Chris Dillow's Blog, page 127

House prices & secular stagnation

Polly Toynbee says policy-makers must do something to curb the "insanity" of rising house prices. I sympathize. But there's a point here that most people are missing. It's that high house prices are not just a problem in themselves but also the result of a wider malaise in the world economy.

High prices might be - in part - a product of secular stagnation. This seems an odd thing to say; if people expect slower growth in incomes, house prices should be lower. However, three mechanisms might offset this:

1. Lower real interest rates. These naturally raise house prices by reducing long-term borrowing costs. It's no accident that the house price-income ratio has trended upwards since the mid-90s at the same time as real interest rates have fallen.

2. A dearth of investment opportunities in the real economy diverts cash towards other assets, such as housing. As both Hayek and Marx noted, when profits in the real economy are low, we get malinvestments. And as Paul Krugman says, in a stagnant economy bubbles are one way to create jobs. If we can't get rich by making stuff, at least some of us can get rich at the expense of younger generations. 

3. The Bank of England is loath to fight rising house prices in part because the economy is still too fragile to cope with higher interest rates, and in part because quantitative limits on mortgage lending would deprive banks of an easy source of profits.

These three mechanisms are reinforced by another. The same lack of safe assets in Russia, Asia and the middle east that has helped drive up bond and gold prices in the last 15 years has also raised central London house prices; folk used to buy houses when they were hopeful, but now some do so when they are fearful.

I don't say all this to deny that rising house prices also have domestic sources, in our silly planning laws and even sillier love affair with "bricks n mortar". And still less do I deny that prices might eventually fall a lot. I merely want to suggest that rising house prices are not just a disease but a symptom of the crisis of capitalism.

The state & inequality

Here are four things I've seen recently:

 - Political Scrapbook reminds us that a hedge fund run by George Osborne's best man made millions from the sell-off of Royal Mail.

 - Suzanne Moore says Camden council gave her £15,000 to leave a council flat in King's Cross that is now on the market for over £500,000; its price rise is no doubt partly due to the publicly-funded regeneration of the area.

 - Tom Streithorst writes: "Without more cops and their more aggressive policing, the average Manhattan apartment today would not be worth $1 million."

 - David Runciman says that Richard Branson "has made his fortune out of the regulated parts of the economy, which he has milked to extract government subsidies, tax breaks, licensing agreements and protected income streams."

These are all examples of how state actions help to enrich the well-off. There are, of course, many other examples. Bankers get a subsidy of billions (pdf) of pounds a year; QE made the rich better off; outsourcing hands millions of pounds of taxpayers money to firms of dubious efficiency and propriety; tax credits are, in part a subsidy for low-wage employers; housing benefit enriches landlords at least as much as tenants; welfare benefits generally help capitalists as well as the jobless; trade union power was broken in part because Thatcher used a state-owned industry, and state policies, to raise unemployment, to do so.

I could go on, but you get the picture. As Joe Stiglitz has said, inequality is "not the result of the laws of nature or the laws of economics. Rather, it is something that we create, by our policies."

One implication of all this is that it is just silly for libertarians to pretend that inequalities are fair. Many - perhaps most - of them arise from the sort of state interventions which consistent libertarians should deplore. When they claim that the inequalities arising from a free market are just, they are talking about a parallel universe of no relevance to the one we inhabit. And, in truth, smarter libertarians have always seen this. In Anarchy, State and Utopia Robert Nozick wrote:

There is no argument based upon the first two principles of justice, the principles of acquisition and transfer, for such a more extensive state [than the minimal one]...If, however, these principles are violated, the principle of rectification comes into play...One cannot use the analysis and theory presented here to condemn any particular scheme of transfer payments, unless it is clear that no considerations of rectification of injustice could apply to justify it. (p230-1, Nozick's emphasis)

However, I don't want to merely poke fun at the right. There's an embarrassment here for the left as well. If the state can be used to increase inequality - not least by selling assets cheaply or by using state policies to attack workers - why should egalitarians look to it as a solution rather than the problem?

* I write all this as a beneficiary of state-induced inequality; state education spending gave me my human capital, and easy money policies and planning restrictions gave me a near £500,000 tax-free gain on my London flat.

On cargo cult management

Alastair Cook and those calling for Ed Miliband to be bold and transformational have something in common. Both are practicing what I've called cargo cult management.

What I mean by this is a focus upon ritualistic aspects of "leadership" whilst neglecting the question of how exactly the rituals are related to outcomes.

For example, Cook says it took a lot of guts to sack Kevin Pietersen. But who cares? What matters is whether the decision was right. And given England's shambolic showing the World Twenty20, this is questionable.

Demands for Miliband to show "boldness" display a similar fetish of courageous leadership to the neglect of outcomes. What matters isn't whether policies are bold or not, but whether they are right. By all means argue for (say) a looser fiscal policy or higher minimum wage, but demanding boldness as a good in itself is just silly: in this sense, I'm with Hopi. Boldness, bravery and guts can easily become recklessness, and cowardice can be prudence. I'd rather decisions were cowardly but right than bold but wrong.

But it's not just Cook and the Labour left that seem to be guilty of cargo cult management. John Kay today reminds us of how New Labour was too, in believing that ritualistically declaiming worthy objectives was somehow sufficient:

The 2008 Climate Change Act supposedly sets a “legally binding” obligation to reduce greenhouse gas emissions by 80 per cent by 2050. The 2010 Child Poverty Act requires that child poverty be eliminated by 2020. Neither piece of legislation makes provision for how these outcomes will be achieved.

The Tories have been guilty of the same thing. For all Osborne's talk about tough policies to reduce government borrowing, this is much higher than either he or Alistair Darling envisaged back in 2010. Any schoolboy Keynesian could tell you why; policies that depress GDP also depress tax revenues.

And whilst the bedroom tax was supposed to be "tough", it has not had the desired effect of forcing people into smaller accommodation but has instead merely forced them into rent arrears. The bedroom tax should be renamed the Wonga subsidy.

In this fetishization of toughness and boldness, politicians are borrowing their ideas from the worst of corporate management. Back in the 1990s, "Chainsaw" Al Dunlap earned a reputation for a tough-minded focus on shareholder value by sacking thousands of workers. But when he joined Sunbeam, this strategy failed, and it transpired that he was merely cooking the books. Sunbeam went bust, and Dunlap has been disqualified from being a company director.

This sort of silly thinking has also infected ordinary people (very ordinary ones). On Sunday, S***s fans got the hump at Tim Sherwood sitting the stands rather than standing on the touchline - without asking how being a few yards nearer the pitch would enable him to achieve the impossible feat of polishing a turd.

In all these cases, there's a common theme. It's a version of the representativeness heuristic - an unthinking belief that causes will resemble outcomes. The Labour left think bold talk will lead easily to better conditions for workers, just as Osborne thought "tough decisions" would reduce the deficit and Dunlap thought cutting costs would raise profits. In a complex world with massive uncertainty and multiple feedback mechanisms, however, the link between macho leadership and actual outcomes is not so simple. As John Kay has so wisely said, sometimes our aims are better achieved obliquely.  

The balance of payments constraint

George Osborne's "commitment" to full employment poses the question: what's stopping us reaching it?

The standard answer is the Nairu; if unemployment falls below a particular rate, inflation will rise.

This answer, though, runs into a problem. Since the start of 1997 the correlation between the unemployment rate and CPI inflation in the following 12 months has been strongly positive - 0.46 in quarterly data. It is high unemployment that has led to higher inflation, not low. Falling unemployment in the early 00s led to low inflation, and the rise in inflation in 2007-08 followed a rise in unemployment. And the recent drop in inflation has followed a fall in unemployment.

This might tell us that inflation and unemployment have both been driven by supply shocks - a low China price in the early 00s and rising commodity prices in 07-08. Or it might just show that the idea of the Nairu doesn't make sense in an open economy. The standard undergrad macro textbook says:

In the closed economy there is a unique unemployment rate consistent with constant inflation. By contrast, in an open economy, there is a range of unemployment rates consistent with the absence of inflationary pressure. (Carlin and Soskice, p343)

However, it doesn't follow that we can achieve full employment simply through expansionary demand policies. There might be another constraint on this - the current account deficit.

Now, you'd expect there to be an inverse relationship between the current account balance and unemployment; when unemployment is high, domestic demand is weak and so imports should be low which should mean a current account surplus, and conversely the high demand that reduces unemployment should also suck in imports, causing a deficit.

However, last week's figures suggest that this trade-off has worsened. We had a near-record deficit of 5.4% of GDP in Q4, despite a jobless rate of 7.2%. In early 2009 the same jobless rate was associated with a deficit of just 1.4% of GDP, and in 1997 it was associated with a surplus.

This suggests that any attempt to significantly cut unemployment by higher demand would suck in even more imports causing an even bigger deficit. This might be sustainable for a while - we're starting with low net overseas liabilities - but it can't last forever.

Worse still, the two obvious solutions here are questionable.

One is for sterling to fall. However, the pound fell by 20% in late 2008 without a major stimulatory effect. And engineering a fall in sterling at a time when other nations are running loose monetary policies might be difficult.   

The other is to simply let overseas demand rise. But this might not be sufficient. OECD data show that the volume of world trade in goods and services has grown by 29.5 per cent since it troughed in the second quarter of 2009. However, during this period the volume of UK exports of goods and services has grown by only 15.1 per cent. This warns us that stronger overseas demand might not be sufficient - because some mix of gravity or some supply-side failure is holding back exports.

Perhaps, then, there is a constraint upon how far we can reduce unemployment through demand policies. There are two implications of this.

The one that's friendly to Osborne is that he's right to see that full employment needs some kind of supply-side policies - though whether tax and benefit reform is sufficient is doubtful.

The less friendly implication is that Osborne (and I suspect Labour too) are giving us another example of cargo cult management. Announcing a target without any idea of how to achieve it is just, well...

On hedonic adaptation

To the untutored eye the typical Gooner doesn't seem to have much in common with Peter Barlow, only one of them being a bell-end*. But he does. Both show the importance of hedonic adaptation.

What I mean is that, from one perspective, Gooners should be relatively happy with their season. Back in August, many pundits thought Arsenal would struggle to finish above S***s. Had you told them back then that they'd enter April seven points clear of S***s, nearer to second place than fifth and with a clear run to the FA Cup, most Gooners would have been reasonably content. This is especially as they are competing with a massive handicap; their three main rivals have collectively spent over £800m more than them.

But they are not so happy. One reason for this is that they've suffered some painful losses. Another is that Arsenal were for months at the top of the table, and that success raised aspirations. Rather than think "we've proved the naysayers wrong again", they think "we were going so well and now it's fallen apart. They had adapted to their good position in the winter, and so now feel miserable,

This is of course a common phenomenon in football. Many coaches have been sacked because they've improved their teams fortunes and in doing so have raised expectations to unreasonably high levels and so left themselves vulnerable to disappointment.

This is where there's a parallel with Peter Barlow. You might imagine that a man who'd copped off with the world's most perfect woman** would be pretty satisfied, especially if he's bringing as little to the table as he is.  Rather than rejoice in his luck, though, he's doing the dirty on her.

What we have in both cases are examples of hedonic adapation. We quickly become accustomed to happy circumstances, and so take them for granted and want even more - even to the point of jeopardizing what we have.

My point here is that what's true for incomes also applies to many other things, as Andrew Clark has shown.

So far, so clear. But here are two complications.

First, not everyone hedonically adapts. Many Gooners are reasonably content with their team. There's heterogeneity here.

Secondly, although such adaptation is sometimes costly - it makes us unhappy and (as Peter Barlow will discover) can lead to behaviour with costly payoffs - it also has an upside. It is the desire for more that drives economic growth and progress. If Steve Jobs had taken my attitude ther moment he'd made decent money - "sod this for a lark, I'm retiring to Rutland" - we wouldn't have the iPod or iPad.  

* We must distinguish here between the median and mean. Although the median Gooner is not a bellend, the average one is. This is because Piers Morgan scores infinity on the bellendomoter, and infinity divided by n equals infinity.

** Alison King is of course yet more evidence that all the best things in England come from Leicester and its environs.

Osborne's spending paradox

In the Times yesterday, Daniel Finkelstein pointed out that most of the squeeze on public spending has yet to happen: "The big battle is only just about to begin" he said.

He's right. OBR data show that since 2009-10, total spending spending fell by only 3.5 percentage points of GDP to 43.5%. But it's projected to drop by another 5.5 points by 2018-19. That would take the share of public spending in GDP to its lowest level since 2001-02, and lower than anything we saw in the Thatcher years.

This raises a question: why hasn't the government made more of a case for a smaller state, preferring instead to stress the need for fiscal austerity? It's failure to do so has drawn criticism from both right and left. Allister Heath has asked where Osborne's vision is, and Phil has written:

The deficit (which does need sorting) has been a policy drawbridge across which Osborne and Dave have marched a phalanx of ideologically-driven cuts to public spending.

To an economist this seems an inversion of logic. The claim "we need to cut spending to reduce the deficit" verges on the nonsensical: see Simon Wren-Lewis, passim. But the claim "a smaller share of government spending in GDP would be a good thing" is if not correct then at least more intelligent than deficit fetishism. You can point to evidence that smaller government promotes economic growth and perhaps even happiness. You could argue, McCloskey-style, that a smaller state and bigger market sector would eventually promote bourgeois virtues. And you could, following Vito Tanzi (pdf), contend that there's no link between public spending and various measures of well-being: Japan and Korea, for example, combine small states with reasonable income equality, and there are good reasons for leftists to favour a smaller state.

This poses the question: why does Osborne - and the coalition generally - use bad arguments for cutting public spending when better ones are available?

One possibility is that the UK has a social democratic culture, so explicit arguments for a smaller state won't wash: the Overton window doesn't exclude merely leftist ideas. This, though, runs into the problem that Osborne merely plans to take the share of public spending in GDP to slightly above the level it was under the first four years of Gordon Brown's chancellorship. That's hardly swivel-eyed minimal statism.

Here, then, are three other possibilities:   

 -  The secular stagnation hypothesis might be right. The private sector might have been vibrant enough to fill the space left by a shrinking public sector in the past, but it's not now.

 - Politicians have lost the ability to argue about values such as the size of the state, and prefer to hide behind pseudo-managerialist gibber about the "necessity" for cuts. An appeal to the deficit bogeyman fits this preference better than the ideal of a smaller state.

 - We can't rely upon efficiency gains to offset spending cuts. Danny calls for "relentless pressure on the public sector to provide the same services for far less money." But this pressure might fail because of counter-pressure from bureaucratic capture or Baumol's disease, or simply because of bounded managerial ability. If so, a smaller state means worse public services - and that'll take some justifying.

I'm not sure what the answer is here. But I'm pretty sure that there's a paradox here, that bad arguments for shrinking the state are preferred to less bad ones.

The tyranny of party politics

There's something I find depressing about the Tory whining about Duncan Weldon's appointment as Newsnight's economics editor. It's a sign of the tyranny of party politics.

Put it this way. Would there be so much moaning if an arts or sports reporter had leftish views? I suspect not, because arts and sports are (mostly) obviously separate from party politics. The fuss over Duncan's appointment therefore reflects a belief that economics reporting is party-politically sensitive.

Of course, this is obviously true for some aspects of economics, such as the debate about fiscal policy. But there's much, much more to economics than this small matter. Many questions can be discussed indepdendently of party politics, such as: are we really in a period of secular stagnation? Will robots take our jobs? What are the pros and cons of behavioural economics? How does evolutionary economics help illuminate social affairs? What, if anything, can we learn from happiness economics, or neuroeconomics? And so on.

The idea that someone's leftist opinions debar them from a job requiring some kind of political neutrality seems to rest upon at least deeply dubious views: that a journalist can't leave his opinions at the door and be impartial; that economics is a branch of party politics; and a narcissistic tribalism that wants to hear its own ideas echoed back to it.

It doesn't have to be like this. I've managed to spend 20 years at the IC, even though - I suspect - most readers aren't sympathetic to my Marxian views. This is because these three ideas don't apply to me; I can, mostly, hide my Marxism; much of what I write about is independent of politics; and my readers are intelligent enough to want to read something interesting rather than stale reminders of what they already believe*.

The tyranny of party politics here consists of two forms. The obvious one is the demand for "impartiality" between the main parties - or, to be more accurate, a balance between truth and falsehood.  

But there's another, more subtle tyranny. If economics is subordinated to party politics, some issues will be kept off the agenda. Neither Labour nor the Tories would be keen on an economics writer who raises thoughts such as: maybe politicians can't do anything to raise long-term economic growth; perhaps bosses pay is a reward for power rather than skill; economic forecasting is impossible so talk about fiscal policy in the next parliament is mostly otious; or perhaps there are more intelligent ways of allocating public goods than by government decree.

Ideally, we would discuss economics without having to defer to imbecilic, narrow-minded (and partly irrelevant) party politicians. And, happily, in many contexts such as this one we can. Duncan, though, has lost this freedom. I think he deserves better.

Another thing. Of course, there is a huge overlap between economics and politics: both are about who gets what and how? But the problem is that party politics is not the same as politics; the latter is about the conscious examination of power, whereas the former quite often is about obfuscating the nature of power.

* Granted, I have few readers - but this only shows that there's a sharp trade-off between quality and quantity.

Randomness in decision-making

Nobody will thank me for saying so, but I have a bit of a mancrush on Ed Smith. Yet again, he has raised a profound point in the social sciences:

Nakedly ambitious people rarely achieve their ambitions...Simplistic self-interest is not just bad PR, it is often bad strategy. It suffers from a fatal flaw: it is predictable.

This draws our attention to the fact that, in some domains, randomness is the best policy.

This is most clear - and has been formalized by game theorists - in the case of games such as rock-paper-scissors where predictability leads to defeat. In such circumstances, the optimal strategy is to randomize.

To what extent do such games exist in the real world? They're common in sport. The penalty-taker who always aims low and left will find goalkeepers quickly wising up. The batsman whose best shots are all on the legside will soon get most balls pitching outside off.

I suspect they exist in other fields. If you're negotiating with a nutter who might randomly choose violence, you might well make concessions that a more rational counterpart couldn't extract; Colonel Gadaffi stayed in power for so long in part because of this, and it seems to have worked for North Korean dictators. One reason why interviewers at Oxbridge or Google have traditionally asked candidates unpredictable questions is to test their powers of thinking on their feet. And one sign of genuine entrepreneurship is the ability to do - or blunder upon! - the unexpected, to wrongfoot rival companies.

However, randomness doesn't just work when the other player is trying to anticipate our actions. It can also work where there's environmental uncertainty.

Take a simple example. Strategy A has a 60% chance of a payoff of 3 and a 40% chance of a payoff of zero. Strategy B has a 40% chance of a payoff of 3 and a 60% chance of a payoff of zero. A is obviously the strategy with the highest expected payoff.

But it doesn't follow that it is the optimum strategy. If the payoffs are the number of descendants the members of a species has, then when that 40% chance comes up, followers of strategy A go extinct.

To maximize the chances of survival, a mixed strategy is needed. The species that randomizes will therefore survive. The one that "optimizes" does not*. This was the failure of the banking system in 2008. In trying to "optimize" banks ran the risk of extinction.

As John Kay showed, very often our goals are reached not through direct optimization, but obliquely.

And as Bruno Frey argues in a new paper, there's much to be said for using random selection in numerous contexts.

This poses the question: why, then, is randomness not used more often? And why do almost no decision-makers admit to using it, preferring instead to emphasize their "careful judgment"?

I suspect it's because we have fallen into a practice of cargo cult optimization and management. In business, politics and even in parts of our personal lives, we use the gestures and language of direct control in the hope that these suffice to achieve our aims. But sometimes, they don't.

* The scare quotes are because I want to duck the question of whether randomization is a form of rational maximization or an alternative to it. In biology, for example, mixed strategies are not consciously chosed by species but rather emerge by selection if they do so at all.

Football as financial economics

Watching the Chelsea-Arsenal game on Saturday - or at least the first 30 minutes - made me think about the parallels between football and financial economics.

In Arsenal's case, we have an odd example in sport of tail risk. Ordinarily, teams play a bit better than normal or a bit worse but performances and results are usually roughly normally distributed. Not so for Arsenal. 10% of games this season acount for 50% of goals conceded. And the 6.7% of playing time before 1.30pm accounts for 32.4% of goals shipped: as the BFG says, Arsenal don't fancy mornings.

In finance this sort of extreme negative performance is sometimes due to hitherto uncorrelated assets or strategies failing at the same time; this is how LTCM collapsed in 1998 and AIG in 2008. A similar thing happened with Arsenal. Normally, one or two players in any game will put in sub-par performances but they will be offset by others doing well. On Saturday all eleven had stinkers.

It's in this context that there's one characteristic of players that is highly prized but rarely fully acknowledged - what we might call negative betaness.

Investors value negative or zero beta assets - things that pay out well in bad times. it's the desire for these that explains: the existence of the insurance industry; the fact that deep out-of-the money put options have a positive price; and the fact that cash holdings are high even at near-zero interest rates.

Similarly in sport, a great player is someone who does well in bad times. It's unimaginable that Arsenal would have lost 6-0 with Tony Adams, because he'd have kicked them into shape.

Most of the best sides of recent years have had negative beta players - ones who didn't just play well, but played well when they needed to and got the vital goal or put in a great defensive performance when under pressure.

One thing that (for now) elevates Robin van Persie over Luis Suarez is his negative betaness. Suarez tends to do well against modest opposition but less so against big teams. But - as we saw against Olymiacos - van Persie gets goals when his team needs them. One's a high beta player, one's a low/negative beta one.

For me, one feature of a truly great player - Keane against Juventus in 1999 or Gerrard in the 2005 European Cup final - is their negative betaness, an ability to produce something when their team is desperate.

The same is true in cricket. Graeme Hick was, notoriously, a flat-track bully - a high beta player. Mike Atherton on the other hand was a negative beta player, scoring runs when they were needed.  

Coaches are forever demanding consistency - in the sense of low variance of performance. What they should also look for is negative beta. Arsenal lacked such players on Saturday.

The parallels between football and financial don't end there. One feature of stock markets, famously noted (pdf) by Robert Shiller, is their tendency to excess volatility as investors over-react to good or bad times. The same, of course, is true in football. One or two good results has that great moronfest 6-0-6 full of callers telling us their team will win the league and one or two bad ones means the manager is an idiot. In the few weeks he's been in charge of S***s, Tim Sherwood has gone from being a promisingly good manager to a lousy one, and back again.

There is, I think, a point to all this. It's easy to think of financial economics as something abstruse and technical. But it's not. As I've said before, the main ideas of financial economics are applicable to other walks of life. 

Ideology & behavioural economics

Tim Harford's brilliant essay on behavioural economics highlights an ideological bias in the way the subject is used.

What I mean is that he presents it as "a hot idea for policy makers". This underplays two things.

One is that politicians themselves might be as prone to cognitive biases as the public. Indeed, it's possible that they are selected for such biases - because the overconfident are disproportionately likely to enter politics and because irrational consumers are likely to make irrational voters. The image promoted by behavioural economics (or its users) - of rational policy-makers operating upon irrational subjects - is therefore questionable.

The other is that there's an alternative use of behavioural economics. It could serve an educational function - of telling consumers what errors people commonly make, and of warning them against them. A lot of my day job is just this.

In this latter context, the complaint some make against behavioural economics - that it is a "patchwork of sometimes-fragile psychological results" rather than general laws of behaviour - loses its force. If you're a policy-maker with a "predict and control" mentality you might want general laws. But if you just want to help others improve their decision-making, the knowledge that some/many people make a particular error in a particular context is useful enough.

Behavioural economics gives economists the chance to live up to Keynes' ideal of them, as dentists giving humble competent advice. And it's a chance they are blowing.

Now, you might reply here that it has always been so, Economics has long been pompous white men in suits speaking to other pompous white men in suits, rather than a dialogue with the public. That's true. But there's a big difference between telling politicians "people are rational maximizers so leave them alone" and telling them "people are stupid and here's how you can manipulate them."

In this context, there's both similarity and contrast between users of behavioural economics and Marxists. Both believe that ideology or cognitive biases (they're much the same) stop people pursuing their best interests. Where they differ is in how they respond to this. Marxists think people should be educated out of ideology and therefore empowered: "the emancipation of the working class must be the work of the working class itself”. Most users of behavioural economics, by contrast, see cognitive biases as just more policy tools, and thus ways of empowering rulers. But it needn't be so.