Teaching economics in schools

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

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

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

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

When ignorance trumps incentives

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

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

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

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

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

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

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

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

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

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

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

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

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

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

City Regulation and the EU

Last month Business for Britain published research on the potential damage to the City from EU financial regulation.  This is an excellent report, full of content, and deserving of careful Whitehall consideration. It did, however, call fundamentally for the City to be regulated by the UK. 54 top City figures wrote to the Sunday Times (22^nd June) supporting this recommendation.  Business for Britain is right about the danger but their solution does not take enough account of the realities of the EU, whether the UK remains in or out. After explaining why their proposal is, frankly, unachievable, an alternative solution is advanced. EU control of financial regulation was President Sarkozy’s price for attending the London G10 Summit in April 2009. To save the Summit, or perhaps his own prestige, Gordon Brown agreed that Brussels would set future regulations, with member states (such as the UK) merely enforcing them. We highlighted the dangers of this in a letter The Times published in June 2009 and a report called Saving the City, but City bosses then seemed unconcerned.

The EU’s position is logical: a single market requires a single set of regulations, and as the main proponent of the single market in financial services, the UK should accept that. Against that, the EU’s lawmaking system is undemocratic and corrupt, and the City, the world’s second-largest financial market, will be at the mercy of 27 other states – most with no interest in its future success, and some that are openly hostile to it.  The UK with far the largest financial services market will have just one vote in 28.

The extent to which George Osborne has enabled the UK to claw back from that, and whether the claw back applies only to banks, is unclear.  As the Business for Britain report (p.19) says “Facing new regulations which it believes are prejudicial to the interests of the UK, the government is so far failing to shape regulation before it is proposed to the point where it supports that regulation; failing to stop the progress of the resulting regulations which it does not support; and then failing to win the resulting legal cases when it attempts to challenge them in the courts.”

A solution which would give comfort to Business for Britain and those of similar persuasion would be to allocate votes on the EU financial regulation committee pro rata to the skin they have in the financial game.  The UK would have about 75% of the votes but as other member states increased their financial services, they would also increased their share of votes. In effect it would still be a single EU market but the regulators would have a genuine interest in the health of the EU financial services market for the long term and its global competitiveness.

The naysayers, citing the 2008 crash, would say that the financial services people cannot be trusted with their own regulation but that is not what is proposed.  The UK financial services market has regulators independent of the traders and that would still be true for the EU.  To have regulation decided by member states that know nothing about it, as envisaged by the current arrangements, makes no sense.  One might as well have the dentistry regulator setting the rules for horse racing.

Leaving the EU is no solution as UK financial services would still be governed by EU regulation when trading in the EU (our largest customer) just as they are by the US when trading in the US.

Achieving this EU reform would not be easy but then none of the reforms we seek will be easy to negotiate.  Given the importance of the City, it should be a priority.

There's a serious problem with this living wage idea

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

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

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

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

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

The BNP Paribas $9bn. and International Financial Regulation

Over the weekend BNP Paribas accepted a US $8.9bn. fine for breaking US sanctions on Sudan, Iran and Cuba and concealing that from US authorities.  One question arising is whether the US authorities are using regulation to gain competitive advantage over foreign banks.  This was a French bank that broke no French or EU law and dealt directly with non-US sovereign countries.  Why should the US be allowed unilaterally to impose US regulations? The technical reasons are that BNP Paribas relies on the US dollar for global trading and that they concealed their dealings from the US authorities, i.e. the sin was the concealment.  Of course, revelation of the deals would have got them into the same hot water.

Supposing all this had been in sterling in the days that the pound was the global trading currency.  Had the French then infringed some British law, would we have been able, successfully, to remove a ton of money from their vaults?  The thought is ridiculous.

The reality is that the US is using regulation to gain competitive advantage for their banks.  EU financial services have to comply with regulation in their own member states, additional EU regulation AND US regulation wherever in the world they may be trading.  US financial services have only to comply with US regulation unless they are trading in the EU.

The US authorities seem to be fining non-US banks more often and by larger amounts than US banks.  That raises the suspicion that the US authorities are partisan but it may, of course, be that US banks are simply more virtuous.

The US authorities using the extra muscle of the US unfairly is only the smaller part of my point.  The global regulatory authorities are not in competition trying to attract more companies to come under their jurisdiction by lighter touch regulation.  This kind of Darwinian evolution may apply to corporate tax rates where company HQs can, and do, move to lighter tax zones.  The regulatory authorities are trying to bring more and more companies under their control. Financial regulation is not shrinking due to competition between regulatory authorities, quite the reverse.  It is growing because of competition between jurisdictions trying to enmesh more companies in their tentacles.

Those who are against excessive regulation should not attack just the number of regulations from any one authority but attack the number of authorities seeking the regulate their business.  The fewer authorities, the better.

Of course we should have a more progressive tax system

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

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

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

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

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

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

Is the UK too equal or too unequal?

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

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

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

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

The EU's purpose may depend on tariffs

What does business want from the European Union? One answer is that of the Confederation of British industry, in its report Our Global Future, which I came across recently. That answer is that business wants to remain in – but ideally, in a reformed EU.

One reform they would like is open trade. The UK is well placed to trade with developing countries, but the high tariff (and non-tariff) external barriers that we sign up to as EU members make this nigh-impossible. Also, the CBI wants the single market to be completed. At present there is a single market in most goods (though often it is very much harder to export to other EU countries than it should be under the rules). But we are still waiting for a single market in financial services, in which the UK has a particular strength.

Will the CBI get the reforms they want? Unlikely. There are just too many vested interests wanting to prevent the UK's financial sector from getting in to their markets. And if the EU were to drop its barriers against foreign trade, why would anyone want to remain an EU member? They could quit and still get the free trade benefits. The EU would have no members left, except the ones living on its subsidies.

People dream of other scenarios. A Norway solution where, as an EFTA member, it enjoys access to the EU market. The downside is that it also pays a contribution to the EU despite getting no say over how its rules are made. But then the UK gets no say in how its export markets in the US, China and elsewhere set their rules either. The Switzerland arrangement has been mooted. It has negotiated scores of bilateral trade deals with the EU. But it is a very complicated set of arrangements. Another model is Turkey, part of a customs union with the EU. But again, it faces non-tariff barriers and has no say in things.

Sadly the EU cannot grant any such arrangement to anyone – otherwise the whole membership, led by the UK, would be queuing up to demand the same concessions. So I remain skeptical that the EU can be reformed in any meaningful way. Of course, if you believe it has a mission in promoting ever-closer political and cultural union, it still has a purpose. But economically, it can only stick together if it keeps its trade barriers high. That is not good for the EU, nor the world.

Well of course we should reform inheritance tax

Another report into inheritance tax and another observation that it doesn't actually do what it says upon the tin:

People with estates worth many millions are able to avoid the brunt of inheritance tax through complex schemes, including moving the cash offshore or investing in agricultural land and small business shares. Those avenues are closed to "moderately well–off" people whose only assets are their home and pension, Mr Johnson said.

It's just about possible to see that the great plutocratic fortunes should be broken up every generation or so to prevent the fossilisation of society: if that's something you tend to worry about which we don't very much. But to have a taxation system which attempts to do this and then doesn't is obviously entirely dysfunctional.

Our current system manages to tax the small capital of the bourgeois while leaving those plutocrats untouched. We therefore really rather do want to change that taxation system.

This is not, I hasten to add, the official ASI line here, rather being a personal musing. But I take it as a given that we don't actually want to tax the petit and haute bourgeois accumulations of capital. Far from it, we'd much prefer to see modest estates cascade down the generations. For reasonable amounts do provide freedom and liberty. In that currently fashionable phrase, enough to do anything but not enough to do nothing. It's also, even if you do worry about the plutocrats, not how much money is left that is the problem but how much money is received. Someone leaving a few billions to be spread among thousands is very different from a few hundreds of millions being left to just one.

So I would muse that we might want to move to a system something like the following. It is the receipt of an inheritance which is taxable, not the leaving of one. Further, there's a substantial lifetime exemption from having to pay tax on receiving one or many. Several millions perhaps: that need to still do something amount.

Alternatively, of course, we could just move the entire taxation system over to being a consumption tax. In that manner we don't actually mind who has what amount of capital nor where it came from. We just tax people when they spend with the capital or the income from it. and given that that's the general trhust of the Mirrlees Report there's good academic backing for the plan.

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The Living Wage campaign is wrong-footing the right

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

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

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

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

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

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

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

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