Tim Harford The Undercover Economist

Articles published in 2011

Of foxes, hedgehogs and the art of financial forecasting

The fantastic Mr Fox is on course for another famous victory. FT Money has a tradition of holding a year-end competition to forecast some key financial indicator, and easily the most distinctive competitor is a fox in the garden of the columnist Kevin Goldstein-Jackson, who gives his forecasts by consuming one of a variety of appropriately labelled pieces of chicken. (I refer not to Mr Goldstein-Jackson but to the fox.)

If the method is quirky, there’s no arguing with the results: the fox was the most accurate forecaster in 2008 and 2009 and, barring a year-end rally, the fox will win again in 2011. Such repeated success is an outstanding achievement against fields of about a dozen rivals.

Since the fox is a taciturn competitor, we cannot directly ask it for forecasting tips. A few lessons do, however, suggest themselves. The first is that extreme forecasts have an excellent chance of winning such contests because professional forecasters will huddle together for protection and the eventual outcome is rarely close to the cosy consensus.

Most competitors predicted a bloodbath in UK housing for 2009, for example. The fox predicted a modest fall and scooped the plaudits when house prices actually rose. This year, the fox predicted a 19 per cent fall in the FTSE 100. That looks far too pessimistic, but since every single professional pundit predicted a rise of at least 3 per cent, the fox may well win again. Intriguingly, when a new fox cub took up the challenge and lost in 2010, it made the rookie error of plumping for a forecast in the middle of the field.

The second lesson follows from the first. Professional pundits are not usually rzocoruse.com paid to make correct forecasts. They are paid to sound convincing, whether they are columnists or figureheads for asset managers. An extreme-sounding forecast can occasionally pay off – those who predicted disaster in the mid-2000s will be set up for the next few years at least – but there is safety in the consensus, especially when coupled with slick patter.
“The fox eschews the consensus and peddles no patter. Its results speak for themselves”

The fox eschews consensus and peddles no patter. Its results speak for themselves. Yet has the fox been offered any prestigious City jobs? Exactly.

The fox has, perhaps, been lucky, but nobody who studies the subject of forecasting will be surprised. The psychologist Philip Tetlock, author of the modern classic Expert Political Judgement, conducted a two-decade investigation into the accuracy of expert forecasts in social sciences. He discovered that regardless of academic field, practical experience, gender or political persuasion, experts make very poor forecasts. By some measures, the “chimp strategy” of randomly predicting that things will get better, or get worse, or stay much the same, matches the best the experts can do. Mr Goldstein-Jackson’s fox is in good company.

Mr Tetlock did find one way of dividing up his experts in a way that correlated with less-awful forecasting ability: that of “cognitive style”. Harking back to an essay by Isaiah Berlin, and before him to the Greek poet Archilochus, Mr Tetlock points to the “hedgehogs”, people who view the world through the lens of a single, powerful, logical idea. They make hopeless forecasters. Less hopeless are intellectually promiscuous, self-doubting dabblers. They are called, of course, “foxes”.

Also published at ft.com.

Can Spam ever be better than gold?

“Can you eat gold? No. You can eat and barter Spam”

– Nouriel Roubini, economist, Dec 14 2011

An intriguing remark, that.

It calls to mind one of the jokes that was circulating during the post-Lehman panic of 2008: “Normally the pessimists buy gold; these days, the optimists are buying gold and the pessimists are buying bottled water and bullets.”

Prof Roubini is one of the pessimists?

He is famous for his apocalyptic economic forecasts, the gist of which has been borne out in the past four years. This isn’t the first time he’s pointed to the logic of canned goods in the worst of economic times.

Well, he’s right: you can’t eat gold.

That was a problem for King Midas, but I think that’s a distraction. You can’t eat bank statements or share certificates. I think what Prof Roubini is really suggesting is that gold isn’t necessarily the best financial investment.

And is it?

Forecasting is for the likes of Prof Roubini. All I can do is point you to past performance and make the observation that it’s no guarantee of future performance. Over the past 40 years or so, the value of gold has been negatively correlated with the value of other assets, making it useful for diversification. Gold was subject to a speculative bubble in the late 1970s and, after adjusting for US inflation, reached a long-standing peak in 1980. Gold proceeded to be an abysmal investment for the rest of the century, but has been booming again more recently. Despite a recent slump, gold has still outperformed the US stock market over the past decade. But what does that tell you, unless you have a time machine?

Surely you can say something about fundamentals?

Not really. When it comes to bonds you can make judgments about inflation and the probability of the money being repaid; with shares, it’s helpful to look at corporate profits. Gold has some industrial and cosmetic uses, but its value to gold investors is that there will always be another investor willing to buy. Because the value of gold is almost entirely tied to future investors’ willingness to buy it, strictly speaking, gold has been in an investment bubble for the past 3,000 or 4,000 years. But there’s the rub: if the bubble has lasted as long as civilisation itself, “bubble” is hardly a derogatory term.

Why do people get so excited about gold?

There’s a particular economic philosophy at work here – the view that government-issued paper money cannot be trustworthy and that currencies should be firmly backed by gold. Presumably the gold enthusiasts have never encountered the Bundesbank. Philip Coggan, author of Paper Promises, points out that there has long been a conflict of interest between creditors, who like their money as sound as possible – making a gold standard attractive – and debtors, who prefer more flexibility. A bit of inflation makes debts less burdensome; what you feel about that depends on whether you’re a borrower or a lender.

So the gold standard helps prevent inflation?

It does. But it also has serious disadvantages. In the early 20th century, currencies were tied to the gold standard, which brought some price stability at the cost of making it impossible to prevent the Great Depression. Now most economists argue that it’s an advantage to have a flexible currency – after all, if tying the lira to the euro has caused so much trouble, imagine if the euro itself was tied to the dollar and the dollar was still pegged to the contents of Fort Knox.

So gold is sometimes a good investment but rarely a good macroeconomic foundation?

That’s my view, and I think I’m in the majority of economists – for what that’s worth these days.

And what about Spam?

Well, Spam is an intriguing prospect. A good currency is fungible, homogenous, non-perishable and easy to carry around. Spam ranks high on the non-perishability stakes, and it’s also homogenous. Notwithstanding the existence of “Spam Hot And Spicy”, most people are likely to take the view that Spam is Spam. It’s not to everyone’s taste, though. Have you considered Mars Bars instead?

Mars Bars?

Nico Colchester, the great Financial Times journalist, once studied the remarkable price stability of Mars Bars. Cocoa, sugar, vegetable fats and milk solids are all valuable commodities and a Mars Bar offers you diversification in a handy ingot form. Prof Roubini might wish to investigate.

Also published at ft.com.

Christmas on credit

Presents for one’s children do not seem like an optional extra though many families may struggle during this holiday

One dark December evening, sometime in the early 1980s, my father sat down to have a serious chat with me. That Lego spaceship I was dreaming about for Christmas? It might never arrive. Our boiler had broken; fixing it was going to be expensive. I should not hope for too much.

Perhaps this was just a bit of smart parenting on my father’s part: perhaps I had taken to viewing a substantial Christmas present as a basic human right and he was just putting a shot across my bows. After all, I did get the Lego. (It was the Space Cruiser, set number 487, a classic that gave me many hours of pleasure. Thanks, Dad.)

Then again, perhaps we really were financially embarrassed, and perhaps my parents were not sure that an alternative source of finance would materialise. Plenty of families will be in a similar situation this Christmas. The Joseph Rowntree Foundation, which uses a thoughtful and innovative methodology to estimate the minimum income necessary to achieve a “socially acceptable” standard of living, reckons that a family of five with one breadwinner – my situation today and my father’s at the time – needs £690 a week before tax. Since 80 per cent of employees earn less than that, it is easy to see why many families require two incomes, and why many struggle at Christmas.

Yet the conversation still feels extraordinary by today’s standards. Christmas presents for your own children do not seem like an optional extra. Is this because Christmas itself has become more of a consumerist blowout than once it was? Surprisingly, the answer is no: Joel Waldfogel, author of Scroogenomics , estimates that in the US the December bulge in retail spending was far larger in the 1930s than it is today, relative to the size of the economy. The modern Christmas is not especially extravagant.

What, then, has changed during the past 30 years? The answer, surely, is the availability of credit. If I was wondering how to buy Christmas presents and fix a broken boiler – actually, both issues are on my list of things to do today – and if I lacked savings to address the issue, I would instinctively reach for a credit card. That is not the way things used to be. Waldfogel – again, using US data – estimates that in the 1930s, about a 10th of Christmas spending was financed through “Christmas clubs”, savings accounts that were easily accessible only in the run-up to Christmas.

Christmas is now financed in arrears, not in advance. Waldfogel reckons, looking at seasonally fluctuating data about credit card balances, that a third of Christmas spending has not been paid off by the end of February. This is a change in spending patterns that has developed rapidly since 1980, and, at an interest rate of 20 per cent or so, it does not come cheap.

What seems so archaic about that fatherly chat, then, is not a change in household incomes or in Christmas bingeing but in the availability of credit.

Over the past three decades we have drawn ever closer to the highly convenient world, assumed to exist in many simple economic models, in which we can effortlessly shift our spending backwards and forwards to whenever suits us. As long as total lifetime spending plus interest equals total lifetime income plus interest, no boy need ever lose out on a Lego space cruiser because of a pesky boiler repair.

Whether you are an ambitious mortgage provider, a European nation state, a first-time house buyer or just a parent without rainy-day savings, the past four years have delivered a tough lesson: access to credit is not a right, conveyed by a disinterested, omnipotent and benevolent free market. It is a privilege, granted by flesh-and-blood creditors. And it is a privilege that is both bestowed and withdrawn on a whim.

Also published at ft.com.

Is payday lending really wrong?

“About half of US states have clamped down on payday loans by capping interest rates, or restricting them in ways that make them less profitable… Faced with a hostile home market, several US companies have hit upon the same solution: to set up shop in Britain.”

That doesn’t sound good.

Oh, I don’t know. Haven’t we been wringing our hands about a “credit crunch” for the past four years? At least somebody has stepped into the market. Payday lending is said by one analyst to be up from £100m in 2004 to £1.7bn in 2010. But that’s modest compared with over £55bn of outstanding credit card debt or more than £200bn of consumer credit – which includes everything from a credit card to paying in instalments for a new sofa. Bank lending is down sharply; consumer credit is up slightly after a big dip; only payday loans are showing strong growth.

You’re being facetious: payday loans are offered at extortionate rates.

I am being facetious – mostly. And yes, payday loans are at extortionate rates. Say you borrow £100 for a month and have to pay £125 at the end of the month. That’s an interest rate of 25 per cent a month, which compounds to about 1350 per cent a year.

This sort of thing is disgusting. Payday loans should just be banned.

Many people think that. An alternative is to cap the interest rate at something like 30 per cent, which would allow most store cards and credit cards but destroy the business model of payday loans. But aren’t we being a little bit hasty? This product tends to be discussed as though it’s something like heroin: profitable but corrosive. Isn’t it worth considering that payday loans are a valuable service, used by people in full control of their senses?

That’s ridiculous.

It’s not ridiculous at all. Consider the fuss that people now make about microcredit – small loans, often at interest rates well above 50 per cent a year that are said to help the very poorest families manage their finances and even become entrepreneurs. That’s a story that many people are happy to accept without examining the evidence, while at the same time condemning payday loans, which appear to be a similar product. Are you sure you’re not just reflecting a prejudice that credit-starved Bangladeshis are heroic would-be entrepreneurs while credit-starved westerners must be trailer trash?

Are you claiming that it is rational to take an interest rate of 1350 per cent?

Of course it could be, the question is whether it is rational in practice. Consider the founding story of microcredit – the moment in 1976 when Muhammad Yunus lent less than a dollar each to 42 rural craftswomen. Those women had previously made baskets and chairs, funded by a village moneylender at a rate of 10 per cent a day, which by my calculations is an annual rate of over 100,000 trillion per cent. I am not aware that anybody argues the women were irrational: until Mr Yunus came along they had no options but to take out the loan each morning to buy materials.

So what’s the evidence?

It’s mixed. For example, the economists Dean Karlan and Jonathan Zinman persuaded a South African consumer finance company providing loans for a few months at an interest rate of 200 per cent, to run an experiment randomising loan approvals for marginal applicants who would otherwise have been rejected. To Mr Karlan’s surprise, the borrowers who were randomly approved for loans did better than those who didn’t get the cash. The reason seems to be that those borrowers used the loans to pay essential bills – fixing a bike, buying clothes – that helped them keep their jobs. But another study by Mr Zinman and Scott Carrell, which paid a lot of attention to disentangling correlation and causation, found that in states where US Air Force personnel had access to payday loans, the combat-readiness of the Air Force suffered. There are reasons to be concerned about these loans, but we shouldn’t assume that they are never put to good use.

Why don’t banks enter this market? Surely competition would drive down rates.

The banks do compete in this market, albeit indirectly, by allowing people “unauthorised” overdrafts and charging them through the nose for them. The truth is that an unauthorised overdraft can be even more expensive than a payday loan. I am not sure that the banks would like to compete in this market more overtly: the current situation seems to suit them rather well.

Also published at ft.com.

Screening: It’s all in the numbers

Bayesian analysis questions how we understand the notion of ‘probability’ and how we update our beliefs in light of new information

You’re a woman in her early fifties. You’re invited to a breast cancer screening unit, and you go along hoping for the all-clear. After all, 99 per cent of women your age do not have breast cancer. But … the scan is positive. The screening process catches 85 per cent of cancers. There is a chance of a false alarm, though: for 10 per cent of healthy women, the screening process wrongly points to cancer. What are the chances that you have breast cancer?

Over 50,000 British women face this awful question each year. I first encountered it – in a less alarming context – as an undergraduate economist. And I was in the audience recently when David Spiegelhalter used it as an example in his Simonyi Lecture, “Working Out the Odds (With the Help of the Reverend Bayes)”. The numbers approximately reflect the odds faced by women who go for breast cancer screening. And the answer – courtesy of the Reverend Bayes in question, who died 250 years ago – is surprising.

Bayes was concerned with how we should understand the notion of “probability”, and how we should update our beliefs in light of new information.

A Bayesian perspective on the apparently grim screening result tells us that things are not as bad as they seem. The two key pieces of information point in different directions. On the one hand, the positive scan substantially worsens the odds that you have cancer. But on the other, the odds are worsening from an extremely favourable starting point: 99 to 1 against. Even after the positive scan, you still probably don’t have cancer.

Imagine 1,000 women in your situation: 990 do not have cancer, which means we can expect 99 false positives, far more than the 10 women who do have cancer. This is why any apparent sign of cancer should be followed up with further tests in the hope of avoiding unnecessary treatments. The chance that you have cancer is 8 per cent 9 per cent – up dramatically from 1 per cent, but with plenty of room for optimism.

None of this proves screening is pointless. It can save lives, but it raises dilemmas. The UK’s breast cancer screening programme is currently under review. A systematic analysis published by the Cochrane Collaboration found that for every woman who had her life extended by early detection and treatment, there would be 10 courses of unnecessary treatment in healthy women, and more than 200 women would experience distress as the result of a false positive.

Bayesian reasoning has implications far beyond cancer screening, and we are not natural Bayesians. Daniel Kahneman, a psychologist who won the Nobel memorial prize in economics, discusses the issue in a new book, Thinking, Fast and Slow. I recently had the opportunity to quiz him in front of an audience at the Royal Institution in London. Kahneman argues that we often ignore baseline information unless it can somehow be made emotionally salient. New information – “possible cancer” – tends to monopolise our attention.

Another example: if somebody reads the Financial Times, should you conclude that they are more likely to be a quantitative analyst in an investment bank, or a public sector worker? Before you leap to conclusions, remember that there are six million public sector workers in the country. Base rates matter.

Sometimes there is no objective base rate and we must use our own judgment instead. I think homeopathy is absurd on theoretical grounds; others find it intrinsically plausible. Bayesian analysis tells us how to combine those prior beliefs – or prejudices – with whatever new evidence may come along.

Whenever you receive a piece of news that challenges your expectations, it’s tempting either to conclude that everything has changed – or that nothing has. Bayes taught us that there’s a rational path between those two extremes.

Also published at ft.com.

You’re wrong – we are all wealth creators

“We will set public sector pay awards at an average of 1 per cent for each of the two years after the pay freeze ends . . . while I accept that a 1 per cent average rise is tough, it is also fair to those who work to pay the taxes that will fund it.”

The chancellor’s autumn statement

“Did you hear about that 1 per cent pay rise?”

“I did. Tough but fair, if you ask me.”

“Why’s that?”

“Well, we in the private sector have to work to pay for you in the public sector. It’s only fair that you show some restraint.”

“Well, ‘show some restraint’ is not quite the phrase, is it? It’s not as if I’m choosing my own pay. You must be confusing me with the chief executive of a major PLC. No need for me to show any restraint; George Osborne is quite capable of showing restraint on my behalf, thank you very much.”

“Good job he is, too. I’m paying for your salary.”

“Is this the ‘hard-working private sector funds the bloated public sector’ line?”

“Funny you should mention that, I guess it is.”

“I’ve never understood that. I’ll admit that you pay for my salary, but I pay for your salary too.”

“How’s that?”

“You work in sales for a mobile phone company. I work as a teacher.”

“Yes, my taxes pay for your salary.”

“But my mobile phone bill pays for your salary. If the government nationalised Vodafone – stranger things have happened – and privatised the school system, my taxes would be paying for your salary while my employer would be sending you a bill for my teaching of your children. But we’d still be paying each other. This is a modern economy. Everybody pays for everybody else’s salary, except the subsistence farmers and survivalists, who look after themselves.”


“Look, communism didn’t collapse because there wasn’t any private sector to pay for the public sector. It collapsed because the incentives were thoroughly screwed up. There’s no logical reason why an economy couldn’t be 100 per cent public sector. You’re making it sound like that’s impossible as a matter of simple arithmetic.”

“Still, communism is hardly an advertisement for the public sector, is it? The private sector creates wealth.”

“No, individual technologists, managers, scientists and entrepreneurs create wealth. Their natural home might well be the private sector but there’s no logical reason why they can’t be employed in the public sector. Tim Berners-Lee invented the World Wide Web while he was working in the public sector.”

“He’s not exactly representative of the public sector.”

“Sure, but Steve Jobs isn’t exactly representative of the private sector either. There are remarkable individuals who do remarkable things, and I’m happy to acknowledge that the private sector is usually the place where those remarkable things have space to grow. But the private sector as a whole is doing something more pedestrian: it’s providing goods and services. And so is the public sector. To suggest that some of these goods and services count as ‘creating wealth’ and others don’t, purely because some are paid for out of taxes and others are paid for in the marketplace, doesn’t make any sense.”

“Still, Osborne was right: we need to make savings. Public sector workers have to do their bit.”

“That’s a fallacious line of reasoning: it assumes that the public sector workers of yesterday are going to be the same people as the public sector workers of tomorrow, after several years of chipping away at their real incomes. They might not be. I might decide to become a mobile phone salesman instead of an economics teacher.”

“The way this conversation is going I wish you’d made that choice a while ago.”

“The question is where you want the best people. Trimming public sector wages might harm current public sector workers, or it might just persuade them to seek new pastures, to be replaced by over-promoted junior staff – or mobile phone salesmen who were sacked because of a sudden influx of better-qualified people who could do their job. It may well be reasonable for Osborne to squeeze public sector pay, but if he does, private sector workers will suffer consequences too. Sometimes when he says that we’re all in this together, he’s right – if only by accident.”

Also published at ft.com.

‘Tis not the season to be shopping

Christmas Day should be the beginning rather than the end of the festive celebrations. But commercial logic points in a different direction

I’m one of those old-fashioned types who reckons the Christmas season should begin late. I like to put the Christmas decorations up the Sunday before Christmas at the very latest, and I even enjoy working on the morning of Christmas Eve – there’s something more magically Dickensian about taking just that afternoon off and heading home with beribboned parcel, rather than taking up residence on the sofa a week beforehand. Christmas Day should be the beginning rather than the end of the festive celebrations.

Commercial logic points in a different direction. There is little profit for Selfridges or Dixons or Hamleys trying to get people in a Christmassy mood at the very last minute. Indeed, the economist Emek Basker has found that in the US, where the Christmas shopping season varies between 26 and 32 days depending on the date of Thanksgiving, longer seasons mean more overall spending (about $8 per person per extra day). Daily spending rises in November after Thanksgiving, but is just as high in December even during the most protracted shopping seasons.

The economist Joel Waldfogel, author of Scroogenomics, estimates that the extra spending on Christmas and Hanukkah in the US in 2007 was $66bn – a substantial sum, and relative to the size of the economy it is even larger in the UK.

No wonder that at this time of year, everyone hurries to publish articles about how the Christmas spending rush is good for retailers. But this is odd. Imagine how much easier life would be for retailers if that extra $66bn was spread evenly across the year.

For a hint at the inconvenience, I spoke to Derek Hayes, of Oxfordshire-based Skyline Promotions. Hayes runs the ultimate seasonal business: a British company producing firework displays. This year was particularly challenging because Bonfire Night fell at the weekend. (Wednesdays are easiest, because they spread the workload across two weekends and midweek.)

Skyline employed 42 people to run 16 firework displays on Saturday, November 5. Because most of Hayes’ staff have unrelated day jobs, the 14 displays on Friday the 4th were even more challenging. But contrast that peak of 42 workers with much of the rest of the year, when Hayes works alone. To cope this year, he called in favours from old associates who travelled from Cornwall and Leeds. He even organised a post-fireworks reunion party.

Firework displays are, of course, particularly challenging: they are extraordinarily seasonal, cannot be stored, and require skilled staff. But other businesses must cope with versions of the same challenge.

Does this matter? The economist Jeffrey Miron pointed out in The Economics of Seasonal Cycles, published more than two decades ago, that a perfectly efficient market will cope just fine: prices, wages and rents will rise at peak times to cover the very real costs of seasonal booms. Customers will either willingly pay extra, because they value the convenience of the timing, or will instead buy Christmas presents in the January sales, order cocktails during happy hour, and organise weddings on Wednesdays in October.

In practice, Miron argued, things are not quite so simple. For various reasons – some cultural, some legal – there are limits to how flexible prices and wages tend to be, and how responsive people can be in return. Some office Christmas parties are successfully moved to January, but few family Christmases are. And most schools will not applaud parents who seek a cheaper holiday by pulling their children out of class. As a result, shops will remain congested and staff harassed during Christmas, and managing inventory will be a logistical nightmare.

My Christmas decorations may be going up late in the season, but I did most of my Christmas shopping early. It was the least I could do.

Also published at ft.com.

When the Christmas stocking shrank in the wash

In an act of last-minute desperation, the prime minister decides to replace his chancellor George Osborne with a figure judged to have broader political appeal: Santa Claus. (The decision was approved by a committee of Liberal Democrats.) The FT can now present a transcript of the conversation the night before the chancellor’s autumn statement:
David Cameron: OK, Santa. It’s time to start slipping some goodies under the Christmas tree for the great British public. What can you do for us?
Santa Claus: Well, young David, the trouble is that nobody put aside any funds for this kind of thing. A Christmas savings account is traditional, don’t you know?
DC: Nobody set aside any money. This was the position we inherited from the last government, Santa.
SC: I understand, David, but the blame game doesn’t get us very far in this season of goodwill to all mankind, does it? Try “Santa didn’t visit because Daddy lost his job at the UK Border Agency” and see how far that gets you on Christmas morning.
DC: Fine, fine. And that’s why we need to give people something. Anything cheap and cheerful? Any stocking fillers?
SC: Stocking fillers? It’s not as easy as that, young fellow. Have you seen the report from the Office for Budget Responsibility?
DC: I know, I know. Even if the eurozone gets its act together, our growth rate is way down.
SC: No, that’s not what I meant. Everybody knows that growth is in the toilet and you can easily blame that on the price of oil, the euro crisis and Gordon Brown. The problem is that the OBR thinks that the UK’s potential growth rate has fallen. The British economy isn’t a floppy oversized stocking begging to be stuffed full of Keynesian stimulus – it shrank in the wash and it’s now a tight constraint on future growth. There is a silver lining, though.
DC: A silver lining to the tight stocking?
SC: No, a silver lining to the OBR’s downgrade of the UK’s growth potential. If the OBR is basically right then the Labour attack on your economic policies is basically wrong. The Keynesian tax cut they want is predicated on the assumption that the economy has plenty of potential to supply but too little demand. The OBR thinks that supply has also been damaged by the credit crunch. It’s disastrous news, but you can console yourself that it would be equally disastrous if Ed Balls was in charge.
DC: This is awful. That’s why I hired you: you’re the man to put a smile on people’s faces. What can you offer me? George was planning to divert £5bn to infrastructure spending over the next few years. Should we keep that policy?
SC: It’s fine as far as it goes, but let’s not get our hopes up. Let’s say that this is £1.5bn a year for three years, and let’s say the spending multiplier is two, which is a Keynesian’s wet dream. And let’s also assume a multiplier of zero for whatever else was going to be done with the cash. If so, the private sector would actually grow by £1.5bn each year as a result of the infrastructure spending.
DC: Sounds great to me.
SC: But it would add only 0.1 per cent to the growth rate – granted our extremely generous assumptions.
DC: What about the £20bn of private sector infrastructure spending we’re planning to mobilise?
SC: That’s fine, too, but why not just borrow the money and spend it directly? Presumably these are basically government-funded projects and the private sector is being used to take it off the balance sheet in time-honoured fashion – and of course at greater expense to the taxpayer in the end.
DC: We’ll stick to our fiscal rules!
SC: International investors seem very impressed by your commitment, but I don’t think they’re going to be fooled by this sort of accounting. Not after Greece. I think it’s best to tell the truth in such matters.
DC: Says Father Christmas!
SC: Listen, sonny. You were the one who sacked your chancellor in favour of a deus ex chimney. George has been dismissing “something for nothing” economics and I’m afraid he has a point.
DC: Santa, thanks for your time. But at least George is willing to pretend he’s going to do something. I think I’ll ask him to present the autumn statement after all. I don’t think Plan B has really worked out.

Back to the glory days of Northern Rock

“People buying newly built houses will need a deposit of as little as 5 per cent under measures designed by the government to help unstick the housing market.”

Financial Times, Nov 22

What’s the story here?

We need to go back to the height of the credit boom, four or five years ago. Banks were handing out mortgages without requiring a deposit. In the case of the most brilliantly managed banks, for example Northern Rock and HBOS, mortgages were offered with loan-to-value ratios of 125 per cent, in effect allowing house buyers to go deep into negative equity the day they collected the keys.

Was that a problem?

Yes, it was. Somebody in negative equity may be unable to move house without defaulting on the mortgage loan, which makes them a risky proposition for the bank, as well as trapping them in other ways – making it hard to move to find new work, for example. There’s also a fair case to be made that loose lending standards in the UK helped drive house prices up to absurd levels. If people tend to get carried away when they see rising house prices, which seems plausible enough, then their spending will be limited only by the giddy enthusiasm of the banks.

Oh. Sounds bad.

It’s good for elderly people who happen to move to smaller houses at just the right moment, and it’s good for presenters and producers of vacuous home-improvement pornography. But it’s bad news for anybody who owns less house than they’d ideally like – which is most of us, given how pokey British houses are – and it’s also bad news for the stability of the financial system. The crisis was triggered by similar loans in the US, not in the UK, but that doesn’t make overstretched UK loans a good idea.

Right. So what’s the problem that the prime minister is trying to solve?

It’s very simple: this unsavoury state of affairs stopped a few years ago, and David Cameron would like to kick-start it again.

I’m sorry, I must have misheard you.

That’s what I thought when I heard the policy being announced, but I am afraid it’s true. Such mortgages only made sense – for both bank and homebuyer – if you had (false) confidence that house prices would continue to rise forever. The government has noticed that banks have lost this confidence and now insist on substantial deposits as a cushion in case house prices fall. So it plans to throw the taxpayer guarantee in there – on top of the deposit cushion, the taxpayer is a kind of airbag. If prices fall and the buyer defaults on the loan, the taxpayer will absorb some of the impact.

On what planet is this a good idea?

Let’s be fair: more house building would be an excellent plan. It’s a contribution to the long-term wealth of the country; unlike manufacturing it cannot be offshored and provides plenty of employment, even from the young and the unskilled. And there aren’t nearly enough houses, which is another reason why prices are so high – relative to earnings they are still roughly at the level at the peak of the catastrophic late-1980s housing bubble. Private companies are building about 100,000 homes a year – low levels not seen since the 1920s. A few hundred thousand more houses each year at a time when prices are high and unemployment is also high would kill several birds with one stone.


But this is surely the stupidest imaginable way to stimulate house building. There are three fundamental problems: prices look high, so banks don’t wish to be exposed to their likely fall by lending either to developers or to house buyers; the banking system itself is fragile, exacerbating the sense of caution; and above all, planning permission is hard to come by, so if you have the money to build a house the local council probably won’t let you. The government’s response is to try to prop up prices with the following proposition: lend money to people who should not be buying such expensive houses, and if things turn sour you can repossess the home, sell it at a loss and the taxpayer will see you right.

What does the opposition think of this plan?

They think it should be much bigger. Not nearly enough taxpayers’ money has been thrown into it, apparently. Without a more determined effort we’ll never get back to the aggressive lending of the glory days of Northern Rock.

What happened to Northern Rock again?

Let’s just say it’s gone to a better place.

Also published at ft.com.

How to stop the bogus bonus

Successful oversight is going to require more transparency about what trades are being made. But transparency is a scarce commodity

It used to be so easy to “earn” a performance bonus in financial services. Step one: agree a contract whereby you are paid if you exceed a modest benchmark with the funds you are managing. Step two: borrow money and invest it in risky assets. Step three: profit! Step three does not follow automatically, of course, if the risky asset does not pay off. But from the point of view of the fund manager and his bonus, it’s a case of “heads I win, tails the investor loses”.

It’s fairly trivial to show that such bonus schemes, if implemented naively, offer disproportionately larger bonuses for ever larger risks. We might hope that investors are too sophisticated to fall for such obvious tricks. Yet Dean Foster, a statistician at the University of Pennsylvania, and Peyton Young, of Oxford University and the Brookings Institution, were warning in the early days of the financial crisis that fund managers could hide risks in far more sophisticated ways.

The problem is, as Foster and Young show, that it is possible for an unskilled fund manager to mimic a genuinely skilled one, in the same way that an insect might mimic a leaf, or a harmless creature mimic a poisonous one.

This mimicry, too, involves three steps: first, invest all your funds in whatever benchmark you need to beat, whether it’s treasury bills or a stock market index; second, make a bet that some unlikely event will not come to pass using the invested funds as security; finally, boast of benchmark beating returns, because you’ve delivered the benchmark plus the additional money from winning the bet. Collect your performance fee. (In the unlikely event that you lost the bet and with it all your investors’ cash, simply cough awkwardly and look at your shoes.)

Rather disturbingly, Foster and Young have proved that if investors can only examine your investment returns and know nothing about your investment strategy, as a fund manager you can always make your numbers look good by taking on small risks of very bad outcomes.

These are the “black swans” made famous by Nassim Taleb: low probability, high-impact events, except that these particular swans are genetically engineered – deliberately manufactured and then hidden away, to escape at unwelcome moments.

The solution seems obvious: pay performance bonuses with a lag, perhaps in company stock, or allow “clawback” – in effect, a financial penalty rather than a bonus – if those pesky black swans do appear. But in a recent presentation, Peyton Young explained that none of these approaches really do much to help. It’s true that deferred bonuses can help evaluate performance itself over a long term, but the mimic strategies will remain available. The mimic can, for example, make a huge bet and then simply go quiet if the bet pays off, making safe, neutral investments until the bonus comes due.

Regulators, investors and senior management simply cannot judge traders and fund managers on the basis of their performance alone, no matter how good it looks – the black swans can always be bred and hidden.

Successful oversight is going to require more transparency about what trades are actually being made. And in many parts of the financial services industry, transparency is a scarce commodity.

Kweku Adoboli, the former UBS employee charged with fraud and false accounting, worked on a “Delta One” desk – and the whole point of Delta One trading is to replicate a certain pattern of returns through trading strategies that need not be disclosed.

The folly of “rewarding A while hoping for B” is – thanks to a famous article by Steven Kerr – now well known. But what about “rewarding A” without realising that in fact you are being given “C” in disguise?

Payment by results is an attractive idea, but in a world where black swans can be deliberately manufactured, results can be treacherous.

Also published at ft.com.



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