Monday, 29 June 2015

The Myth That We're Running Out Of Resources

In response to my last blog on the fallacy of destroying the planet there have been a few misapprehensions floating around. Consequently, I feel compelled to tell you that we are not running out of resources. It's a myth, and quite a big one, as most people (apart from most geology experts and most economists) seem to believe it. For that reason I'm not surprised the above blog post turned out to be quite contentious.

The fallacy of depleting resources is usually comprised of a misunderstanding of the word 'resources' and the word 'reserves'. Usually when people tell us we're depleting the earth's resources at a precarious rate they are confusing reserves with resources.

Here's the difference. Reserves are the materials that have been planned for use in the coming decades, consistent with current mining technology at current prices. Depleting our reserves is quite normal. Resources on the other hand are of a much greater quantity - they are all the potential reserves that haven't been factored into the forecast of reserves. And those, we are not going to run out of. One of the reasons potential reserves remain as resources is because beyond a few decades we don't know how much we'll depend on them or what future our innovations will do for us in terms of our being weaned off current dependencies.

People who warn us that unless we are careful we are going to run out of resources are misunderstanding both numbers and resources, namely regarding what we've planned to use and what we actually have the potential to use. To give you an analogy. My wages give me an indication of what I have to spend each month. If I have a particularly expensive month, that doesn't mean I'm always going to be short of money, because future pay days will be forthcoming. My wages this month is my reserve, and my future potential earnings are my resources.

I did some research on this matter a few months ago, consulting the works of several experts in this field - and they all said the same. They are the source of much of what I've said above. People with a green agenda, like George Monbiot and the Green Party, tell us differently - they tell us that we are in dire straits. What do you think is more likely: that the experts have got it wrong, or that amateur, agenda-driven green people have not grasped the difference between reserves and resources? Please note, I am not aiming this point at people who are merely green-conscious - for they are often caring people without a hidden agenda or a self-serving ideological drive.

Anyway, let's suppose you're still not sure who to believe. There is, as it happens, an economic way to test who is right out of the experts vs. the greens, and that is with the world's best mechanism for measuring the supply and demand levels of resources. I'm talking about prices. Prices are the key. If there were precarious times ahead with scarcer quantities of  paper, oil, gas, manganese, copper, zinc, bauxite, tin and chromium - you wouldn't find prices continuing to drop, you'd find them increasing, particularly if demand increases. But the reason they continue to fall is twofold - in part because supplies are not scarce, but also because newer technology reduces the demand. Remember too, all supply and demand markets are transitory - we don't continue indefinitely to rely on the same resources with the same level of demand. As I pointed out in this Blog post:

Because of the limitation of the earth’s resources, supply-side initiatives in the free market engender innovation, which creates value, but also brings about a change in the way we use the earth’s resources. For example, we used to burn a lot more coal than we do now. Currently the technology for electricity, gas, and solar energy has weaned us off coal dependency, which means we use less of it. Another example is paper. We used to use a lot more paper. Currently the technology for digital interfaces (laptops, mobile phones, iPads) has weaned us off much of our paper dependency (with much more still to come), which means….. you guessed it…. we use less of it. So when we see economic growth, and increased prosperity, as well as people continually being lifted out of poverty because of it - that growth is not defined as a calibration of any single resource we consume - it is the value created consistent with how the market most efficiently allocates the ever-changing use of varying resources.

When resources do actually become genuinely scarce (remember, 'resources', not reserves), the prices rise, which provides a signal to consumers that they should use less of them, and to manufacturers that they should look to alternate technologies. Or if possible, that suppliers should find ways to produce more of the scare resources. Thankfully, as far as I know, there isn't a single known resource in the world that we are predicted to run out of - not just because we have so much in terms of potential supplies, but also because there isn't a single resource that we are going to have to depend on for longer than our capacity to wean ourselves off it.

One last thing, all this doesn't mean we have to deny that bad things are happening and that people are misusing our planet in all sorts of cruel, careless and wasteful ways. But what we must never do is what it is easiest to do - to look at incidents of bad things happening and make that the entire argument. Of course if you only focus on the bad then pretty much everything is negative. But it just won't do.

What's always needed is a proper cost-benefit analysis that factors in everything - that is, all aspects of human progression, and all aspects of human retrogression (or to the best of our ability). The moment a balanced view is attempted, things change a great deal - and I must admit, I find it bizarre, given the incredible progression-explosion that has occurred, that people find it so easy to focus so much on the costs.

Don Boudreaux has a neat illustration for this progression explosion - what he calls "The Hockey Stick of Human Prosperity"- so named because if you graphed the living standards and life expectancy of humankind over the last few millennia, they would mostly be flat until the exponential advances that occurred in the aforementioned progression-explosion in the past two hundred years.

It is vital to emphasise just how good the hockey stick illustration is in conveying two important things - not just in conveying the benefits of becoming advanced at the point in human history at which the hockey stick's heel and toe curves upwards, but in conveying just how comparably bereft human beings were for so many centuries when they were without the things we take for granted. One can see the astonishing progression-explosion not just by how much we've reaped the benefits of capitalism, industry, science and technology in the past two centuries, but by the absence of these things in every century that pre-dated the Industrial Revolution, and in all the present day countries that lack the qualities of free enterprise, and a basic political structure, stable government, rule of law, and the conditions and technological capabilities to lift them out of poverty as quickly as we'd like.

Wednesday, 24 June 2015

What The Pope Doesn't Get

I wasn't going to write a Blog post on the Pope's latest perorations - but a few people have asked for my views on it, so I had a quick look at his thoughts. Where he’s going wrong can be summed up in one of his most strident statements:

“The idea of infinite or unlimited growth, which proves so attractive to economists, financiers and experts in technology is based on the lie that there is an infinite supply of the earth’s goods, and this leads to the planet being squeezed dry beyond every limit.”

Oh dear – alas, the head of an institution as grand and powerful as the Catholic Church ought to be much better informed on the basics of economics. The Pope’s argument would be okay if the predicates were correct (ditto every other anti-progress person who continually spouts green-bytes). That is, if the free market system was based on the error that we rely on an infinite supply of the earth’s resources, and that to run out of certain resources is going to put us all to hell in a hand cart, then yes the Pope’s encyclical would be right on the mark.

But the truth is, Pope Francis starts with an assumption that turns reality upside down, so his analysis is frivolous. People who understand economics don’t of course think that the earth’s goods we consume are based on an infinite supply of resources. Quite the contrary - the subject of economics is built on the reality that in a supply and demand market, resources are finite and need allocating in the most efficient way.

Because of the limitation of the earth’s resources, supply-side initiatives in the free market engender innovation, which creates value, but also brings about a change in the way we use the earth’s resources. For example, we used to burn a lot more coal than we do now. Currently the technology for electricity, gas, and solar energy has weaned us off coal dependency, which means we use less of it.

Another example is paper. We used to use a lot more paper. Currently the technology for digital interfaces (laptops, mobile phones, iPads) has weaned us off much of our paper dependency (with much more still to come), which means….. you guessed it…. we use less of it.

So when we see economic growth, and increased prosperity, as well as people continually being lifted out of poverty because of it - that growth is not defined as a calibration of any single resource we consume - it is the value created consistent with how the market most efficiently allocates the ever-changing use of varying resources.

Pope Francis has lots of good qualities – it’s such a shame his understanding of the basics of economics and human progress is meagre, and his pontificating so lacklustre here.

Tuesday, 23 June 2015

What Nobody Is Talking About In This Beheading Tragedy

Nicholas Salvador detained over woman's beheading

This case is terribly sad, and at the same time it also presents us with an intriguing consideration of the human mind and the nature of mental illness.

Nicholas Salvador beheaded an elderly lady, believing her to be the human incarnation of a malevolent demon figure. He has now been declared insane on grounds of suffering from paranoid schizophrenia, and obviously we all agree he was mistaken about the old lady's demon status. But if you think about it, the mistake is predominantly in the projection of demonic forces, not in the morality of the act.

That is to say, the reason we recoil in horror at what happened is not because we think a malevolent demon figure is benign and undeserving of death, it is because we are upset at her death and because we don't actually think the old lady was demonic. If any of us thought we were face to face with a demonic figure capable of wreaking havoc on men, women and children, we'd be the first to call for its execution (a practice not uncommon in several American States, lest we forget).

So while Nicholas Salvador's mental illness led him to the tragic mistake of killing what he thought was a malevolent demon, thinking he is actually killing a malevolent demon does demonstrate that an element of cogent sanity is very much present in his act - which, as I said at the start, presents us with an interesting consideration of the nature of sanity and insanity.

Monday, 22 June 2015

The Fixed Pizza Fallacy

I love it when I happen to come across a perfect illustration like the one above that so neatly sums up why anti-austerity campaigners like Owen Jones, Russell Brand and Charlotte Church have everything still to learn. What we're seeing from them is something very similar to conspiracy theory, where economic growth and the concomitant inequality are seen as a bogey from which the government needs to rescue us.

It's unsurprising people are so cautious about economic growth - our evolution primes us to be cautious by nature. Suppose you're a distant ancestor still making sense of the world - you will gain by false positives, but you are liable to lose a lot if you get things wrong. A rustling in the bushes may be the wind, but it may be a predator. It's less costly to assume it's a predator and find out it's the wind than to assume it's the wind and find out it's a predator. So over the years we have been primed for false positives - to sense potential dangers and ascribe them to something predatory, even when such things are not there. The anti-austerity crew are like people seeing a tiger in every rustling bush - except in this case they are seeing conspiracies against the poor in every instance of economic growth.

The big fallacy that's behind so much of the left's thinking is what's called the fixed pie fallacy - the mistaken assumption that wealth is like a pie, where if I have a slice of it, it leaves less for you. But as the pizza illustration shows, the economy isn't fixed. If the economic pizza is larger, then the slice sizes increase for everyone too, even the poorest people with the smallest pizza slices.

Anyone who actually cares about the incomes of the poor would favour faster economic growth, not lament the increase in inequality that is so often a product of increased economic growth. With a growing economy everyone's absolute gains increases, even if the gains at the top increase exponentially greater. To be averse to this means you should not to be praised for being caring, you should be reproached for being envious.

It’s ironic that the richest in society bear the brunt of the left’s opprobrium, because what makes the whole of the pizza grow is primarily the top entrepreneurs and investors (usually the wealthiest) - they are the ones doing the most to make life better for everyone else in absolute terms.

Instead of the faulty fixed pie metaphor, economic growth is a bit like knowledge. Knowledge is not pie-like, because it is not zero-sum. Jack can increase his knowledge without decreasing Jill's. In fact, the more Jack increases his knowledge, the more chance Jill has of increasing hers too. The same is true of wealth - it can keep expanding - and as recent history indicates, it probably will continue to do so.

Thursday, 18 June 2015

Are We Seeing The Labour Party Sliding Into Oblivion?

Recent history demonstrates that in the future the Labour party is probably going to have to choose between being slightly economically right of centre and having a chance at winning an election again, or reverting back to its left wing roots and never winning an election again.

You have to consider why this is probably true. Labour has not won an election majority since the 1970s, except for when the slightly right of centre Tony Blair led them on three successive occasions. Even more so than anyone expected, Ed Miliband's shift to the left away from Blair's New Labour made them unelectable again. The upshot is, left wing parties don't win UK majorities anymore (the SNP exception to this in Scotland is too meagre in numbers to have any real bearing on the UK as a whole).

What about Labour's response then? Recently I suggested that people even further to the left than Ed Miliband would probably end up splitting off into another group, as it's clear from recent events that back to the centre-right is where this next Labour is heading under either Andy Burnham, Liz Kendall or Yvette Cooper.

This is a shame. While far left is very far from my position economically, the working classes won't have any proper representation under Burnham, Kendall or Cooper, because their job is not to make Labour socialist again, it is make them electorally popular again - and the only way they can do this is by vying for the centre-right ground.

That's why I predict a left wing split at some point in the near future - the socialist faction is going to demand some better representation, and short of moving to Scotland, they are not going to find it in this current Labour lot.

If there is a Labour split, then the party will surely gravitate towards a political void, just as the Liberal party did in the 1930s, leaving a very fractionated opposition to the Conservatives that is unlikely to budge them for decades to come.

The 19th century Liberal party rose to the fore due in no small part to the dynamic and forceful rise of industry against conservative land owners, and the 20th century Labour party rose to the fore due in no small part to the dynamic and forceful rise of the unions against what they saw as the capitalist pig.
But with so many more people educated about the extent to which the free market has been the biggest driver of human progression in the past two centuries, and how private enterprise is more efficient and innovative than public ownership, it seems to be the case that, apart from the relatively small number of socialists chomping at the bit, there is currently far less to grumble about, which, as recent history has shown, makes it nigh-on impossible to be a successful left wing opposition party. Incidentally, polls also suggest that less than 15% of the UK population consider themselves socialist, and 71% of people now consider themselves middle class.

The other thing to realise on the back of this is that, as is evidenced by London's success, most future prosperity will not come about through the hard sweat of manual labour, it will come through skills like those found in science, technology, financial and other service based industries, which continue to make Britain far more prosperous than in days gone by - perhaps explaining why so many people now feel like they belong in the middle classes.

That's even more reason to suspect that the divide will narrow, as people's absolute gains become ever more important than the relative inequalities. For that reason the age-old class conflicts of rich vs. poor and capitalists vs. the workers are gradually sliding into oblivion. Not wholly so - and not yet of course, as there are still plenty of societal wrongs to be put right, and still many people struggling on a daily basis - but I'm pretty certain that as we carry on my prediction will come to pass and we will see the end of the Labour party as we know it.

Tuesday, 16 June 2015

Socialism Is Fine If You Keep It Away From Economic Policy

I often find myself having to write about where I think socialists are going wrong, but I've also spoken in the past about the relationship and the distinction between the socialist in the socio-personal economy and the socialist in the market economy, which does explain why many socialists think as they do, but also does at least attempt to find as much common ground as possible, and acknowledge the merit in the socialist aspiration. The main thing socialists are getting wrong is that in their attraction to the economic left many young people are confusing the socio-personal economy (our social behaviour) and the market economy (our financial behaviour) by lumping them together in a way that misses the important distinction.

When it comes to the evolutionary socialist in us - the one that assents to kinship, inter-personal bonds and shared-interest groups, the predominant force is the socio-personal economy, explaining our natural assent towards sharing, being generous and kind, and mutually assisting one another. This legacy has primed us for millennia, long before any such thing as a market economy of trade came into place. Consequently, on grounds of adhering to our socio-personal make-up, we are justifiably faithful to a socialistic framework in our ways of thinking. In other words, in terms of our social behaviour, most of us are socialist to a great degree.

That is not the same, though, as saying that because of our mindful social behaviour we can justify socialism on market economy grounds. As the history of hard left economics taking root in China and Russia shows, and as is still being shown today several EU countries, the market economy operates under a different arrangement to the socio-personal.

In the socio-personal world our affinity with friends and family is based on bonds of attachment, either blood-connection (relatives) or like-mindedness (beloveds, friends, and social groups). But the market economy extends way beyond these affinity rings, where success isn't just about familial bonds or connecting with like-minded people, it is about connecting with the rest of society too - the vast majority of people who are not like us. I may have little in common with the Indian chef who cooks my chicken biryani, or the garage mechanic who fixes my car, or the vet who cares for my auntie's cat, but what connects us is our ability to specialise in a market economy where goods and services create value, and where diversity augments that value through multiplicity.

The qualities of the affinity rings related to the socio-personal are not the sort of qualities that can be artificially engendered from on high in a top-down organisational hierarchy, which is why socialism in the market economy is futile as well as being empirically imprudent. The economy is too complex, and people's tastes and incentives are too multifarious to be governed from the top down. What's happening with the economic left is that they are trying to rivet on to their (our) socio-personal socialism a justifiable market socialism, which is a bit like trying to justify sleeping at work on the grounds that we sleep at night in our own homes.

There is a natural limit to manageable social groups, beyond which socio-personal factors like kindness, generosity and reciprocity start to peter out. That's just another way of saying that the ties you have with strangers are weaker than those with people close to you. You've probably heard of the Dunbar number - its Robin Dunbar's suggested cognitive limit to the number of people with whom folk can maintain stable social relationships. The Dunbar number maxes out at about 150, after which maintenance of that social circle becomes prohibitive. Socio-personal socialism remains at its strongest in those Dunbar groups, but becomes diluted as we add more and more people to the mix.

If there's one thing that causes a chasm between economic socialists and libertarians it's that economic socialists have never made the proper distinction between the socio-personal economy and the market economy. It is through knowing that distinction that one can then realise that an increased number of participants increases the range of goods and services available, that then increases the value created in society by increasing the number of customers willing to partake in the mutually beneficial exchanges. It is through the socio-personal economy that value is created amongst friends and loved ones, but it is through the free market economy that value is created in the wider society.

In that sense, trade is a bit like doing good things for strangers. To succeed in the market economy requires innovation and ingenuity, as well as good character and reputation. Just as in biology copulation mixes up combinations of genes so that heritable survival traits occur more frequently for natural selection to act on the genotype, similarly the market economy produces survivability in business and commerce, where less-good suppliers are out-competed by better ones. A socialism that extended beyond the socio-personal into the market economy would be bound to retard innovation and progress, just as trying to organise biological organisms from on high would inevitably be less successful than the mechanism of natural selection already working in nature.

The upshot is, socialism only works successfully in small groups, and the market economy is not a small group - ergo, socialism doesn't work in a market economy. The benefit of the market economy is that trading with strangers transcends the limitations of the Dunbar-esque socio-personal economy, bringing about huge mutual benefits, not just for both buyer and seller, but also to everyone in society too. To try to arrange such an economy in an attempt to mirror the socio-personal economy, as socialists try to do, is a bit like being in a field full of 30 million bees trying to make them all fly clockwise. 

* Photo courtesy of

Saturday, 13 June 2015

When Scandalous Governments Are Unnoticed

A lot of people over the past few days have been bemoaning the fact that George Osborne is going to sell our stake in RBS for a £7 billion loss. Such people need to remind themselves of the sunk cost fallacy (that is: acting imprudently in the present to protect past costs), but they also need to understand something else more general. Sometimes governments do scandalous things and the world recoils in horror, like when politicians in Kenya, Zambia or Zimbabwe rig votes and maltreat their people. There are other times, however, when governments do scandalous things and hardly anyone recoils in horror because they don’t understand why those things are bad. A prime example of this is when governments bail out businesses that have failed in the free market.

Some politicians bail out businesses to the tune of millions, sometimes even billions of pounds or dollars (Alistair Darling's bank bailouts and George Bush’s airline bailout spring to mind). Be clear firstly that bailouts, like small business subsidies, are ultimately not socially useful. But on top of that, they also cause lots of societal harm. An analogy will illustrate why.

Imagine a company called Canyon Flights that does helicopter tours around the Grand Canyon. Due to competition in the shape of competitors Canyon Views, Canyon Flights loses money. Barak Obama’s second cousin owns the struggling Canyon Flights, so he decides to help them out with a government bail out. As well as all the other obvious reasons why this is bad, the bail out won’t actually put any Canyon Flights helicopters over the Grand Canyon. Helicopter rides over the Grand Canyon only take place when it’s profitable to do so – that is, when the cost of transporting passengers is less than the money made in ticket sales. This is true irrespective of whether Obama bails them out or not.

The reason Canyon Flights is doing poorly is because Canyon Views is doing better. If Canyon Flights goes bankrupt then Canyon Views will pick up their customers, maybe even expanding in the process. Or perhaps a new competitor will enter the market. Either way, just like the issue of small business subsidies, money poured in from politicians won’t have any significant impact on the business’s efficacy, it will only enrich the company owners at the expense of everyone else (taxpayers). Taxpayers don’t get a share of the profits when private businesses do well, and they shouldn’t pick up the costs when they do poorly, which is what happens with government bailouts.

A fully reformed, highly deregulated, banking sector would work towards seeing banks lending with fully costed capital, making insolvency much less likely, and taxpayer bailouts nigh on impossible. For a full explanation of this, see my blog post here.

Friday, 12 June 2015

A Brief Conversation About Extremes

A brief conversation I had recently that highlights a common error of judgement seen in many of our politicians:

ANTI-CAPITALIST BLOKE: The most efficiently greedy people are, of course, psychopaths - so would you say James Knight that psychopaths are the best people to run businesses and countries?

ME: Of course not. Here's an equally silly question: Precipitation is a vital provision source for our agriculture. Do you think farmers prefer steady precipitation rates or rainstorms that flood their land?

ANTI-CAPITALIST BLOKE: But if we accept the premise that "greed is good" then it follows that the most greedy (psychopaths) would be the best people to run businesses, and by extension, countries.

ME: I'm afraid not - your premise is flawed to begin with. Just because something is good, doesn't mean we can't have too much of it. What you're missing is that things can be good *because* there isn't too much or too little of them. Being able to drive on the roads is good; if everyone drove at the same time the experience would be less good. Roast dinners, chocolate, and warmth are good - but it doesn't follow that if you have too much of them they will be better. The same is true of the free market - all innovators need drive, enthusiasm and keenness to make a living - but they also need to come up with something that people want, be it a new invention, a good set of songs for an album, a better version of a product already on the market, a service people would value, and so on. The right amount of commitment, diligence, inspiration and hard-work will do you good. But if that spills over into unhelpful greed, cupidity and status-mongering, it won't just be bad for the individual's psychology - it will probably affect his or her ability to be innovative too. Striking the right balance is the key.

*Conversation then ended*.

* Photo courtesy of

Monday, 8 June 2015

It's About Time The 'Eat The Bankers' Myth Was Put To Bed

I don't know how many more times we have to keep hearing that the financial crisis was caused by bankers' reckless greed, and that the only recourse is to ramp up regulation in the financial industry. It is not untrue that greed played a part in the crisis, but it certainly is untrue that more regulation is the solution. The solution is, in fact, less regulation - and it was in no small part due to the fraught regulation in the first place that the bankers were encouraged to be so recklessly greedy. To explain why, let me offer you an analogy.

Suppose you have built up a successful ice cream shop over the past 20 years. Now you want to have a six month holiday and employ someone to run your shop for you for while you're away (let's call him Brian). How could you best pay Brian to ensure he keeps your shop profitable? You could pay him an hourly rate, say £8 per hour. But if he gets paid irrespective of sales he may slack off and lose some of your shop's vital customer service. Alternatively you could pay him by offering him a proportion of all the ice creams sold. This is more likely to make him work harder to increase your profits, but remember he's only there for six months so there's no guarantee that paying him in proportion to the goods he sells will give you long term profitability. For example, in trying to sell as much as he can short-term to maximise his earnings he may bulk-buy from a lower quality supplier, or he may neglect to do the weekly paperwork, or he may sell artificially low by over-working the ice cream generator even though it diminishes its functional life-span long term.

There are many things that would maximise Brian's profits short-term but be detrimental to the business long term. The best kind of Brian to employ would be a Brian whose desire to do what's best for your business correlates with what's best for him too. In other words, the best employees are those whose interests are closely matched to those of the employer.

In the financial industry this is an especially vital part of banking. Most of our politicians (in America and Europe) think that the financial crisis of 2008 confirmed once and for all that politicians need to regulate the heck out the banking industry. The regularly confused Owen Jones reminded us just last week that it was the greed of the bankers that wrecked our economy, and that more regulation is the only recourse.

Alas he fails to understand how the banking industry is driven by innovation of incentivising employees, rather like how the manufacturing industry is driven by innovation of new saleable products. The banking industry is complex, and risks are hard to decipher in prospect, which means that experimentation in competitive advantage is what drives money-making in banking. Over-regulation hinders this, which then goes on to create less stable banking. A key example of this is in State-guaranteed bail outs, which, as you might expect, increases risk instead of diminishing it. Of just under 30 banks that have failed in recent times, almost all of them were bailed out by governments. A banking industry that is guaranteed against failure by the government is going to increase risk not diminish it. If I go to a casino with the knowledge that I get to keep my winnings but a billionaire friend will reimburse me for all my losses, I'm going to be a pretty bold gambler that night.

The same is true with many bankers. If they perform well, there is not much of an upper ceiling regarding how much equity can grow for the shareholders. Losses on the other hand amount to only the cost of the shares. Shareholders interested in share prices are not averse to this kind of risk-taking. What quells risk-taking is creditor action in the form of risk premiums, which are charges for borrowing. It is because of government guarantees that creditors can lend to banks with artificially low risks, which, as you can imagine, distorts the market signals that would ordinarily keep bankers' behaviour in check. The huge irony that all the banker-blamers don't get is that distorting risk premium processes is, in effect, a State-funded subsidy on precarious risk-taking.

The other way that regulation is supposed to help is in quelling the detrimental outcomes associated with narrow short-term visions. Regulation mostly fails here too, largely due to the fact that senior bankers don't, in fact, have very narrow, short-term visions to begin with. A significant proportion of bankers' bonuses are commensurate with the share prices of the bank (they are paid either in shares or in cash), where those share prices are determined by forecasted profits. If a banker undertakes disproportionately risky deals to obtain short-term profits then the forecasts will likely predict much bigger losses in the future, which means share prices will immediately drop. Hence, managers paid in shares cannot afford to risk the narrow vision.

The banking risks that brought about the financial crisis were down to excessive gambling because the credit markets and stock markets didn't factor in those risks. Had this failure not happened banks would have seen a rise in the cost of capital and a drop in share prices much sooner, giving the natural incentive for bankers to reduce the risk voluntarily to maximise their variable pay. 

To see why the regulatory proposals will increase recklessness not decrease it, imagine we did go down the injudicious path of awarding variable pay when profitable ventures are completed instead of at the point of making them. It's pretty clear why that won't help things. Consider corporate lenders A and B who each lend out £1 million to 2 identical clients on a 4 year plan. With government regulations, any bonuses A and B procure on the deal should be deferred until the 4 year period is up, subject to the loans being fully paid off. If A's client defaults within that time period then most politicians think A should receive no variable pay. Here's the problem; how on earth can this improve A's decision-making? At the time of lending, the known risks presented by the 2 clients were factored in to the deal. It is a combination of varying factors way beyond the lender’s foresight that client 1 turns out to be one of the few that ends up defaulting. The risk is taken at the point of the loan, not at any time thereafter - so it is ludicrous to try to improve initial analyses by basing variable pay on unforeseeable future circumstances.

Such a proposal does not adjust risks, it adjusts unforeseen consequences - hence it is imprudent to evaluate financial restitution based on such factors, because it increases bankers' incentives to heighten risks. If they have to wait for the culmination of repayment you'll see a huge increase in risky deals because a great proportion of loan deals are low probability of high loss, so lenders might as well make more deals, particularly as the cost of huge losses won't be incurred by bankers' themselves but by bail-outs. The way to incentivise bankers to calculate the risk more diligently when making loans is to have them bear the cost of that risk at the time of making the decision by imposing a banker's insurance premium for the risk that that decision engenders (this is how banks insure using buffers for capital, where a premium for every loan can still be weighed).

Suppose the lender was paid variable pay equal to 10% of his contribution, where "contribution" means the interest margin he earns from the loan minus the premium charged to insure against the risk of the loan defaulting - the banker will have an incentive to only make the loan if the interest margin is greater than the cost of the risk-insurance. The bankers' role would be to calculate these loans using a risk analysis, and make the ones that seem economically viable, enjoying their bonuses on the profits, and bearing the costs on the losses. If you underestimate the risks then the insurance premiums will be too small, and there will be excessive lending - but this issue isn't solved by changing variable pay and bonuses, it is solved by improving the calibration of risks in the first place.

The impression created by many politicians and social commentators alike is that high-paid, big-gambling bank managers are the real failure of corporate governance. They are not - it is the other way around - it is low-paid, risk-averse bank managers that are failing the system. Firstly, managers tend to take fewer risks than shareholders (despite most people thinking the reverse is true), as most shareholders have diversity in stocks that are not correlated with each other, so all the eggs are not in one corporate basket. Managers on the other hand more often have all their managerial eggs in the basket of the company for whom they work, so if their company fails they'll lose their salary plus any company shares they own.

In a healthy system then, big bonuses, therefore, have the positive effect of increasing appetite for risk - which is a good thing because if risks pay off then appreciation of equity increases hugely, whereas if the risks don't pay off, the most the shareholders can lose is the value of the shares they bought (in other words, a few eggs in their basket). That is why shareholders benefit from risk, and why they want managers whose appetite for risk is voracious (the best way to achieve this is if when it comes to shares owned in companies managers have diverse portfolios). 

There are brakes in place to stop the risk culture going out of control and becoming a culture of recklessness, but they are not government regulatory brakes. What stops (or should stop) companies engaging in crazy lending is that a company's creditors (either a single investor or another company) have a claim on the services of the company taking risks, by providing something (a property or service) under the contractual agreement. As creditors don't share in the company's profits they don't gain from their company's risks - which is reflected in the risk premium agreed by the first and second parties (it is the increasing cost of borrowing that places constraints on corporate leverage and other risky ventures).

A mother would be foolish if she kept buying her young son lots of cakes and chocolate and then complained that he’d got fat. But if a boy wants lots of sugar he cannot be blamed for accepting his mother’s sweet subsidies. Similarly, a company's executive who rejects government subsidies does something irresponsible because he drives down the value of his company's shares. Given that a government's guarantee of bank deposits severely reduces the risk premium that banks must pay on their debt capital, it is clear that these kinds of bail-outs are unadvisable, and bad for the general public, who as taxpayers benefit much better when markets are left alone. When the government acts as a creditor they won't often demand higher interest rates commensurate with risk-taking, which is why it is better when non-government creditors incentivise against foolish risk-taking by reining in recklessness.

As I said earlier, government guarantees basically amount to a state-subsidised risk encouragement, by removing or depleting the standard market risk-taking discipline that creditors charge. Consider that bankers were not regulated 100 years ago, yet banks were still full of profit-seekers. Bankers will only make deals they think are profitable. But if depositors no longer benefit to the same extent by bankers' felicity, their incentive to look for prudence is diminished. When the government guarantees the losses of depositors, the depositors no longer have to monitor carefully whether the bank is a prudent lender. But as well, in such a culture, depositors are primed to favour riskier bankers, because higher risks increase the chances of higher rates of interest for their depositors in successes, whereas they only increase the chances of a government (i.e. taxpayers) bail out in failures. The government are the ones laying down a cushion for recklessness

On bonuses
One more final point, the bonus culture is not the financial bogey that so many people seem to think it is. If a bank can get away with apportioning some of the salaries in the form of bonuses, it is better than paying inflated salaries. That is to say, it would be a good idea to scrap bankers' salaries and get them to work on a bonus-only culture relative to their success. This is not alien to many bankers anyway; a great many have variable pay in shares, or in a bank bonus, contingent on the share price. These are reliable indicators because share prices are a good measure of a bank's performance - but the system probably needs tweaking to give greater incentive against failure.

Ask yourself this: which bankers are most likely to be attracted to such a pay structure? Fairly evidently it is bankers with the greatest ability to make lots of money for their bank. It is for that reason that the system of bankers selling their talents for pay-based rewards would work best. It's best for talented bankers with financial nous and business acumen, it's good for shareholders, and it's good for the economy too, as I explain in this blog post with the following analogy:

"Consider a car boot sale as an analogy. With car boot sales sellers pay a few pounds for a pitch because they expect to make more than the pitch fee in items sold. A car boot sale with a £5 pitch fee is pretty standard in the UK. If all prospective car boot sale sellers in the UK were suddenly hit with a mandatory £15 sellers' fee you'd find people with lower quality items would be less inclined to bother buying a pitch. Those with lots of quality goods might still be tempted, though, because they would have confidence that their net sales would exceed the £15 pitch cost. Charging a pitch fee, be it £5, £10, £15 or whatever is a great way to organise a car boot sale, because the fee, and the effort to drive down and set up, attracts only sellers who think they have enough quality items to sell and return a profit.

Imagine what would happen if, instead of charging for a pitch, car boot organisers started to pay people to set up stalls. There'd be recklessness, as sellers would turn up in their droves, pitching lower quality items safe in the knowledge that they'll make a bit of money anyway. Now apply that to bankers pitching for their own successes. Just as you don't need to pay car boot sellers with lots of quality goods to sell, you don't need to pay bankers with lots of business acumen and financial nous inflated salaries to perform well. To get them to make good decisions, you only need to give them share-based or bonus-based incentives to do what they do best, because their own wealth is tied up in their success. The banking system would be much better if bankers' bonuses were more, not less, and their salaries capped at zero - because increased bankers' bonuses would mean increased revenue for the bank as a result of prudent investments, or increased revenue for the bank as a result of overseeing a profitable merger for which they receive a percentage of the bank's often very large fee."

Wednesday, 3 June 2015

Quick Thought On The Alton Towers Crash

Just listening to some chatter on Radio 2 about the ride that crashed at Alton Towers yesterday, with some guy suggesting that this accident will put off future customers from using theme parks. It might, but it should not. Crashes are extremely rare, and while unfortunate for those injured, they are anomalous breaks from normalcy that are likely to bring about extra checks and increased stringency in theme parks in the foreseeable future, and probably revised working protocols too. Far from this accident being a rational disincentive, the reality is that the foreseeable future is likely to be the safest time to take your family to a theme park. 

The other thing that came to my mind is that theme park rides are supposed to be about thrill-seeking - so all those who remain unaware that they are not now in more danger of crashing are presumably going to be going on rides in the near future with the spectre of crashing in the back of their minds, which presumably for some people will increase the thrill.


Tuesday, 2 June 2015

Ladder-Climbing Needn't Be A Zero Sum Game

You've probably heard of the term "Keeping up with the Joneses" which is all about living up to the statuses others have attained, or in many cases acquiring a better status than others. Robert Frank, one of the most popular economists in America, has written a book called Choosing the Right Pond in which his central thesis is that ladder-climbing is a zero sum game, because if Tom acquires a better social status than Dick, Dick has acquired a worse social status than Tom, meaning on aggregate there is no gain.

While I agree that being obsessed with prestige is bad for people, to me it's obvious that Robert Frank is wrong (and uncharacteristically off form) in his assumption that ladder-climbing is a zero sum game - it need not be. That is to say, for every win there doesn't have to be a concomitant loss. Tom can acquire a better ladder position than Dick while at the same time seeing Dick acquire a better ladder position than him. The reason why is clear when we see ladder-climbing for what it really ought to be (and often is), not as a world full of people climbing the same ladder, but as a world full of people each with their own ladder and lots of climbing potential. Now, sadly, it is certainly true that people are often overly competitive in trying to obtain prestige - but they are the ones for whom status is an unhealthy thing, because they are more worried about their relative position in a sphere of rivalry and one-upmanship than they are getting to the top of their own ladder of potential.

Once we break away from metaphors and see how this happens in everyday life you'll know exactly what I mean. Suppose we randomly picked seven people from Trafalgar Square this lunchtime - Mary, Hristo, John, Hank, Gabriella, Ahmed and Debra. Each of them values their own skills, talents, interests and achievements, but they also realise that they are in a group in which every member has different skills, talents, interests and achievements, and that no one in the group is particularly worse off because of that.

Hank is a big muscular American doorman. Physically he is the strongest, toughest, and is top of the ladder on machismo. Ahmed is nowhere near as physically tough, but being a theoretical physicist he is top of the ladder when it comes to analytical thinking. Debra isn't as tough as Hank or as analytically smart as Ahmed, but being a teacher she is top of the ladder when it comes motivation, patience and tutelage. Hristo is a painter and decorator, which means he is the expert if you need your living room renovated. Gabriella is a dancer, and is queen in her ballet shoes. John is unemployed, but there are several things at which John excels that the other six do not. No one can touch John on his skateboard, or on the running track. If all seven were having a 400 metre race, John would win hands down.

Everyone in the group has different skills and talents, but here is the other important thing; their individuality means that their skills and talents need not come at the cost of anyone else's skills and talents. Gabriella can be queen of the ballet without having that status in the least bit ruined by the fact that John would trounce her in a race, or that Hristo can artex a ceiling to a higher level.

Clearly, as long as folk are not so terribly insecure that they constantly need validation and reinforcement by being seen as better than others or of a higher social standing, everyone can thrive by being the best that they can be. That is to say, what should matter is doing the best you can do in an absolute sense, not in a sense that's relative to other people's achievements.

You are going to find yourself in many situations where you are top of the ladder in a particular context, but low down on the ladder in other contexts. In one group you'll know the most about history and be looked upon to speak the most wisdom. In another group you'll be the one who can best inspire confidence in people's ability to mentor. In some groups you'll be the best at DIY, in other groups you'd best to delegate these responsibilities to someone better suited.

Here’s the other important thing that stops it becoming a zero sum game. In a group in which literary insight is highly valued, people will value literary insight if you can provide it. But people who don't have any literary interest do not lose any status in the literary circles by being unapprised of Thomas Hardy, James Joyce and Jane Austen. Similarly, people who value having the right 'look' in fashion or sporting prowess or the rarest collection of fine art are going to have kudos in some groups, but their accomplishments will be of little interest to those unaffected by such a milieu, because people outside that milieu wouldn't confer status or prestige on anyone because of fashion, sporting ability or collectable art.

Clearly then, status is not zero sum - there can be multiple winners. Chris wins if he gets to the top of his field in piano playing. But his status imposes no cost on me if I want to get to the top of my field in theological prose. The only people who get despondent about other people's relative success are those who are competing for the same ground - and that's a despondency they can avoid by becoming more rounded people..