Notes on Real Life (archive)
Are we stupid?
- 19 Mar 08, 11:12 AM
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?
At 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.
Central banks get together
- 11 Mar 08, 05:37 PM
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.
Flat market
- 26 Feb 08, 09:13 AM
Have we overdone it with city centre flats?
Or apartments as they are often called in the sales literature.
Arrive at almost any railway station - from Norwich to Nottingham - and you can't help but be struck by how many new blocks have appeared.
But there's some evidence the flats are not selling.
The tallest residential block in Britain is Beetham Tower, the iconic Manchester building that opened less than two years ago. Some colleagues of mine have found fifty of the flats in there are now on sale - getting on for a quarter of the 220 built.
The bulk were bought by investors hoping for capital gain. They can reportedly still get tenants to rent them out, but capital gain will be harder to come by if they try to sell them with so many others doing the same thing down the corridor.
In Leeds too, the situation is said to be bleak.
has reported that a thousand flats lie empty - but many thousands more are in the pipeline to be built. One can only assume most will never be constructed.
And you don't have to go to big cities to find stories of the flat phenomenon going too far.
In Colchester, one surveyor told the latest RICS lettings survey that there are signs buy-to-let investors failed to do their homework; they believed unrealistic valuations. Investment clubs have been a problem, and surveyors acting for them had better watch their backs, he said.
Another interesting piece of evidence is that housing associations are reportedly being offered new flats for social housing - at discounts of about 15%. A reversal of the principle of council house sales.
All in all, flats have been where the property market action has been most extreme over the last decade - prices have risen faster there, speculators have invested more in them, homebuilders have constructed them in ever larger numbers.
It suited the authorities, who produced numerical targets to build more dwellings…never mind how large they are.
And there was an apparent economic logic given the growing number of single person households.
Alas, it seems that the new singles are not urban youngsters enjoying a latte on the balcony as depicted in the hoardings. They are elderly widows and divorced dads, who aspire to having a family home with a garden.
And now the market seems to have turned against flats more ferociously than other types of housing.
It's patchy and anecdotal for the moment and local conditions certainly matter.
But when the dust settles watch for blame to be attributed by some people who will have lost money…in a market not so much flat, as falling.
Migrants go home
- 21 Feb 08, 04:09 PM
This title is not a ±«Óătv correspondent adopting a slogan the British National Party might use. It is a statement of fact.
Migrants go home, as well as arrive in our country, with consequences for the economy.
And at this conjuncture where many things we’ve been used to for the last decade are now moving into reverse (most notably house prices), it’s worth asking whether inward migration from central Europe is about to turn as well.
The starkest reason to think it might is that the Polish zloty has risen against the pound by 20% in the last year.
The earnings you can make here don’t look nearly as impressive to your friends and family back home anymore.
In addition, wages in Poland are rising fast: 7% in 2007 (with inflation at 4%).
So overall, UK wages relative to Polish wages measured in Zloty, have fallen by a quarter.
That’s a pretty big change in 12 months.
A second possible factor that will begin to bite, is that the UK construction boom has probably peaked. The latest data is inconclusive, but new construction orders in the second half of 2007 were down on the first half.
Anecdotally, it is demand in construction that has fuelled a good deal of the central European migration.
Reliable and up-to-date statistics on inward migration are hard to come by. The data we have on accession country workers registering here suggests the inflow peaked in the second half of 2006; but this gives us no bearing on the outflow at all.
The Times reported earlier this month that the Polish embassy had noted that a “tipping point” had been reached, with more Poles returning. But so far, the evidence is mainly anecdotal.
If it is hard to know whether the exodus is underway, it is even harder to assess the consequences.
The City consultancy, Capital Economics concludes that “potential GDP growth is likely to slow gradually from the recent rates of 3% or even higher, to more like 2.7%”.
That is undoubtedly possible. But it is worth thinking about the effects in more detail.
And surely the labour market is where to look. If the economy slows, outward migration might soften the impact. As the demand for labour goes down, instead of unemployment going up, the supply of labour might adjust.
In that sense, one could view migration as a buffer that has softened the inflationary wage pressure of a boom, and which can now soften the labour market effect of a slowdown.
It would almost be as though UK plc had chosen to hire temps for a few years, to see it through a rather busy period.
The outflow of workers might have less benign consequences too.
If migrants have held wage inflation down, an absence of migrants might drive it up, just at a time when there is a threat of inflationary expectations rising.
And away from the labour market, think about house prices! At a time when they are falling, a reduction in migrant numbers might intensify the difficulties faced by buy-to-let investors, and the market as a whole.
This is still in the realm of speculation.
In reality, it’s far too early to call an end to the accession migration boom. And it is undoubtedly the case that many of the recent wave of migrants will settle in the UK permanently.
But one can reasonably hypothesise that if migration reverses, the things that we have associated with migration over the last decade, will do so as well.
Banking parallels
- 19 Feb 08, 09:22 AM
Nationalising a bank is a big deal. But it is not unprecedented.
It is worth reading the history of Continental Illinois, nationalised by the in 1984.
You can get the full story from the FDIC itself (pdf link). But let me give you a potted account.
The Bank was the biggest in Chicago and the seventh biggest in the US. It had grown very fast and had received glowing approvals from Wall Street observers in earlier years. (Not dissimilar of course, to Northern Rock which had, for example, been rated a “buy” by Deutsche Bank analysts less than two years ago when its share price was around £11).
A few voices had suggested that Continental Illinois was in fact simply engaging in an ancient banking technique for achieving short term growth – that of taking bigger risks than more cautious rivals would countenance.
Problems first surfaced in 1982 with the collapse of Penn Square Bank in Oklahoma. Continental Illinois lost more than any other bank, having participated in careless oil and gas loans.
Its share price dipped and its credit rating was downgraded. As a result, it became dependent on tapping the foreign money markets for its financing, borrowing short term to keep costs down.
It was not a bank that had secured a very large retail deposit base.
By the spring of 1984, problems in Continental’s loan book were mounting and rumours surfaced of problems. On May 9th, a Reuters journalist asked the bank whether it was true that it was on the road to bankruptcy (the suggestion was dismissed as “totally preposterous”). Foreign depositors didn’t wait to find out how preposterous it was, they started to withdraw their cash.
Even the Chicago Board of Trade Clearing withdrew $50 million and quickly the bank became victim to an “electronic bank run”.
The Federal Reserve ended up supporting the Bank through its “discount window”, but more support was needed.
On May 17th, the FDIC announced that all deposits at the Bank would be guaranteed. Extra federal support was provided, and some assistance from other banks too.
While this bought time, a permanent solution was sought.
The preferred option was for a private takeover of some kind, but it could not be arranged.
In the end, the FDIC itself constructed a complicated arrangement that involved it taking 80% of the equity, with the bank continuing to operate.
You don’t need me to tell you that there are some parallels to Northern Rock here: the bank run, a deposit guarantee, a delay while private solutions are sought, and nationalisation.
And that sequence is not fortuitous. At each stage of the process, there are only a limited number of options, and the ones chosen (then and now) are chosen for a reason – that the others look even more unattractive.
The good news is that when the last pieces of Continental Illinois were eventually sold off (seven years later!) the FDIC had apparently netted a profit. Whether that profit truly compensated for the state’s backing I’m not sure.
Splitting the difference
- 7 Feb 08, 03:29 PM
Today's decision was unusual in that it could have gone three ways - it could have conceivably been a half point cut or no cut at all.
The reason there's such a wide span of options is that the economy is sitting at a crossroads. It could take one of three routes from here, but we don't know which one it will be. Unfortunately, we know those three routes take us to three very different destinations with very different implications for interest rates.
One route is towards an unpleasant recession -- the kind of early 90s experience.. or even worse, the Japanese 1990s experience.
With the housing market falling and the banks suffering, you might reasonably worry about such a scenario. And if you do, you would probably think a half point cut is needed. i.e. the sort of central bank action that you get in the US.
But while the US appears to be on course for some kind of recession, the situation is far from clear-cut in the UK. We still face a second possible road that takes us towards inflation.
With the pound falling and global commodity prices rising, we might actually need some kind of significant slowdown just to kill off the pressure for prices to rise. If we knew we were heading in that direction, it would have certainly justified holding rates as they were.
In the event, the Bank opted to split the difference on rates, evidently hoping the economy will take the third road -- towards a rebalancing of the economy.
This involves a relatively gentle slowdown with only a temporary upturn in inflation. The rebalancing part of the story sees the economy shift away from its dependence on consumer spending towards exports.
We can be sure that this third road is the one we want the economy to take. Unfortunately, we can't be sure it's the one the economy will take. Economists are divided over which direction we are moving in.
The statement -- released with the quarter point cut -- makes pretty clear that they recognise the economy is sitting at a crossroads, and all three routes are still possible.
Their job is simple: to navigate us towards the good rebalancing route, away from the bad inflation and ugly recession.
Today's number: Eight billion
- 30 Jan 08, 10:45 PM
I don't like to reduce the hard work of the much respected and to a single number. Their annual Green Budget is after all 299 pages long. (It is nothing to do with environment incidentally, it's green in the sense of a green paper).
But I know that most of you will not be reading those pages, and good journalism is often about boiling things down.
So I'm happy to boil down the green budget into one number: ÂŁ8bn.
That's the tax rise needed by spring 2009.
The tax rise is required for the Chancellor's self-imposed fiscal rules. He needs it to ensure he meets his sustainable investment rule. And also to get the key measure of borrowing into surplus (the current balance, the measure used to assess the "golden rule".)
The IFS did not advocate tax rises last year, but over the course of 2007 it's become evident that the government's finances are far shakier than former Chancellor Gordon Brown expected at the time of his last budget.
In fact, the books now look ÂŁ7bn worse than a year ago. And that, it should be said, occurred before any economic slowdown had time to bite. Corporation tax and stamp duty revenues have already been disappointing.
So what's to be done?
Well, the Institute for Fiscal Studies is the most respected source outside of government on the public finances - and in recent years has had a rather better record than the at predicting the need for extra money.
Each year it looks at the books, and today it said it thinks taxes need to go up by that ÂŁ8bn, or the equivalent of about two pence in the pound on income tax if the economy performs more or less as Alistair Darling expects.
If the economy takes a serious dive, vastly more will need to be done.
This may not seem like a great time to hit households with extra tax - after all, the American government is allowing itself to borrow more in order to stimulate its economy.
But the IFS suggests that interest rates should be left to do the work of stimulating the UK...while the government needs to sort out its fiscal position.
In fact, the best reading of the IFS work is that the re-balancing that needs to occur for consumers - who will probably need to save more and borrow more carefully - applies also to the government.
The Chancellor and his predecessor have allowed themselves to assume that in years ahead, the good times will roll and money will flow in to the exchequer.
In fact, it seems the good times have just passed. That means both households and government have to adjust their expectations and spending accordingly (hence the impending economic slowdown).
It's just unfortunate, if the IFS is right, that the consumer and government cycle are so well synchronised. It might have been preferable for the two to be offsetting each other in the economy cycle, not supporting each other.
The real budget is expected in March - the Chancellor can update us on his thinking.
So far, the government has recognised that its medium term fiscal position needs some attention and has been restraining the growth of public spending as a result. But the IFS makes clear, a whole lot more needs to be done on top of that.
It's worth stressing that having boiled the IFS Green Budget down to an ÂŁ8bn tax rise, that's not a prediction of what will happen - just their statement of what ought to happen.
Cathartic recession?
- 25 Jan 08, 11:20 AM
Is there such a thing as a "cathartic recession"? A recession that purges the demons of excess from the economy and punishes the badly-behaved for their sins?
I'm not sure there is. But I unwittingly found myself in an argument with the former US Treasury Secretary Larry Summers on the subject.
I asked him whether central banks should be modest about how much they can hope to achieve and whether they might sometimes have to accept that economies slowdown.
My question was motivated by a sense that there's a limit to the imbalances an economy can accumulate to keep itself running at a good speed. (You can hear the interview on Saturday's Today programme).
Maybe I shouldn't have raised the topic.
He certainly put me in my place, arguing that the very question betrayed an adherence to one of most cruel, fatalistic and mistaken beliefs of the economics profession. It was the view held in 1929 he said.
He's once of the brightest economists around, Larry Summers and one of the most articulate. (His forthright views have got into trouble on more than one occasion). And his views need to be taken seriously.
As it happens, I don't actually believe in cathartic recessions, but his vociferous denunciation of them invites us to think carefully about exactly what it is we should believe of the economy at the end of a bubble. We might be right to tolerate a slowdown as part of a process of sensible rebalancing while also having to avoid a deep recession that wastes the potential of the population and needlessly makes people poorer than they should be.
My view is that the correction of imbalances probably involves some slowdown and we should live with that. Larry Summers' view (I think) is that we should not talk that way, because it will soon lead us into tolerating or creating the needless cathartic recession.
After he had finished with me, Professor Summers said he had been inspired by my questions (the sheer stupidity of them) to give a talk on this very subject.
It's good to know that my interview was so inspirational.
The importance of love
- 24 Jan 08, 01:57 PM
Sometimes it's the "Davos fringe" which provides the most stimulating discussions.
To that end, I just enjoyed a constructive 15 minute diversion from the sub-prime blues, chatting with an American anthropologist called about love. (You should be able to hear it on Friday's Today programme).
She is addressing a couple of sessions here and her message is essentially that love is very important to all of us. But she's not echoing the usual John Lennon type calls for world leaders to reject war, and find love and peace. She has performed brain scans on lovers of different types to see what effect it has on us.
I won't tell you everything she has to say, except the two practical tips she offered me. First, don't get married in the first euphoric phase of a romantic attachment – wait for the love to settle down. And secondly, once it has settled down, to keep it alive do novel things together and don't let it become routine.
As we recorded our conversation on a rather unromantic sofa in one of the lobbies, I noticed that people sitting nearby were listening in.
John Lennon would probably have been pleased.
Economic nationalism
- 23 Jan 08, 11:35 PM
I only arrived in Davos a few hours ago, but I've had three conversations and they've all ended up coming back to the same kinds of issues – protectionism and free trade, economic nationalism and the shift of economic power in the world.
If you'll forgive the name-dropping, two of those conversations involved George Soros and Henry Kissinger, who I actually spoke to before I arrived. (You can hear Soros online and Dr Kissinger will be broadcast on Thursday's Today programme).
But my not-very-representative sample of three conversations is clearly not altogether off-agenda, because I notice that David Cameron is here this evening, giving a speech on the subject as well.
"The heroes will be those who held their nerve and stood up for free trade" is his line, (while commending John McCain for doing that in the US election campaign).
It is not surprising the issue of trade has come up.
First, the US election has displayed some signs of gentle (or not so gentle) economic nationalism.
Secondly, it is – as you might have noticed - an interesting time in the world economy, and there might be a temptation for countries to retreat into the language and diplomacy of "looking after their own workers".
It might make sense at a selfish level for individual nations to put up trade barriers - although few economists would concede even that – but it rarely makes sense for the whole world to look after their own workers, because what we gain by protecting our workers, we lose by others protecting theirs.
Anyway, I expect the general issue of America's response to the rise of the emerging economic powers to absorb quite a few people here.
I'm not going to suggest it will dominate the Davos coffee-bar conversations of the investment bankers and private equity guys, but it does have a resonance at the moment.
Bubble bursting?
- 22 Jan 08, 03:30 PM
We escaped the last big bursting of a bubble - the - with a relatively light US recession. On that occasion, the world economy found its way back on track fairly quickly.
And that time, it was activist monetary policies - ie the slashing of interest rates that appeared to save the day. No wonder the has chosen to repeat the formula today.
But this episode seems more serious than the dotcom one however, and it probably won't be resolved quite as easily.
Why? Because in 2000, we only managed to soften the landing from the crashing of the stock market bubble by creating a housing bubble. That supported American consumer spending, (enabling Asia to carry on exporting).
Alas this time there are no more obvious bubbles to create.
So today's cut in interest rates will struggle to support consumer spending at the levels necessary to act as a motor to the global economy.
Indeed, fiscal policy will struggle to do that either.
If you want to know the challenge facing the world, it is summarised by the American savings ratio - the proportion of disposable income saved by American households.
Back in 2000 and 2001, it was about 2%. It has now drifted down to zero (if not actually negative this year). That figure at some stage will probably have to drift up to something more normal, around 5%. As American consumers save more, the US imports and spends less.
The rest of the world feels the effect.
Now the fact that the American consumer motor is unable to power the world economy anymore, does not mean the world economy has to endure a long breakdown. We just have to replace the engine.
That means the world really needs spending in Asia to rise, to offset the slowdown in the US.
At the moment though, it's looking hard to see how Asia can pick up the baton as quickly as the world needs.
Which brings us to today.
The potential for a serious slowdown in global spending is spooking the markets.
But the markets themselves now threaten to exacerbate the very downturn of which they are so scared.
The Fed is spooked by the markets, so no wonder the Fed felt it needed to take drastic action. Even if it isn't going to work as well as it did in 2000, it might at least prevent markets and the economy driving themselves ever deeper in to a quagmire.
2008: Looking ahead
- 28 Dec 07, 09:46 AM
Tis the season for predictions again. Yesterday you'll have read my reflections on what I said this time last year - and whether it was useful or not. But now it's time to look ahead...
If you asked how I’d like 2008 to go, given where we are now, I would be looking for
• a consumer slowdown;
• offset by a rise in exports;
• driven by a falling pound.
The overall economy would slow, but only to 1.5 to 2.0 per cent growth.
There are two interesting questions about 2008, that should tell us whether that scenario is achievable.
The first is whether the seed of inflation has already been planted in the economy and is now going to grow into a significant problem. If it has, economic life will be very much more complicated than my scenario outlines.
If we have already let inflationary pressure start building, then we can’t allow a falling pound to drive up prices, so we can’t promote more exports, so any slowdown in domestic spending is unable to be offset and becomes more serious.
Or to put it another way, the authorities will need more than a mild slowdown to kill the inflation.
The second question is whether the turning point now reached in the housing market combines with banking and financial problems to form a self-reinforcing downward spiral in asset prices, confidence, spending and growth.
The key words here are “self-reinforcing”. If we get to a point where a bit of slowing sets in motion more slowing, then the authorities will struggle to keep the economy on a desirable path. You need to hang on to your hat.
With those points in mind - here are my observations and forecasts for next year.
1. On inflation, my guess is that it will rise but then fall back and it won’t turn out to be a serious problem. I say this because a mild slowdown will be sufficient to tame the inflation, and at least a mild slowdown seems very likely. I wouldn’t say I’m sure of this, but that would be my guess. Inflation seems less of a threat than it did in 1989.
2. On the slowdown, my guess is that it won’t be self-reinforcing; but that it will be very significant. I expect the UK economy will probably grow less than most forecasters currently estimate (1.9 per cent is the current consensus). This slowdown will derive from the fact that consumers will start being more cautious, increasing the savings ratio. As a result, domestic spending and demand will grow rather modestly. I wouldn’t think consumers will stop spending in a very abrupt way - shopping habits die hard.
3. On house prices, they now appear to be falling. I expect they will continue to fall, by 5 to ten per cent over the year. This is not because of the credit crunch; it is simply that once people lose the sense that house prices are rising, they don’t want to buy them anymore and the demand for houses falls. In addition, the oversupply of city-centre flats and the inevitable sale of buy-to-let properties will lead to downward price pressure. I wouldn’t rule out the falls being much bigger, but the market tends to turn quite slowly (remember the US housing market started turning in 2006, not 2007).
4. On the pound, my guess is that it will fall alongside the dollar. The UK economy has to switch its emphasis from domestic consumption to exports; that requires the pound to fall, and the authorities will let it do so. If I’m wrong about inflation, the falling pound will cause problems and may be curtailed by interest rate rises.
Incidentally, I expect China will let its currency drift up significantly further against the dollar, and this will significantly ease the path to global re-balancing.
5. On interest rates, I expect the bank rate to fall, ending the year at 4.75 per cent. If I’m wrong about inflation or the severity of the slowdown, I’ll be wrong about this too! But my view is that rates can come down to contain the slowdown to the level just necessary to deliver falling inflation.
6. The government finances will probably turn out to be worse than Alistair Darling has forecast. The current balance (borrowing in excess of investment) for the 2007/08 year should exceed the pre-budget forecast by about four billion. It will be quite a problem as the chancellor’s forecasts for future years will look more and more shaky.
Those are my forecasts and observations. But let’s face it, there is a lot to go wrong. The US could slide into recession, China could overheat, oil prices could soar or banks could collapse. I’d love to predict that these will or won’t happen, but none can be foreseen with certainty, and none can be dismissed.
Mervyn King said he wanted to make monetary policy boring. He failed in 2007, and it looks like he’ll be struggling to do so in 2008 as well. My final prediction is that Mervyn will be reappointed to make it boring again – at least by 2013.
2007: A look back
- 27 Dec 07, 01:38 PM
Tis the season for predictions again. Predictions of what the world holds in store for 2008.
For me in fact this is the time of year when I publish a list of useful observations and am forced to attach some forecasts to them. My observations are usually more important than my forecasts, which are worth approximately nothing - i.e. about the same as everyone else’s.
Tomorrow I'll publish my thoughts on how the year ahead is likely to pan out. But today we have to face the difficult bit - how did I do last year?
These are the forecasts I made, which I described as uninteresting. (The full article can be found .)
• Base rates to end the year at 5.25%
• House prices to rise by 5 to 10%;
• Inflation to edge back down towards its target;
• The economy to grow by 2.5% or thereabouts;
• There would be a new chancellor by this time next year.
On base rates, house prices, inflation and the chancellor I was close enough. On the economy I underestimated the growth of the UK (it grew at about 3.1%).
But anyway, those forecasts, as I said, were uninteresting. The meat of last year’s article looking ahead to 2007 was that although the economy would probably chug along as normal, it might not. The argument was summarised in this paragraph:
“...the seismological analogy is a good one, because in many respects, you might think of the world economy as residing in a place like San Francisco. A place where the climate is benign, and the lifestyle comfortable, but a place located on top of a rather ominous fault-line, of global imbalance. 2007 will probably be quite normal in the world economy and in San Francisco for that matter. But if those fault-lines get disturbed in some way, it could turn out rather differently.”
The point was that 'business-as-usual forecasts' are mostly right, but rarely interesting. Just occasionally, the economy reaches a turning point and is genuinely interesting, but is then particularly hard to forecast accurately.
2007 is a year that we reached a turning point, although it didn’t turn enough to affect my core forecasts of inflation and house prices. So while I didn’t forecast the turning point, I did at least anticipate the possibility.
Come back tomorrow for my thoughts on 2008.
Apocalypse now?
- 6 Dec 07, 12:08 PM
... No surprise there, given the evidence that market interest rates are higher than intended and a slowdown is gathering pace.
Is the world saved? Can we now all relax?
Probably not. The main challenges remain, and the risks are sufficiently worrying that even if one tries to disregard apocalyptic language about recession, this is a pretty good time to allow oneself a bit of scary hyperbole.
For the most cogent example of that, see in The Times today.
My own personal view is that things may well go quite well next year. However, there is a sufficient risk they will go badly or very badly.
At the outset, it should be said that whether things go well or not, the economy seems to have reached a turning point, with an end to an era of rising house prices, rising borrowing, strong consumer spending, a deteriorating trade deficit and relaxed bank attitudes to lending.
Those had to end at some point and they have probably now done so. No problem there.
However, there are two reasons to worry that the turning point we've arrived at may result in significant problems.
First, there is a risk that a small degree of incipient inflation has been allowed to creep into the economy, which will make it hard to manage the changes occurring.
It's not obvious yet, but with inflation starting this difficult period just above target, and with energy and food prices rising fast, we can't dismiss it.
Indeed, if inflation is an issue, a mild repeat of the 1990s experience may be necessary to get rid of it.
But secondly, even if inflation is not a problem, we might be in for a difficult period. The Bank of England will have more room to cut interest rates, but lower interest rates are not a very powerful lever against certain forces. It can be hard for the Bank to engineer a controlled slowdown.
Once falling house prices take hold and consumers decide to save, there may be nothing monetary policy can do to get them spending again. In fact the best proof of that is that monetary policy has struggled to contain the boom in house prices enjoyed over the last few years. If households believe they need to save, to repair their personal balance sheets, there will be little point in trying to get consumers out into the shops again.
Now this raises the risk that even with more interest rate cuts, the economy can run out of steam, and then get itself into a downward spiral. A slowdown causes job losses, which causes more slowdown and more job losses.
On my recent trip to New York one economist, Jan Hatzius of Goldman Sachs, made the point that we should regard the words "vicious circle" as a pretty good definition of what a recession is. Once it takes hold it can be hard to stop, as the Japanese found out when their own share and property price bubble burst in the early 90s.
This is where the credit crunch and the difficulties of the banks come in. I suspect these are not causing the economic turn we are witnessing because the turn had to occur at some point anyway.
But credit problems may well end up being an accelerant, transforming the economic drama of an inevitable house price correction into a full-blown crisis. If the banks are unable to lend, the economy will probably slow more than it needs to for the various imbalances to correct.
If things do go into a tailspin we have no idea how deep or how long they could last. If confidence collapses, there is no good economic model to tell us when it will be restored. That's the apocalypse scenario we need to worry about.
Now for the good news.
Things might go actually quite well.
The economy has momentum, companies in general are profitable and so have a little cushion to fall back on, the labour market has not yet suffered (and even if it does, unemployment may not rise because there is a large supply of migrant workers who may choose to move to other more successful economies instead).
Inflation may not turn out to be a problem and interest rate cuts may put a floor under the housing market, the credit crunch and the slowdown.
And it might be that a gentle fall in the value of the pound allows the economy to steam ahead, built on exports rather than on domestic consumer spending.
It doesn't all have to go wrong.
Does that mean we should not allow ourselves to be apocalyptic? Well, I've tended to use the earthquake analogy. If you live on a fault line, you should be wary of the horror of an earthquake, even if there may not be one.
And in the economy right now, we can hope for the best but need to prepare for the worst.
Captain's update
- 14 Nov 07, 03:51 PM
Some quick thoughts on the ...
The economy is an aeroplane, and the captain (Mervyn King) has come across the tannoy with a rather complicated message. In essence, he said - "there's a bumpy ride ahead for the economy, but with a couple of rate cuts next year and a bit of skilful piloting, the economy can come through by 2010". I.e. - we'll be landing on time.
It's an interesting announcement by the standard of these things, but buried within it were a number of sub-lines, each of which deserves mention on its own.
Nightmares
Firstly, the governor wasn't ruling out some rather unpleasant scenarios. The plane shouldn't crash, but it could be a very bumpy ride indeed.
Personally, I'm glad he did not sound complacent on these possibilities.
My own personal view is that the famous fan charts the Bank publishes to present its economic forecasts offer a slight sense of false reassurance. They visually anchor one's gaze on to the most likely scenarios, when more attention should be given to the unlikely but far serious scenarios.
After all, there is unlikely to be a major plane crash today, but I nevertheless think the world's airlines should be very alive to the possibility.
But at least the governor's words were not designed to produce unjustified reassurance. He recognised the nightmare by which an economy can get trapped in a vicious circle of house prices tumbling, consumers slowing their spending very sharply, and the economy spiralling down with job losses and collapsing confidence.
And at the press conference, talk of recession was not dismissed as silly; an effort was made to show how the Bank's apparently benign forecasts do in fact allow for the possibility.
Spillovers
A second interesting message was that the Bank noted the spillovers from the credit crunch to the real economy have so far been rather modest. The governor spoke of a dichotomy between events in the city, in the housing market and in London, and the rest of the economy which has so far carried on producing much as before.
Or, to use my plane analogy - so far it's only passengers in first class that are feeling the bumps.
Mr King even pointed out that the financial sector in the city is perhaps a smaller part of the economy than generally supposed. Maybe that's why the rest of the economy has thus far escaped lightly.
Dilemmas
The third message I took from the press conference was the complexity of steering the economy through the turbulence it is now entering. Higher inflation next year, and slower growth. It's a tricky combination - it's the problem I described yesterday.
Using one control to keep the economy flying at the right speed, at the right altitude and in the right direction is a formidable task for any pilot.
Why inflation matters
- 13 Nov 07, 01:05 PM
Inflation is up to 2.1%. That may not seem a very big deal.
And as we have a symmetric inflation target of 2.0%, 2.1 is about as close to good news as you could imagine.
But in these fragile times for the financial sector, my own inflation preferences are decidedly asymmetric. At the moment, anything above target severely complicates the management of the economy over the next two or three years. Here's why.
In essence, the argument is that dealing with one problem is far harder than dealing with two. Just as doctors find it harder to give a heart by-pass to a patient with renal problems, a central bank finds it harder to deal with an economic slowdown and falling asset prices, while there's inflation lurking around in the system.
But this argument is particularly important at the moment, as most of the indications suggest the economy is at an interesting turning point. The Bank of England needs room for manoeuvre right now.
To understand exactly why, one needs to follow the chain of events that is likely to occur.
After several years of strong consumer spending underpinned by rising house prices and growing consumer debt, house prices will probably stagnate at best and consumers will probably start to retrench. The turning point has been a long time coming, but it seems to have arrived.
These things happen and do not, on their own, constitute a problem. If we buy more cars than we need in 2006, we buy fewer than we need in 2008. If house prices rise too much in 2006, they fall back to where they should be in 2008. Indeed, I would personally argue that one might see the current economic turn as good news rather than bad.
However, falling house prices and declining consumer spending do become a real problem if they leave the economy with too little spending to keep everybody employed. In that situation, the downward momentum can become self-reinforcing. The slowdown leads to job losses, which lead to further house price falls and further
slowdown, and more job losses.
This is where the central banks come to the rescue. They can prevent that downward spiral by cutting interest rates and stimulating spending.
They probably won't stimulate consumer spending as consumers won't borrow and spend more, whatever the level of interest rates, if they feel they have already borrowed enough.
So the role of the central bank in this situation is to stimulate exports by cutting interest rates and allowing the pound to fall to make exports more competitive.
That leaves the economy a perfectly good escape route from its obvious challenges. The central bank can ensure that at a difficult time the economy continues to grow, workers stay in work, consumers improve their finances and save more. All because exports rise.
But here's where inflation can get in the way.
If the pound falls, domestic prices tend to rise, which obviously adds upward pressure on inflation. If inflation is already above target, the central bank can't allow that to happen.
At a time when we need to extricate ourselves from a difficult situation, we may not have any way out. And we get back into the downward spiral of declining demand and rising unemployment.
The pre-existing inflation can end up being the equivalent of the locks holding the fire escape doors shut. In the end most macro-economic management issues come back to inflation. This is because you can convert many macroeconomic problems - like unemployment and falling house prices - into inflation problems if you want to by printing money to stimulate demand.
This means that as a simple rule, most problems are curable in the absence of inflation, and few problems are curable in the presence of it.
There are still grounds for debate on whether inflation is really a problem at all at the moment. Remove energy, and our rate is on target. And one of the economists I rate most highly, Graham Turner, thinks the Fed may be acting far too cautiously in cutting rates, fighting a non-existent battle against price rises. He was an astute of the Japanese economy over the 90s and knows a thing or two about asset price deflations in leveraged economies.
I'm personally agnostic. I just don't know whether inflation is back or not. I've written before about how the "China effect" which has kept our inflation low is surely a temporary one (although a very long temporary), and the current inflation news from China is discouraging.
Moreover, I certainly don't believe in excluding the fastest rising prices when assessing underlying inflationary pressure at home. 2.1 is 2.1 in my book.
But we'll see whether underlying inflation is at or above target over the next year, as the economy undoubtedly slows.
However, there is one general lesson to be drawn from recent experience: it is that flexibility around the symmetry of an inflation target might be helpful.
If things go as crazy as they have over the last few years, with asset prices booming and the economy and consumer spending strong, we would probably have done well to have erred on the side of keeping inflation below target. That would have ensured there is almost no risk of it being above target, so that when this crunch moment inevitably arrives we can stop the drama turning into a crisis.
Oil prices
- 10 Nov 07, 08:54 AM
Imagine. $100 dollars. It is a lot for a barrel of oil. In fact, it's way up there.
Since the 1860s, when people stopped killing whales for oil and dug it up in Pennsylvania instead, the price has averaged a little over $25 a barrel in today's money. We're at four times the long term average price.
And as recently as 1998, only nine years ago, oil - on some measures - dipped below $10 a barrel. Although in today's money, for the year as a whole the price was more like 17.
It's clear that $100 a barrel is very high. Although it's worth saying, it's still not a record.
1864 was in fact the most expensive year for oil. It was over $104 in today's money. Notwithstanding that record (and most of us in the media will ignore it when talking of record highs in the next few weeks - we'll be using the high of $104.7 reached in 1980 after the Iranian revolution) we can at least say an impending $100 barrel is getting historically significant.
One does have to wonder why the price fluctuates so enormously… it makes the housing market look stable.
Well, there are several oddities that drive the oil market.
Geo-politics is one - Iran has a tenth of the world's oil reserves, so you can't ignore what's going on there for example.
Geo-economics is another factor - the falling dollar means oil prices are not rising in euros and pounds as fast the dollar price suggests.
Finance matters too - the oil price doesn't just depend on oil, it also depends on bits of paper called derivatives that are bought and sold by people trading in oil. That can exacerbate price movements.
Each of these might be adding 10 or more dollars to the current price of oil. But you can't pin the price or the volatility of the price just on those.
The economics of supply and demand ultimately play the largest part, the demand of China in particular at the moment. As a rule, its economy is growing much faster than its oil consumption, but that still leaves its oil consumption growing very fast.
And there's a simple rule about commodities - a small gap in supply and demand can lead to a big swing in price.
After all, if there's 1% too little oil in the world for current demand, the price needs to rise. But there's no reason to think the price needs to rise by just 1%. It needs to rise enough to persuade 1% of the users to switch - and that can be a lot more than 1%.
But the point of volatile market is that it swings both ways.
The longer we have higher oil prices, the more we can economise on oil - by switching to smaller cars for example. And the more oil that gets produced – a small excess of supply over demand - and the price can plummet.
The lesson of history, is that when oil prices soar up to record levels, they usually then fall back down.
On the buses
- 5 Nov 07, 11:41 AM
Here’s a multiple choice question. Try and answer it before you read on.
What effect do you think it has, if a British bus company employs a bus driver from overseas?
a) it takes away the job of a British bus driver?
b) it increases the number of bus drivers we have?
c) it undercuts the wages of British bus drivers?
d) it reduces bus fares for British passengers?
A lot of people will probably choose (a), so let’s discuss that first.
Much of the recent coverage of migrants in the labour force has been written in a way that implies there is a fixed stock of jobs, so the more that migrants take, the fewer there are for native Brits.
A that says “Britons lose out on jobs and housing” or a describing how “The number of British nationals in work has fallen in the past two years as 540,000 foreign workers have replaced them and taken all the net new jobs in the British economy” can easily give the impression that the labour market is a kind of musical chairs with only so many places to go round.
Economists are sceptical of this view of the world – they call it the “lump of labour fallacy”. In essence, they argue that if a migrant takes a job, they may well create a job that would otherwise not have existed too.
For example, they may fill a gap that no-one British was available to fill. They may demand a lower wage, creating a job that would otherwise have been unviable. Bus company employers would certainly argue this is the case, and point you to answer (b) in our question above.
Even better, if a migrant bus driver allows a bus to operate that would otherwise remain idle, then many other jobs could potentially be created for people who could then travel to new workplaces more flexibly and easily.
In practice, we do not know whether the labour market effect of any particular new migrant employee is to create many other jobs, to create the one job they themselves fill, or to create no jobs at all, and hence to displace one domestic worker.
We can’t be sure, and it is likely that some migrants displace, others don’t.
But if pushed, I would tend to adopt the simplifying assumption implied by a fully functioning, competitive labour market, that on average migrants create exactly as many jobs as they fill. If 1.1 million migrants are employed, there are probably 1.1 million extra jobs.
It’s only an assumption, but it’s not a bad one. And perhaps I can defend it by using an analogy. If migrants eat 8% of our food, it would be silly to think that in the absence of migrants, the native British would eat 8% more.
Far more realistic is the idea that the supply of food adapts to the demand of migrants. Similarly, it is realistic to assume the demand for labour adapts to the supply of migrants. That’s where a competitive labour market gets you.
That deals with options (a) and (b) in our bus driver multiple choice question, but many of you might have been inclined to adopt option (c).
It is very plausible that competition from migrant bus drivers undermines the wages that British bus drivers can attract. Indeed, one reason why the presence of migrant bus drivers can create new jobs is that they make it cheaper to hire bus drivers.
And businesses are pretty open about admitting that the low cost of migrant labour is one of its attractions.
But if you are right to tick option (c), don’t you also have to tick option (d)? After all, if there are more buses driven at lower cost, one would imagine that competition or regulation would create lower bus fares too.
And that’s important.
If the presence of migrants on the buses pushes down wages and fares, it pushes up the spending power of everybody using the buses. So the bus passengers’ real wages – their wages after inflation – tend to go up.
You might tell where this is going. A second simplifying assumption. Like the first, it is reasonable if one assumes fully frictionless and competitive markets. It says that on average the presence of migrants has no effect on the real wage level of the British workforce.
The wage cuts of some workers are offset by the real wage gains of other workers.
In fact, if migrants were dispersed uniformly across the economy (which of course they are not), all of us in work would lose a bit in facing more competition for our own job, but would gain a bit in being able to buy other things more cheaply. Net it all out and we are back where we started.
My two assumptions are a bit extreme in their simplicity, but they are not extreme in their implication. They end up with a rather simple conclusion: that migrants are neutral.
They don’t do the harm that some think, nor the good that others like to pretend. They expand the population, the workforce, employment and national income by more or less the same proportions. The rest of us get on with what we do.
Or, to put it another way, my assumptions imply that the employment rate and incomes of a country with 30 million workers are probably about the same as an otherwise identical country with 31 million workers.
Of course, in reality, I am assuming away all the interesting things migrants have to bring. They have different skills, work in different industries, use housing in different ways to the rest of us, and take up the scarce space of the UK.
To draw a more realistic picture we would need to engage in detailed empirical study as to what the actual effects are, not the supposed effects.
When more sophisticated economists perform more rigorous work, using more complex economic models, they invariably come to the conclusion that migrants modestly benefit the domestic population on average. But that does not preclude them hurting some particular groups.
However, I’ve taken 1,029 words and have yet to answer the multiple choice question I started with.
As is so often the case in multiple choice questions, none of the four answers are quite satisfactory. I would say, (e), all of the above. In the short term, (a) might be true, but in the long term, (c), (b) and (d) come in to play.
A Crowded Island?
- 24 Oct 07, 10:17 AM
Can we fit 71 million people in?
Believe the latest population projections, and we had better start preparing ourselves. On realistic assumptions, that's the population we can expect the UK to have by 2031.
Indeed, the official figures go much higher. We'll apparently be up to 84 million by 2081.
Can we take it?
My suspicion is that we can. Most people hugely underestimate the amount of "empty space" we have in our country. Fly over the UK, and you see that human settlement does not fill up the UK at all. It accounts for something of the order of 15 per cent of the landmass.
So physically, we could probably fit another ten million people in - or 16 per cent of the population - without toppling into the sea.
As it is, the UK is not the world's most crowded country. Belgium, Japan and the Netherlands are more densely populated than we are, and would remain so even if we had anther ten million people.
Indeed, if the UK had the population density of the Netherlands, it could accommodate 90 million people. And believe it or not, if the UK had the population density of the quaint island of Jersey, we would actually accommodate another 120 million people on top of the 61 million we already have.
So, yes, I suspect we could accommodate another ten million people.
But that does not mean we would want to.
The British quite reasonably like empty land, and may prefer to keep it empty rather than turn it into a country like the Netherlands.
And anyway, the population growth now being projected will not fill the empty bits of the UK (the Highlands and Islands which could arguably do with more people). It will fill yet more of the same places that are already among the world's most densely populated areas. England's population is projected to grow far faster than Scotland's.
Making that worse, the projected speed of population increase is very rapid. In the next ten years, we will grow as much as we have in the last thirty years, and will in effect absorb the equivalent of the population of Ireland.
And in twenty-five years time, we will have added the population of Belgium to the UK.
This can be done, but it won't be done very comfortably by simply squeezing more and more people into the existing infrastructure of houses, roads, shops, GP surgeries and schools. Nothing will make the country feel more crowded than an unmanaged surge in population without proper account being taken of water, energy and food security, and new infrastructure.
In short, if we are going to accommodate the population now being projected, we had better start spending some money, and building.
But before we do that though, it is worth asking how seriously we should take the projections now being made. Before we let people get too alarmed about this talk of 70 or 80 million people, and before we entice investors to buy property now, in anticpation of higher house prices as the population grows, there are a few things to bear in mind.
First, as the statisticians like to remind us, the figures published today are projections not predictions. Projections do not profess to tell us what will happen, just what would happen under various assumptions.
Secondly, the assumptions get more and more ridiculous the longer you extrapolate them. So, while it is reasonable to assume the UK population will grow 0.6 per cent a year for the next ten years, or even for the next twenty-five years, it is absurd to carry on projecting that indefinitely. (If you do, you can project the UK population reaching a billion by 2464. It's all a bit silly.)
And thirdly, the projections can be very wrong even on shorter time frames. In the 1960s, demographers thought the baby boom would be a permanent feature of life, not a temporary one. So they predicted there would be 75 million Britons by 2000. It didn't happen that way. The baby boom was just that - a boom.
You might even remember the fabulous film, , made in 1973, which depicted New York in 2022. It was so overpopulated that Charlton Heston had to step over the sleeping bodies occupying the staircase of his apartment block. There was not enough food so people had to eat Soylent Green. I won't spoil the end suffice to say it was a great film undermined by poor demographic projections.
Today's projections suffer all the problems of previous ones. In particular these ones are dependent on one assumption about migration, and annoyingly that assumption is both the most important and the least reliable.
Migration accounts for 70 per cent of the projected population growth over the next few decades (taking into account the direct inflow of people, and also the indirect fact that migrants are often of child-bearing age, so push up the number of births.)
This all means the overall projections are only as good as the assumption that net inward migration will continue at 190,000 a year, or roughly last year's level.
That might come to pass - it might be too conservative. But equally, we maybe experiencing a temporary inward wave that will soon fall back.
Or most likely of all, it may be that confronted with the prospect of such rapid population growth and an unwillingness to pay what it takes to prepare for it, the government decides to take further action to stem the inward flow.
PS: A version of this article appeared on the main ±«Óătv News website yesterday.
Do economists do good?
- 17 Oct 07, 09:24 AM
Radio 4 asked me this week to summarise the contributions of in 50 seconds. It wasn't easy.
Firstly, there isn't in fact, a Nobel Prize for economics; officially, this one is called the "Sverges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel". As it takes almost 50 seconds to say that on its own, most of us refer to it as the Nobel Prize for Economics.
Secondly, the economics prize-winners never seem to make contributions that can be described simply.
This year, the Nobel notes (to be found ) cite practical examples of the three winners' work, in - for example - improving the design of insurance policies.
Big deal.
They haven't invented a cure for a disease, or brought peace to a region of the world. As usual in the Nobel season, the practical applications of the economics winners sound rather small compared to the others.
But contrary to the casual impression one might pick up, economics is useful. In the social sciences, intellectual breakthroughs are a big deal. They may not cure diseases, but they can cure muddled thinking. They may not bring peace, but they can bring clarity to regions of public and private policy.
And take this year's Nobel winners as an example. Their contribution is called mechanism design theory.
A mechanism is some kind of procedure for allocating things. Like an auction, or a vote, or a market. Society uses mechanisms to allocate things all the time - lotteries are a mechanism; dictators are another. We use some kind of mechanism for making every material decision. We use markets for allocating beans, and elections to decide on defence spending.
The issue is how to design these mechanisms to make them as efficient as possible.
This already sounds as though it is getting quite abstract.
But let me take a simple example of a mechanism. You want to divide a piece of cake between your two greedy sons, with as little fuss and argument as possible.
My mum faced this issue pretty frequently, and had a solution to the problem that was tried and tested around the world with parents through the generations. She let one of us divide the cake in two, and the other have first choice over which half of the cake to have.
This works far better than alternative mechanisms. For example, cutting the slices yourself inevitably leads to arguments about who gets the bigger slice.
Letting one son cut and choose would surely be an enticement to cut the slices unequally. You might ask him to cut them as fairly as possible, but how are you to know whether he is truly doing his best or not?
The "one-divides/other chooses" rule is perfect as it is - in economics jargon - "incentive compatible". The cutter has the perfect incentive to cut as well as possible. You don't need to ask him to do so, you know that he'll give exactly the right effort to cutting, because it is him that suffers when he doesn't.
Now, my Mum doesn't have a Nobel prize. And I suspect it was not economists who first devised the divide and choose rule.
But it raises some issues that come up all over the place in life, and which academic economics has gone long way to clarifying.
All over the place, there are issues in life where you want to ensure people reveal in their behaviour what they are really thinking; whether they are cutting the cake as equally as they can.
For example, how do you design an auction? It sounds simple, but in an efficient auction, you really want sellers and bidders not to play tactical games - you want them to make offers which honestly reflect their willingness to do a deal, not ones that try to second guess other people's bids.
Or, when you design a voting system, ideally, you want people's votes to tell us what they really feel about an issue. If I ask people whether they want ÂŁ1bn more defence spending, I'd like them to tell me how much they value defence regardless of whether they think they personally will pay more tax as a result. Otherwise, the vote probably just reveals that people who don't think they'll be paying the tax, want a lot more defence.
If you are regulating the prices or profits of a monopoly utility, you'd like to know if it is as efficient as it could possibly be. But you don't know whether it is or not. And simply asking the utility is unlikely to give a very revealing answer.
In all these cases, it is possible to design mechanisms like Mum's divide and choose rule, that do their best to frame incentives for players to reveal their true thinking. And this year's economics prize-winners between them defined the problem, laid the foundations of the science, and did quite a lot of the building work on top of that foundation.
Probably the biggest value is in spotting the similarities between splitting a piece of cake and regulating a utility. Once some of the common features have been put into formal maths, the practical applications and understanding can follow.
None of those applications on their own sounds particularly grand, but taken together they amount to something. And there is no limit to the number of future issues which might be advanced using the same body of economics.
It may not sound like saving the planet, but the Nobel laureates can be reasonably satisfied their work is useful.
Return to normality
- 5 Oct 07, 08:51 AM
Among the many highlights of the Pre-Budget Report will be an update of the government’s borrowing forecasts for the next few years.
Alas, the revisions to be made may not be in the most attractive direction. So far this financial year, government borrowing has deteriorated not improved. Tax revenues are coming in below expectations.
The missing money might come in later as the figures are always volatile and were very volatile last year. But it seems that corporation tax in particular is not as lucrative as the Treasury thought it would be.
As a result the government is set to borrow about £5 billion this year, on its “Golden Rule” measure of borrowing ie the amount it borrows in excess of the amount it invests in long term capital projects.
The economy has hitherto been strong not weak, so there is no obvious explanation for the shortage of cash.
Now there’s no need to pour blame on to the Treasury for getting it wrong this year. They are only one or 2% adrift on their revenue forecasts, and it’s hard to predict tax revenues more precisely than that at the best of times. And they may still turn out to be right – we’re not even halfway through the year.
But it does have to be said that in recent history the government’s forecasts have usually turned out to be too optimistic. And there’s quite a bit of history to this which is worth re-visiting now, as we see the borrowing problem remain as stubborn as it is.
Before the 2005 election, the government was that it was being too optimistic in its revenue forecasts; not just by oddballs and opponents but by the consensus of credible expert opinion.
Indeed, in January 2005, the Institute for Fiscal Studies (the most respected independent analysts of the public finances) published projections showing that unless the government changed policy by raising taxes or cutting spending, it would be borrowing ÂŁ10 billion this year (on the Golden Rule measure).
Two months later, Gordon Brown published projections showing a surplus of ÂŁ4 billion for this year. In other words, there was a ÂŁ14 billion gap between the chancellor and the IFS.
Since those projections were made in 2005 there have been four Budgets or pre-Budgets, which have between them announced tax rises raising ÂŁ4 billion this year.
So, if we do end up borrowing ÂŁ5 billion this year, the IFS will be seen to have been almost bang on back in 2005, while the chancellor was overly-optimistic by about 13 billion.
Ironically, at the time the Treasury said of its forecasts “The use of cautious assumptions audited by the National Audit Office builds a safety margin into the public finance projections to guard against unexpected events”. This was seen as incredible at the time, and with hindsight people were right to have viewed the use of the word “cautious” with scepticism.
However, a consequence of those overly optimistic Treasury forecasts was that inadequate action was taken to sort out the borrowing problem, and the borrowing has persisted.
Of course, deficits don’t always matter. Governments expect to run surpluses in the economically buoyant years and run deficits in the downturn years. Then the two average out over the cycle as a whole.
But we have been in deficit for the last six years and these do not feel like they have been sluggish. Observing strong corporate profits, the private equity boom, the way house prices have moved and consumer spending, it doesn’t feel as though we have been in years of famine with the feast about to start and with tax revenues now just starting to ready themselves to walk through the door of the exchequer.
If anything, with the credit crunch biting in the City it feels as though the boom is coming to an end and normality is about to return. That’s why forecasters universally think growth next year will be slower than this year.
If the economy is in for a few slower years, (and that is still a big “if”) the new chancellor might wish his predecessor had sorted out the borrowing earlier on.
A quick primer
- 4 Oct 07, 03:48 PM
For those caught short by the possibility of an imminent major financial statement (which could even be on Monday) here’s a quick guide as to what it is and what to look out for.
What is it?
This is a combination of two big parliamentary financial statements.
First, the Comprehensive Spending Review sets out spending plans for each department for the three years 2008/09, 2009/10 and 2010/11.
Second, the annual Pre-Budget Report (which is normally in late November) which sets out the government’s forecasts and projections for the economic growth, and for its own tax, spending and borrowing until 2012/13.
What do we already know about the statement?
We already know the spending totals for the next three years (they were set out in the Budget and should be confirmed in the CSR). What is new is the departmental allocation of those totals.
We also already do know a number of departmental budgets, most importantly:
• Education, which gets a real spending increase (i.e. above inflation) of 2.2% a year
• ±«Óătv Office / MoJ combined which get 0.7% a year real cut
• Defence, which gets a 1.5% real increase each year
We also know that spending on the running costs (or administration) of Whitehall departments is set to be cut by an ambitious 5% a year for the three year spending review period.
What to look out for?
1. A possible downgrade of the government’s economic forecast for next year.
In the March Budget, the Treasury used a forecast of 2.5% growth for the UK economy next year. At the time, independent forecasters said it would be 2.3%. Now, independent forecasters say 2.1%.
Mr Darling should probably cut the forecast by at least a quarter point. He may choose not to – but would then look incautious in his assumption.
2. General spending restraint.
The total spending figures already set out tell us that spending will grow at 2% above inflation for the next three years. That compares with a rate of 3.2% over the last ten years. These figures will simply be confirmed – but lets not forget the overall story.
To put it at its simplest, for public spending, the party’s about to end. We’re in the last year of it.
Crucially, over the last ten years, public spending has grown faster than the rest of the economy. Over the next few years, it will grow more slowly than the rest of the economy.
This implies that the share of national income spent by government will slowly fall from about 42.6 % this year, to 42.1% in 2011.
It also implies that the chancellor’s plans “share the proceeds of growth” using the Conservatives definition of that phrase.
3. The NHS is about to feel a squeeze.
Health is the most interesting department to await its spending settlement.
It will do far better than other departments in this tight spending environment – but it will still feel like dramatic retrenchment. Spending there has been growing at over 6.2% a year over the last ten years. It’s likely to be more like 3.5% now.
Also look out for the other departments though - , local government, , will all find out their fate.
4. The government’s is probably borrowing slightly more than they thought at the time of the Budget.
It has become something of a tradition for Gordon Brown to rattle through the borrowing figures in his Budgets and pre-Budgets. In fact, in every Budget and pre-Budget since 2001 with only one or two exceptions, Mr Brown has had to admit his borrowing is worse than he had previously thought.
We will have to see how fast Alastair Darling can read lists of numbers when he stands up. But he will probably at least have to follow his predecessor in confessing to higher than expected borrowing.
That’s because so far this financial year, the data indicates tax receipts are coming in below the forecasts in April (companies in particular are not paying as much as expected).
The most important measure of borrowing is the so called “current balance” or “current budget” which is the borrowing measure used for calculation of the Golden Rule. It is the amount of borrowing which is not used to cover investment spending, but is used to cover day to day spending. (I suppose one can say it is like the government’s credit card borrowing, rather than the mortgage to buy a house!)
At the moment, the government’s Golden Rule implies this measure should balance out over the economic cycle, so that any deficits are offset by surpluses. On the government’s assessment, we are just in the first year of a new economic cycle.
Back in the March Budget, Mr Brown expected to have a deficit of £4 billion this year, (a slight improvement on the £4.7 billion last year). However, this year’s borrowing figure might now have to be upgraded to five or six billion.
It is not ideal that we now enter a possible economic slowdown, with the current Budget in deficit. There has not been a surplus in the Golden Rule measure of borrowing for six years.
5. There will be something else as well. A rabbit out of a hat.
The Pre-Budget Report is not really an occasion to announce tax changes – that’s for the Budget.
But chancellors can do as they please, so don’t be surprised if there if some tax change is announced. Or indeed, if there is some other dramatic measure on the day. In fact, I’ll re-phrase that. Be surprised if there is not some other dramatic measure on the day.
Lack of defence
- 20 Sep 07, 04:26 PM
I don't think one can overestimate the importance of what Mervyn King told MPs this morning.
In effect, he told them that Britain currently has no proper defence mechanisms against bank failure. We built up the Maginot Line to protect us, only to find that when the Germans wanted to invade, they could wander in through Belgium.
At its first big test, the current system has quite spectacularly failed to prevent a bank run - indeed, worse than that, our defence mechanism caused one.
Why did our system fail?
We used to have old informal arrangements that did work. The Bank of England could orchestrate an immediate, secret takeover of a failing bank to be announced as a fait accompli before the depositors could let panic get out of hand. Or, the Bank could use its famous lender of last resort facility to help a struggling bank, without depositors knowing there was a problem.
That old system worked rather well.
But now we have laws against that kind of thing. The shareholders need to be told what's going on. The banks need to disclose material facts. So with everything in the open, when the lender of last resort facility is used, it (rationally) engenders panic among the depositors.
We could do everything in the open - and avoid panic - by ensuring that enough depositors have a secure enough guarantee of immediate access to all their money if the bank fails, that they don't need to queue to get their money out.
But our compensation scheme is slow and inadequate as well. Inferior to those elsewhere, the Governor told us this morning.
This is all pretty shocking.
And it's hard to see how this could have been avoided by early action, because at any stage you act openly, without full protection of depositors, you run the risk of creating panic.
Is Mervyn King just making excuses for his early inaction and failures to swamp the money markets with cash? Possibly. But injecting the whole market with the volumes of cash that would have been needed to protect Northern Rock, would have made life rather too easy for some other banks.
So where do we go from here?
Ironically, the one aspect of the system that MPs thought might be to blame - the splitting of authority between the triumvirate of the Treasury, the Bank and the FSA - is not the bit that didn't work, according to Mervyn King.
Others may not agree with him. But that is probably the least immediate area for reform.
The two (related) issues that need addressing are the deposit guarantee arrangements; and the insolvency arrangements for banks. We need to find a better system for guaranteeing retail deposits in respectable institutions; and the insolvency arrangements have to favour the depositors.
At the moment, the boom in securitisation (by which banks like Northern Rock sell their mortgages or borrow money secured against them) implies that the depositors are at the bottom of the queue for assets in the event of insolvency. The capital market investors have a prior claim to the mortgages which are the security for the loans they have made.
That is all fine, but not if it involves the depositors being unprotected, or protected at the expense of the taxpayer.
It's no wonder that Mervyn King believes we urgently need some thinking and some action - preferably in that order.
Rock climbing
- 20 Sep 07, 09:49 AM
A group of experienced climbers decide to enjoy a party on the top of a mountain. It seems quite sunny, so they pack a few drinks and as they reach the top, they crack open some bottles and blithely dismiss the warnings of impending storms that come from the mountain rescue people patrolling the area.
The climbers are very drunk when the storms eventually hit, but pretty soon they sober up as they realise they can't get down the mountain. So they call for the rescue helicopter to come and and get them and their picnic boxes.
Instead of sending a helicopter straight away, the mountain rescue team tells them to dump their picnic stuff and to try to make their way down the mountain alone. The rescue chief thinks they can still get down safely, and anyway he thinks it's only right to let them learn their lesson.
But he's wrong. They get into a bit of trouble, one is injured (although no-one dies). Once he sees there is trouble, the chief does relent and sends the helicopter for them.
This is not a very unfair characterisation of the situation between the Bank and the banks.
And who at the end of this tale should get punished? The experienced climbers? Or the boss of mountain rescue team?
At the moment, there is a keen desire for someone to blame, and the spotlight is falling on Mervyn King.
The case against him is pretty clear. He could have taken actions that would have avoided the Northern Rock debacle. He could have pumped cash into the banking system that would have obviated the need for Northern Rock to humiliate itself and come and get some on its own, creating a bank run. But he didn't.
Mr King would have had to pump quite a bit into the system, because to give enough to Northern Rock would have required giving a lot to many banks who didn't need it so badly. And if he had just injected a little cash, it wouldn't have found its way to Northern Rock.
But in the tripartite division of responsibilities, Mervyn King was the only one with the rescue helicopter, and he chose to use it later than many others wanted.
And as if to prove he was wrong, he made the U-turn yesterday, and did what everyone else had wanted all along.
The case in the defence of Mervyn King is pretty strong too, however.
It's quite simple. Rescuing the banks by validating their reckless behaviour has a cost. It encourages them to be reckless in future and it strengthens the relative competitive position of mis-managed banks over well-managed ones.
In addition, the Bank maintains that any solvent bank can get cash, just as long as they are willing to pay for it at a penalty interest rate. If they don't want cash, it's because they are too concerned with preserving their profits to borrow it.
In addition, Mr King has always recognised that there is a trade-off between letting the banks suffer from their actions, and helping the economy. He has always been clear, you can change your mind about where we are on that trade-off without performing a U-turn. He changed his mind this week.
For many, the subtleties of the argument are irrelevant. There has been a problem, someone should resign. It would be undoubtedly convenient in the city and in Westminster if it was Mervyn King.
But whatever the case on both sides, and whether or not Mr King keeps his job (I suspect he will, incidentally, but may not get his term in office renewed) the real questions after this affair are not so much about the handling of it in the past three weeks, but about the handling of it in the past three years.
The blame game
- 8 Sep 07, 08:50 AM
It's perhaps a bit early in this crisis for the blame game to start - but somehow I can't resist getting the ball rolling.
Now you know that when children mis-behave, there's typically an argument about whether it is them, or their parents who are to blame. Well, it's not that different in this episode.
The banks have - arguably - got us into this by their behaviour. But is it they who are to blame? Or the grown-ups, the central banks and the other authorities?
Obviously, you start with the banks:
• they lent money stupidly; and devised clever ways of lending more than their regulators allowed by getting other organisations to lend on their behalf.
• they made enormous profits in recent years, but failed to anticipate the most obvious problem in their business model - that they were lending money out on a long term basis, but depended on borrowing it week by week.
• and it was the banks who created sophisticated financial instruments that obscured the risks that they were taking.
In fact, given all of this, one of the most remarkable features of this recent crisis is that the banks most complicit in it have been so unapologetic. They talk up the crisis when criticising the lack of help they're getting from the Bank of England, but they have not suggested the crisis is of such a magnitude that their own presidents should lose their jobs.
So yes, the banks do have a lot to answer for.
But then, banks will be banks. Maybe they should have just been brought up better.
Look for example, at the banking regulators. This crisis has perversely been made worse by banking regulations that have allowed banks to push their activities off their balance sheets, and have indeed made it highly profitable for them to do so. The world's banking regulators will have some thinking to do when it's over.
And then there are the central banks, who made credit very easy in the first place.
That induced banks to lend recklessly in a search for new markets, where they could lend more profitably.
Our own Bank of England kept interest rates low for ages - it was trying to stimulate the economy to stop inflation going too low. But its success at stimulating the economy partly came out of the banking sector's willingness to lend money so freely. That's been stimulating things all too well. If the banks hadn't done it, the Bank of England might have just had to cut rates even more than it did.
So, maybe the central banks got the banks they deserved.
Well, in the blame game, these thoughts are just a first move. There'll be many more.
But don't obsess on blame right now - it can get us too far in the mindset of teaching the banks a lesson, "making them suffer".
Of course, the most guilty banks should suffer - but the problem at this fragile time is that we don't them want to suffer so much it backfires on the rest of us.
The ±«Óătv is not responsible for the content of external internet sites
I'm Evan Davis, the former ±«Óătv economics editor.
I've now moved on to a new job, presenting Radio 4's Today programme. Evanomics will continue to exist in some form, as yet undecided.
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