How Much Debt is Good Debt?

Debt is now one of the most talked about issues in current affairs. Debt seems to be everywhere. Governments are borrowing to finance their spending. House buyers are taking on mortgages to 'get on the housing ladder,' and millions of young people are borrowing to put themselves through college. The slightest sign that interest rates might change can send shockwaves through financial markets.

But debt has got a bad name. Excessive mortgage lending lay behind the 2008 financial crisis, inflating a house price bubble while parceling out financial risk to investors distant from the original loans. National governments around the world, from the US to the UK, Greece to Japan, are struggling under piles of debt; many countries have received bail-outs and others are on the brink of default. And student loans have created a higher education bubble, with so many students graduating from Universities that many now struggle to find ‘graduate-level’ employment [the Financial Times has run some fascinating analysis of the situation in the UK - helping confirm my earlier conclusion that the new tuition fees regime is hopelessly unsustainable].

As a result we see much talk of 'deleveraging,' meaning a reduction in the overall level of debt in the economy. This process is inevitably a source of economic stress, at least in the short run. If people slow down their spending, in order to pay off their debts, the economy stops growing and may go into recession. This phenomenon lay behind Japan's economic stagnation since the early 1990s, and seems highly likely to take hold in Europe.

All this begs the question, how much debt is good debt? We could moralize about the issue, and say no debt is good, a position taken by some religions and political ideologies*. At the opposite end of the spectrum, the laissez faire view would suggest any debt is acceptable so long as both parties are happy to enter in to it. However, it was this attitude that led to the financial crisis. The structure of the financial system was set up in such a way that there were huge problems of incentive misalignment, information asymmetry and misjudged risks.

To answer the question 'how much debt is good debt' we need to go back to some straightforward economic fundamentals. Taking out a loan is good so long as we invest the money we receive in something that yields a return greater than the interest payments required. The archetypal example is someone purchasing a car on credit. Owning a car means greater mobility, thus a greater range of employment opportunities and higher future wages. The extra wages can then pay off the debt. This cost-benefit calculus is the best way to assess whether a loan is wise, whether you are a government minister looking to borrow $50bn for rail investment, or a young person borrowing $200k to go to college.

Seems simple, so what's the problem? The problem is that we rarely know with any precision whether what the future return is on our invested cash. For government infrastructure projects, teams of consultants are hired to make projections 30 years into the future - but in truth their estimates are little better than guesswork. No one can possibly foresee how the transportation market will progress in the next 30 years. Likewise, it is fruitless for a young person to try and guess how much a University degree will be worth over the course of their career. The UK government is keen to highlight statistics such as 'Graduates earn an average of £100k more than non-graduates over their career,' but this is disingenuous, in fact it is dangerously misleading. While the statistical methods used to calculate this are quite sophisticated, and take into account that it is more able students who choose university, the analysis faces the fundamental difficulty that it uses historical data. It is therefore inappropriate to draw the inference that this 'graduate premium' will continue to apply, since far more young people are now going to University.

One economist who understood the risks of debt and its role in financial crises was Hyman Minsky. Minsky identified three types of borrowers. The first are genuinely creditworthy, the ‘hedge borrowers,’ able to pay back both principle and interest from incoming cash flows. The second are ‘speculative borrowers,’ able to keep up their interest payments, but not to pay back capital. The third are 'Ponzi' borrowers, who can pay back neither capital nor interest from their cash flows, and rely on asset values appreciating indefinitely – which they clearly cannot.

Minsky saw that in a booming economy, more and more credit is extended until it is eventually offered to the Ponzi borrowers. When it becomes clear that much of the capital will never be repaid, the boom turns into bust, and falling asset values can drive all three types of borrowers to default, even creditworthy hedge borrowers. As the economist Nouriel Roubini foresaw, this cycle describes well what played out in the 2008 financial crisis.

Unfortunately Minsky’s work still lies outside of the mainstream of economic education. Until more economists take the vicissitudes of human behavior into account, and take Minsky’s work more seriously, I fear we won’t learn from history, and so we are condemned to repeat it.


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*Sharia law, for example, forbids interest payments and requires any loan to be backed by a physical asset with an associated income stream; it is telling that Sharia-compliant investment products fared better than Western funds during the recent crisis.

Nassim Nicholas Taleb's Antifragile in 1000 Words (not 500 Pages)

What is the opposite of ‘fragile’? Most of us would naturally give the answer ‘robust’ or ‘resilient.’ Nassim Nicholas Taleb, however, points out that this is incorrect. An object is fragile if it suffers negative consequences from volatility or stress, he reasons. The direct opposite, then, is not a lack of consequences, as robustness implies, but rather positive consequences from volatility or stress. 

Thus Taleb introduces the concept of ‘antifragility,’ the central idea to which everything else in his book is tied back. He argues that antifragility is a very general concept, but one that has been pretty much overlooked in science and philosophy up until…his book. He provides examples of things-that-are-antifragile in a wide range of domains. In physiology, muscles strengthen after being stressed; in finance options become more valuable when markets are volatile; in the media an attempt to supress information leads to its wider dissemination (the Streisand effect). Evolutionary processes lead to antifragility at the system level as environmental volatility kills off weaker members of the population.

Once you get beyond the enticing prologue, the rest of Taleb’s tome is a rather painful read. It contains many interesting ideas but they are wrapped into an exposition that seems designed to alienate. Taleb expresses a disdain for most other human beings, and comes across as an arrogant know-it-all. To give an example, even though Taleb lauds the efforts of entrepreneurs in taking risks and pushing forward technological progress, he gives obnoxiously unflattering descriptions of the few technology practitioners he has actually met:

“Technothinkers tend to have an ‘engineering mind’ – to put it less politely, they have autistic tendencies. While they don’t usually wear ties, these types tend, of course, to exhibit all the textbook characteristics of nerdiness – mostly lack of charm, interest in objects instead of persons, causing them to neglect their looks. They love precision at the expense of applicability. And they typically share an absence of literary culture.” [p.314]

As an ardent fan of Taleb’s earlier books, “Fooled by Randomness” and “The Black Swan” I made the effort of seeing this one through to the end¹. As such, I shall try to summarize three of its core concepts, which in addition to the notion of antifragility, make up the meat of the book.

1.) Non-linear Effects
The human mind deals quite easily with linear effects. Double an input and, as a first approximation, we tend to expect output to roughly double. If you drive twice as fast you get to the destination in half the time. If you put in 10% more effort you expect a result 10% better, and perhaps to end up 10% more tired afterwards. 


We find non-linear effects less intuitive. For example if you drive twice as fast you use up four times as much energy, so your fuel costs will be four times higher. And in some circumstances, being 10% better than average at something can earn a payoff 100x the average. In reality, non-linear effects abound.

In Taleb’s earlier books he looks at our poor understanding of probability, and so in this book he combines this with the concept of non-linear effects. Fragility, for example is a non-linear response to a shock, where small shocks have no effect but large shocks have a catastrophic effect. This changes our interpretation of variance²: an increase in variance makes large shocks, and thus catastrophic impacts, more likely. A high variance regime is therefore qualitatively different from a low one. We observed this in the financial markets in 2007-08 when the above-normal volatility brought us close to financial Armageddon.

2.) Causal Opacity
Uncertainty is one of Taleb’s favourite topics, and in this book he focuses a lot on the uncertainty that surrounds causal relationships. He is extremely sceptical of theories about causal mechanisms. Many systems in the world are highly complex, so our attempts to rationalize them are often futile. It is wiser to be honest about our ignorance and focus instead on empirical regularities and phenomena than abstract theories.

A key field in which this philosophy has practical implications is medicine. Taleb believes we should rely on medical intervention a lot less than we presently do. His key insight here is that the negative side-effects of interventions are potentially large, and intrinsically opaque. Some side effects take decades, or generations, to manifest. The risks inherent in any medical treatment are impossible to quantify, so the wise approach is to be conservative and only intervene for very serious conditions.

Taleb further points out that doctors and pharmaceutical firms have skewed incentives in favour of providing treatments. Doctors want to be seen to be doing something – and Pharma companies want to make a profit. Taleb urges readers to be resilient to minor problems, letting the immune system do its job; after all, the immune system is the result of millennia of evolution which has given us a degree of antifragility.

3.) The Ethics of Transfers of Fragility
It is clear throughout the book the Taleb harbours a visceral anger towards the Western elite, firstly for promoting a culture of competitive materialism, and secondly for fixing the system so the dominance of the elite is perpetuated.

Taleb identifies that transfers of fragility (and antifragility) are a key method by which those with power prosper. A transfer of fragility means we make ourselves antifragile (i.e. susceptible to large gains) by making others more fragile (i.e. vulnerable to large losses). Many examples of this exist in the asymmetries of the financial system. For example fund managers take a large proportion of their fund’s profits but do not pay up if the fund make a loss. A bond trader who makes a large profit gets a bonus, but the worst-case if he or she makes a large loss is to get fired, while the loss is borne by the bank. Even the banking system as a whole has an asymmetric incentive to take risks as it can be bailed out by the government if it loses.

The more fundamental insight is that while we tend to notice first order monetary transfers (e.g. taxes and welfare payments), we also need to think probabilistically about such transfers. Any conditional cash transfer can been viewed as a probability distribution, so we must consider the higher order moments, for example the variance and skewness, of these distributions when we consider the ethics of such transfers. A transfer that seems equitable and ethical if we look at the ‘expected’ payoff may be quite biased once we take the whole probability distribution into account.

Taleb is clearly an intelligent guy, so I can only conclude that the abrasive presentation in much of his book is a result of his disdain for copy editors and an attempt to cause controversy. I could easily have written an entire blog post about the things I dislike about the book. However it does contain many ideas of value, of which I hope I have given you a flavour here. 

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1  If you do decide to pick up a copy of Antifragile, my suggested reading plan would be the prologue and Book 1, then skip directly to Books 5, 6 and 7.

2 And not just variance: the interpretations of the other higher moments change, with skewness and kurtosis also important.


 

Is Economics On the Verge of a Paradigm Shift? David Orrell's Economyths and the Perils of Financial Engineering

Is economics on the verge of a paradigm shift? This is the question raised by David Orrell’s excellent book Economyths, in which he dissects the flaws at the heart of neoclassical economics and argues not only that it is not fit for purpose, but that it is responsible for many of society’s current problems. As a book that sets out to ‘change your world view’ it really fits the theme of this blog. While I had an existing scepticism of the state of economics when I began reading it, the book has really opened my eyes to the breadth and depth of the problems, and did so in a rigorous but also highly readable way.

The book is neatly structured in ten chapters, each of which is focused on different problem with economics. Orrell re-visits the early thinkers from the classical school of economics to tease out where the foundational assumptions of the field came from. It turns out that many of the problems of modern economics can be traced back to the influence of physics, which led to an atomistic and deterministic view of human behavior. This paradigm served us well initially, and led to some useful insights about the nature of markets. But economics has become elevated to the status of mathematics, in which any theorem is deemed to be true as long as it can be derived from the accepted axioms. Few academics at the heart of the economics establishment outwardly question these axioms, and those that do are often marginalized and labeled as ‘heterodox’ ¹. In trying to become more like a science, economics has ended up becoming more like an ideology.

Orrell describes a wealth of data that should lead us to doubt the axioms and theorems of neoclassical economics. People are not rational; markets are not efficient; the policy prescriptions drawn from economics aren’t working. He deftly draws on some of the alternative schools of economics (e.g. behavioral economics, ecological economics) and brings in the work of some allied fields that could have major implications for the way we think about the economy (e.g. neuroscience, psychology). Far from being a pessimist, he points towards some areas of scholarship that could be the basis for a paradigm shift in economics, highlighting in particular the fields of network theory and complexity theory².

Having attempted to summarize the book, I would like to highlight one idea in particular which plays a small role in the book but made a big impression on me. Dwelling on the modern job title of ‘financial engineer’ (people who develop new financial products, such as CDOs, CDSs, etc.) Orrell observes that in every traditional engineering discipline there is a formalized code of practice and a requirement to build a ‘factor of safety’ into the system³. In fact safety-critical mechanical and structural products typically have a safety margin of over 100% (i.e. they can withstand double the load or stress they are designed for before they break). This extra layer of redundancy means that even when the products (whether cars, airplanes, or buildings) encounter extraordinary conditions, outside of their design specification, they will still function. When a product fails, the firm that built it is legally liable for losses and the engineer who designed it can be personally held responsible.

One could well imagine that the effective functioning of the economy might be deemed  safety-critical. A malfunctioning economy leads not just to discomfort but to starvation, deprivation and a rise in the suicide rate. And yet there is no formalized code of practice for modern financial engineers⁴. They do not have to build in margins of safety into their products. They are not held accountable when the products they develop fail. This observation is not just based on the 2008 financial crisis, in which financial engineering playing a massive part, but in many previous crises such as the junk bond debacle in the 1980s and the bankruptcy of Enron in 2001.

Prompted by Orrell’s comparison, I’ve begun thinking about other sectors in which unorthodox types of ‘engineer’ are involved in developing mass market, safety-critical products. Food engineering is an interesting one: a majority of food we eat in the West has been processed by a big corporation and has been mathematically optimized to be as appealing as possible for the least possible cost to the producer. This is why the foods contain so much Salt, Sugar and Fat (the title of another book I want to read, by Michael Moss). To the companies, the long-term health effects of these products are a secondary concern, and if we get ill it isn't the food companies that will be held liable. How would things be different if food engineers were held to the standards of traditional engineers? Could they build in a ‘margin of safety’ to make it hard for us to over-consume unhealthy ingredients, and easy for us to get the nutritional sustenance that we need?

Economyths is far from the only book out offering a penetrating critique of the financial system, but it is one of the best⁵. Moreover, by pointing towards possible paths forward it goes further than many other books in the ‘crisis economics’ genre. Orrell shows that the crisis isn’t just with the financial system, but with the intellectual system that underwrites it, and as Thomas Kuhn pointed out, it is a sense of intellectual crisis which acts as a catalyst of ‘scientific revolutions.’ If Orrell is correct, a scientific revolution in economics is already underway.

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1 Interestingly Orrell suggests that many economists are unhappy with the current state of affairs, but don’t question it in public for the sake of their careers and credibility.

2 I was pleased to read this as both these fields are close my own interests.

3 Upon Googling 'margin of safety' the first reference I find is to an appropriation of the term in the field of value investing, so while the concept clearly exists in finance it is not part of a financial engineer’s design responsibility.

4 The CFA Institute's Code of Ethics is probably the nearest equivalent, but it is rather narrowly applicable to fund managers, who by all accounts seem to routinely flout it anyway.

5 Another one which I’ve just begun reading is Nassim Nicholas Taleb’s polemic Antifragile – I look forward to reporting on it shortly.

Why David Cameron's Foreign Trade Claims are Flawed

I don’t tend to pick on individual politicians to criticize, but David Cameron’s piece in today’s London Evening Standard newspaper is worthy of some commentary. You can find the article here.

Let’s analyze what he says:

“This country is in a tough global race to succeed… the world does not owe us a living, we have to earn it.” – this much I agree with. We are, indeed, part of a global economy in which countries compete for economic activity.

But the message of Mr. Cameron’s piece is that we are being successful at attracting foreign investment. He trumpets major capital investments from abroad in the UK telecoms and energy industries and in real estate development. He seems to entirely miss the point that the kind of economic competitiveness that matters most is the ability to produce exports.

As a nation, the UK consumes vast amounts of imported goods, mostly paid for on credit, and as long as the country fails to increase its own exports, it will be increasingly indebted to the countries that supply these goods. Imports help people live wealthy-seeming lifestyles today, but then the debts are left over for future generations to pay off.

The three industries mentioned above, telecoms, energy and real estate, are all services sold back to the people within the country. No exports there, I’m afraid. Just highly inflated housing prices in London, as a direct result of foreign investment in the capital’s real estate. Well done, Mr. Cameron, for attracting all of that investment. Kudos.

Something that might benefit the country, and lead to products and services we can export, is innovation activity. And a good way to stimulate innovation is by supporting entrepreneurship.

Maybe Mr. Cameron realizes this, as he says, “the red carpet is rolled out for entrepreneurs.” But for some reason that doesn’t ring true, for example if the would-be entrepreneurs are from outside the EEA and have to jump through laborious hurdles just to get a visa. Last week Theresa May announced a new policy clearly tailor-made to attract thousands of foreign entrepreneurs: a £3,000 bond that must be deposited before visitors from some select countries are even allowed in the country. Cameron, to his credit, had the good sense to quash this one, but in generating so much uncertainty and confusion much damage has already been done. The sudden and arbitrary changes that are regularly being made to the Byzantine student visa and post-study work visa regulations also exemplify the country’s enthusiasm for attracting talented foreigners.

The third thing that irritated me in the article is Cameron’s joke about his most recent trade mission, “Just last weekend I was in Kazakhstan (but I missed out on the camel’s milk).”

I will leave critiques of his sense of humour for another time. Why, I ask, is our Prime Minister visiting Kazakhstan to attract investment, a country that ranks 133rd out of 176 in Transparency International’s corruption perceptions index, and in the bottom 15% of the World Bank’s control of corruption measure? A country that shoots dead protesters who dare to oppose the oil and gas industry? Is it because these unstable, autocratic, petrodollar-backed regimes are the only ones who both need and can afford one of our biggest actual exports, namely weapons?

Cameron has the gall, two paragraphs later, to trumpet the UK’s “stable democracy, where there are property rights and the rule of law.” He clearly cares very dearly about these things. We may as well put out a sign saying, “Billionaire oligarchs from despotic backwaters welcome here!”

Then, finally, comes the Battersea Power Station project, the “jewel in the crown” of the infrastructure investments Cameron cites. This will be backed by an £8bn investment and will “create 15,000 jobs.” Never mind the fact that jobs created on building projects are only ever temporary, and no substitute for sustainable job-creation. The thing that struck me here was the irony of it. The source of the funding – Malaysia.

Maybe Mr. Cameron is not familiar with the history of economic crises, but if he were he would surely stop boasting about foreign investment being the route to riches. Malaysia, Thailand, Indonesia and their neighbours know this well, from their experience of a financial crisis in 1997. Long before the credit crunch showed the Western world that laissez-faire capitalism has its risks, South East Asia experienced a severe currency crisis and long recession due to the aggressive inflow and then flight of foreign capital. Foreign investment is neither a stable nor a sustainable route to economic growth.

Whether the Battersea project will come to fruition remains to be seen, and I don’t have strong opinions either way (I give its odds of success maybe 1 in 3). But its use by Mr. Cameron as a piece of propaganda is entirely disappointing. Economic growth is important (though not nearly as important as most politicians think) and if the UK wants to pursue it the country needs to look for competitive industries inside its borders that create value for customers elsewhere. There is, perhaps, one investment referenced in the article that involves exports: the Tata group’s purchase and expansion of Jaguar-Land Rover. This investment has helped re-juvenate British manufacturing and create long-term jobs. When Mr. Cameron comes back with more of these type of investments to shout about, it might be worth getting excited about.

What is the Half Life of a Social Network? The Problems of Digital Baggage and a ‘Move Fast and Break Things’ Philosophy

It is a little over a year since Facebook went public in a c.$90bn IPO, and I find myself amongst a growing group of people questioning what the future holds for ‘The Social Network’. Social media is a new industry and the rules of competition are being discovered as we go along. And the same things that caused Facebook’s meteoric rise may end up making it irrelevant.

Online technology companies (by which I mean social media as well as services such as search, email, blogging, etc…) face the unenviable situation of being violently pulled in two directions at once. On the one hand is the imperative for constant change: that constant struggle to capture the attention of the general public while hundreds of competitors are trying to do a similar thing. In this light we see firms as locked in an arms race, repeatedly adding features and revising designs in a bid to stay fresh. On the other hand, there is the need to provide consistency and reliability in the service being provided. Users become accustomed to the current set of features, so any changes will tend to cause discomfort and lead to inevitable outcries.

In a way this tension is faced, in some form, by all businesses. But in the online tech industry it is particularly acute, because there are such low barriers to entry, and thus there are so many entrants trying to displace whoever is leading at any point in time. There is also an implicit premium on mere ‘newness’ as trend-setting users like to explore new services in order to be ‘at the forefront.’

In most industries, the most common problem is resistance to change, an inability to adapt to changing user needs and changing social pressures. It’s my strong feeling that in social media, the opposite problem holds. Companies like Google and Facebook are pioneers at experimentation, trialing possible changes with randomized subsets of users, and implementing the ones that appear to work on a wider scale. This is epitomized in Mark Zuckerberg’s famous management philosophy: “Move Fast and Break Things.”

The problem is that while this philosophy may be suitable for a small or mid-sized start-up, it suddenly becomes a lot more dangerous for a large corporation. With every change that is pushed through, Facebook risks alienating some fraction of its users, and of those, some fraction is likely to disengage (see my comments on community pages in 2010). Take, for example, Facebook’s algorithm for deciding what gets put on your Newsfeed. This is one of its most important pieces of technology, as it determines both how users interact with each other, and how advertisers interact with users. When this algorithm is changed, it will always have the effect of giving some posts more attention and other posts less attention – and the people or businesses getting less attention will be irritated. I noticed this last year, when Facebook changed the algorithm at the same time as it introduced paid-for “promote this post” options, earning the moniker 'The Biggest ‘Bait N’ Switch’ in History'. I’ve also noticed another change in the last few months, which has led to my newsfeed being filled with less relevant posts (and more advertising than before) and my own posts getting less attention than they used to. I am already changing my Facebook engagement habits as a result, and using Twitter more as a source of interesting links.

This excess of change is far from the only risk. Two others are worth highlighting. An article in the Financial Times last week focused on investor disquiet over FB losing its ‘coolness’ as a result of people’s parents joining. Young people are the key audience for social network, and tend to direct posts to their friends, and the growing presence of older relatives is reducing the perceived freedom of the space. I’ve seen an example of this myself, when one of my friends posted about having a ‘too many drinks’ – and minutes later their father making a rather embarrassing comment on the post, along the lines of ‘I thought you were more sensible than that.’ This is all just rather off-putting, given that the original appeal of Facebook in its early years was based around it being restricted to peers at the same university. Private social networks, such as Microsoft’s Yammer, could begin to capture the attention of users looking for a more exclusive forum.

Then finally there is the issue of digital baggage. This is something I’ve realized recently: much of my activity on Facebook in the early years after I joined in 2005 has left a very large, quite personal digital trail. Furthermore, since I created the content, joined groups etc., the architecture of FB has changed, as has its privacy policies. This makes it rather difficult to see who has access to what. And even if I correctly manage my privacy settings today, there is no guarantee that privacy policies won’t be changed in the future. To give concrete examples, I discovered several photo albums which I thought were ‘friends only’ were actually reachable by the general public with a simple google search. Also there was a set of ‘groups’ that I set up for University colleagues (which are now years out-of-date) but were visible to the general public. These examples struck me as disconcerting, and I realize now that the only way to ‘leave that baggage behind’ would be a make a fresh start with a new social network – for example Google+. I’m not going to do that just yet, but I expect other people will. The Facebook timeline was famously glorified in this video as a way of having a record of your entire life in one place. But that idea is actually quite scary. I, personally, do not want that record in the (potentially) public domain, and I doubt that I’m the only one.

During its initial rise, the trend of Facebook’s subscriber figures was exponential growth. To look at the graph, if it referred to a share price it would definitely look like a bubble. Of course it is not a share price, and so I don't expect it to ‘pop.’ But I think user engagement with FB will decay. However much effort it puts in to try and stay relevant, it is nevertheless likely to be displaced by newer start-ups offering cool new services. The proportion of cognitive real-estate it can command will decline as other services manage to win more. My message to Facebook investors is therefore, get out while you can.

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Agree? Disagree? Please leave comments below

Schelling, Focal Points and the Problem with Partial Vegetarianism

Following my previous post on Thomas Schelling’s contributions to Game Theory, I have been reflecting on another key idea from his 1960 book ‘The Strategy of Conflict’. Schelling introduced the concept of ‘focal points’ in situations where two parties have to coordinate. The idea is that when faced with several options, people often have a sense of which is the ‘most obvious,’ and when coordination is required they are likely to pick this obvious solution, in the knowledge that the other party is also likely to pick it.

 The classic (abstract) example of such a coordination problem is when and where you would go to meet somebody in New York City, if you had not agreed this ahead of time and communication was, for some reason, cut off. What do you think? When and where would you show up? (see below for the solution*)

The idea of the focal point is important for several reasons, of which I will highlight two.

Firstly, focal points do not fit well with standard ideas in economics. Most modern microeconomic theory deals with curvilinear relationships between variables: equilibrium is defined by the utility-maximizing point on a curve. We find this point using calculus and marginal analysis, and so we assume the curve is continuous. The focal point concept throws continuity out of the window. Even when we introduce game theory – a critical implement in the modern economist’s toolkit – this only tells us that Nash Equilibrium outcomes are stable, not which Nash Equilibrium is most likely. Somehow focal points allow people to efficiently choose between different equilibrium positions, even without communicating.

This leads onto the second, deeper, point. Focal points challenge the economist’s mechanistic idea of ‘rationality.’ It is very hard to specify what constitutes an ‘obvious’ choice. Often the cues that lead to particular choices are idiosyncratic to that particular context. Given a number of different equilibrium positions, standard models of rational behavior might suggest picking randomly between them, or undertaking exploratory search to see what the other players pick. It is difficult, if not impossible, to identify focal points using a mechanistic or analytical solution, the best we can do is identify heuristics for finding them. Yet gravitating towards focal points tends to lead to better outcomes for individuals than a strictly ‘rational’ behavior, and so behavior is in some sense ‘hyper-’ or ‘super-’ rational.

The idea of focal points has been broadened from Schelling’s original coordination-game context, to the general tendency for people to fixate on certain ‘obvious’ equilibrium points of behavior. The tendency to do this seems to be deeply rooted in human psychology. This has major consequences for self-control and our inability to ‘do things by halves.’ It is much easier to give up a certain behavior outright than to stop doing it half the time – for example, I am fully aware that meat production is environmentally very damaging. Vegetarianism would therefore be an ethical behavior for me to adopt – but I love eating meat so much that I can’t bear the thought of giving it up entirely. Now, I could halve the environmental damage my meat consumption does by halving my consumption. However, as I have found (upon trying to limit my meat consumption), it simply does not work like that. A plan to only eat meat on Fridays falls apart when there is a delicious steak on the cafeteria menu on Wednesday!

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*This example, conceived by Schelling, has been used many times by researchers as a quiz question. Overwhelmingly people opt for 12 noon as the most ‘obvious’ time to meet. The place chosen varies between two obvious locations: New York residents tend to pick Grand Central Station, whereas out-of-towners choose the top of the Empire State Building.

Strategic Delegation and the Cypriot Financial Crisis

An interesting thing happened in the eight days between the ‘first’ Cypriot rescue plan was announced on Saturday 16th of March and the ‘second’ plan was announced on Monday 25th March. The Cypriot parliament voted down the first plan, rejecting the levy on deposits and sending the President back to the negotiating table. But it also voted to allow the President to make a new agreement, which could include a bank levy (renamed as a 'restructuring'), and which would not need further Parliamentary approval. This is a noteworthy event: the Parliament relinquished its own decision-making ability. In a situation where the stakes are so high, for a powerful actor to give up its own power is, on the surface, quite shocking.

Why did it happen? It seems to be a textbook case of strategic delegation. The idea of strategic delegation was introduced by Thomas Schelling in his seminal 1960 book, The Strategy of Conflict. Schelling’s work highlights something that, from the perspective of economics, is paradoxical: having one’s choices restricted is sometimes a good thing. In traditional economics, freedom to choose between more options is never a bad thing, as each option may lead to a better outcome. Schelling shows that in multi-agent negotiations, less choice is sometimes better.

When our negotiating opponent makes their choice based on what they expect us to do, it can be an advantage to have very limited options. As a result, it can be beneficial to commit oneself to a particular course of action before the strategic interaction even begins – and let the opponent react. The classic example of this is set in a military conflict: a defensive force ‘burns its bridges’ to cut off its means of retreat. Realizing that the defensive force cannot retreat, and preferring to avoid a fight to the death, the attacking force does not advance. In Schelling’s terminology, the defensive force has made a credible commitment to stand and fight, and this in itself is enough to win the day.

Schelling identifies two uses of a bargaining agent. The first is to pre-commit oneself to a course of action, as in the burning of bridges strategy above. The second is to gain from using an agent whose incentives differ from one’s own.

When the Cypriot Parliament delegated power to the President, it was a highly strategic maneuver. They knew that the resolution of the crisis would require accepting a bailout, and that negotiating the bailout would require painful sacrifices be made on behalf of the Cypriot people. They realized that while they might privately support an agreement that causes pain, there is a high chance that in a public vote a painful agreement would, again, be rejected. The Parliamentarian’s objective is to make a decision that is popular, so they have an incentive to not be seen to support a bank levy. They chose to ‘bind their hands’ to prevent themselves from interfering in the future. The President, by contrast, had the overwhelming incentive to resolve the crisis, so he was appointed as an agent, and, ultimately, a scapegoat who could take the blame for an unpopular agreement.

To some, Game Theory is easy to dismiss as a parlor trick, a mathematical abstraction with little relevance for the real world. However the work of Thomas Schelling illustrates just how relevant it is to every moment of every day – hence why he won the Nobel Memorial Prize in Economics in 2005. Much of his work was inspired by the tension of the nuclear arms race and potential for Mutually Assured Destruction. In a world once again threatened by nuclear conflict, we could do worse than to revisit Schelling’s classic work to help us make sense of the situation. 

72 Hours to Decide the Fate of Cyprus: Will it Go Down Like Lehman Brothers?

The financial crisis in Cyprus is presently at a critical juncture. Having rejected a tax on bank deposits early this week, the government needs to come up with another option for financing, or face a liquidity crisis in the next 72 hours that renders the country effectively bankrupt.

From here there are several things that could happen, of which I list three in the order of relative likelihood that I would assign them.

     1.) The Russian government contributes to a bailout

The reason for proposing the bank levy initially was that the EU and IMF are unwilling to completely bailout Cyprus themselves. The EU and IMF funding is structured as loans. Despite the fact that the extra sum required is small compared to bailouts in other Eurozone countries, the Cypriot economy cannot support any greater level of debt than is currently being planned. What is needed is more 'equity' rather than debt, either from a direct fiscal transfer, or an internal source such as a bank levy. 

A fiscal transfer would be untenable to the EU, and Germany in particular, for two reasons. Firstly, this would set up a 'moral hazard' problem, such that other countries lose the incentive to be financially responsible. The impetus for austerity measures in Greece and elsewhere would be severely weakened. Secondly, a key beneficiary of the transfer would be Russian depositors, who were outspoken opponents of the bank levy as originally proposed. A bailout that transfers EU funds directly to wealthy Russians is rather unpalatable, both ethically and politically.

This leaves the Russians themselves the most likely participants in a bailout agreement. It is their own citizens that stand to lose out from default, and the Russian leaders have already shown their solidarity with the depositors, even if they are using Cyprus as a tax haven.

     2.) A bank levy is reinstated on large deposits

Having observed the outcry at taxing deposits universally, the Cypriot leaders probably wish they had limited it to large deposits in the first place. It is far more politically palatable to place a windfall tax on the wealthy than on the poor. They even amended the proposed bank levy before the vote in parliament, but by that time it was too late as it had already lost all support. However, since Cyprus is so low on outside options, a resurrection of a tax on larger deposits is a real possibility.

     3.) Default

There are many commentators arguing that default will not be allowed to occur, and EU authorities will relent and cave in to a larger bailout. In my view, default is a very real possibility. I outlined above why the EU is unlikely to provide a direct fiscal transfer; such a transfer is beyond the remit of the IMF and anything less than an equity injection will leave the Cypriot banks insolvent. This means the European Central Bank will cease providing them with cash, and they will be bankrupt.

In this case the likely consequence would be a Cypriot exit from the Euro. The mechanics of how this might be conducted were closely examined in case it were needed in Greece. The banking system would be put on hiatus while the currency is switched to Cypriot Pounds. Bank assets and liabilities, including customers' deposits, would be re-denominated. The new Pounds would instantly depreciate against all the major currencies. Simultaneously the government would probably default on its external debts, either directly (by ceasing payments) or indirectly (by denominating the debts in Pounds and printing money, leading to hyper-inflation.) In short a lot of people would lose a lot of money, and they would end up wishing they had accepted the bank tax originally proposed.

From the perspective of the rest of the Eurozone, the great big unknown in this situation is the knock-on effects. 

A very good parallel here is the Lehman Brothers bankruptcy at the peak of the credit crunch in 2008. This was allowed to happen by the US authorities on precisely the 'moral hazard' grounds that make the EU reluctant to completely bail out Cyprus. The Lehman bankruptcy had devastating consequences, which were unanticipated largely due to the opaqueness and intrinsic complexity of connections in the financial system. Small details, like where assets were parked overnight, went on to have major ramifications as it led to different bankruptcy laws being applied. With a national economy we are faced with a whole different set of opaque connections, complex dynamics and ambiguous legal territory.

The EU leaders know all this, and yet may still allow it to happen. If nothing else (and assuming the Euro survives the contagion), a Cypriot exit would provide a test case for how a bigger Eurozone nation might later conduct an exit.

My thoughts go out to the leaders currently negotiating the future of a nation. I hope you bring us back from the edge.

When the Music Stops: The Past, Present, and Future, of HMV

There are a two big myths circulating about HMV, the last-music-retailer standing on the British high street, which recently went into administration. Myth #1: HMV was killed by iTunes and downloaded music. Myth #2: HMV is, indeed, dead.

      1. HMV was killed by iTunes and downloaded music

This is a convincing narrative being propagated in much of the business press, but I don’t buy into it. There was, is, and will continue to be a market for hard-copy CDs and DVDs. Many people have not switched to downloading music, preferring the tangible feel of a disc in their hands.

No, from the product side, HMV’s competition comes from Amazon.com on the one hand, and from the supermarkets on the other. When it comes to buying the mass market, top charting movie release or pop record, it is simply easier to bung it in the trolley at Tescos instead of make a special trip to HMV. When it comes to buying niche, specialized albums and movies it was a safer bet that you would find it on Amazon. HMV has neither convenience nor range: it is stuck between a rock and a hard place.

      2. HMV is, indeed, dead

Reports of HMV's demise have been greatly exaggerated. As I write this, HMV has gone into administration, which means that it will be run as a going concern until a buyer can be found. Only if this proves impossible will it be wound down.
 
Most media commentators seem to miss the crucial point that on a going-concern basis HMV has still been reasonably profitable. It has been caught out because for years it relied on rising sales to support its working capital base. As I pointed out in this blog two years ago, its sales growth had halted, and it has been caught in a working capital trap. The administration process will wipe out its equity holders, allow a restructuring of debts and closure of unprofitable stores, but then the remaining assets should be able to continue running as a viable business.
 
One big risk factor here is the inexplicable decision of administrators to stop accepting HMV gift cards at the stores that remain open. This will have caused HMV’s credibility and brand value to plummet. In theory, as the last remaining record store on the high street it should have a reliable stream of customers. But the messy handling of the administration has caused much of its remaining value to evaporate. I would not be surprised if its future sale was accompanied by a complete re-branding to distance the firm from the current disarray.

*****
Update (21st Jan): Administrators have announced that HMV will accept gift cards. An eminently sensible decision, although much reputational damage has already been done.