that's not what I meant. Everybody knows that growth is in the toilet and you can easily blame that on the price of oil, the euro crisis and Gordon Brown. The problem is that the OBR thinks that the UK's potential growth rate has fallen. The British economy isn't a floppy oversized stocking begging to be stuffed full of Keynesian stimulus – it shrank in the wash and it's now a tight constraint on future growth. There is a silver lining, though.

DC: A silver lining to the tight stocking?

SC: No, a silver lining to the OBR's downgrade of the UK's growth potential. If the OBR is basically right then the Labour attack on your economic policies is basically wrong. The Keynesian tax cut they want is predicated on the assumption that the economy has plenty of potential to supply but too little demand. The OBR thinks that supply has also been damaged by the credit crunch. It's disastrous news, but you can console yourself that it would be equally disastrous if Ed Balls was in charge.

DC: This is awful. That's why I hired you: you're the man to put a smile on people's faces. What can you offer me? George was planning to divert £5bn to infrastructure spending over the next few years. Should we keep that policy?

SC: It's fine as far as it goes, but let's not get our hopes up. Let's say that this is £1.5bn a year for three years, and let's say the spending multiplier is two, which is a Keynesian's wet dream. And let's also assume a multiplier of zero for whatever else was going to be done with the cash. If so, the private sector would actually grow by £1.5bn each year as a result of the infrastructure spending.

DC: Sounds great to me.

SC: But it would add only 0.1 per cent to the growth rate – granted our extremely generous assumptions.

DC: What about the £20bn of private sector infrastructure spending we're planning to mobilise?

SC: That's fine, too, but why not just borrow the money and spend it directly? Presumably these are basically government-funded projects and the private sector is being used to take it off the balance sheet in time-honoured fashion – and of course at greater expense to the taxpayer in the end.

DC: We'll stick to our fiscal rules!

SC: International investors seem very impressed by your commitment, but I don't think they're going to be fooled by this sort of accounting. Not after Greece. I think it's best to tell the truth in such matters.

DC: Says Father Christmas!

SC: Listen, sonny. You were the one who sacked your chancellor in favour of a deus ex chimney. George has been dismissing "something for nothing" economics and I'm afraid he has a point.

DC: Santa, thanks for your time. But at least George is willing to pretend he's going to do something. I think I'll ask him to present the autumn statement after all. I don't think Plan B has really worked out.

Back to the glory days of Northern Rock

"People buying newly built houses will need a deposit of as little as 5 per cent under measures designed by the government to help unstick the housing market."

Financial Times, Nov 22

What's the story here?

We need to go back to the height of the credit boom, four or five years ago. Banks were handing out mortgages without requiring a deposit. In the case of the most brilliantly managed banks, for example Northern Rock and HBOS, mortgages were offered with loan-to-value ratios of 125 per cent, in effect allowing house buyers to go deep into negative equity the day they collected the keys.

Was that a problem?

Yes, it was. Somebody in negative equity may be unable to move house without defaulting on the mortgage loan, which makes them a risky proposition for the bank, as well as trapping them in other ways – making it hard to move to find new work, for example. There's also a fair case to be made that loose lending standards in the UK helped drive house prices up to absurd levels. If people tend to get carried away when they see rising house prices, which seems plausible enough, then their spending will be limited only by the giddy enthusiasm of the banks.

Oh. Sounds bad.

It's good for elderly people who happen to move to smaller houses at just the right moment, and it's good for presenters and producers of vacuous home-improvement pornography. But it's bad news for anybody who owns less house than they'd ideally like – which is most of us, given how pokey British houses are – and it's also bad news for the stability of the financial system. The crisis was triggered by similar loans in the US, not in the UK, but that doesn't make overstretched UK loans a good idea.

Right. So what's the problem that the prime minister is trying to solve?

It's very simple: this unsavoury state of affairs stopped a few years ago, and David Cameron would like to kick-start it again.

I'm sorry, I must have misheard you.

That's what I thought when I heard the policy being announced, but I am afraid it's true. Such mortgages only made sense – for both bank and homebuyer – if you had (false) confidence that house prices would continue to rise forever. The government has noticed that banks have lost this confidence and now insist on substantial deposits as a cushion in case house prices fall. So it plans to throw the taxpayer guarantee in there – on top of the deposit cushion, the taxpayer is a kind of airbag. If prices fall and the buyer defaults on the loan, the taxpayer will absorb some of the impact.

On what planet is this a good idea?

Let's be fair: more house building would be an excellent plan. It's a contribution to the long-term wealth of the country; unlike manufacturing it cannot be offshored and provides plenty of employment, even from the young and the unskilled. And there aren't nearly enough houses, which is another reason why prices are so high – relative to earnings they are still roughly at the level at the peak of the catastrophic late-1980s housing bubble. Private companies are building about 100,000 homes a year – low levels not seen since the 1920s. A few hundred thousand more houses each year at a time when prices are high and unemployment is also high would kill several birds with one stone.

But?

But this is surely the stupidest imaginable way to stimulate house building. There are three fundamental problems: prices look high, so banks don't wish to be exposed to their likely fall by lending either to developers or to house buyers; the banking system itself is fragile, exacerbating the sense of caution; and above all, planning permission is hard to come by, so if you have the money to build a house the local council probably won't let you. The government's response is to try to prop up prices with the following proposition: lend money to people who should not be buying such expensive houses, and if things turn sour you can repossess the home, sell it at a loss and the taxpayer will see you right.

What does the opposition think of this plan?

They think it should be much bigger. Not nearly enough taxpayers' money has been thrown into it, apparently. Without a more determined effort we'll never get back to the aggressive lending of the glory days of Northern Rock.

What happened to Northern Rock again?

Let's just say it's gone to a better place.

Also published at ft.com.

How to stop the bogus bonus

Successful oversight is going to require more transparency about what trades are being made. But transparency is a scarce commodity

It used to be so easy to "earn" a performance bonus in financial services. Step one: agree a contract whereby you are paid if you exceed a modest benchmark with the funds you are managing. Step two: borrow money and invest it in risky assets. Step three: profit! Step three does not follow automatically, of course, if the risky asset does not pay off. But from the point of view of the fund manager and his bonus, it's a case of "heads I win, tails the investor loses".

It's fairly trivial to show that such bonus schemes, if implemented naively, offer disproportionately larger bonuses for ever larger risks. We might hope that investors are too sophisticated to fall for such obvious tricks. Yet Dean Foster, a statistician at the University of Pennsylvania, and Peyton Young, of Oxford University and the Brookings Institution, were warning in the early days of the financial crisis that fund managers could hide risks in far more sophisticated ways.

The problem is, as Foster and Young show, that it is possible for an unskilled fund manager to mimic a genuinely skilled one, in the same way that an insect might mimic a leaf, or a harmless creature mimic a poisonous one.

This mimicry, too, involves three steps: first, invest all your funds in whatever benchmark you need to beat, whether it's treasury bills or a stock market index; second, make a bet that some unlikely event will not come to pass using the invested funds as security; finally, boast of benchmark beating returns, because you've delivered the benchmark plus the additional money from winning the bet. Collect your performance fee. (In the unlikely event that you lost the bet and with it all your investors' cash, simply cough awkwardly and look at your shoes.)

Rather disturbingly, Foster and Young have proved that if investors can only examine your investment returns and know nothing about your investment strategy, as a fund manager you can always make your numbers look good by taking on small risks of very bad outcomes.

These are the "black swans" made famous by Nassim Taleb: low probability, high-impact events, except that these particular swans are genetically engineered – deliberately manufactured and then hidden away, to escape at unwelcome moments.

The solution seems obvious: pay performance bonuses with a lag, perhaps in company stock, or allow "clawback" – in effect, a financial penalty rather than a bonus – if those pesky black swans do appear. But in a recent presentation, Peyton Young explained that none of these approaches really do much to help. It's true that deferred bonuses can help evaluate performance itself over a long term, but the mimic strategies will remain available. The mimic can, for example, make a huge bet and then simply go quiet if the bet pays off, making safe, neutral investments until the bonus comes due.

Regulators, investors and senior management simply cannot judge traders and fund managers on the basis of their performance alone, no matter how good it looks – the black swans can always be bred and hidden.

Successful oversight is going to require more transparency about what trades are actually being made. And in many parts of the financial services industry, transparency is a scarce commodity.

Kweku Adoboli, the former UBS employee charged with fraud and false accounting, worked on a "Delta One" desk – and the whole point of Delta One trading is to replicate a certain pattern of returns through trading strategies that need not be disclosed.

The folly of "rewarding A while hoping for B" is – thanks to a famous article by Steven Kerr – now well known. But what about "rewarding A" without realising that in fact you are being given "C" in disguise?

Payment by results is an attractive idea, but in a world where black swans can be deliberately manufactured, results can be treacherous.

Also published at ft.com.

Music for love not money

There seems no objective justification for the idea that good music has simply dried up since file-sharing took off

"A digital vampire" – not the title of this season's bestselling young adult novel, but an ageing rock star's description of Apple's online store, iTunes. In his recent John Peel lecture, the guitarist for The Who, Pete Townshend, railed against "the Aluminums" (Apple, I gather) and suggested changes to their business model that would be more supportive of musicians. He also wondered whether the modern, digitally distributed music industry could support the kind of careful listening and risk taking that the late DJ John Peel exemplified.

A reasonable response to Mr Townshend is that he could have picked more obvious targets – notably file-sharing sites and software, which facilitate outright piracy. (He did offer one sharp observation on the subject: "The word 'sharing' surely means giving away something you have earned, or made, or paid for?")

It is beyond doubt that the traditional music industry is dying: high street record shops are closing their doors or stocking alternative products, and music sales have fallen by about 40 per cent during the past decade.

Digital music sales through retailers such as iTunes are manifestly failing to plug the gap from sales of physical CDs, but that is not the fault of the Aluminums.

Yet a more interesting question is how much this matters. According to Joel Waldfogel of the University of Minnesota, three-quarters of pirated music would never have been purchased anyway. In such cases the consumer gains but the producer does not lose. Alas, for the major record labels – and, perhaps, for the artists too – the one-in-four acts of piracy that do reduce sales seem to be quite enough to corrode the industry's business model.

But, says Waldfogel, "consumers don't care about the well-being of the recording industry. We care about the existence of good new products." Is piracy damaging these new releases? Conventional wisdom used to be that piracy consumes itself: by damming the flow of money it causes a creative drought. Few people want to give up their day job to create music for no financial reward.

But is this true? In a new working paper, Waldfogel manfully attempts to estimate the continued flow of high-quality new music since the emergence, at the turn of the millennium, of Napster, the daddy of all file sharing services. There is no perfect way to do this, of course.

One technique is to look at lists compiled by critics of the best albums. Another approach is to look at radio air-play. Radio stations tend to be biased towards playing two things: recent music, and music that listeners are likely to enjoy. In a golden age of music one might expect radio stations to play a lot of recent releases; in a weaker creative period one would expect radio stations to play more vintage stuff. A third approach looks at albums which continue to sell well a long time after their release.

Waldfogel tries all three, and produces some intuitively sensible results: the late 1960s were the pinnacle of the past 50 years, while the 1980s were dark days indeed. Judged by the critics, the post-Napster years were unremarkable, and no worse than the 1990s. Judged by airplay data, the past decade has seen something of a renaissance in quality music. Certainly there seems no objective justification for the idea that good music has simply dried up since file-sharing took off.

Quite why this should be is a puzzle, but Waldfogel suspects it has something to do with the ease with which any band can produce and distribute music – a fact reflected in the growth of independent record labels. The money may be drying up, but the beat goes on.

Also published at ft.com.

What's all the fuss and bother about ratings?

"Plans to ban sovereign credit ratings in "exceptional circumstances" have been shelved by Europe's top financial regulator after he came under pressure to retreat from the controversial measure to rein in the agencies that issue the assessments of national financial strength."

Financial Times, Nov 16

What are rating agencies again?

They are private companies that express opinions about the likelihood that, for example, Italy will pay the money it owes bondholders. Sometimes they express opinions about how much money people will get back if Italy defaults on its loans. One way or another they're providing opinions about the risks that creditors face.

That's it? Just a bunch of opinions?

Basically, yes. And there are plenty of other opinions out there from journalists and particularly from people who put cash on the line and buy and sell these bonds. But the rating agency opinions have real-world significance in a way that a bloke in the pub doesn't. Many investment funds promise their investors that they will only hold assets with ratings above a certain level. If a rating is downgraded, those funds have to sell, even if they think the asset is a bargain. Ratings are also hard-wired into regulatory rules, with similar effect. And another thing: unlike most opinions, they're quantified.

Quantified on a scale of 1-10?

No, quantified on a scale of D through CC+ and BBB- all the way to AAA. Or alternatively, au choix, from C through Caa2 and Ba1 to Aaa. Depending on which agency you're looking at.

Why?

For ABSOLUTELY NO GOOD REASON.

You seem a bit touchy.

I'm not the only one. Rating agencies are not popular. Start with the timeliness of ratings upgrades and downgrades. Moody's, for example, did not downgrade Lehman Brothers to A2 until two months before its bankruptcy, and did not place the A2 rating under review until five days before bankruptcy.

That seems quite late in the day to be giving a low rating. Come to think of it, is A2 a low credit rating?

No it isn't. The A2 rating indicates low credit risk although acknowledges the presence of long-term risks. Perhaps by "long term risks" what it meant is "bankruptcy by Monday morning". Hard to say.

The most notorious problem is the way rating agencies seemed happy to publish very positive opinions about structured sub-prime mortgage products that subsequently turned out to be utterly worthless.

I see. So European legislators want rating agencies to be tougher and quicker out of the blocks?

Of course not. They want rating agencies to be a lot gentler and slower out of the blocks. European governments have been very grumpy about what the rating agencies have been doing. The previous Greek finance minister complained bitterly about a downgrade of Greek debt in March. The Portuguese were not impressed by a downgrade in July. And Paris was livid last week when Standard and Poor's accidentally told website subscribers that they were downgrading France, when in fact they weren't. It is fair to say that the French, at least, have a valid point.

So what is the European Commission proposing?

It's quite simple. It was about to propose disbarring ratings agencies from downgrading countries at awkward moments. Then it changed its mind.

Shame. It would have been good for somebody to fight back against the agencies.

The enemy of my enemy is not necessarily my friend. The commission's plan was pretty strange. For one thing, if the commission suddenly suspended the credit rating of Italy next week how is that likely to be received by people lending money to Italy? Are they likely to say, "oh well, no news is good news"?

I see the point.

The whole thing seemed almost calculated to make the situation worse. It's common for the agencies to downgrade somebody – Japan, or more recently the US – with investors not batting an eyelid, either because they don't care or because it's old news. The European Commission screeching into town, sirens blaring, and metaphorically sealing off the crime scene, is guaranteed to make everybody take notice of ratings for a change.

So they did the right thing to dither and pull back?

It seems to be the default response for Europe's leaders, and for once it is the right one.

Also published at ft.com.

Taxing my music can't be good, can it?

"Exploitation of a controversial value-added tax relief on low-value goods such as CDs, DVDs, memory cards and contact lenses shipped from the Channel Islands will be blocked next April, the Treasury announced on Wednesday."

Financial Times, Nov 9

No more cheap CDs from Amazon?

Strictly speaking the cheap CDs come from a company called Indigo Starfish, Amazon's "preferred vendor", which is based in Jersey and not subject to the UK rate of 20 per cent value-added tax. UK customers should be paying that VAT when they import CDs, but for decades cheaper items have been exempt from this requirement with the idea of keeping administrative costs down. No longer.

So this means I'll have to pay an extra 20 per cent for my CDs?

Possibly, although the pre-tax price might come down a little now that companies don't have to fulfil your order out of a warehouse somewhere off the coast of France in order to save on tax.

Won't this cost lots of jobs in Guernsey and Jersey?

Quite possibly.

Doesn't this just prove that raising taxes costs jobs? Shouldn't the government be scrapping VAT completely rather than finding new ways to charge it?

That doesn't follow at all. It depends on the price-elasticity of demand and that in turn depends on the availability of substitutes.

In English?

Ordering an offshore DVD feels very much like ordering an onshore DVD, so customers will plump for the cheapest price. The onshore DVD mail-order industry can be wiped out by a very small tax disadvantage. That doesn't mean that a tax on all DVDs would destroy the DVD industry. Closing this loophole probably won't cost many jobs, it will just relocate them from somewhere near Cherbourg to somewhere near Coventry.

Are there any other industries that exist only because of tax breaks?

Probably, although perhaps the international financiers favour the Cayman Islands chiefly because of the weather.

It's amazing that taxation can have such a profound effect on our behaviour.

There have been stranger examples. Consider the window tax introduced in the late 17th century in England and Wales. It was an easily administered, non-intrusive way of taxing people with grander homes. However, it led to windows being blocked up for tax reasons.

Reminds me of the Douglas Adams character Hotblack Desiato.

Ah yes, Mr Desiato was spending a year dead for tax reasons. Life imitates art: the economists Andrew Leigh and Joshua Gans found that in response to a change in Australian inheritance tax rules in the late 1970s, one in 20 deaths were successfully delayed for a few days with the effect of exempting the estates from inheritance tax.



Didn't Benjamin Franklin say that nothing in life was certain except death and taxes?

Something like that. And in Gone with the Wind, Margaret Mitchell wrote: "Death, taxes and childbirth! There's never any convenient time for any of them." Franklin and Mitchell were both wrong: Mr Gans and Mr Leigh also discovered that many Australian mothers successfully postponed the births of their children in late June 2003. This was because the Australian government unwittingly gave them a financial incentive to do so. July 1 2003 broke records for the number of babies born. Whether you're entering the world or leaving it, tax breaks matter.

So these tax breaks are like a superpower? You can get people to do anything you want?

Like all superpowers it can be used for good and for evil. I think of these taxes as being a bit like a selective breeding programme. Breeders can develop tastier, more disease-resistant crops, or strong, loyal dogs. Or they can breed malformed show dogs that can't mate or go through labour without assistance. It all depends on how the selective breeders go about their task. Similarly, through appropriate tax incentives governments can summon up logistics hubs on remote islands, or create dingy town houses in London and Edinburgh.

Any thoughts of these taxes being used for good?

Taxes on cigarettes and alcohol are the obvious example. The gaping omissions are carbon taxes and congestion taxes. If tax incentives can create a "fulfilment industry" in Jersey and Guernsey, miracles can happen.

Also published at ft.com.

The real cost of keeping warm

If we are to deal with climate change, the price of carbon-intensive energy is going to have to rise

With the price of domestic gas and electricity soaring, the cost of keeping warm, never off the politicians' radar screens for long, is firmly back on the agenda. The latest wheezes to emerge from the coalition are some mild utility-bashing from the prime minister, and a "green deal" from the energy secretary, Chris Huhne, which is intended to make it easier to borrow money for energy-saving home improvements.

I may have missed it, but I am not aware of either man stating the unpalatable truth: if we are to deal both with climate change and with the security of our energy supply, the price of carbon-intensive energy – and at the moment that means energy in general – is going to have to rise.

No sign yet of any push towards that goal: domestic fuel is taxed at just one quarter of the standard VAT rate. According to a review by the Institute for Fiscal Studies, the percentage of tax revenue attributable to "green" taxes peaked at the end of the 1990s – it was less than 10 per cent then – before it began an inexorable slide. The story behind that slide is simple: the only significant "green" taxes are paid by motorists. Emissions from industrial sources, aviation and – yes – our homes have got away lightly so far. But that situation can't last forever.

It's clear enough why politicians don't care to dwell on such inconvenient truths, and favour instead the kind of regulatory engineering put forward by Huhne. At least his idea addresses a genuine problem: people fear that if they move house after buying an energy-efficient boiler or double-glazed patio windows, the new occupants will reap the benefits without paying more for the house. The "green deal" leaves the home-improvement debt behind, to be repaid through utility bills.

Yet regulatory pushes are limited at best and produce bizarre consequences at worst. In the US, Corporate Average Fuel Economy standards, designed to encourage more efficient cars, have had some benefits but also two dramatic failures. They boosted the rise of the giant SUV, which was exempt from the standards that applied to regular cars. More prosaically, once the standards had been met there was no incentive to do more, and much engineering effort was devoted to making cars bigger and faster rather than more efficient.

In the UK, the "Merton Rule" – it originated in the Borough of Merton and has been widely emulated – demands that substantial new developments include the capacity to generate 10 per cent of the building's energy needs through renewable sources, on site.

Alas, such a rule is hopelessly slack for an out-of-town supermarket – an environmental disaster because of all the driving it encourages, yet with plenty of real estate for solar panels. Meanwhile it is too challenging for a city-centre skyscraper, which is naturally a low-energy building because of its compactness and proximity to public transport.

All this explains why a carbon price has to be the centrepiece of any policy on climate change. A price on carbon acts in more subtle ways than any regulator will be able to, encouraging a switch away from coal and towards nuclear energy and renewables, encouraging energy efficiency in every choice we make, and in the last resort, encouraging us to do without products, services and activities where the energy cost is just too high.

We live in a world of seven billion people, many billions of distinct products, and countless decisions every day that have the effect of releasing carbon dioxide into the atmosphere. Without a carbon price to guide all those decisions, the cost of responding to climate change is far higher than it has to be.

Also published at ft.com.