Teaching economics in schools

At the weekend I spoke at a conference in Berlin organized by the Friedrich Naumann Foundation on teaching economics to teenage school students. I took them through my preferred method, which is to avoid jargon and equations, but to build up understanding instead by starting with first principles and building up logically upon them. Value, I said, is necessarily subjective. Because we are different we value things differently. Value is in the mind; it does not reside in the object itself, and it is because we value things differently from each other that we trade. From value I build up to price, and to specialization and trade, and so on. Those who have looked at my "Economics is Fun" videos on YouTube will see how this works. My audience took delight in the fact that my first 30 seconds dealing with value completely destroyed Marx's labour theory of value, and with it 'surplus' value and exploitation and all the class hatred that follows from it.

My aim fundamentally is not to teach students a set of facts or rules, but to inculcate a way of thinking. I take the view that understanding is more important than learning.

Sometimes I teach this in schools by working through ten widely held and widely propagated views that are in fact wrong. These include claims that the world is running out of scarce resources leaving none for our children, or that the world will become so over-populated that it cannot sustain the numbers.

In showing why and where these are incorrect, I try to have the students thinking things through for themselves and taking a more critical attitude toward popular nostrums. My experience has been that young people appreciate this approach, and that it armours them in the years to come against much of the nonsense that politicians in particular talk about economics.

When ignorance trumps incentives

When something bad happens it is often helpful to think about why it has happened in two ways: did someone have a reason to make it happen, or did it happen by accident? This can also be expressed in a slightly different way: were incentives to blame, or ignorance? Jeffrey Friedman and Wladimir Kraus have made a compelling argument that ignorance explains more about the world than we often realize, using the 2008 financial crisis as an example. This post is an attempt to summarise their argument.

Economists often remind us that incentives matter. Indeed this is sometimes said to be the cornerstone of ‘the economic way of thinking’. Russ Roberts gives the example of death rates on British ships bringing convicts to Australia in the 18th Century – rather than attempting to raise ship captains’ awareness of the badness of letting their passengers die, the government gave captains a bonus for every convict that walked off their ship. This was very effective.

Clearly this way of thinking can be very powerful. It is the foundation of the price system, which is the mechanism that markets use to allocate resources effectively in a world where information is dispersed: if demand for pizza rises, the price of pizza rises, giving cooks and restaurant owners an incentive to sell more pizza. It helps to explain why some people stay on welfare payments for long periods of time: the welfare money they lose when they go into work represents a significant disincentive to work. Or, if you offer something like a bailout to businesses that go bust, you reduce the incentive for them to act prudently to avoid going bust.

This last example is what is known as moral hazard. And it is a popular and compelling explanation for the 2008 financial crisis. Banks expected to be bailed out if they went bust, so they acted more recklessly than they would if they thought they would be on the line for their mistakes.

However, Friedman and Kraus argue that this popular and compelling explanation may in fact be wrong. A good way of testing it would be to compare how the bankers involved in making bad decisions acted where perverse incentives applied, and how they acted where perverse incentives did not apply.

One strong piece of evidence against the incentives narrative is that bankers seem to have acted the same way with their personal investments as they did with their business investments.

Many bankers lost a lot of money personally in the crisis because their personal portfolios were not ‘bailed out’ in the same way that their banks were. If we are to treat the ‘incentives story’ as a falsifiable proposition (as all claims about the world should be treated), this might be a fairly strong reason to disregard it.

This may be where ignorance comes in. If bankers acted the way they did because they were unaware of the risks they were taking, then we would expect their private and business investments to be pretty similar.

However, it is strange that so many bankers seemed to make the same mistake. We know that they were not acting in a neutral environment: as Friedman and Kraus have shown, regulations like the Basel accords and the US’s recourse rule directed banks to prefer mortgage debt to business debt. Other regulations directed banks to rely on the risk judgments of three specific ratings agencies, giving those agencies protection from competition.

(On the ratings agencies point, astonishingly, it seems that nobody realized that these agencies were basically protected from competition. Both bankers and regulators assumed they were being subjected to market forces, leading to everyone trusting them a lot more than they would if they knew they were dealing with protected monopolies.)

These regulations were designed to make banks act prudently: the regulators had no incentive to make banks act badly. It seems possible that they did not realize the error of their ways until it was too late. Perhaps regulatory ignorance was to blame.

It is important to stress that the regulators should not be blamed personally. They probably made the best choice they could have made given the information available to them. Rather it is the position they found themselves in that seems to have been to blame. If a single bank (or even a handful) makes a mistake, that bank will suffer but the whole sector probably won’t. It is only when a whole sector of a market (or almost all that market) makes an error that we should worry. (Incidentally, as shaky as the housing and financial sectors were, the real trouble did not begin until monetary policy tightened unexpectedly, as Scott Sumner outlined at our recent Adam Smith Lecture.)

Given ignorance, we should expect errors to take place. Because regulation necessarily applies to everyone in a market, a regulatory error affects everyone.  That may be the fundamental problem with regulation, and a reason to have a strong ‘prima facie’ objection to regulation. It is better to have one hundred firms making one hundred different mistakes that happen at different times and in different ways to one hundred firms making one single mistake that happens at the same time for everyone.

None of this implies any special knowledge on the part of firms. Indeed regulators may be much more expert than the firms they are regulating, but the danger of a collective error would still give us a reason to generally object to regulation in principle, no matter how sensible it may seem.

There's a serious problem with this living wage idea

The Living Wage Commission has pronounced: yes, it would be an exceedingly good idea if everyone got the living wage. Bit difficult to think of them saying anything else really, eh?

When this was all first announced, the existence of the Commission and the preparing of this report, I took the time to write to the Archbishop. To make my usual point that the difference between this desired living wage and the current minimum wage is entirely the income tax and national insurance that we, heinously, try to charge to the working poor. Clearly not much note was taken of this point for in the report they note that:

Savings and additional revenue An analysis of the impact of the fiscal impact and public sector cost of extending coverage of the Living Wage provided by Landman Economics for the Living Wage Commission shows that universal coverage of the Living Wage would result in a net increase in revenue to the Treasury of £4.2 billion. This is shown in Figure 3 and is made up of an additional £2.8 billion in increased tax and National Insurance receipts, together with a decrease in in-work benefit and tax credit spending of £1.4 billion.

It's not just that they've ignored the point it's that they positively revel in it. They really are saying that it's a good idea that we should raise the incomes of the poor so that they can pay more in tax. Completely missing the point that what we actually desire is that the poor have more money after tax, more money to consume with, meaning that we should be attempting to reduce the tax bill on those working poor.

This isn't just an economic point this has crossed over into being a moral one. They're glorying in the idea of taking more money out of the pockets of the poor: this is simply an inexcusable moral stance.

Of course we should have a more progressive tax system

The Guardian is getting very het up about the fact that we don't seem to have a very progressive tax system:

These last two charts suggest that while redistribution of income does happen, it’s mainly due to receipt of benefits by the poor instead of progressive taxation.

There's a reason why we don't have a more progressive system too. Which is that there's a limit to how much you can tax incomes and capital returns before you manage to completely cease all economic growth (or, in the extreme, all economic activity). Which means that if you then still want to stuff ever more gelt and pilf into the maw of the State then you've got to tax consumption, sins and other things, those consumption taxes inevitably being regressive taxes.

And we're around and about at those limits of income and capital taxation. The Treasury certainly believes we are: they've said that income tax at 45% (plus employers' NI etc) is the peak of the Laffer Curve, capital gains tax at 28% is similarly at that peak.

At which point we find that we thoroughly agree with The Guardian: we too believe that the UK tax system should be made more progressive. And given that we cannot increase taxes on incomes any further and that consumption taxes are regressive, this means that the only way to do so is to reduce the income taxes on the poor. So, as we've said around here before, the personal allowance for both income tax and NI (yes, employees' and employers') should be raised to, at the very minimum, the equivalent of the full time full year minimum wage. Or around £12,500 at present.

This would make The Guardian happy as it would make the tax system more progressive. It would also mean having to shrink the size of the State which would make us doubly happy. What's not to like?

Is the UK too equal or too unequal?

Whether the UK is too unequal or too equal is not something that actually has a certain answer. Sure, we can posit that some of the things we do to reduce inequality might make us all poorer (and some of the things we do do) but what is the "right" amount of inequality is something that's up to the moral precepts of each observer.

However, what we can do is make sure that we understand how much inequality there actually is. That figure above comes from here. My thanks to Christie Malry for pointing it out. And yes, of course the ONS is telling us the truth here. It might well be that you think that the original inequality in the UK is unfair, something that should be changed. That the top 20% have 15 times the income of the bottom 20%. But do note that things are indeed done to change this. So much so that the final inequality, after all taxes and benefits are accounted for, is only 4 to 1. It's even possible to think that this is still too high but everyone should be able to agree that it's very different from 15:1.

Malry has named my repeated insistence that this difference matters "Worstall's Fallacy". We can't make decisions on whether we should be doing more about something unless we look at the effects upon whatever it is of what we're already doing. We need to know how much we're already changing income inequality before we can demand that more (or less) be done. The same is true of wealth inequality, people living under the poverty line, even the concept of the Living Wage (where the only difference between that Living Wage and the current minimum wage is the amount that we shamefully tax off those earning low wages). We muct look at the current end result before deciding upon any future action. BTW, the TUC did a very similar exercise a couple of years back but looking at the top and bottom 10%s rather than quntiles. Inequality of market income dropped from 30:1 to 6:1 in their results.

We already do a great deal to reduce income inequality in the UK. And the only way we can possibly decide upon what to do next is by acknowledging that fact and discussing whether, after all of the taxes and benefits, we have too much or too little income inequality.

The Living Wage campaign is wrong-footing the right

I’ve long taken an interest in the Living Wage campaign, both as an opponent of their ultimate goal but also as an admirer of their strategy. Their aim, I believe, is the statutory enforcement of a ‘Living Wage’, which would effectively mean a pretty hefty hiking of the National Minimum Wage across the country. Though well intended, this is a bad idea: we would need a lot of evidence to discard the Econ 101 principle that price floors cause oversupplies, which in the case of labour we refer to as ‘unemployment’ and the evidence is, at best, divided.

But the Living Wage Foundation (and the LW campaign in general) has been far too canny to call for this outright. Instead, they have focused on getting big firms like Goldman Sachs to voluntarily sign up to pay their workers at least a Living Wage.

This isn’t hugely significant in financial terms: it's fair to assume that most employees and contractors at firms like Goldman Sachs were already earning above the Living Wage before they signed up. A jump from the NMW to the London Living Wage is very significant from the point of view of the individual employee (an extra £100/week for someone on 40 hours a week) but not too significant from the point of view of an employer like Goldman Sachs.

For these firms, signing up to pay a Living Wage may be a relatively cheap PR move. Or, to go back to that Econ 101 point: what these firms are paying for is not just the cleaning, but the image boost that comes from paying all of their their employees well. It’s possible that they’ve reduced employee breaks or labour hours, as often happens when the minimum wage is raised, but who knows.

I'm very pleased that Goldman Sachs is paying its cleaners more. I'd be pleased if more firms spent more of their marketing budgets on cash transfers to low-income workers in this way. But, as they say on the internet, the obvious point is obvious: even if Goldman can afford to pay a small number of its workers more to improve its image, firms in a less financially secure position may not be able to increase wages without bringing on the negative side effects previously mentioned. And, again pretty obviously, such PR only works if there are other firms that do not pay their workers a Living Wage.

The other interesting thing that the Living Wage Foundation has done is focus on government contractors – usually cleaners – who earn less than a Living Wage. Again, I don’t really mind this – there are reasonably good arguments that the government should set pay for civil servants as competitively as possible, but when it comes to cleaners earning a pittance, who really cares? As 'wastes' of taxpayer money go, this is hard to get worked up about.

This is all interesting to me because it puts free marketeers in an extraordinarily difficult position. Say nothing and the case for the Living Wage appears to be unopposable – perhaps allowing it to gain enough credibility that eventually it seems completely obvious that it should be legislated for. Go up against them, and we’re in the bizarre position of at least appearing argue against a private firm voluntarily paying its workers more because of consumer pressure. Isn’t that exactly what the market is supposed to do?

Low pay is a serious problem that will probably get worse before it gets better. We on the right do have our own answers: Tim Worstall has pointed out again and again that not taxing minimum wage workers would effectively give them a Living Wage. And reform of the welfare system to subsidise wages (perhaps through a Negative Income Tax) would be a very market-friendly way of helping the poor. But these don’t seem to have gained much traction as specific alternatives to raising the minimum wage. I'm left feeling quite glum: a voluntary Living Wage is basically a good thing, but a mandatory one would be terrible. Is there anything we can do to oppose one without seeming to oppose the other? I'm not sure.

Video: Adam Smith Lecture 2014 by Scott Sumner

Scott Sumner's Adam Smith Lecture, delivered last week, is now online. For my money it's the best outline of his view of the Great Recession and the correct role of monetary policy that I have yet seen. Scott's presentation can be downloaded here, and Scott wrote about his trip for TheMoneyIllusion here.

Is Uber worth $18bn?

James Ball, at The Guardian, thinks that Uber's implicit $18bn valuation is "a nadir in tech insanity". His case is that tech firms are overvalued because although investors know this, they always assume there are other "suckers" they can palm their securities off on. That is, they think the other guys are "behavioural" (falling prey to the sorts of biases detailed in behavioural economics and behavioural finance) but they themselves are rational. Ball is responsible for some very good and important work, but I think this particular piece would benefit from the application of some financial economics.

It's always possible that prices are irrational. And because we can never test investors risk preference separately from the efficient markets hypothesis (the idea that markets accurately reflect preferences and expected outcomes) it's very hard to work out if prices are off, or just incorporating some other factor (usually risk). This is called the joint hypothesis problem. But when there are two alternatives, there is a reason economists put rational expectations in their models—it's a simpler, better explanation. Finding truly suggestive evidence of irrational price bubbles is the sort of thing that wins you a Nobel Prize not something that a casual onlooker could easily and confidently observe.

Ball might say that even if irrational pricing is rare because of the strong incentives against it in a normal market, there have certainly been episodes of it in the past. Quoting J.M. Keynes, he might say "markets can remain irrational much longer than you or I can remain liquid". He might point to the 1999-2000 peak of what's commonly described as the "dot com bubble". But I urge Ball to consider a point raised in this email exchange between Ivo Welch and Eugene Fama:

How many Microsofts among Internet firms would it have taken to justify the high prices of 1999-2000?  I think there were reasonable beliefs at the time that the internet would revolutionize business and there would be many Microsoft-like success stories based on first-mover advantages in different industries.

Loughran and Ritter (2002, Why has IPO pricing changed over time) report that during 1999-2000 there are 803 IPOs with an average market cap of $1.46bn (Table 1).  576 of the IPOs are tech and internet-related (Table 2). I infer that their total market cap is about $840 billion, or about twice Microsoft's valuation at that time.  Given expectations at that time about high tech and the business revolution to be generated by the internet, is it unreasonable that the equivalent of two Microsofts would eventually emerge from the tech and internet-related IPOs?

Has not the second wave of cyber firm success (Facebook, Google, arguably Apple) been even more impressive than the first wave? It may well be only 25% or 10% likely that Uber turns out to be one of these behemoth firms, through network effects, first mover advantages, name-recognition or whatever—but even if the chance is small the potential rewards are huge.

But Ball may point out that even if this is true, in the (putatively) 90% likely scenario, of Uber being a failure, then all this capital is being wasted. It could be put in the projects he prefers: "green energy, modern manufacturing, or even staid-but-solid sectors like retail". Even if rational expectations—the idea outcomes do not differ systematically (i.e. predictably) from predictions—and the efficient markets hypothesis are not violated, and risk-adjusted expected (private) returns are equal across industries, it might be that social returns from these staid-but-solid sectors are higher—after all, lots of capital is being apparently wasted when so much goes to Uber.

This does not obtain—from the prospects of society, Uber could deliver huge welfare gains. If it does turn out that Uber has enough in the way of network effects to generate returns justifying its price tag (or more) then it would have to create lots of value, by saving taxi-consumers serious money. If they are using less resources to create the same amount of goods, then they are making society better off. Since society is big and diversified, it can afford to be relatively risk neutral (at least compared to an individual), and take even 9-1 punts on the chance that one memorable, semi-established network might be a particularly good way of running a taxi market.

The eurozone is in dire need of nominal income targeting

It may well be that, in the US and UK, nominal GDP is growing in line with long-term market expectations.* It may well be that, though we will not bring aggregate demand back to its pre-recession trend, most of the big costs of this policy have been paid. And so it may be that my pet policy: nominal income/GDP targeting, is only a small improvement over the current framework here in the UK or in the US. But there is one place that direly needs my medicine. As a whole, the Eurozone is currently seeing very low inflation, but plenty of periphery countries are already suffering from deflation. And this is not the Good Deflation of productivity improvements (can be identified because it comes at the same time as real output growth) but the Bad Deflation of demand dislocation. The European Central Bank could deal with a lot of these problems simply by adopting a nominal GDP target.

When it comes to macroeconomics, the best analysis we really have is complicated econometric models on the one side, and highly stylised theoretical models on the other. Both are useful, and both can tell us something, but they rely on suspending quite a substantial amount of disbelief and making a lot of simplifying assumptions. You lose a lot of people on the way to a detailed theoretical argument, while the empirical evidence we have is really insufficient to conclusively answer the sort of questions I'm posing.

In general, I think that very complex models help us make sense of detailed specifics, but that "workhorse" basic theoretical models can essentially tell us what's going on here. Unemployment is a real variable, not one directly controlled by a central bank, and a bad thing for the central bank to target. But in the absence of major changes in exogenous productivity, labour regulation, cultural norms around labour, migration and so on, there is a pretty strong relationship between aggregate demand and unemployment. Demand dislocation is almost always the reason for short-run employment fluctuations.

Unemployment rose everywhere in 2008-9. But it nudged down only marginally post-crisis in the Eurozone, whereas in the UK and US it soon began to steadily fall toward its pre-crisis rate (the red line, though not on this graph, has tracked the green one very closely). In the meantime the Eurozone rate has risen up to 12%. This is not at all surprising, given the almost complete flattening off of aggregate demand in the Eurozone—this means a constantly-widening gap with the pre-recession trend (something like 20% below it now).

Although intuitively we'd expect expectations to steadily adjust to the new likely schedule, three factors mean this takes a while: firstly the ECB is very unclear about what it is going to do (and perhaps unsure itself), secondly some plans are set over long horizons, and thirdly the lacklustre central-bank response to the 2007-8 financial crisis is unprecedented in the post-war period.

1. We have a huge literature on the costs of policy uncertainty—the variance of expected outcomes has an effect on firms' willingness to hire, invest, produce, independent of the mean expected outcome.

2. Many firms invest over long horizons. It may have become clear at some point in 2011, when the ECB raised interest rates despite the ongoing stagnation and weak recovery, that the macro planners, in their wisdom, were aiming for a lower overall growth path and perhaps a lower overall growth rate in nominal variables. And so, after 2011 firm plans started to adjust to this new reality. But many plans will have been predicated on an entirely different 2009, 2010, 2011, 2012, 2013, 2014, and so on. And as mentioned before, the gulf between what was expected for the mid-2010s back in 2007 and what actually happened is actually widening.

3. Thirdly, and finally, the period 2008-2010 is unprecedented and will have slowed down firm adjustment substantially. As mentioned above, even if firms set plans with a fairly short-term horizon (a few years) they wouldn't have been able to adjust to the new normal in 2008, 2009 and 2010 unless they really expected the ECB's policy of not only not returning to trend level, but not even return to trend rate!

All of these three issues are convincingly resolved by nominal income targeting. It's very certain—indeed the best version would have some sort of very-hard-to-stop computer doing it. It promises to keep up to trend. And it is very stable over long horizons.

Recent evidence reinforces the view, implicit in our models, that (unconventional) monetary policy is highly effective at the zero lower bound, even through the real interest rate channel (!) All the ECB needs to do is announce a nominal income target.

*This reminds me: isn't it about time we had an NGDP futures market so we could make claims here with any kind of confidence?

QE boosts equities by boosting fundamentals

Many people suggest that the recovery in equity prices since 2009-2010, seen around round the world but particularly in the American Nasdaq, S&P500 and DJIA, does not represent a general economic improvement. Instead, they believe that these numbers are simply being buoyed by new money pumped into the system. I don't think this argument holds, and I will attempt to explain why. First let's consider why we think people hold equities. Essentially, people hold equities because they expect a given real return for a given risk profile. In our simplest model, people hold portfolios of assets based on their risk tolerance, their subjective judgements over probabilities, and their preferences. Adding in banks, insurers, pension funds and so on makes the overall picture more realistic, but doesn't change our theory much. People pick financial intermediaries that hold the assets according to our preferences—the intermediaries add value through scale, or through providing a payments system and settling accounts.

Why might electronic money printing (which we call "quantitative easing" or QE) affect equity prices?

Well, firstly, we might not expect an effect from quantitative easing under one circumstance. QE increases the amount of narrow money we have—that is the number of notes, coins and bank reserves in the system. Generally we think broad money—which includes bank accounts people can debit or write checks on, and is much, much larger—is what interacts directly with the real economy. The ratio of broad money to narrow money is called the money multiplier, and usually a rise in narrow money leads to an even bigger rise in broad money—but this multiplier is not stable. It's at least possible (although not historically typical) that a rise in narrow money could be completely counteracted by a fall in the money multiplier.

But assuming this doesn't happen, there are three reasons why QE might boost equity prices. First would be because it increases inflation and the future price level. If prices rise, cash is worth less, so relative to a given nominal amount of cash, all things being equal a given equity is worth more. In other terms, the firms' nominal expected returns would rise.

The second reason is that in a depressed economy monetary easing like QE may boost real growth, which we would expect to raise any given company's expected real returns. It might also reduce the risk of very bad economic outcomes. Since equities are riskier than bonds, gilts and cash they pay a risk premium to those who hold them—a higher return (lower price) to compensate for this. If risky outcomes in general become less likely, these risk premia might narrow, making equities more desirable and expensive.

The third reason QE might raise stock prices is because it increases overall social wealth, and thus may lead to greater risk-tolerance overall, if people are willing to bear more risk as they get wealthier, and thus shift towards riskier assets like equities.

In each of these three, the jump in equity prices comes from fundamental factors. One could certainly drive up stocks by creating lots of inflation, but we can easily check if that's what's happening by looking at inflation. Any real/relative growth in equities would refute that explanation. In contrast, real growth, reduced risk and shifted preferences due to extra wealth are all legitimate reasons for higher equity prices.

Accounts of why QE buoys stocks without improving fundamentals (and hence part of the argument that stock indices are not good proxies for economic health) tend to rely on a narrative that QE "flows into equities". But as explained, people try to hold their wealth in the portfolio that fits closest to their preferences. If QE money did "flow into equities" then people would now be holding more of their wealth in stocks than they wanted to—they would rapidly rebalance their portfolio. Typically people needn't even do this themselves, because their pension fund will do so for them. QE has to improve the fundamental factors in order to boost equities.