Chris Dillow's Blog, page 174

What are politicians for?

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

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

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

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

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

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

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

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

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

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

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

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

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

Equality vs big government

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

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

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

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

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

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

And the Spectator's leader says:

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

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

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

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

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

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

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

Rational overconfidence

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

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

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

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

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

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

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

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

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

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

All this raises a distinction which is often overlooked.

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

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

Some feminist economics

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

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

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

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

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

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

QE: a modest proposal

The Bank of England's extension of QE on Thursday has been greeted with a big "meh". Other policies - a fiscal boost, credit easing, a helicopter drop, whatever* - might be necessary. So, here's a modest proposal. The Bank of England should buy the debt not of the UK government, but of the Spanish, Italian and Portuguese governments.

This is not a cranky idea. In a famous speech 10 years ago, Ben Bernanke said:

The Fed has the authority to buy foreign government debt, as well as domestic government debt. Potentially, this class of assets offers huge scope for Fed operations.

Such a move would have several advantages:

- It would help weaken sterling, thus supporting UK exporters and manufacturers.

- In improving European banks' liquidity and solvency it would help avert the tail risk of financial collapse and so improve lending conditions and business confidence not just in the euro area but around the world.

- In helping resolve the euro crisis, it would boost aggregate demand in the region and so further help UK exporters.

Sir Mervyn has repeatedly said that "the biggest risk to the [UK] ecovery stems from the difficulties facing the euro area." So why doesn't he do something about those difficulties?

The economic argument against the above is that, to the extent that UK exporters price to market, they will respond to a fall in sterling by raising export prices and profit margins rather than volumes. This means output and employment might not benefit much. Sterling's big fall in late 2008, for example, did not obviously have a massively supportive effect on the economy.

I suspect, though, that the real barriers are political. It would be awkward for the Bank to explain to the Daily Heil why it is using "our money" to support Europeans: the fact that we suffer no material loss from conjuring money out of thin air wouldn't cut much ice.

Also, such a policy would be seen as treading on Europeans' toes, of failing to recognize national jurisdictions. The English are often accused of being insufficiently communautaire, but it's also possible to be too much so.

And herein lies my point. All of this highlights a longstanding fact. Economies, firms and markets have become globalized - the euro crisis is having global effects - but governmental institutions, and political attitudes, have not kept pace. And this is doing more damage than generally supposed.

* Targeting NGDP, in itself, is not an alternative. It would merely be a means of facilitating genuinely stimulative policies, be it printing money or fiscal expansion. 

Can banks survive?

There's one question that's been sharpened by the Libor scandal which hasn't had the attention it deserves - namely, could banks as we know them survive in a proper, honest, market economy?

I ask for three reasons:

1.Banks are supported by a massive implicit subsidy - the fact that their borrowing costs are kept artificially low by the belief that the government will bail them out if they fail.The Bank of England estimates this subsidy to be worth up to £120bn. This is more than all the profits banks made between 2004 and 2011 (table B3.2 here).

2. Banking, in its present form, creates a large negative externality in the form of risk pollution: all of us suffer when a banking crisis leads to economic crisis. This externality might be so large as to swamp the profits that banks do make. As Andy Haldane of the Bank said (pdf):

Fully internalising the output costs of financial crises would risk putting banks on the same trajectory as the dinosaurs.

3. The Libor affair suggests that some of the profits that banks do make are thanks to, ahem, sharp practice. If we heed Warren Buffett's maxim that there's never just one cockroach in the kitchen, we must ask what else are banks up to? How far are profits boosted by mis-selling, or front-running, or insider trading or other dubious deeds?

These facts raise an uncomfortable possibility - that if we were to ever have an idealish market economy - in which businesses don't get state subsidies, behave honestly and do not impose externalities upon others -  then banks as we know them couldn't exist.

Banks as they presently exist are not exemplars of a free market economy but rather means whereby a few oligarchs can enrich themselves at the expense of the rest of us. 

Those who rightly rail against crony capitalism - as Sam Brittan does - fail to see that a genuine market economy requires very radical change in the banking system indeed - much more so than the Vickers report envisages.

The origins of misbehaviour

Why do people in positions of power behave badly? A new paper shows how experimental economics can shed light on this question:

Using a laboratory experiment, we fi…nd that senior workers often attempt to exploit junior workers...This occurs both when junior workers have complete information about how their effort affect the senior worker’s earnings, and when they have incomplete information about how their effort affects the earnings of the senior worker. These attempts, however, are more frequent and pronounced under incomplete information.

This means that the standard political response to misbehaviour by the powerful - to demand a resignation whilst maintaining basic structures of organizations - is often mistaken. As Marx said, and as subsequent research has shown, bad behaviour does not originate merely from the idiosyncratic impulses of nasty people, but rather from organizations which incentivize and facilitate bad behaviour.

But what are the organizational features that matter? These experiments suggest three inter-related things:

1. Social norms. In their experiment, there was a norm in favour of an equal division. This meant there was a default position of non-exploitative behaviour.

2. Information. Where juniors could see that they were being exploited - because they could observe seniors' pay-offs - they were empowered to resist exploitation. Not that such resistance was always necessary, because seniors - fearing it - adhered to the norm of equality in anticipation.

3. Power. The possibility of exploitation emerges because seniors have power over juniors.

It is, of course, trivial to apply this framework to Barclays' Libor fiddle. There was a social norm in favour of maximizing returns rather than for honest reporting.The process of reporting Libor was not as transparent as it could be; Libor is a hypothetical rate which in October 2008 had as much relevance to real behaviour as the price of unicorn meat. And power structures, rather than promoting honest behaviour, might even have militated against it.

The point here is that Barclays' problem was not that Bob Diamond is a bad person - the fact that he's a Chelsea fan proves that - but rather that structural pressures led to dishonesty.    

Evidence, overconfidence & the crisis

One of the strongest complaints about the coalition is that many of its policies - for example, on taxes, EMA, or troubled families - are not based upon evidence.I wonder whether this failure is connected to the financial crisis.

To see what I mean, start from Andrew Lo's point that financial markets are neither efficient not inefficient but rather adaptive. Profitable opportunities regularly emerge, only to disappear as traders recognize them and bid them away.

To take just one example, in the 1980s it became increasingly well-known that smaller stocks had for years beaten the market. This sparked increased buying of them, but such buying pushed their prices up to a level from which subsequent returns were poor.

This means that evidence-based rationality can be counter-productive in financial markets. If you wait until there is huge evidence that a particular strategy works, it's likely that other people will also be aware that it works, and their buying will have moved prices against you. This was the fate of those who bought small caps in the late 80s.

In this sense, the trading mentality is the antithesis of the academic mentality*. The academic is cautious, proportions his beliefs to the evidence and wants more research.But the trader who waits for strong evidence will have missed the profits. The academic wants to be right, the trader wants to be first.

What's true of trading is, to at least some degree, true of entrepreneurship and business generally. The entrepreneur acts on hunches, often against the prevailing wisdom. There's a reason why many business-minded people feel frustrated in big bureaucratic firms that demand more market research, and why businessmen and academics often have a mutual incomprehension.

Which brings me to my point. If the trader's mentality enters politics - either because politicians have a business background or because they are influenced by association with business rather than academia - then we will have policy-making without an evidence base. What's appropriate in one sphere is not appropriate in another.

But what's this got to do with the crisis?

Plenty. To trade in adaptive markets, you must act upon a shaky evidence base, and this requires overconfidence. I suspect that if there is one character trait which links traders, it is not greed or amorality but overconfidence.

And, of course, it was overconfidence in various forms - in RBS's belief it could pay billions for ABN Amro, in Northern Rock's reliance on wholesale finance, in other banks' holdings of mortgage derivatives - which triggered the crisis.

If I'm right, or nearly so, there's an implication here. It's that the crisis was due not simply to individuals' failing, but rather was the result of the over-application of the sort of mentality that it is actually often necessary to have in financial markets.In other words, the crisis arose from the very nature of markets selecting for particular character traits**. The qualities that help a species thrive can also - when the environment changes - also hasten its demise.

* I'm speaking here of stereotypes. Some academics (those who want celebrity!) have a trader's mentality, and some traders are more academic than others.

** Yes - this is a variant of Minsky's financial instability hypothesis.

On happiness inequality

Here's a curious finding:

Within-country happiness inequality has fallen in the majority of countries that have experienced a positive income growth over the last forty years, in particular in developed countries...This mean-preserving declining spread of happiness happens via a reduction in both the share of individuals who declare a very low and a very high level of happiness.

This is true for the US since the 1970s, Germany since the 80s and the UK since the mid-90s.

You might find this paradoxical, because during this time income inequality has generally increased, which you might expect to increase inequality of happiness.

However, the paradox is only superficial. Rising income inequality, ceteris paribus, does tend to increase happiness inequality - which is one reason why the US (pdf) has seen a partial reversal of the decline in happiness inequality since the late 90s. It just happens that, over the long-run, economic growth has reduced happiness inequality by more than rising income inequality has increased it.

One possible explanation for this lies in Abraham Maslow's hierarchy of needs. As the economy grows, the basic needs of the poor for nutrition and health are more easily met, and so the numbers of people in misery decline. However, the more neurotic rich increasingly ask "if I'm so rich, why aren't I happier?" and focus upon the lack of fulfilment of their needs for self-actualization. The number of very happy people thus also declines.

So, how embarrassing is this for egalitarians?

It is awkward for green egalitarians, because it means the case for economic growth is stronger than supposed, if you value equality.

It is also awkward if income inequality is necessary for economic growth - because if this is so, then income inequality is a price we must pay for increased equality of happiness.

However, in another sense, it might strengthen egalitarians' arguments.

First, if income inequality (pdf) is bad for growth, as Joe Stiglitz argues, then the case for income equality strengthens - because income equality would raise economic growth and thus increase happiness equality.

Secondly, if the hierarchy of needs explanation for increased happiness equality is correct, then inequalities of power in the workplace become more pernicious as incomes rise because they frustrate demands for self-actualization and so prevent rising incomes from leading to rising happiness. In this sense, egalitarians and utilitarians (and proper libertarians too!) can make common cause.

Blindness about collective action

Vince Cable says:

The governance at the top of our leading banks has been lamentably weak...shareholders have to get a stronger grip on weak boards and out-of-control executives.

But there is a reason why shareholders do not have a powerful grip on companies, and will not even if legislation permits them greater control. It lies in the problem of collective action. For any individual shareholder, the costs of overseeing day-to-day corporate behaviour are considerable in terms of time and hassle, whilt the benefits of better governance are diffused across all shareholders, and indeed the general public.Each individual shareholder thus has an incentive to free-ride on others' efforts at oversight, with the result that shareholders collectively don't exercise effective control and company AGMs are disproportionately attended by the lunatic fringe.

This should, of course, be well known. So why doesn't Cable seem to know it?

His error is not an individual idiosyncrasy. As I've pointed out, a consistent theme of this government - from encouraging panic-buying to its attitude to welfare reform - is a failure to realize see that individually rational behaviour can be collectively self-defeating.

This is puzzling. Traditionally, it has been thought that one of the prime purposes of politics is to solve problems of collective action: to supply public goods that a free market would (might?) under-supply; to rectify market failure; to provide a legal framework which helps ensure that the pursuit of individual interest doesn't clash too horribly with the social interest.You'd expect, therefore, politicians to be especially alive to the problems of collective action - because it is such problems that (should) give them a reason for existing. And yet Cable's comment here suggests that he is as blind to this issue as the Tories.

Why? I can think of two possibilities.

First, the decision to enter politics is not taken as a result of an intellectual interest in social science, but rather as an emotional urge - something people feel they have to do, without really knowing why. Gordon Brown is a good example here. He became consumed by a desire to become PM, and yet when he achieve that office he hadn't a clue what to do with it.

Secondly, it could be that our politics has become dominated by a bastardized version of free market thinking which denies the possibility of a conflict between individual and collective interests - unless, of course, those individuals are workers or benefit claimants. This ideology is so ubiquitous that even intelligent men such as Cable are blinded by it.

* In fairness to Cable, his call for tighter regulation and alternative business models for banks suggests he is groping towards a recognition of this problem. But he doesn't seem to see the fundamental conflict between private ownership and the collective interest as clearly as he should.