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Are we stupid?

As we sit in the midst of what seems like an historic episode I find myself struck by one question: how can we have let ourselves get into this again?

Didn’t we know this might happen?

For sale signsAt least we should have seen a turn in the housing market coming, surely? It’s not just in the UK that we have had several years of warnings of house price corrections, comparisons to the 1980s, graphs showing scary upward trajectories.

Yet some of the world’s best paid people lent money secured against inflated house prices, and appear to be surprised that the market is not what it was.

There’s a ±«Óătvr Simpson quality to the analysis that led us here…you can picture ±«Óătvr attempting to grab a donut well out of his reach, banging his head, and then repeating the mistake time after time. That’s where we appear to be in the housing market.

One colleague suggested to me today – rather acutely - that housing market cycles last eleven years, while our memories last nine. There is always a two year silly frenzy that has to be undone.

The idea is not very different to that expressed by Alan Greenspan in . He bemoaned the obvious failure of the commonly used risk-management and econometric models to cope with the episode we are now in.

They do not fully capture “the innate human responses that result in swings between euphoria and fear that repeat themselves generation after generation with little evidence of a learning curve” he wrote.

It’s probably the only point on which and would agree.

Interestingly, human irrationality is a hot topic in economics at the moment. it’s called, on the cusp of economics and psychology.

While it is dismissed by some old-school economists as a bit flaky, and by others as intellectually lazy, it is a subject that is hard to dismiss entirely, particularly as we look at the repeated cycles of boom and bust.

Put simply, behavioural economics argues that human beings’ decision-taking is guided by the evolutionary baggage which we bring with us to the present day.

Evolution has made us rational to a point, but not perfectly so. It has given us emotions, for example, which programme us to override our rational brain and act more instinctively.

Those emotions probably worked well for us in the savannah, where it wasn’t really very useful to spend time thinking about whether to flee the tiger or not. But the instinct is still with us now, it affects our behaviour, even that of apparently very rational people, and it can’t be ignored.

Emotions are just one example of behavioural effects. The general point is in explaining our behaviour, evolution can trump economic theory.

Two current books make the case for taking behavioural economics seriously rather well.

The first is which details the many experiments that have been performed on people to demonstrate systematic behavioural traits.

The second – released soon – is Basic Instincts, by Peter Lunn. It is an excellent book; a feistier defence of behavioural economics and more of an attack on traditional economics.

Personally, I don’t see old economics and behavioural economics as opposed. It is useful to assume people are rational as a good approximation to their long term behaviour, but it would be unwise not to think how in practice their behaviour may deviate from that simplifying assumption.

Both books are well worth reading.

You will read about fascinating lab tests on people, demonstrating the ways in which honest people allow themselves to be dishonest, about how sexual arousal affects judgement and how we tend to work less hard if we are paid by results, than if we are doing something as a favour for someone.

And talking to Dan Ariely in recent days, I find he comes up with at least two ways in which the literature is relevant to where we are now.

First is the insight that emotion (greed, fear) can override rationality when we make decisions (we repeatedly tend to buy too much food if we visit the supermarket when we are hungry).

And secondly is a tendency to see evidence selectively. We give more weight to the facts that support the theory we have in mind.

So in the upswing, it is easy to find facts to support the upswing…other evidence is overlooked. Only when the countervailing evidence becomes unarguable, do we change our mindset and start fearing the uncertain.

The literature does not imply we’re stupid. We’re just not as clever as we like to think.

It is a good point to bow out on, as this column represents the last post for the Evanomics blog for the time being.

I stop being Economics Editor this week, as the excellent Stephanie Flanders takes over. (I’m not sure if it be called Stephanomics, but her blog will be worth reading whatever the name.)

I will strive to do some writing, but my new day job (or night time job to be more accurate) will be presenting the Today programme on Radio 4 (for a year at least).

It’ll be a fascinating test, to see whether the mind-set of an economist can contribute to discussions on subjects as diverse as Pakistan and frog spawn.

Thank you for reading Evanomics, and to the News blogs team for ensuring that some of the most egregious errors are dealt with.

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Taboo of nationalisation

Is it a good time to nationalise the banks?

The taboo of nationalising a bank – evident in the government’s reluctance to accept that option for Northern Rock – may have to be overcome in the next few years.

This is one lesson to draw from previous banking crises. The for example, is generally regarded as well handled. And the solution there was to take ownership of the failing banks, to strip out the bad assets and to put them into separate well-funded asset management companies whose only job was to extract as much value from them as possible.

Once that had been done, new “cleaned up” banks could be re-established and operate again very quickly. It worked for them, although it was helped by buoyant economic conditions.

But it tells us that a successful resolution of a bank crisis can involve governments or central banks owning more of their banking systems than they would probably like.

The relevance of this argument today is that the banking crisis we are now in is one in which the banks’ own capital has been eroded by losses they have incurred on their past decisions.

The banks' capital is best viewed as a relatively small rock, on which the rest of their activities sit. Before they can borrow and lend £12, they need £1 of their own capital to serve as a kind of safety cushion. That capital is one thing that makes it safer to lend your money to a bank, than it is for you to lend directly to the bank’s borrowers.

It is no wonder that bank capital is regulated. When borrowing and lending is profitable, it is tempting for banks to scale up their operations and to borrow and lend too much in relation to their capital, in effect reducing the effectiveness of the potential capital cushion.

The problem for all of us is that when bank capital is eroded, the banks’ lending has to be curtailed, with broad economic consequences. Whatever the central bank rate of interest, or whatever the credit-worthiness of potential borrowers, banks are constrained from lending and sometimes have to call in loans that have already been made.

We want banks to lend responsibly, but we don’t want them to curtail lending too far.

So the goal has to somehow be to get more capital into the banks.

That’s not about us putting deposits into banks, or central banks lending money to banks… it is about extra money finding its way into the banks, to rebuild the capital rock on which successful banking depends.

Who can invest new money in banking right now?

The most obvious candidates around the world are the sovereign wealth funds sitting on large amounts of spare cash.

But in the absence of clear information about how much the banks are worth, the funds may be reluctant to throw more money in.

(The experience of may put other investors off. As China’s biggest brokerage firm, it promised last October to invest $1bn in Bear Stearns in return for 6% of the company, a price that looks high given the news that has occurred since.)

If wealthy foreigners are not going to inject capital into the banks, and if the crisis is as bad as some suggest, the best candidate to inject capital might instead be our own governments.

It’s not quite bailing the banks out, and it would not be aimed at rescuing the shareholders – the new money would go in, and in return the state would obviously have to take a stake in the banks future profits. The existing shareholders would lose some of their share.

These kinds of solutions are not infrequently adopted, but normally occur when the banks have run out of money. But does it have to be a 100% stake in a bank? And does it have to wait until the bank is in dire trouble?

Ultimately the solution to the problems of the banks is clear: the full scale of losses incurred in the bad lending of recent years has to be recognised; the failing assets written off without a fire sale of assets; and for the banks to be recapitalised and re-launched from a healthy base.

Taxpayers might object to their money being sent in to support banks, but it is probably money well spent if it supports the economy generally, and stops the rot quickly.

In fact, there is one final lesson to be drawn from history, from the , which was less well-handled than Sweden’s.

As problems unfurled in the early 90s, the public objected to the idea of helping banks and only one trillion yen of support was mobilised. By the end of the decade, as the crisis worsened, more like 6o trillion had to be found.

These things can get very out of hand.

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Chancing it

The slogan for the Budget - you mustn't grumble, it's not too bad.

Sure, the next year or two is not what we thought it'd be, but it's not all permanent damage to the economy we're facing.

In other words, while he is not dismissing the current problems as a mere blip, the chancellor is at least arguing that some of it is simply a temporary disturbance to normal service.

So, on the economy, the chancellor concedes that some growth in the next two years will be lost - and it won't come back later (which is in itself a major concession. His predecessor always assumed that any growth lost returned later).

But at least by 2010, the economy will be growing again at its normal rate. And there'll be no recession in the meantime.

The same pattern occurs on government borrowing. After several years of painfully slowly trying to bring it down, the chancellor is now actually predicting and allowing for more borrowing next year. Overall, the finances are ÂŁ5-8bn a year worse than he'd expected last year.

But again, you mustn't grumble. The public finances improve with time, and there's only a modest new overall tax rise to help recoup some of the revenue lost during the slowdown.

Fair enough. But behind this scenario though, people might still find things to grumble about.

By 2010, on Mr Darling's forecasts, the economy is a little smaller than the Treasury had been expecting; prices are a little higher and while public spending will be the same, it won't go so far, in that world of higher prices.

And then above all, what if the next few years are far worse than the chancellor has allowed? With so much going on outside the UK, you really can't rule that out.

That may lead to full scale moaning.

The chancellor though, is chancing it - at least , until the next election.

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Shrinking economy

I was wrong an hour ago, to say the Golden Rule measure of borrowing was looking better than it had been in 2012. Sorry, bit rushed.

Looking at the data, the chancellor is conceding that by 2011, the economy will be 0.5% smaller than he had thought. And he doesn't appear to be thinking that "lost growth" will magically re-appear later.

That is a real concession. It’s says the slowdown is not all a blip.

This all means the Treasury have "lost" revenue and has extra costs, amounting to a five to eight billion a year deterioration in the public finances for each of the next few years. Of that, about 1.9 billion is being raised in new tax rises

But fortunately for the chancellor, the finances would be even worse than they are, but for the fact that inflation is higher than it was meant to be when he last spoke to us. Higher prices bring tax revenues in.

Perhaps the clearest way to see this story, is to look at the changing Treasury view of the year 2010. Compared to the picture in the Pre-Budget Report, the economy is half a per cent smaller, prices are 0.75% higher and the finances are 6.5 billion worse than expected, but taxes go up 2 billion to recoup some of the money lost.

Public spending is the same as before, but with prices higher, that will make the public spending settlement tougher to deliver than it was going to be.

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As expected

The Budget has the shape I expected… a downgrade of the near term, and a bounce back in the medium term. By 2012, the golden rule measure of borrowing actually looks better than it did back in October. I suspect that means it is a net tax raising budget, with the tax rises delayed.

We've already had one tax rise from 2010 - the return of a new fuel tax escalator, with the half pence per litre rise in tax each year, over inflation. The MPs barely seemed to notice it, but it is a tax rise that the next government will find itself dealing with.

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Real change of direction

Alistair Darling adopted the technique beloved of his predecessor of rattling through the borrowing figures. But the news this year was good - it seems lower than it was expected to be. The bumper tax receipts that the government received in January seem to have helped.

But the more significant thing is that borrowing is expected to rise in the chancellor's new forecasts. That marks a real change of direction. In the past few years, Gordon Brown always budgeted for borrowing to fall. Of course, his forecasts were often wrong but he always budgeted for borrowing to come down.

Mr Darling does think that by 2012 borrowing will be right back to where he thought it would be.

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Not so cautious

The economic forecast is more realistic than it was, having been downgraded this year and next. For 2008 1.75 to 2.25, for 2009 2.25 to 2.75 and for 2010, 2.5 to 3.0. The current consensus among outside forecasters is for growth of 1.7% this year, and 2.0% next.

The chancellor focuses on the bottom range of his forecasts and calls this "cautious", but in reality, the risks are mostly on the downside next year, and those risks could be quite significant. Mr Darling's forecasts appear reasonable, but not very cautious.

notes_on_real_life

Central banks get together

The world's central banks are back. They're taking collective action again - all for one and one for all.

They learned back in December that co-ordinated action works better than individual action.

In any case, moving together at least prevents the stigma facing any one of them that takes individual action, which inevitably invites the question "What do they know? Things must be very bad on their patch."

But why have they all moved now?

Well, it is partly because the action they took back in September is expiring so it needed to be renewed.

But it is partly because the problems they "solved" back then have crept back. The LIBOR spreads - the best measure of the banks' reluctance to lend to each other - have been rising again (though they're not as high as they were last year).

At the same time, there has been a stream of bad news - rising delinquency rates in the US mortgage market, (and not just in sub-prime) worries about hedge funds, about an affiliate of the Carlyle Group, about , and about a worsening economic situation... which all mean confidence is in short supply. The central banks are doing what they can to re-instil it.

What the central banks are doing is lending money to banks. These are secured loans - but they are secured against assets the borrowing banks possess. Unfortunately the assets are often the very ones other banks are themselves a bit wary of lending against (like mortgage-backed securities).

I'm not questioning the merits of lending against dodgy assets, although others might.

But it is worth questioning whether long term, the central bank action to lend money (albeit against assets that would otherwise be moribund) will work any better second time around than when it was tried last December.

Maybe, but maybe not. Here's the argument as I see it.

The evidence is that the credit crunch has been in two distinct phases - the first was a liquidity crisis, when banks needed cash to help them absorb their off-balance sheet affiliates which found they couldn't re-finance themselves as easily as they needed.

The central banks can provide liquidity - that's what they are designed for.

But that phase has passed. Since late October, we have been in a second phase of the credit crunch which has seen a reluctance for banks to lend to each other not out of liquidity shortages, but out of a general worry that the banks they lend to won't be able to pay them back.

It is, in other words, a crisis of confidence in bank solvency. It's not that banks don't have cash to lend; it's that they don't trust each other to have sufficient assets.

The problem with the central banks’ operations back in December and now, is that they don't really affect bank solvency, so don't have much effect on the underlying solvency worries.

To be more solvent, the banks don't need to borrow extra cash from the central banks, they need extra long-term capital from investors (from say, rich oil states, sovereign wealth funds, or the UK taxpayer).

Lending money doesn't affect the solvency at all, unless it props up confidence that would otherwise be lacking, or unless it injects an implicit subsidy to the borrower or unless it props up the value of some of the assets which the banks hold.

But the measures taken today are not designed to subsidise banks, or prop up the value of assets.

So the "active ingredient" the central banks themselves place emphasis on is the injection of confidence.

That may have a useful short-term effect.

It may stop confidence problems getting out of hand, with fears becoming self-fulfilling.

But long term, confidence will only have a sustainable effect on the solvency of our banks, if the confidence ultimately seems justified.

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