Articles published in October, 2008

Why Eugene Fama should get a Nobel prize

I read this light-hearted essay on the Today program on the morning of 13th October.

Someone recently grumbled to me that, given the appalling state of the world’s financial system, nobody should be awarded today’s Nobel memorial prize for economics. That’s a little harsh: some economists did warn us of trouble on the horizon.
Still, Nobel-watchers think that this will not be the year that the prize is given to a man called Eugene Fama. Fama, a Professor at the University of Chicago and a long-time contender for the prize, is best known as the man who believes that financial markets are efficient. The timing would seem awkward.
I think that’s a shame. The belief that financial markets are efficient sounds like some Thatcherite creed, but it means something quite different: that the price of shares today reflects everything we currently know about their value. There are no obvious bargains, no easy forecasts, no get-rich-quick schemes. Learn More

Why are some prizes more Nobel than others?

On Monday, the winner of the 2008 Nobel prize in economics will be announced. That statement is not quite true: there is no Nobel prize in economics, merely a more recent prize established in memory of Alfred Nobel.

The existence of a quasi-Nobel in economics infuriates some. One objection is that Nobel himself would not have approved. I do not much care. A more serious objection is that economics is not incontrovertibly a science, but then neither is peace or literature.

Nor am I convinced that the economics Nobel is, as some claim, an instrument for the enforcement of orthodoxy. The prize committee has been broad-minded, occasionally even daring. The prize has gone to Keynesians such as James Tobin and to Friedmanites such as, um, Milton Friedman, to a psychologist (Daniel Kahneman), a mathematician (John Nash) and to the unclassifiable Herbert Simon.

Gunnar Myrdal, a socialist politician, shared the prize in 1974 with Margaret Thatcher’s inspiration, Friedrich Hayek. This provoked the joke that economics is the only subject in which two people can share a Nobel prize for saying opposite things. (Myrdal complained that a prize that could be won by the likes of Hayek and Friedman should be abolished.) When Kahneman shared the 2002 prize with Vernon Smith, another joke did the rounds: Smith won the prize for showing that economic theory works, while Kahneman won the prize for showing that it doesn’t. If this isn’t a broad church, I’m not sure what is.

The odd thing is, whether the Nobel memorial prize is a Nobel prize or not surely shouldn’t matter very much: either way, the prize winners are economists considered worthy of distinction. And yet, the Nobel-ity of it does matter, somehow.

The economics Nobel attracts more attention, for example, than the John Bates Clark medal, awarded every two years to the best American economist under the age of 40. This disparity is curious. The Bates Clark medal has gone to many of the same economists, and more promptly. It has a longer pedigree – it was first awarded in 1947, 22 years before the Nobel memorial prize – and it is much rarer. Most early Bates Clark medallists went on to win the Nobel, but many eligible Nobel laureates failed to win the Bates Clark medal – after all, there have been 20 John Bates Clark medallists since 1969, compared with 61 Nobel laureates.

Nobel prizes also attract more attention than, say, the Crafoord Prize, another Swedish prize for sciences. Despite a $500,000 purse, I am still trying to convince myself that the Crafoord Prize actually exists.

All this made me muse about the vagaries of prizes. What is it that makes a prize – the Nobel, the Booker, the Oscars, Olympic gold – truly prestigious? A long history and a sharp public relations team no doubt help.

Yet there is an economic rationality, too. A prize is worth winning if it proves that the winner beat an impressive field on credible criteria. To an extent this is self-fulfilling: lots of people want to win prestigious awards, and that makes them more prestigious. Because everyone wants to win Olympic gold, the victor will be seen to have defeated every important opponent; that is why everyone wants to win Olympic gold.

It’s not easy to begin that process from scratch, but a big purse helps. The prize money attracts a strong field, which legitimises the winner and helps attract another strong field next time.

In the economic jargon, then, successful prizes become “focal points”. We owe that insight to Thomas Schelling, who shared the Nobel prize in 2005. Or was it the 2005 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel? Whatever.

Also published at ft.com.

Should I subscribe to the Financial Times?

I have a question which, I hope, you will be able to answer with particular insight. Should I subscribe to the Financial Times?

I buy the FT Weekend every Saturday, for $2.17 including California sales tax. I recently received an e-mail offer to receive the FT for $8.25 for four weeks, which would be a saving of 43 cents, and yet provide me with the newspaper every day.

However, I am conflicted because I primarily enjoy the FT Weekend for the cultural and political coverage. I am somewhat interested in the financial news, but my concern is that I will spend too much of my time following the soap opera that is Wall Street these days. But if there was a time when it would be advisable to read the FT, this would be it.
John Halbert, Los Angeles

Dear John,

I am not sure what puzzles me more, the fact that the FT subscription department is trying to get you to pay less in order to receive more, or the fact that you hesitate to accept.

The most likely explanation is that both you and the subscription department suspect the Financial Times of being an addictive product. They hope that once you are hooked, you won’t stop. Admittedly, this assigns the subscription department the role of crack-pushers, but we should call a spade a spade here.

The story is further complicated by the fact that not all addictions are harmful. You may find yourself addicted to the Pink’un for the happiest of reasons: an infatuation with Lucy Kellaway – or Gideon Rachman, if you prefer.

I suggest that you put this offer to one side, because the sums involved are trifling. Instead, buy and read the FT every day for a week. If you’re hooked by Friday, it will be because you’ve found the daily newspaper to your taste. You can then take advantage of the next subscription offer to feed your habit cheaply.

Also published at ft.com.

Time to drop the baggage that comes with moral hazard

During the bail-out of AIG, Fannie Mae and Freddie Mac – and, at the time of writing, the still unresolved debate over the bail-out of the entire US financial system – the phrase “moral hazard” has become popular, typically in conjunction with the phrase “privatising profits and socialising losses”. It’s easy to sympathise: the erstwhile masters of the universe seem to have forgotten the meaning of both “moral” and “hazard”. Why should they be helped now?

Still, we might usefully remember what the antiquated jargon “moral hazard” means. The term originated in insurance, recognising the idea that people with insurance may be careless – for example, paying for secure off-street parking looks less attractive if your car is insured.

Moral hazard can sometimes take extreme forms. According to the Florida newspaper The St Petersburg Times, in the late 1950s and early 1960s, more than two-thirds of insurance claims for the loss of a limb originated in the Florida Panhandle. At the epicentre, “Nub City” – the tiny town of Vernon, Florida – almost 10 per cent of the adult population had lost a limb. One man was said to be insured by dozens of companies when he lost his foot; fortunately he had been carrying a tourniquet at the time of the accident. He pocketed a million dollars. Another man shot his foot off – “while aiming at a squirrel” – just 12 hours after buying insurance. Now that’s careless – and that’s moral hazard in spades.

Sometimes moral hazard is so severe that it makes insurance impossible. Footballers would like to insure against losing football matches, and students would like to be compensated if their exams go poorly. Tough: moral hazard makes such insurance contracts absurd. But all these examples exaggerate the problem. So does the archaic use of the word “moral”. It used to carry no ethical connotation, referring merely to a risk arising from human action rather than natural forces.

Forget the baggage that comes with the word “moral”. While moral hazard makes insurance more expensive and less efficient, many insurance markets work well enough to be useful. Moral hazard need not destroy them, and it need not destroy financial markets either. If AIG had shot off its own metaphorical foot to claim a government bail-out, the argument against the bail-out would be compelling. But it didn’t, and it isn’t.

This perspective can suggest lessons for today’s bail-outs. The government will not help you replace your possessions if you smoke in bed and your house burns down, but government-funded fire engines will put out the blaze, moral hazard or not. That is partly because fire can spread, and your neighbours should not suffer for your carelessness. The same motive lies behind the current spate of rescues. It is also because a civilised society tries to save people from accidentally burning themselves to death. If the consequence is a little more carelessness, so be it.

A second lesson is that remedies for moral hazard will always be imperfect. Insurance companies could fight moral hazard by checking that your behaviour is consistently safety-conscious. Because that’s impractical, deductibles have to serve as imperfect proxies. The current bail-outs are a strong argument for tighter regulation, but regulators cannot be everywhere, any more than a claims adjuster can ride around in your car all day.

Bail-outs can save the innocent as well as the culpable, but even when they don’t, it is fantasy to expect governments to refrain from them. It is useless to pretend otherwise: bail-outs are inevitable and sometimes they are even desirable. The moral hazard they provoke is also inevitable. The final lesson: insurers get paid for the insurance they provide; it would be nice if the taxpayer were shown the same courtesy.

Also published at ft.com.

Should I take Lehman’s collapse lying down?

I work as an escort in Canary Wharf. I wonder if you might have some sound business advice on how workers in my industry should tackle the sudden drop in demand following the collapse of Lehman Brothers?
Miss C

Dear Miss C,

I wasn’t aware that escort services were pro-cyclical, but I shall take your word for it. You have three options, none of them perfect.

One: relocate. Canary Wharf is a pure banking play, and you could seek a more diversified market. The West End is full of hedge funds, oil barons and old money. However, I recognise that it will take some effort to find new clients. The economist Steve Levitt and sociologist Sudhir Venkatesh discovered, in a recent analysis of Chicago street prostitution, that the industry was very concentrated because prostitutes and clients would otherwise fail to find each other. You, of course, are not in quite the same game and may be able to relocate with ease.

Two: tough it out at Canary Wharf and hope that supply falls to match demand. Levitt and Venkatesh found that the supply of street prostitution was highly elastic in response to a demand surge. (The fourth of July holiday provokes a spike in trade for prostitutes – who knew?) Existing prostitutes would work longer hours, other prostitutes would travel to the area, and women who didn’t normally work as prostitutes at all would dabble in the business. This suggests that many of your rivals will find something else to do in the tough times.

Three: you may find that escort services are a little like estate agency, in that even severe demand shocks don’t tend to reduce fees. You’d find yourself well paid when in work, but frequently idle. That spare time could be used to study or find a part-time sideline.

I would give exactly the same advice to an estate agent.

Also published at ft.com.