Tim Harford The Undercover Economist

Articles published in March, 2013

What Oxbridge can learn from YouTube

The British educational establishment should ignore online open courses at its peril

A couple of years ago, I showed my daughters a video put online by the Khan Academy, which has become famous as a pioneer in open-access education. The video was an amateurish but charming explanation of basic arithmetic. We had fun but the girls were not transformed into mathematical prodigies. Their mathematical education remains the sole responsibility of a rather traditional school in North Oxford. The only thing YouTube has taught them is how to draw manga cartoons.

That experience would not surprise the British educational establishment. Massive Online Open Courses (Moocs) are all the rage but the top universities seem to regard them as mere amusements, unlikely to threaten traditional methods, which may be costly but are exclusive and of excellent quality.

The vice-chancellor of Cambridge university, in a speech in January, said that online courses would “challenge the nature of higher education” but that they would not change what happened at Cambridge.

Educational expert Karan Khemka seems to agree, explaining in this newspaper’s comment page that the Mooc approach would eventually improve higher education, but “through incremental change rather than massive disruption”.

I am not so sure. Clayton Christensen of Harvard Business School has become famous for his explanation of how “massive disruption” tends to happen. A new technology appears, and it’s cheap and cheerful. Examples: small hydraulic shovels when the standard was large cable-driven mechanical diggers; small steel mills devoted to melting down scrap metal; slow, low-capacity hard drives in a world of mainframe computers. The dominant players in the industry look at the upstart technology and ignore it. This isn’t just a case of snobbery: their customers don’t want the new cheap technology either. They are already paying for a high-quality product that fits their needs perfectly.

The cheap technology is embraced by new entrants, who supply a totally new customer base. Construction companies didn’t want cheap, weak hydraulic shovels but landscape gardeners did. And then, of course, the new technology got better and better. Eventually it overtook what the incumbents had to offer and, despite all their advantages, they had absolutely no idea how to make or deploy the upstart technology that had become the state of the art.

My colleague Michael Skapinker has dismissed Clayton Christensen by providing a (perfectly reasonable) list of the ways in which a face-to-face learning experience beats a YouTube lecture hands down. It is most unlike Michael to miss the point.

Of course, a few online videos, chat rooms and multiple choice questions pose no threat at all – for now. Why go online when you can receive expert tuition in small groups, receive an exclusive stamp of achievement on your CV, and still have time to get drunk with the future masters of the universe? Online courses have little to offer current students at the world’s top universities.

That is why they are such a disruptive threat: if Oxford and Cambridge ignore Moocs now, what happens when the digital component of education has evolved to become indispensable?

If “content on demand” isn’t a killer application, then the ability to measure each student’s progress and tailor courses accordingly may well be.

The wise move has to be to follow MIT and Stanford, and indeed the UK’s Open University, embracing Moocs not for what they offer now but for what they might one day become. It is time for the UK’s greatest educational establishments to learn a few lessons themselves.

Also published at ft.com.

Statistical tomfoolery spins in Treasury

Osborne has hurled himself down the slippery slope, writes Tim Harford

‘I’m going to level with people about the difficult economic circumstances we still face and the hard decisions required to deal with them.’
George Osborne, chancellor of the exchequer, Budget speech, March 20

Did he?

George Osborne was very good at levelling with people about how bad things are in the eurozone and how badly Labour managed the economy. He wasn’t quite so keen to draw attention to the plank in his own eye.

Nobody can be surprised that Mr Osborne spun things to his own advantage. But are you actually accusing him of statistical tomfoolery?

Of course I am. I’m ever more struck by the bizarre symmetry between Gordon Brown and Mr Osborne: both enormously pleased with themselves; both ideologically pre-committed to a particular course of action, regardless of the evidence; and both absolutely addicted to statistical fiddles.

But Mr Osborne established the independent Office for Budget Responsibility. You have to give him credit for that.

But he is in danger of making the OBR look ridiculous. The OBR is indeed independent and appears to be perfectly competent too, but it is obliged to respect statistical conventions. The chancellor has exploited those conventions without shame.

For example?

It is very important to Mr Osborne to be able to claim that the deficit is falling by some tiny amount – and equally important to his opposite number, Ed Balls, to be able to claim that the deficit is rising by some tiny amount. Just for the record, these are the only two men on the entire planet who care. Nobody else gives a flying fiscal target about it. But because these two overgrown school bullies care, Mr Osborne must manufacture a falling deficit, no matter what. He has done so through transparently shabby means. The most shamefaced is that he has informed the OBR that he will not be mailing his cheque to the World Bank until the next tax year, which begins in a fortnight.

Why does that help?

In practical terms it makes no difference to anything, except perhaps to mildly embarrass us in Washington. Nothing about the UK’s fiscal position is changed if Mr Osborne accidentally leaves that stamped addressed cheque to the World Bank in the glove compartment for a fortnight. But the OBR is obliged to recognise the spending as taking place next year. Mr Osborne could even change his mind about delaying the payment to the World Bank, now that the OBR estimates have been published – although even he might find that embarrassing.

What other tricks has he used?

He has moved cash from the Bank of England to the Treasury. The Office for National Statistics has decided that the appropriate way to account for this is to reduce the deficit. Any sane observer would conclude that the underlying economic reality has not changed.

At least he hasn’t used the off-balance sheet tricks so beloved of Mr Balls and Mr Brown.

Mr Brown was a master at this. He launched his unsuccessful election campaign in 2010 in a brand new hospital in Birmingham that was paid for using the private finance initiative – or to be more precise, which we are therefore all still paying for and will be for many years. But Mr Osborne’s big flourish this week was an attempt to pump air into the UK’s slowly deflating housing bubble by borrowing extra money and lending it on to homebuyers. He said proudly, “because it’s a financial transaction, with the taxpayer making an investment and getting a return, it won’t hit our deficit”.

But he’s still borrowing extra money – isn’t he?

Of course he is. But it’s off the balance sheet. It’s true that Mr Osborne is borrowing to invest in equity in British housing and so it’s possible that he will make a profit on the deal in the long run. But Mr Osborne could equally, and more wisely, borrow to invest in much-needed infrastructure. That could also pay off in the long run – but the accounting is less convenient.

This is ridiculous. Isn’t somebody supposed to be stopping him getting away with this kind of thing?

My colleague Chris Giles fears the ONS has been losing its independence.* But I suspect the truth is that if politicians decide to twist the statistics, they will succeed in doing so. And it will always be a pyrrhic victory. Whether or not you back Mr Osborne’s policies, nobody takes his statistical spin seriously any more. Mr Balls no doubt understands how that feels.

Also published at ft.com.

EDIT: Because of an editing error, the starred sentence above was originally published reading “The ONS has been losing its independence.” I respect Chris’s views but they are Chris’s views and not mine.

Geoengineering, a monster of our own making?

The core case against the science is a radical uncertainty about its consequences but it would likewise be irresponsible to turn our backs on it

While holidaying in the Alps with Lord Byron and Percy Bysshe Shelley, the young Mary Godwin was stranded indoors by unending rain. Stuck for activities to fill the days, she dreamt up a horrific story of a brilliant scientist whose hubris has tragic and unpredictable consequences. She later became Mary Shelley, and the story later became Frankenstein.

We now know that the dreadful weather of 1816 was induced by the vast eruption of Mount Tambora in Indonesia. Two centuries later, the use of imitation volcanic clouds is being seriously contemplated as an antidote to global warming. The word “geoengineering” is on the lips of the world’s atmospheric scientists.

The trigger for the discussion of geoengineering was a 2006 article by Paul Crutzen, a Nobel laureate and expert on the ozone hole. Many scientists share his concern that substantial climate change can no longer be prevented: we are emitting too many greenhouse gases and our plans to stop are tardy and timid.

Geoengineering proposals fall into two broad categories: we can try to remove carbon dioxide from the atmosphere, or we can try to reflect sunlight away to counteract the greenhouse effect that carbon dioxide produces.

Both ideas are superficially tempting. Carbon dioxide lingers for many decades, which means that, even if we stopped pollution tomorrow, warming would continue. Removing carbon dioxide would allow us to undo past harms more quickly and might prevent some tipping point being reached.

Solar radiation management – by creating reflective fluffy clouds to screen the dark oceans, or by using the volcano effect and pumping sulphur particles into the stratosphere – has its own attractions. For one thing, it seems absurdly cheap. So what’s the catch?

The catch is obvious enough. The world’s climate is complicated and we don’t really know what the consequences might be of interfering with it. We can guess at a few: some modelling suggests that a stratospheric sulphur shield could lower global temperatures to where we want them, but would not prevent the oceans acidifying, might affect the monsoon in India, and would cool the tropics while failing to cool the poles.

There are other risks, of course. What if geoengineering becomes a weapon? Clive Hamilton’s otherwise useful book, Earthmasters, is marred by dark mutterings about the connection between geoengineering and Lawrence Livermore National Laboratory, a centre for nuclear weapons research. This doesn’t worry me much. We have far simpler ways to obliterate our enemies.

No, the core case against geoengineering is a radical uncertainty about its consequences. But this cuts both ways. Global warming is a threat not only because of the likely scenario in which the climate changes in harmful ways but we adapt; but in the less likely (but plausible) scenario in which some runaway process makes the planet uninhabitable as we know it. For example: reflective ice melts, exposing dark oceans that absorb heat; warming accelerates; methane is released from the melting tundra; methane exacerbates the greenhouse effect; repeat.

While it would be irresponsible to rely on geoengineering to get us out of our present fix, it would also be irresponsible to turn our backs on the possibility that it might one day prevent catastrophe. Geoengineering experiments are, in any case, already happening – and they are cheap enough for a rogue nation or even a rogue Bond villain to have a go at something quite ambitious. It is time to start thinking about this, and quickly. As Mary Godwin realised, science plus overconfidence can produce an awful mess.

Also published at ft.com.

Budget 2013: Five ways to fix our national joke

The chancellor should start by abolishing national insurance, writes Tim Harford

In his opening words, George Osborne dismissed the idea of “easy answers to problems built up over many years”. A shame. There may be no way through our economic swamp, but there are plenty of things Mr Osborne can do to sort out the national joke our Budget process has become. Here are five.
The chancellor was keen to encourage hard work, but offered instead a national insurance exemption for small businesses that looks vulnerable to abuse.
Here’s an alternative: scrap national insurance entirely, and raise the lost revenue through income tax instead. If NI ever made any sense it was as part of a system of social insurance, designed for an age of the male full-time breadwinner, in which workers chipped into a central pot and withdrew contributions when needed. We no longer have that system.
This means that NI is just another income tax. It is an income tax levied on a narrower tax base, penalising workers and favouring those who live off capital. It is an income tax levied on a different basis and calculated in different ways, breeding cost and confusion. Mr Osborne has raised income tax allowances but NI has not kept pace. When the chancellor boasted of 2m low-paid people being taken out of tax altogether, it was untrue: almost all of them will still pay national insurance.
If NI was replaced with an equivalent but broader-based income tax, the effective tax rate on employment would fall, creating jobs and encouraging aspiring people to work harder – exactly what Mr Osborne says he wants. It would create some very vocal losers and would reveal that income tax rates are not quite as modest as they appear. That must be why neither he nor any of his predecessors has had the courage to scrap national insurance.
Mr Osborne’s second reform should be to impose value added tax on almost everything, including a VAT-like tax on financial services. VAT is an excellent tax: it is broadly based and it does not much distort decisions. VAT targets consumption rather than income, which makes it a good way to tax people’s long-term income prospects rather than their transitory income. This also encourages people to save. But VAT has so many exemptions that these benefits are frittered away. Many of these exemptions are arbitrary: children’s clothes are zero-rated but educational toys are not; Jaffa Cakes are spared VAT but chocolate biscuits attract it. The reduced rate for burning fossil fuels to heat our homes is just perverse.
The obvious objection to a broad VAT base is that it would be regressive. It would indeed be if Mr Osborne did not offset it, using income tax and benefits to cushion the blow. The Institute for Fiscal Studies believes such a reform could be introduced in such a way as to compensate pretty much everyone, while still generating £3bn of extra revenue.
Item three: Mr Osborne should scrap business rates, which are a distortion to the process of doing business, and introduce a land tax, which is not.
And for item four, the chancellor should replace council tax with a straightforward proportional tax on the value of property, a simpler and more progressive approach. He should scrap stamp duty on property: even if you gave a roomful of special advisers all year to try, they would be hard-pressed to invent a clumsier and more foolish tax.
All these ideas suggest themselves quite naturally to anyone willing to step back and survey the tax system as a whole. Most of them are explored in tremendous detail in the Mirrlees Review, published by the Institute for Fiscal Studies in 2011. The review has been quietly absorbed by Treasury officials but has made no discernible impression on the chancellor himself.
The one genuinely praiseworthy measure in Mr Osborne’s Budget – an attempt to encourage parents into work by providing tax breaks for childcare – could have emerged from a reading of the Mirrlees Review. I am willing to bet that it is a happy accident instead.
None of this is Mr Osborne’s fault alone. Successive chancellors have seized the occasion of the Budget to juggle, to conjure, to deceive and to wait for the applause. Mr Osborne’s announcement of cheaper beer, a penny off the price of a pint, was a parody of these tricks. The chancellor almost laughed as he announced the wheeze, and he knew that the newspapers would play along with the joke.
And so, a fifth and final suggestion for Mr Osborne. He should abolish the twice-yearly circus of Budget and Autumn Statement, and start thinking as seriously about his long-term strategy for tax as he thinks about his long-term strategy for re-election. It is time for William Gladstone’s famous old red box to seek its rightful place in a museum.

Originally published in the Financial Times

“You’ve never had it so good” – my brief history of British living standards

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Chinese takeaway leaves Britain hungry

The economy needs more than a pot noodle factory, writes Tim Harford

‘A British food producer is delivering arguably the ultimate blow to the one-time factory of the world – it is transplanting noodle-making from Guangzhou to Leeds.’
FT.com, March 12

Wow. Undercutting the Chinese on noodles – that’s like shipping coals to Newcastle and beating the Geordies on price.

Not really. Symington’s aren’t planning to sell pot noodle to the Chinese, I don’t think. They’re planning to sell them to hapless British students, the same as always.

But they are planning to make them on UK soil. This is an important trend, I think: British companies giving up on “offshoring” their manufacturing.

We should reserve judgment on that: it’s not clear that it’s a trend and neither is it clear that it’s important. Symington’s are going to create 50 jobs in the UK, about 0.0002 per cent of the UK workforce. Good for them, but let’s not get carried away.

You’re being deliberately dense. Leeds’s noodle boom is an instance of something bigger.

I am sure there are many other examples. There are also plenty of examples of British companies merrily continuing to close factories in this country and shift production overseas. And there are countless other influences on the UK trade balance and the health of British domestic production. On Tuesday, for instance, the latest trade figures came out: the trade deficit was £2.4bn in January, up from £2.1bn a year previously. That does not suggest any switch towards domestic production.

You’re such a pessimist.

Not really. In the long term, the picture is remarkably stable: the UK has had a trade deficit for decades as a result of a persistent trade surplus in services outweighed by a larger persistent trade deficit in goods. The British share of world trade has been shrinking, which is pretty much what you’d expect in a world where China and other emerging markets are growing so rapidly. But British trade has grown strongly over the years. We still don’t ship many coals to Newcastle, so to speak – in 2008, before the full crisis broke, we exported more to France than to Brazil, Russia, India and China combined. That is progress of a sort: in 1998 we exported vastly more to France than to Brazil, Russia, India and China combined.

It sounds as though we are getting left behind in the race to trade with the key emerging markets.

A little. For almost every emerging market, the share of imports which came from the UK fell between 2002 and 2007, according to a report from the Department for Business, Innovation and Skills, published in 2011. This is partly because many emerging markets have developed stronger regional trading partners, and partly because of their growing appetite for commodities, not something the UK specialises in exporting.

So you are not excited by this revival in British manufacturing?

I’ve nothing against it. It will be interesting to see whether it does continue. It seems, at least in part, to be a function of the weakening pound, which in turn surely reflects the enthusiasm with which the Bank of England has created new money. But it may also have something to do with the relative decline of two of the country’s successful yet most problematic industries: crude oil and financial services. Both have contributed a great deal to our trade balance; and both have helped to keep the pound strong, making life difficult for companies producing tradeable products in other sectors of the economy. They employ lots of capital and relatively small numbers of very highly paid workers, so neither industry is brilliant for generating large numbers of satisfying and well-paid jobs, even if they do generate a lot of tax revenue. But we all know how the City has fared in the past five years and the UK became a net importer of oil in 2005. This decline may help other sectors, including manufacturing. But don’t you feel we place too much emphasis on manufacturing?

Not at all. Manufacturing is a vital part of generating sophisticated economic activity. I know that we can in principle pay for everything we need just with oil or financial services. But in practice such monocrop economies are rarely resilient.

You may have a point: oil, banking and selling services to oilmen and bankers is not much of an economic strategy. Manufacturing will surely play a part in any revival. Alas it’s going to take more than a pot noodle factory to regenerate the British economy.

Also published at ft.com.

16th of March, 2013Since You AskedComments off

A hateful abuse of algorithms

Putting the blame on badly supervised computers for releasing offensive products is not much of an excuse

“Keep Calm and Hit Her”. At first glance the T-shirt design seemed to be yet another example of the way violent misogyny has become a joke for some – a literal punchline. No wonder that earlier this month the internet was up in arms at the discovery of such a T-shirt, not from a street trader or a Soho sex shop, but on Amazon.co.uk. And “Keep Calm and Hit Her” wasn’t the only example. There was also “Keep Calm and Rape A Lot”.

When we see such T-shirts for sale through the website of one of the UK’s largest retailers, we naturally imagine that somebody designed the shirt and some buyer at Amazon said, “We’ll take it.” The fact that similar jokes are a staple of the stand-up comedy circuit makes it all the easier to believe that.

But “rape a lot” is not only outrageous, it’s an odd phrase. And what about “Keep Calm and Skim Me”? This was also among the hundreds of thousands of T-shirts available from Solid Gold Bomb, the company which sold them via the Amazon website. (The T-shirts are no longer for sale.) Solid Gold Bomb issued a profuse apology and delivered an intriguing explanation: it wasn’t that somebody had decided these T-shirts would be good business – it was that the T-shirt slogans were being suggested by a computer run amok.

The T-shirts didn’t exist in physical form: a computer algorithm suggested a range of different slogans, and if any of them were purchased the T-shirt would then be printed to order. Now you might well ask what kind of computer algorithm would include the word “rape”; or why Solid Gold Bomb didn’t check the output of the computer (or did check, but didn’t pull the offensive logos). Well, indeed: “my algorithm made me do it” is not much of an excuse here.

The idea that men might crack jokes about rape is all too familiar. The idea that computers are algorithmically generating entire product lines is a new one on me. And while the algorithm excuse is unpersuasive in this case, the algorithms are coming. Search Amazon.co.uk for “Philip M. Parker”, a business school professor who has patented software to write dictionaries, benchmarking studies and other narrow genre books: I saw 113,000 results.

What next: algorithmic blasphemy? Algorithmic child pornography? Hard to say: by their nature, algorithmic processes tend to produce surprises. They can also be a force for good. Using the blind power of variation and selection, computers can design a better nozzle, a better surfboard, even a better campaign to persuade people to quit smoking. The key insight is that a very high error rate is acceptable because the successes are retained and the errors quickly discarded. But what if one of the errors goes viral instead?

One solution is to rapidly remove rogue results. But that introduces a different problem: when the environmentalist author Mark Lynas published The God Species, the book was briefly removed from the Amazon website during the launch campaign. Amazon’s site reported that it had received complaints that the product was “not as described”. Lynas suspected sabotage from his political opponents, and remains unsure as to what really happened. Complaints-based takedown procedures can themselves be abused in a world full of algorithms. (Disclosure: Lynas is a friend.)

Another option is more diligent pre-screening of results. That would have worked for the rape T-shirts. But it, too, has its own costs: millions of customers looking for legitimate niche goods may find that online retailers cannot be bothered to check the long tail of products, and turn back to the mass market.

As I watch my daughters grow up, I suspect they will have even more serious feminist concerns than offensive T-shirts designed by badly supervised computers. But something tells me we haven’t heard the last of algorithmic products.

Also published at ft.com.

A ‘simple rule’ about migrants and benefits

Clues to the UK’s woes lurk in its own backyard, writes Tim Harford

‘Iain Duncan Smith, the work and pensions secretary . . . said the number of EU migrants claiming benefits in Britain had reached a “crisis” and confirmed the government was “looking at what we can do” to limit new arrivals’ access to welfare’
FT.com, March 6

Never a man to waste a good crisis, that IDS fellow.

Or manufacture one. Mr Duncan Smith’s declaration hits all the right notes for a Conservative politician: the welfare scroungers are picking our pockets; there are too many foreigners around; and it’s all the fault of the EU. But behind the mood music there isn’t a lot of substance. We don’t know for sure how many EU migrants claim benefits but Mr Duncan Smith’s Department for Work and Pensions did publish a fascinating estimate in January 2012.

Which found?

The DWP looked at people who were of working age, and who were not UK citizens at the time they applied for a national insurance number. They found that in February 2011, 6.6 per cent of such people were claiming a working age benefit such as jobseeker’s allowance.

That must be hundreds of thousands of people, though.

Over a third of a million people, yes. But 93.4 per cent of the working-age immigrant population are not claiming working-age benefits. This ratio compares very favourably indeed with the homegrown working-age population: 16.6 per cent of us were claiming working-age benefits. Is this really what an immigrant benefit crisis looks like?

But Mr Duncan Smith particularly drew attention to immigrants from the EU.

I don’t know why. The DWP’s own figures show that EU accession countries hardly figure in the list of benefit claimants, who are much more likely to come from India, Pakistan, Somalia or Bangladesh. There are a lot of Poles in the country but they only come seventh on the list of benefit-claiming immigrants.

But immigrants also use public resources such as care in the National Health Service or school places.

And they pay for them too. An analysis by University of College London’s Centre for Research and Analysis of Migration, published in July 2009, found that immigrants from the EU8 accession countries had been net contributors to the public purse in every year since May 2004, when these central and eastern European states joined the EU. Given that the UK population as a whole had been draining the public purse by running a deficit, this is an impressive achievement.

But the situation might change when Romanians and Bulgarians are allowed to work here next year.

Lots of things might happen. Forecasts on this question have been very poor in the past. Official forecasts of how many immigrants might show up when the borders were opened to eastern Europe in 2004 were dramatic underestimates. But despite this unexpected immigration bulge, things have been fine. I mean, the country has gone to the dogs since 2004, but it’s hard to make a case that the Poles themselves caused any trouble.

Unless Gordon Brown has a Polish grandmother?

Or George Osborne. Or Fred Goodwin. Or Sir Mervyn King. Whoever you want to blame for the state we’re in, it needs a peculiarly xenophobic mindset to point the finger at immigration, even if it did happen on a far greater scale than anyone expected.

Social cohesion has to be an issue. I see Ed Miliband wants to ensure that people speak English. No wonder: the 2011 census found a million households in England and Wales that speak no English.

So a number of commentators claimed – for instance Jackie Ashley in the Guardian. The census actually found something different: 1m households where English or Welsh was not the first language. But that doesn’t tell us anything about whether English was spoken well, poorly or not at all.

The Labour leader wants a ‘simple rule’: to make sure people who work in the public sector, face to face with the public, can speak English.

Does this country really hire lots of public sector workers who are unable to function because they can’t speak English? If we do, that’s a sign of a serious problem and one that will not be fixed by the sticking plaster of Mr Miliband’s “simple rule”. The British economy and public finances are in a bad state. If our borders had been closed to eastern Europe in 2004 they would be worse.

Also published at ft.com.

A theorem fit to terrify bankers

Bankers have tended to argue that too much equity means that banks will make fewer loans at higher rates. M&M shows us that this argument is wrong in theory

Looking down the list of winners of the Nobel memorial prize in economics, two names are causing bankers across the world to break into a cold sweat. They are Franco Modigliani (laureate in 1985) and Merton H. Miller (laureate in 1990). Both men have been dead for years but their most important idea lives on with the undignified name of M&M.

M&M refers to an important-seeming decision for any company: how much should it be funded by borrowing, and how much through raising money by issuing shares or retaining profits? Some companies, famously Apple, have no debt to speak of. Others, including any bank you can name, raise most of their resources by borrowing rather than issuing shares.

I say “important-seeming”, because M&M, the Modigliani-Miller theorem, is an elegant proof that under certain circumstances the debt/equity mix of a company’s funding doesn’t actually affect its value at all.

Imagine a company called Papple. It has issued 100 shares, each a claim on 1 per cent of Papple’s future profits. Papple has big plans, which it could fund by issuing 100 new shares, making each old share worth only 0.5 per cent of Papple’s profits. Alternatively, Papple could borrow money, leaving each shareholder with the right to 1 per cent of Papple’s profits, but pushing shareholders to the back of a queue behind the company’s creditors. That second option is riskier, but more profitable for shareholders if the expansion plan works. If the plan fails and the debt can’t be serviced, Papple will be bankrupt.

It seems a fraught decision, but M&M says that it doesn’t matter what Papple does, because investors in the company can always hedge their bets if Papple seems too risky, or borrow money to buy extra Papple shares if they feel that Papple is too boring an investment without such leverage.

M&M requires assumptions that never hold, of course. But the core of the argument is rock solid: companies which take on debt expose their shareholders to higher rewards and higher risks; the shareholders can take steps to offset these risks at the cost of giving up some rewards; the whole decision is less important for the company’s value than you might think.

But this neat little textbook theorem turns out to be very weighty indeed for the question of bank regulation, a cause championed in a new book by Anat Admati and Martin Hellwig, The Bankers’ New Clothes. Regulators want banks to fund themselves more through equity and less through debt. Bankers are reluctant.

M&M applies to banks, too, but with a twist. Banks that get into financial trouble cause systemic damage, so even if M&M applies from the point of view of investors, society would prefer less debt and more equity. But bank investors want the opposite, because the “too big to fail” subsidy means that shareholders enjoy successful gambles while creditors are bailed out if things go wrong. This subsidy means that debt-laden banks are more valuable to investors. If M&M holds, the taxpayers’ loss is the bankers’ gain.

Bankers have tended to argue that equity is scarce and expensive and too much equity means that banks will make fewer loans at higher rates. M&M shows us that this argument is wrong in theory.

In practice, M&M roughly holds: as leverage falls, equity becomes substantially cheaper. Banks are tempted to take on more leverage not because debt is efficient but because debt is the route to an implicit government subsidy.

Banks should be obliged to use more equity funding – or in the misleading jargon of the industry, to “hold more capital”. But equity is not “held”. It’s perfectly good money, provided on flexible terms. It can be lent to businesses and homebuyers just like debt – and with far more resilient results.

Also published at ft.com.

A way to burn a hole in Britain’s pocket

Negative rates might tackle the liquidity trap but they are unlikely to be introduced, says Tim Harford

‘In evidence to the Commons Treasury committee, Paul Tucker [deputy governor of the Bank of England] raised the possibility of imposing negative interest rates on a portion of banking reserves, effectively charging banks rent to hold money at the BoE, but stressed that any action was not imminent.’
FT.com, February 26

It’s about time the banks got a taste of their own medicine. They’ve been borrowing my money and charging me for the privilege, one way or another, for years.

Oh, stop moaning. This isn’t the Parable of the Horrid Banker. Mr Tucker has floated this idea – very hypothetically, I should add – not because it would punish the banks but because it might encourage them to lend money to the likes of you and me. The BoE has been creating money enthusiastically with the hope that people may spend it. Yet nervous bankers have undone much of this effort because they are hesitant to lend. Negative interest rates on the reserves held at the BoE could nudge them into expanding their ambitions.

Ultimately, then, this is all about getting lending and spending going again. Wasn’t that what quantitative easing was all about? What’s wrong with the economy if printing squillions of pounds can’t persuade people to spend?

It is awkward, I agree. But it’s not entirely unexpected. There’s this thing called a “liquidity trap”, which sounds like the sort of thing that a Bond villain would unveil in a monologue but instead describes the situation where people (or companies, or banks) would rather stick their cash under a mattress than spend it. If the central bank prints money and hands it out we just sock that cash away too.

Surely a central bank with the ability to create infinite quantities of money should be able to do something about that?

That seems right, and we’re not in a pure liquidity trap: people will spend money. They just need a lot of prodding. The BoE has created about £6,000 a person and spent it on UK government bonds. There is surely some amount of money – £60,000 a person? £60m? £60bn? – at which people will be tempted to spend, or someone in whose pocket the money will burn a hole.

And then inflation will take off.

It might, but the thinking is that before it does, inventories will fly off the shelves, laid-off workers will find jobs again and the economy will recover. And at that point the BoE can hoover up the cash again, as long as it hasn’t done something silly such as write off all that government debt.

But printing literally trillions of pounds might be difficult to undo – is this why there’s this talk of negative interest rates instead?

Yes. If the economy is in some kind of liquidity trap, or slowed down by a few liquidity potholes, then the bank might look for more elegant ways to get people spending than what Ben Bernanke, the US Federal Reserve chairman, once approvingly called “the logic of the printing press”. Negative interest rates on bank reserves are one approach. Another is to threaten that even if inflation is difficult to produce, once the BoE has found some at the back of the kitchen cupboard, the British public will get that inflation good and hard for years to come.

Why on earth would a central bank want to promise to create inflation?

It’s that liquidity trap thing again. If the economy is in a slump, then people may hold on to whatever cash they can lay their hands on and this behaviour will simply prolong the slump. But if the BoE threatens to create enough inflation to evaporate our savings, and if we believe the threat, then we will spend money and that should get the economy moving again.

So why doesn’t the BoE threaten a decade of double-digit inflation?

The Monetary Policy Committee has a mandate to hit an inflation target, so such promises are probably illegal. George Osborne may in private be urging the MPC to create inflation, but the chancellor has not dared to change the inflation target. And without a change in mandate, central bankers who threaten to create inflation are like soft parents who threaten to withhold TV time. Nobody believes a word of it and so the threat has no effect. Central bankers are reduced instead to musing idly about ideas that won’t happen – such as introducing negative interest rates.

Also published at ft.com.



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