Tim Harford The Undercover Economist

Articles published in October, 2013

How to make money from a Nobel cause

‘It’s hard to beat the market, and you should probably be suspicious of people who claim to be able to pull off the trick’

At last, they’ve given out a Nobel memorial prize in economics for something that could make money for you and me. Eugene Fama and Robert Shiller have, between them, saved me many thousands of pounds. (Lars Peter Hansen, who shared this year’s prize with Fama and Shiller, developed statistical techniques that, I’m sad to report, have never made me a penny.)

There have been practical prizes before, of course. Only last year, Al Roth shared in the prize, in part for his work designing ways in which possible kidney donors and recipients could be matched with each other for maximum advantage. Ronald Coase, who won in 1991 and died this September, inspired markets to control pollution. And Thomas Schelling, a winner in 2005 for his wily and practical take on game theory, arguably helped prevent the cold war turning into something more catastrophic.

But hard cash in my pocket is something else. And the odd thing is, Fama and Shiller disagree with each other.

Fama’s most famous contributions have been in refining and testing the idea of efficient financial markets. The efficient markets hypothesis, or EMH, is much maligned, so let me state it in the form that has spared me anxiety and saved me money over the years: it’s hard to beat the market, and you should probably be suspicious of people who claim to be able to pull off the trick. As Fama himself told me in a rare interview for the BBC last week: “People spend lots of money … trying to hire managers that can pick stocks although the evidence says quite conclusively that that is probably impossible to do.”

But let’s consider two reasons why we should treat the EMH with scepticism. The first is that it may have led regulators astray by encouraging them to leave markets alone when they should have intervened. Maybe the EMH is a better guide for investors than it is for regulators – although I feel allowing excessive leverage was the ultimate regulatory sin before the crisis, and one not closely connected with the EMH.

But a second reason to disbelieve the EMH is the experience of the dotcom and subprime bubbles. “I don’t even like the word,” says Fama. “If your meaning of the word bubble is that prices went up and then went down, that’s fine. But if your meaning of the word is that prices went up and then it was predictable that they would go down, then I don’t think there’s any evidence to support that.”

Shiller would disagree. He is the pioneer of “behavioural finance” – putting psychological factors back into a study of market behaviour. And a single graph drawn by him saved me from being swept up in the dotcom mania.

Shiller simply plotted a standard measure of stock market valuation – the price/earnings ratio – but rather than looking at a single year’s earnings he looked at average earnings over a decade. The resulting graph showed a huge peak in 1929 – just before the Wall Street crash – that is unique in market experience between 1880 and 1995. Then in the late 1990s, a far larger peak built. In 2000, I showed this graph to many people – and stayed out of the market. It saved me a lot of money.

Of course, it is hard to reconcile Shiller’s conclusions with Fama’s. But when I spoke to Shiller last week, he summed up the tension rather well: “It’s a little bit like religion, you know. There’s all these different sects and, when you look at them in the whole, it doesn’t seem to make any sense, they contradict each other so fundamentally. But maybe there’s some wisdom about living that comes out of all of them.”

That may sound a little far out but in my experience it has proved absolutely true.

Also published at ft.com.

Teachers could predict exam grades better – but not much

Teachers forecast the right results nearly half the time. Few professions can boast such a record

“Half of A-level grade predictions prove to be wrong, figures show, raising questions about the use of predicted grades in university applications. Just 48.29 per cent of the grades forecast by teachers last year were accurate, according to statistics published by OCR, one of England’s biggest exam boards.”The Guardian, October 22

That’s bad.

Is it? There are seven grades available, including the U grade (fail, to you and me) and the new A*, so the chance that a dart-throwing bonobo would pick the right grade is about 14 per cent. Cambridge Assessment, the group that analysed OCR’s exam statistics, reckons teachers are accurate almost 50 per cent of the time. Some 92 per cent of forecasts were within one grade of the result. Better than any bonobo could achieve.

Am I supposed to be impressed that teachers are better forecasters than dart-throwing bonobos?

It impresses me. Few other professions can boast such a record. The psychologist Philip Tetlock, in a landmark study of expert forecasting, once gathered 27,450 quantifiable forecasts from about 300 experts. Over two decades he was able to observe how good those forecasts were. In each case he grouped the range of possible outcomes into three roughly equal ranges chosen based on historical outcomes.

You’re going to tell me that the experts fared poorly against the bonobos.

I am. And Professor Tetlock wasn’t focused on “random-walk” processes such as the movement of stock prices; he was asking for predictions on political and economic outcomes that were, in principle, predictable. The experts, whether journalists, diplomats or academics, fell short. No doubt forecasting exam grades is a simpler matter than making political forecasts, but picking the right grade almost half the time is no bad performance.

But could it be better? I note that grammar and independent schools managed to deliver more accurate forecasts.

Fractionally more accurate. But they had an easier job. The top grades were more likely to be forecast correctly, and I’m afraid top grades are disproportionately the preserve of independent and grammar schools. Teachers at these schools were also less likely to be optimistic. One imagines darling Felix and Felicity drifting into Oxbridge on a wave of effusive fluff from their teachers, but students from independent schools are almost three times as likely to get at least three A grades as those from state schools, at which point it becomes hard to deliver over-optimistic predictions.

But there is a general tendency for teachers to deliver rose-tinted grade forecasts, isn’t there?

Yes. Erroneous forecasts were three times as likely to be too high as too low. That might not be a problem – students whose exam results fail to live up to teachers’ promises are often turned away from the first-choice university to find a place somewhere less competitive. Far rarer is the process of “adjustment”, where a student’s final grades are better than predicted and he or she manages to win acceptance to a more prestigious course than originally admitted for. So teachers may be right to err on the side of optimism.

Sounds like cronyism.

Well, teachers’ predictions can’t match Wall Street analysts’ earnings forecasts for optimism. In the past 25 years, analysts have on average been too optimistic 22 times and too pessimistic three times.

Nobody takes Wall Street seriously any more. But exam forecasts are important: universities use them when making offers.

Universities do take other factors into consideration, but you are right. The situation is hardly reassuring. There is one consolation, though: the results being predicted here aren’t flawless measures of student ability. They’re just a snapshot of how a student coped on the day with hay fever, menstrual cramps or just an unfortunate choice of questions. Teachers may not forecast the vicissitudes of exam season correctly – but who’s to say their predictions may not be just as good, or better, indications of how talented students really are?

So all is well.

Perhaps. A final note of caution. These forecasts were submitted to OCR as late as May, four months after forecasts made for university admissions. For all I know, the forecasts that really matter – those made for university admissions – are optimistic beyond the dreams of Wall Street.

Also published at ft.com.

Unemployment stats aren’t working

‘The unemployment rate is the result of millions of individual stories of finding and losing jobs’

The unemployment rate seems a thoroughly straightforward economic statistic. It’s currently 7.7 per cent in the UK – which means that for every 12 lucky souls with a job, there’s an unlucky 13th looking for one.

The reality of the labour market is a little more complex. There are, for example, three times as many “economically inactive” people of working age (defined archaically as 16-64) as there are unemployed people. These are people who do not have jobs and, in principle, do not want them. If you’d like to understand the distinction between them and the unemployed, the unemployed are both available for work and actively looking for it; the economically inactive are not. It is not a distinction that can easily be observed by a government statistician.

Consider a 20-year-old undergraduate en route to a solid engineering degree. She’s actively looking for part-time work in a bar or restaurant to help keep her debt under control; she can’t find that kind of work, so is relying on student loans to pay the bills. Meanwhile the 50-year-old former coal miner with health problems is on incapacity benefit: he wants a job but with little optimism that he will find one, he has stopped pretending to look. Common sense suggests that the middle-aged man is unemployed, and the young woman is not. The Office for National Statistics would reach the opposite conclusion.

Perhaps the strangest thing about the unemployment rate is the impression it gives of stability. Over the course of the recent severe recession and subsequent doldrums, the number of unemployed people rose by more than a million. But the number of jobs that have been lost is approaching 20 million – not far off the size of the entire British labour force.

What’s going on? Churn. In a typical three-month period in the UK, about one employed person in 80 leaves or loses his or her job. (That is an understatement: it does not include people who immediately step into new jobs.) Over the same period, one in three or four unemployed people finds a job. Even a severe recession only has a modest effect on these numbers: the quarterly job-loss rate briefly hit one in 50 at the depth of the 2009 recession; during the years of flatlining that followed, it was one in 70. The job-finding rate has sunk somewhat, but gently.

The odd truth is that almost all of the people who lost jobs during any particular quarter of the recession would have lost them anyway. Michael Blastland and David Spiegelhalter, in their recent book about risk, The Norm Chronicles, put the additional risk of unemployment every three months during the no-growth years as one extra person in 500.

The recession is no illusion, of course – if the chances of losing a job rise a little and the chances of finding a new one fall a little, over time the ranks of the unemployed will swell alarmingly. What is an illusion is the idea that economic booms provide substantially greater job security than recessions. They do not.

The unemployment rate is the result of millions of individual stories of finding and losing jobs. There is more than one way, then, to get the unemployment rate down: reduce the rate at which old jobs disappear, or increase the rate at which new ones are created. It isn’t hard to see which of these two options is likely to go hand in hand with a more dynamic, creative and higher-growth economy. Nor is it hard to see why so many workers naturally value protecting the job they already have, rather than some abstract promise of a new job in the future.

Creating jobs is not the same thing as making people feel secure in their jobs – not the same thing at all.

Also published af ft.com.

Patience pays off for long-game investors

Stockpickers who persevere with their ‘pets’ are rewarded when they perform impressive profits

“Neil Woodford, one of the colossi of British fund management, is leaving Invesco Perpetual after a quarter of a century to pursue his conviction that modern investment has become too short-term.”, Financial Times, October 15

One of the colossi?

I know, I know. I’d have plumped for one of the colossoi myself. Or one of the colossuses. Or maybe one of the giants.

I wasn’t being pedantic. I was wondering whether there really are any colossi in stockpicking. Wasn’t the Nobel Prize in economics given this week to Eugene Fama, who showed you can’t beat the market?

Speaking of pedantry, it’s not a Nobel Prize. It’s best described as the Nobel Memorial Prize. And, yes, Professor Fama did show you can’t beat the market. But whether or not he’s correct, investors believe in star stockpickers, from Benjamin Graham and Warren Buffett to Anthony Bolton and Mr Woodford. So there’s likely to be a stampede for the exit at Invesco Perpetual, which could be hard to manage.

Do you think Mr Woodford is merely the beneficiary of a lucky streak, then?

It’s devilishly hard to know. His record is excellent – over the past 25 years, the market as a whole would have turned £100 into £1,000; Mr Woodford would have turned it into £2,300. A modest degree of outperformance, delivered with reasonable consistency over a quarter of a century, will do that to your portfolio. Maybe those results are a matter of luck – there are, after all, many fund managers in the world, and somebody has to be the best. But maybe it’s real skill. Quite possibly both. One of Prof Fama’s findings was that smaller companies, with low market value relative to book value, have tended to outperform the market as a whole. This may be because such companies are riskier and the high expected return is compensation for taking that risk. It turns out that such companies have played a significant part in Mr Woodford’s success.

It might also be that he takes an interest in the companies he invests in.

He’s certainly had substantial shares in some of them for a very long time. This is similar to Warren Buffett’s approach, and is reminiscent of John Maynard Keynes’ behaviour while investing on behalf of King’s College, Cambridge. Keynes invested for the long term in a few favoured companies, which he called his “pets”. These were extremely profitable – in contrast to the investments he made earlier in his career, when he tried to deploy his knowledge of the business cycle to time his trades.

Timing the market didn’t work out for him?

No. Buffett-style value investing did very well, though.

But this long-term vision isn’t just an investment strategy, is it? There’s a sense that stock markets are insanely short-termist these days, and Mr Woodford’s activist approach and “buy-and-hold” tactics are good for capitalism as a whole.

It’s curious. One of the points of an equity market is that, by making shares easy to trade, it allows investors to take a long-term view of profits. As a shareholder in a non-traded company, you care about when it makes its money because it directly affects your own cash flow. But if you hold shares in a publicly traded company then you don’t need to worry about the precise timing of profits: you can cash out at any time by selling to someone who is able to wait.

I understand the theory but things are different in practice, aren’t they?

It seems so. John Kay, an FT columnist who chaired a government-commissioned review into equity markets, felt many British companies were too focused on short-term returns. The reason for that was the behaviour of Mr Woodford’s competitors and all the other intermediaries that stand between company managers on one side and savers and pensioners on the other.

But Mr Woodford has directly benefited from a long-term perspective – as did Mr Buffett and Keynes. Why don’t other investment managers acquire a few “pets”, if it’s so good for business?

That’s a good question. We are unwittingly rewarding investment managers for sticking with the crowd and following some particular benchmark. More independent-minded managers are taking a big risk – if their decisions don’t pay off at first, they are unlikely to get another chance. Even Mr Woodford has had bad years: if they had come early in his career, I wouldn’t now be talking about him.

Also published at ft.com.

Dr Osborne’s bitter medicine is no cure

The chancellor’s claim that Britain’s slow recovery vindicates his policies is drivel

‘The International Monetary Fund has dropped its criticism of George Osborne’s austerity drive after revising up the UK’s growth forecast by more than any other leading economy.’
Financial Times, October 8

Good news for the chancellor, then.

He’s had a pleasant week. The independent Office for Budget Responsibility also said this week that his austerity policies were “not the most obvious reason” that economic growth had been so weak until recently.

Pretty embarrassing for his Keynesian critics, eh?

That depends on whether his Keynesian critics are embarrassed by the sneers of cloth-eared nincompoops or not. I don’t see how any thoughtful, open-minded person can believe that Mr Osborne’s critics have been proved wrong by events.

How so? Growth is back! Isn’t that an endorsement of government policy?

OK. I’ll use small words to explain this. Let’s say that a man gets sick. He picks up some pills from the chemist.

What sort of pills?


That isn’t a small word.

Oh, shut up. So our man begins taking the antibiotics, but almost immediately gets an appointment with Dr Osborne, who declares the antibiotics a quack treatment. Dr Osborne confiscates them and instead prescribes prolonged bed rest. Our friend is sick for a long, long time. But recently, he’s been feeling better. He’s out of bed, pottering around and thinking about taking a shower, getting dressed and heading out for a walk. Dr Osborne claims vindication. He says the quacks who suggested antibiotics were wrong because the man’s getting better. But this is the argument of a fraud or a fool – or, of course, a politician. Sick people usually get better. Sick economies usually get better, too. That fact, enormously welcome though it is, proves nothing.

Mr Osborne has said that the opposition couldn’t explain why the economy was recovering despite continued austerity.

That’s drivel. No sane person would claim that austerity – a catch-all term for higher taxes and lower government spending – is the sole cause of economic performance. A simple textbook model would suggest short-run economic performance is determined by demand while long-run economic performance is determined by supply: of the British people, their skills, the buildings, infrastructure, equipment and institutions that surround them. We’d expect austerity to dent demand in the short run – two or three years. In the long run, as Keynes reminded us, we are all dead. This simple model says that Mr Osborne’s economic vandalism can hold the economy back for a long time, but not forever.

I’m sure there are kinder ways to characterise the chancellor’s policies.

It’s simple logic. Austerity doesn’t explain everything about the recession, but that doesn’t mean it explains nothing. Let’s be clear: the UK economy is suffering the slowest recovery of gross domestic product since credible records began by a colossal margin. Sixty-six months after each began, in the awful recessions of the 1920s, 1930s, early 1970s and early 1980s, GDP had recovered to 5-8 per cent above the pre-recession peak. This time, we are still about 2-3 per cent below it. We are looking back – I hope – at an unprecedented economic catastrophe. The OBR says Mr Osborne’s austerity wasn’t the only cause – or indeed the largest cause. He didn’t cause the financial crisis any more than Dr Osborne infected our patient. Our sick man had many things wrong with him and the antibiotics would have cured only one of the conditions. But it’s cheeky of the chancellor to claim the limpest recovery in British history vindicates him.

We don’t know that for sure – not like we know that antibiotics kill germs.

True. But we’re reasonably confident austerity damages economies in recessions.

You’re talking as though Mr Osborne had a choice. Our deficit was vast and it’s still big; he couldn’t have risked a debt crisis.

Markets – aided by the Bank of England, with unlimited ability to print sterling – have been happy to buy UK government debt. They might not have been so sanguine if the 2010 election had delivered a lame-duck minority government. But with a solid coalition Mr Osborne could have taken credible steps to encourage spending during the slump while charting a course to long-term fiscal rectitude.

Why didn’t he do that?

Political timing. Mr Osborne’s economic mismanagement has cost a lot of people their jobs. It may well keep his own secure.

Also published at ft.com.

Guest list angst – a statistical approach

‘Assumptions look doubtful and like many economists, I appreciate the free market’s messy reliance on trial and error’

Here’s a ticklish problem: how many guests to invite to your party? If it’s a rave on a beach, as many as you like. But a formal affair such as a wedding will have a venue with firmer limits.

Ideally, one would invite the guests, wait for their responses, then book the venue, but that’s rarely practical. Yet none of the alternatives really satisfy. Sending invitations out in stages takes too long because people rarely reply quickly. And if the guests who were invited on Facebook talk to the guests who received gold-leaf invitations six months in advance, things may get awkward.

An alternative is to be conservative, inviting no more people than the venue can accommodate. This feels like a shame because space at the venue is bound to lie idle while friends who could and would have joined are forced to stay at home.

Simply guessing at the acceptance rate isn’t much good either – few people hold enough weddings to master this, and anyway the rate may change after the groom’s first three or four marriages. And heaven forbid that one is forced to withdraw invitations after overshooting.

What to do? A young statistician with a wedding to organise, Damjan Vukcevic, recently outlined his experience in Significance magazine, a glossy rag published by the Royal Statistical Society. Vukcevic and his then-fiancée, Joan Ko, wanted to mail out all their invitations at once, filling the venue snugly without spilling over. Their solution: statistical modelling.

Vukcevic placed his guests into four categories, ranked in order of likely attendance, from “definitely” to “unlikely”. He assigned each category a probability and added some further assumptions: families would either attend all together or not at all; beyond that, one guest’s decision to attend would be uncorrelated with another guest’s. With a target of 100-110 attendees, and an absolute maximum of 120, Vukcevic and Ko celebrated with … 105 people.

A triumph for statistical modelling? Well, if Vukcevic was a “quant” at a hedge fund he’d be claiming his performance bonus – but we should look more closely. Vukcevic’s assumptions were flat-out wrong. For each of the four categories, the actual attendance rates were lower than forecast. (“Likely” attendees had an assumed attendance rate of 80 per cent and an actual attendance rate of zero.) Vukcevic predicted that the chance of having 100 or more invited guests attend was more than 99 per cent; only 97 did, a result which the model said was vastly unlikely.

Other assumptions look doubtful: a conflicting wedding, or football match, could reduce attendance probabilities of many guests at once. Vukcevic predicted invitations for three friends’ weddings and he overestimated the attendees every time – in one case by a dramatic margin.

And yet Vukcevic and Ko celebrated with “an ideal number” of attendees. How so? Another assumption proved felicitously flawed: that the chance of uninvited guests was zero. Happily for Vukcevic and Ko, their failure to account for wedding crashers cancelled out all the other mistakes. I wish them every happiness as a couple but this is hardly reassuring.

Do I have a better suggestion? Not really. But, like many economists, I appreciate the free market’s messy reliance on trial and error. I also think the embarrassment of inviting several waves of guests – or even disinviting guests – while large, is not so very large as to be out of the question.

This may explain why, at a recent party, I filled the venue perfectly – but only after multiple rounds of invitations and disinviting a few friends close enough to take it on the chin. One assured me she would forgive me if I wrote a column about party invitations and “the need to consider and plan to capacity”. I trust she is now satisfied.

Also published at ft.com.

The price of a loaf is of little importance

Cameron’s critics chose a singularly useless indicator, writes Tim Harford

“Clueless David Cameron doesn’t know the price of a value loaf of bread showing just how out of touch he is with the British public. And the PM risked alienating himself from voters further when he tried to defend his ignorance by saying he used a pricey BREADMAKER instead.”, The Daily Mirror , October 1

I thought David Cameron was in trouble for not knowing the price of a pint of milk?

You are thinking of the Mayor of London, Boris Johnson, who admitted he didn’t know. Or possibly you’re thinking of an insult thrown at the prime minister and his chancellor, George Osborne, by a member of parliament, that they were “two posh boys who don’t know the price of milk”.

MPs do throw a few choice insults across the floor of the House.

Actually the insult came from their own side – it was Nadine Dorries.

Oh. But they are posh boys, aren’t they?

They certainly are posh. But I think we already knew that without these bizarre trivia tests on how much particular products cost. It’s ridiculous. David Cameron is the prime minister. He’s busy. Do we really expect him not only to do his own shopping but also to keep careful track of what every item costs? There are a lot of people in the country who don’t do that – most of them men, I suspect.

Still, the prime minister should know the price of a loaf of bread.

The prime minister did know the price of a loaf of bread. He said it was “north of a pound”, and the Office for National Statistics reckons the average price of an 800g loaf of white sliced bread is £1.31. Sounds like he was about right. The prime minister is being accused of being out of touch only because he didn’t know the price of a particular lump of processed fluff called a “value loaf”, sold in Tesco or Sainsbury, which is much cheaper. And I should point out that this makes the entire business even more nonsensical: the general story is supposed to be that David Cameron does not understand how high the cost of living has risen. What this proves is that he doesn’t realise how low the cost of living really is.

How much is a value loaf, then?

I read in the newspapers that it is 47p, although I hope you’ll forgive me if I don’t go and check.

You’re out of touch too!

Listen: there are about 10bn distinct products and services on sale in London alone, according to an educated guess by the complexity economist Eric Beinhocker. If each of them had a single undisputed price, and if Mr Cameron were to memorise every one of those prices at a rate of one a second in some prodigious feat of being-in-touchness, the process would take 317 years.

But ordinary people do know the price of what they buy.

Some do and some don’t. Believe me, I know: one chapter in my first book did little more than note unusual patterns in supermarket pricing. You’d think I had solved Fermat’s Last Theorem from the response that got: many people are genuinely surprised to discover that prices of apparently similar goods vary in intriguing ways from one store to another, or even from one shelf to another. If they really had been paying attention they would know that already.

We’re all out of touch!

Some people know the price of a tin of beans to the penny, and are savvy shoppers. The rest of us simply assume that the savvy shoppers keep the supermarkets honest.

Surely people do at least know the price of a loaf of bread.

Perhaps. There is some evidence – and grumbles from the Competition Commission – that supermarkets use the price of certain products, such as bread and milk, to lure shoppers in before mugging them with a high price for some less familiar product. Far from being a bellwether of the cost of living, there are few prices less informative of what food really costs than the price of a loaf or a pint of milk.

Tough. Politicians have to pay attention to the price of bread. “Panem et circenses” and all that.

Yes, yes – bread and circuses. The lesson through the ages is that nobody cares about what politicians do, so long as people are well fed and entertained. These days, when the political stakes are high, and Mr Cameron’s government has advanced a broad range of substantial changes to the way the country is run, all anybody seems to care about is whether he knows the price of a loaf of bread. That’s the true circus.

Also published at ft.com.

Capital – some good news on banking

Five years after the Lehman Brothers collapse, a study shows that the regulators’ medicine is working

The banking crisis had many causes, some of which are complex enough to make a quantum physicist’s head spin. But a central cause is simple: banks relied far too much on debt to fund their activities – they used too much leverage. That’s why a new study, quietly released by the Bank for International Settlements almost exactly five years after Lehman Brothers collapsed, makes for encouraging reading. It suggests that attempts to reduce leverage are paying off. The regulators’ medicine is working – and with fewer side-effects than feared.

A highly leveraged bank gets most of its money from debtholders, which is risky because those debts must be repaid on schedule or the bank is bust. A less leveraged bank gets more of its money from shareholders and it is not obliged to pay them anything in particular at any given time. In troubled times, the less leveraged bank is far more resilient.

Despite this, banks resist funding their activities with equity capital rather than debt. No wonder: because highly leveraged banks are at greater risk of collapse, they enjoy a larger implicit “too big to fail” subsidy from the taxpayer. While such implicit subsidies continue to exist (for ever, I suspect), bankers will prefer to fund themselves with risky debt and rely on the taxpayer to provide the free safety net.

For all these reasons, regulators have begun to demand that banks provide their own safety net, in the form of much plumper capital cushions. The banks, however, say that rather than raising more capital, there is a danger that they will shrink to fit the capital they already have, choking off their lending.

Mark Carney, the Bank of England’s new governor, doesn’t seem to buy it. (In a recent speech he declared that “the reality is the opposite”.) Still, the concern that capital requirements might damage business lending prompted the business secretary Vince Cable to grumble about the “capital Taliban” at the Bank of England.

So how have banks actually reacted to demands that they rely less on debt and more on capital? It’s this question that the Bank for International Settlements research addresses. The author, Benjamin Cohen, looks at the actions of more than 80 large global banks between 2009 and 2012.

Cohen finds that they do have thicker capital cushions, as required. So far, so good. There is some evidence of shifting to portfolios with lower risk ratings, which may (or may not) indicate some gaming of the system. But chiefly the increase in capital seems quite genuine.

Equally encouraging, bank lending from these big global players has not, in aggregate, fallen. It is rising less strongly than before the crisis – but that is, perhaps, no bad thing.

How, then, have banks pulled off this trick? It’s not quite as hard as it seems. All banks need to do is make profits (an elusive goal for some, admittedly) and keep the cash rather than paying dividends. When capital cushions are thin, retaining even modest profits quickly thickens those cushions – that’s the happy flipside of risky leverage. Cohen’s research finds that this is exactly what banks have chosen to do.

Is there any bad news to spoil this cheery picture? Pessimists might complain that while bank lending hasn’t fallen, it’s hardly surged either. And banks are charging slightly higher spreads on their loans. Indirectly, then, bank customers are contributing to the recapitalisation. (It’s worth it.)

There are plenty of dangers still lurking in the financial system: “too big to fail” banks are even bigger; regulations are ever more complex, which always brings risks; shadow banking is growing and remains a cause for concern. But let’s notice when something has gone right: regulators demanded well-capitalised banks, and got them. It is a refreshing change.

Also published at ft.com.


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