Griffenomics - Issue 2 by Abingdon Publications

ABINGDON SCHOOL'S

GRIFFENOMICS LENT 2014

ISSUE TWO

An Interview with a Citibank economist Adrianne Lui tells us about getting our careers onto the inside track. page 15

ALSO INSIDE: War! What is it good for? Can you beat the market? The Black Swan Effect The Credit Crunch

GRIFFENOMICS

Contents: War and Economics

managing director BEN PONNIAH

Is War Good For the Economy?

chief editor WILLIAM TONG

The Credit Crisis

The 2014 World Cup

copy editors LIAM FRAHM

An Interview with an Economist

contributors HENRY CHEUNG LIAM FRAHM JACK GU ADRIAN LEI RICHARD MATOUSEK NICKLAUS PANNU-YUON DANIEL TONG WILLIAM TONG ALEX TURNER

London and The Rest: Could HS2 make things worse?

The Black Swan Effect

Can You Beat the Market?

The Living Wage

Animal Spirits

NEWSPAPER

design editor ASTEN YEO

publisher NICK FIELDHOUSE Design by Asten Yeo Cover and inside cover photos by Michael Man

Want to join the Griffenomics team? Contact us at griffenomics@abingdon.org.uk

Griffenomics is online! http://issuu.com/abingdonmagazines/stacks

by William Tong

by Alex Turner

by Jack Gu

by Daniel Tong

by Nicklaus Pannu-Yuon

by Richard Matousek by Henry Cheung

by Adrian Lei

by Liam Frahm

by Adrian Lei

A Letter from the Editor: As Frederich von Hayek once said, “the curious task of economics is to demonstrate to men how little they really know about what they imagine they can design.” Indeed, Economics has, for centuries, eluded even the best of mankind. Yes, economists have developed formulas, hypotheses, and countless theories; but even with the world’s most powerful computers and the world’s most brilliant minds, Economics still stands as a social science---meaning that it cannot be scientifically and objectively studied. In this second issue of Griffenomics, we seek to bring to you the ambiguous and the intriguing. Our diverse articles range from the peculiar effect of war on economics to whether one can succeed in the thrilling world of stock markets. Let your curiosity guide you into the enigmatic realm of Economics, and do keep an open mind, because the one thing you can be sure about economics is that you cannot be sure of anything. William Tong Chief Editor of Griffenomics

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WAR SPECIAL FEATURE

WHAT IS IT GOOD FOR?

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THE NUMBER OF BATTLE RELATED DEATHS PER 100,000 PEOPLE

War & Economics AN ALTERNATIVE EXPLANATION FOR THE SLOW ECONOMIC PROGRESS OF DEVELOPED COUNTRIES

“There is no instance of a nation benefiting from prolonged warfare.” T

his was a famous quote from Sun Tzu, the ancient Chinese military general, strategist and philosopher. I think that most people would agree with this statement from a moral and ethical point of view, as it is not in society’s interest to wage wars because lives will be lost and property destroyed. However, there has been evidence suggesting that continuing sluggish economic growth in developed countries of the world may be attributed to the persistence and expectation of peace in the global community. I am not saying that countries should all start wars with each other in the hope of improving economic growth, this is merely a hypothesis backed up with evidence to provide an explanation for the low growth rates seen in high-income economies. This simple explanation is that the very possibility of conflict forces governments to be more deft, decisive and thorough when making some basic yet essential decisions, such as managing investment in different industries or deregulating and privatising major industries to improve efficiency and introduce competition. Such examples can be seen throughout American history; the main driving force behind fundamental innovations such as nuclear power,

DROPPED FROM OVER 25 IN 1950 TO JUST 0.3 IN 2010

computing technologies, and the modern aircraft was the eager desire of the American government to defeat the Axis Powers in World War II or later, to win the Cold War against the Soviet Union. Moreover, while Silicon Valley now stands as a metonym for the pinnacle of the global technology sector, its prosperity came about as a result of heavy investments by NASA into local aerospace firms in the late 1950s after Sputnik I, the world’s first space satellite, was launched by the Soviet Union. Therefore, it can be said that the Soviet launch of the Sputnik satellite stimulated American interest in science and technology, which has driven a series of innovations that the world relies on today, such as the semiconductor. The prime example of effective and efficient decision-making is the Manhattan Project; it only took six years to build an atomic bomb from scratch and this project consumed about 0.4% of GDP annually. This shows that war introduces urgency and necessity for the government to invest and make decisions efficiently, which arguably is not as prevalent during the persistence of peace. Another great example of how the preparation for war can affect economic growth in recent history was Nazi Germany’s economic recovery following the defeat of Germany in World War I. The Nazis ascended to power in 1933, a time when its economy was left in ruins with a hefty sum of war reparations and no prospective foreign investors or creditors. The Great Depression in the United States also affected the German economy because American banks could no longer give loans to German firms. However, through a series of effective decision making and strategic planning, the Third Reich was able to turn a bankrupt Germany into the strongest economy in

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Above: The world’s first artificial satellite, launched by the Soviet Union on October 4th, 1957

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Europe within four years in the lead up to World War II. Nonetheless, I am not advocating Nazi philosophies, but the effectiveness of its economic policy between 1933 and 1939 is undeniable. The propagator of this series of economic policies was Hjalmar Schacht, the President of the Reichsbank and the Minister of Economics. He introduced a series of Keynesian reforms, which included large public works programs supported by government spending. The Reinhardt Program combined tax reductions and government investments in waterways, railroads and highways, which resulted in a massive expansion of the German construction industry which reduced unemployment by absorbing a lot of manual labour. More specifically, the construction of the Autobahn road network caused unemployment to decrease significantly from 6 million in 1933 to just 300,000 in 1939. The reduction of unemployment brought about an overall increase in the levels of consumption, which led to a revitalisation of the German economy; the recurrence of inflation was prevented through the introduction of price controls on essential goods such as food and fuels. In 1936, Hermann Goering replaced Schacht with a mandate to make Germany completely self-sufficient to fight a war in what became known as the Four Year Plan. However, the world prices for raw materials, which Germany imported, were increasing, while prices for

manufactured goods, which were Germany’s chief exports, fell. This meant that Germany found it very difficult to maintain a balance of payments surplus as more money was leaving the domestic economy than entering it. Therefore, the Nazi government changed its trade policies and only traded with countries in Southern and Eastern Europe, most of which were within the German sphere of influence. Numerous bilateral trade agreements made countries such as Greece, Bulgaria, Hungary and Romania heavily dependent on German exports and, in exchange, they sold raw materials to Germany. By 1938, over 50% of the trade transactions of these countries were with Germany. Domestically, the Nazi government imposed a regime known as command-capitalism; businesses had little entrepreneurial freedom due to state control and tax rates as high as 98% on profits, which restricted the self-financing of firms. This meant that most firms were dependent on, and therefore controlled by, the state; investment was guided through regulation in compliance with the needs of the government. However, this is not to say that centrally planned economies are necessarily more effective at producing goods than capitalist free markets. Nonetheless, even if there was a relationship between war and improved economic growth, would countries really go as far as to begin a military conflict just for the sole purpose of potential long term economic prosperity through innovation? Whilst we can have a preference for higher rates of economic progress, GDP figures are not a perfect measure of living standards, many factors can influence our quality of life just as much as material possessions and financial gains. Living in a peaceful world with a 1.5% GDP growth has many advantages over living in a world with a 7% GDP growth rate but many more deaths in combat. Hence, while economic stagnation or even decline may not be very appealing, the real question that we should be asking is whether the recent prevalence of peace among developed countries can be sustained or is it simply a transient illusion waiting to be shattered? FURTHER READING: ‘War and Gold’ by Kwasi Kwarteng

THE WAR ON TERROR IN IRAQ AND AFGHANISTAN WILL

Is War Good for the Economy? THE ENIGMATIC RELATIONSHIP BETWEEN WAR AND ECONOMICS Below: Tank commander in the Second Gulf War in Iraq

n the light of recent conflicts unfolding in Syria, Iraq and Afghanistan, it would seem ironic or even callous to ask whether war will, in fact, benefit an economy. We see pictures of misery and destruction on our television screens daily and sympathise with the victims of war, so how could economic positives ever outweigh the destruction, devastation and loss of hope? In fact, the reality is far more complicated and in this article we shall delve deeper and offer a balanced view based

COST THE US MORE THAN $5 TRILLION.

on some real world examples of how wars have impacted nations in the past. On the balance sheet of war, the immediate impacts are often negative. In a total war, the normal flow of an economy is disrupted and the state diverts the resources into war production and national survival at the expense of consumer goods and investment for a peacetime economy. Trade is also distorted: controls on the importation of non-essentials and the exportation of strategically important materials are often introduced and the state intervenes to fix prices, ration goods and direct manpower to important war needs. For example, the diversion of manpower towards munition manufacturing means that there are fewer consumer goods to be traded. Moreover, in almost every case where war has broken out in the last century there has been a significant impact on trade with inflation often a direct result of this. The Iraq War, for example, led to a rise in inflation, with the price of oil increasing six fold from $25 in 2004. This is because the war led to a halt in the production and exportation of oil in Iraq while the demand for world oil from other countries, such as China and India, was constantly rising. With excess demand, suppliers then increased their prices causing a rise in the price of oil around the globe. War does not come cheap. Military action has to be paid for and this can mean a combination of higher taxes and reductions in non-essential spending. In some cases, governments are forced to run up large debts and these debts can have huge effects for the countryâ&#x20AC;&#x2122;s economy for years

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Above: Female factory workers in Slough, UK, during WWII

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“The balance sheet of war looks very negative.” to come. In fact, Germany only recently paid off its WWI debt, due to the large interest, despite the war having finished more than nine decades ago. All of this is before we calculate the impact of military action itself. Wars have a destructive impact on three main areas of the economy: people, infrastructure and materials. In the First World War, for example, people talked about a ‘Lost Generation’ - the young, talented people who were killed in their thousands in action and whose contribution to society was sorely missed. Furthermore, even those who did not die and returned shattered in mind or body had to be supported, imposing additional claims on society. The strain on healthcare is greatly increased, even once a war is over, with the injured needing care for years (especially post-WWI). The social effect of a huge decrease in the young adult male population in the case of World War I should also not be forgotten, leading, as it did, to a shortage of men. Then, there is the physical impact of war. In the Second World War, for example, mass bombing of cities became widespread and destroyed

large areas of housing and railways in Germany; many people were homeless during and after the war. These effects, of course, are most hideous in cases of total war but as we have seen in Syria and Libya they also affect today’s bloody civil wars. So far, the balance sheet of war looks very negative. But if a country can be protected from destruction on the home front, then the immediate effects of mobilising the economy can be quite positive. For example, prior to WWII, the USA had been struggling economically, enduring the decade-long recession known as the Great Depression. However, after the US joined the war in December 1941, huge domestic investments in shipbuilding, tank production and ammunition manufacturing were evident. This created large scale employment for those previously jobless, with a multiplier effect of increased spending from workers. In turn, business revenue increased and so firms could afford to employ more people to match the demand for their products. The US economy boomed and employment opportunities were created for both men and women. World War II led to a significant increase in the number

of women employed in previously heavily male dominated industries in many countries. With most able bodied men away fighting, women workers were brought in to maintain the output of vital production and munitions. This greatly improved the skills of women. The social impact was also large, even if, as was frequently the case, women were forced to return to the home when peace came. There were also huge advances in technology as a result of war, some of which dramatically increased the productivity of manufacturing. In the Second World War alone, innovation led to the invention of the world’s first electronic computer (the Colossus computer which was used by British codebreakers to decipher the vast quantity of encrypted high-level telegraphic messages between the German High Command and their armies throughout occupied Europe). Also, the mass production of Penicillin; the V2 rocket, which provided the basis on which the Apollo moon rockets were later built; and huge advances in aerospace design, which laid the foundations for modern day commercial air travel, were all the result of wartime innovation. Indeed, without the war, such technological breakthroughs may never have been attempted, as wartime necessity was often the mother of invention. The ‘Shadow Factory Scheme’, for example, was a plan developed by the British Government to implement additional manufacturing capacity for the British aircraft industry in the buildup to World War II. Once the war was over, these relatively new factories were converted for automobile production and in the process output and productivity rose dramatically. In the long term, countries, such as Japan, UK, USA and Germany, all profited from the wars they were involved in. After the Second World War, huge parts of Germany were left devastated due to bombings by the Allied forces. The immediate social impact was crushing; however, this allowed Germany a fresh start to completely rebuild its economy from the bottom up, replacing factories, buildings and houses. It took the nation a mere 10 years to completely recover because, despite the physical infrastructure being ravaged, the fundamental capabilities and resilience of the German people remained and allowed the country to benefit from reconstruction. Of course, many of the so-called benefits of war could be cited as examples of the ‘Broken

Window Fallacy.’ Thus, the money spent on the war effort which may seem as though it is benefitting the economy is money that could, in fact, be better spent; for example, on food, clothing, health care or other areas. The stimulus felt in one sector of the economy comes at a direct – but hidden – cost to other sectors. This is known as the opportunity cost: the benefits you could have received by taking an alternative action. So, the economic stimulus to one nation's defence sector is offset not only by the costs of the damage to the country it attacks, but also the immediate opportunity costs at home. To conclude, no one should think that promoting war is the path to successful economic development: the immediate consequences to those involved are too painful to contemplate. But, war often has unintended consequences, accelerating learning, removing barriers to progress and shifting the way people think and act. FURTHER READING: ‘Britain’s War Machine’ by David Edgerton

Below: US Soldiers in a field hospital in New Guinea

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t was a few years after the Credit Crisis when I came to understand its impacts and thus realised why people around me were panicking at that time. It was shocking how just a small change in interest rates had such a huge effect globally. So, I present to you a summary of the events leading up to the Crisis.

Right: The New York Stock Exchange

The Credit Crisis The whys and the hows of the subprime mortgage crisis THE START OF THE CRISIS, BUILDING BEFORE THE COLLAPSE It all started with the bursting of the dot-com bubble. Alan Greenspan, the chairman of the Federal Reserve, lowered interest rates to 1% in order to increase economic activity and prevent the economy from dipping into recession. This lowered the return for investors who purchased Treasury Bills; this then incentivised investors to invest elsewhere. OTHER EFFECTS OF A LOW-INTEREST RATE; LEVERAGE, LEVERAGE AND LEVERAGE The fall in the rate of interest also made it cheaper to borrow, which encouraged banks to vastly increase their use of leverage. Leverage is borrowing money in order to amplify the outcome of a deal. To make this more understandable, imagine you have £100. You buy a brand new pair of Nike trainers for £100, but then decide to sell it to a friend for £110 because you don’t like the colour of it. What you gain from the deal is £10. However, what a banker with £100 does is borrow an additional £99,900 and purchases 1000 pairs of Nike trainers. He then sells all the pairs of trainers for £110,000. He then has to remove the £99,900 plus interest, but is left with a considerably larger profit than if selling one pair of Nike trainers. This is how leverage works. Now swap the Nike trainers to mortgages and increase the amount borrowed to millions, and you’ve got one of the main factors to cause the credit crisis.

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The emergence of CDOs; slices holding promising returns Let’s go back to the investors. The low return had deterred them from investing in Treasury Bills, but their daily expenditures are not going to pay for themselves, so they had to make money. With the use of leverage by banks to purchase huge quantities of mortgages (mortgage-backed securities to be precise), investors saw an opportunity in purchasing CDOs (Collateralised Debt Obligation), which were financial products that pooled together cash– generating assets (mortgages) that could be sold to investors. The CDO was split into three layers: the top layer was safe and had a credit rating of AAA, but had a relatively low rate of return; the middle layer had a BBB rating which was okay and had a medium rate of return; and the lower layer was unrated and extremely risky but with the highest rate of return. Investors could purchase one of these layers based on the risk they were willing to take. However, wouldn’t mortgages in the CDO become worthless if homeowners defaulted on their mortgage? When a mortgage payer defaulted, the mortgage owner (traditionally a bank, but thanks to CDOs it can be many investors) would receive the mortgage payer’s house that could then be put up for sale. Since house prices were rising, the mortgage owner would still receive a considerable amount of profit from the sale of the house.

IT IS ESTIMATED THAT THE TOTAL GLOBAL LOSS OF THE

FINANCIAL CRISIS COULD BE AS LARGE AS $15 TRILLION.

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Banks simply had no spare credit to lend. compete with other sellers; a chain reaction soon followed. As the value of houses fell, people who were still paying for their mortgages decided it was irrational to pay for their mortgages at its original value when the value for houses had fallen so dramatically, so they simply defaulted. As more and more mortgage payers defaulted, the mortgages that once held a promising amount of return quickly became ticking time bombs as the value of housing continued to fall.

NINJA MORTGAGES AND SUBPRIME BORROWERS Investors, bankers and mortgage lenders wanted to make more money, so they decided to lower the standards of lending and lent money to almost anyone who wanted a mortgage. This meant that the borrower could have no income, no job, and no qualifications but still receive a mortgage. They were referred to as sub-prime borrowers. This seemed risky, but since house prices had not shown any signs of falling and mortgage owners could simply claim the house if the borrower defaulted, the benefits seemed to completely outweigh the costs. This led to the emergence of NINJA (No Income, No Job and no Assets) mortgages, which were used in CDOs.

Above: Alan Greenspan, former chairman of the Federal Reserve

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The downturn This was the turning point. Although it had worked out fine to begin with, a downturn soon followed. As more and more subprime borrowers defaulted, and the houses were put up for sale by the investors, the supply of houses in the housing market exceeded the demand for housing. This excess supply resulted in a dramatic fall in house pricing, as sellers had to lower prices in order to

RESULTS OF THE CREDIT CRISIS By the time people realised that their mortgages had become worthless, it was already too late. Investors, mortgage lenders and bankers had already bought thousands of mortgages through leveraging, which had cost them millions of dollars; it was now impossible to sell these investments, and they were at the brink of bankruptcy. This also affected firms that were not involved in the housing market as well, because the banks, from which these firms borrow credit from, were stuck with worthless mortgages and a heavy load of debt. Banks simply had no spare credit to lend. This lead to the freezing up of the economy, as economic activity slowed to a dribble. As time went on, firms had to cut the quantity of labour because they could not afford it, which lead to an increase in unemployment. The increase in the number of unemployed also led to a decrease in demand for products produced by firms, which resulted in the bankruptcy of many firms as the revenue of firms decreased severely and they were forced to close down. FURTHER READING: Investopedia Website: Credit Crunch www.investopedia.com/ask/answers/credit-crunch.asp

A STAGGERING NUMBER OF 17.3 MILLION PEOPLE WATCHED THE 2014

The 2014 World Cup An application of AS economic concepts to a highly controversial sporting event

fter the World Cup, many Brazilians were not happy with the economic impacts. Can the potential long term effects be a consolation for Brazil’s economy? That is, can it bring long term growth to Brazil? Below, I want to analyse how the World Cup affects Brazil. There are debates about whether the World Cup improved Brazil’s economy; were they able to cope with the high demand on their resources? Other than stadiums, did Brazil manage to provide tourists with quality hotels and better public transport? These problems reflect the current economy of Brazil. Brazil has a GDP growth rate of 1% and an inflation rate of 7%, at the time of writing. We can see that the growth rate is slowing down: A global sample of economists estimate that the World Cup will only add 0.2% to Brazil’s economic

growth this year. As a result, hosting the World Cup in Brazil may not significantly improve the economy. In order to host the World Cup, scarce resources such as land, labour, capital and enterprise were used and utilised; they are known as the factors of production. Building stadiums for football matches is very important, so land is the primary factor of production. However, protests arose because people disagreed with the government spending millions on stadiums instead of on other facilities such as healthcare and school education. Moreover, the government raised transit fares, which led to more protests and stadium construction decreased the land available for building housing. Hence, this led to an opportunity cost. Furthermore, the World Cup may increase the number of people gambling, as it is also a kind of entertainment. This causes a negative externality of consumption, which is defined as a cost imposed on a third party. People who lose bets may cause problems which affect other people; for example, by turning to crime in order to pay debts racked up through gambling. The construction of stadiums contains certain costs, such as large quantities of raw materials, which are imported from countries such as China. This attracts foreign investments because stadiums are used for a long period; this leads to a sustainable and high rate of return. This, in turn, benefits investors and also boosts both long run and short run growth in Brazil as the increase

Right: Manaus, the 2014 World Cup final’s stadium

BRAZIL WORLD CUP FINALS, EITHER LIVE OR ON BROADCAST.

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Below: Inequality in Brazil

in investment leads to an increase in aggregate demand. However, there may be disadvantages, such as the cost of insurance when workers get injured. Reports confirmed that eight workers died during World Cup stadium construction in Brazil. This may affect the public image of Brazil, where people may worry about watching the match inside one of these stadiums because of concerns over the structural integrity of the site. This could lead to a fall in tourism and, hence, spending in the economy. The 2014 World Cup’s cost of $13 billion was mostly spent on stadium construction but is using in excess of $10 billion on stadiums really worth it? By applying our knowledge of opportunity cost - the sacrifice incurred in terms of the next best alternative - we can make a decision more easily. For example, the government could spend part of the $13 billion on building better infrastructure or hotels. Better roads would improve productivity, when Brazil is crowded with tourists. Building better hotels allows people to spend more in the economy, thus boosting aggregate demand. This creates a multiplier effect, the change in one of

the components of aggregate demand leading to a more than proportional change in real national income. This is because better roads and new hotels may benefit the Olympics which will be hosted by Rio de Janeiro in 2016. By that time, the real national income will have increased as hotels will be there. Also, large companies such as Coca Cola who invested in the World Cup were an increase in investment, raising aggregate demand. The four main macroeconomic objectives are: sustainable economic growth, minimising unemployment, controlling inflation and balance of payments equilibrium. Brazil’s recent unemployment rate is 4.9%, which has decreased. Unemployment is defined as the number of people who are willing and able to work but are unable to find a job. The reason why unemployment fell is because of the large scale constructions for the World Cup, which employed mostly low skilled labour. Reports showed that 3.6 million jobs were generated due to the World Cup. However, some of these jobs would have only been temporary and thus unemployment may rise again soon. As a result, this doesn’t solve the long term problem. Lastly, the increase in investment from abroad and an increase in spending during the World Cup boosted aggregate demand, leading to an increase in GDP growth. On the other hand, we have to consider that it may have a risk in increasing inflation: the general and sustained increase in the price level. Government spending of $3.6 billion was poured into stadiums. However, people don’t expect the tax paid to be used mainly on stadiums. If the government used its budget on education and railways, it would increase the quality of the factors of production and improve productivity. Education is a merit good with an associated positive externality, where it provides a benefit to a third party. Better standards of education can reduce unemployment and also lead to more entrepreneurs who pay tax, leading to a boost in public services. Since Brazil is now in a recession, maybe hosting the tournament might not have been the best option for recovery as people value healthcare and infrastructure more than entertainment. FURTHER READING: ‘The Economics of Football’ by John Goddard

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An Interview with an Economist

itting across from me in a café sipping on ice cold lemon tea in the buzzing central business district of Hong Kong is Adrienne Lui – an economist at Citibank. Adrienne is a Vice President at Citibank in Hong Kong and is the economic and market analyst for Hong Kong, Taiwan and Mongolia. Adrienne did her undergraduate degree in Economics in Canada and her master’s degree in Economics at Warwick University. Adrienne was very kind to give up her valuable time to share her thoughts around the

skills she needs to do her job, the markets she analyses, some thoughts about the financial crisis and advice to potential and budding economists. So, could you please tell us briefly about your job? AL: I cover 3 countries – Hong Kong, Taiwan, and Mongolia. I provide macroeconomic updates for the three countries to my clients, management and various departments in the bank. Essentially, what I do is collect information through various sources and provide research reports to affect decision making for

Above: Adrienne Lui speaking at the 2014 global export forecast exhibition

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the various parties that I mentioned earlier. Things such as growth drivers or emerging risks of the economies enable informed decision making. Hence, my job also involves a certain amount of travel. What kind of skills are expected of an economist in a bank? AL: My job requires me to be able to source data from multiple channels, either primary or secondary, synthesise the information, form views and present them in a logical and comprehensible manner â&#x20AC;&#x201C; either in research reports or in verbal presentations. To achieve this, the primary sources of information would be through meetings with government officials, regulatory authorities or monetary authorities. Hence, one must also be a good communicator. What would be a typical day in the life of Adrienne? AL: No morning would be complete without reading newspapers and searching the Internet for any hot topics such as any major announcements from the governments. We also hold meetings to discuss data which could also involve presenting our findings to seniors. Sometimes, there are meetings with the financial regulators as they want to see that we are complying with the stringent rules imposed on us. The media could get involved as well if there is anything of interest to them. How has the financial crisis of 2008 affected the Bank and your department? AL: The banks were significantly impacted by the financial crisis. Almost all the banks went on a major cost cutting spree and because of the regulatory oversight of banking products, banks had to pare back on their risk taking. Some of the consumer redress initiatives led to significant penalties on many major banks, which definitely affected their profit margins. In addition, regulators stepped up their control over banks, which created more of a regulatory and risk averse environment in banking.

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So, what adaptations have been made following the financial crisis? AL: I think banks have woken up to the fact that they have a role to play in society and that they need to value shareholder as well as consumer interests. Banks have shed significant resources to comply with a toughened regulatory oversight and have now swung the pendulum from extreme pro-growth to extreme anti-risk. I personally think that the balance needs to be drawn somewhere in between. Focusing on yourself, after graduating with an economics degree, how did you plan to apply your knowledge in a bank? AL: So essentially, during the 6 summers while I was doing my undergraduate and masterâ&#x20AC;&#x2122;s degree, I did various summer jobs, including writing up research reports in equity firms, sales for institutional investors, building data files for officials, et cetera. It really came down to a process of elimination, and I realised that you canâ&#x20AC;&#x2122;t really decide whether you will like a job or not until you have really tried it. Of course, with an economics degree you can pursue careers in academia, the World Bank, the IMF, or even in specialist fields such as actuarial science, or government bodies. I was very lucky as I could apply what I learned in my degree on a daily basis. Finally, what advice would you give to students who are considering studying economics in either secondary school or university? AL: At secondary school, you would be required to look at it from a qualitative perspective, whereas at university level, there is significant emphasis on the mathematical logic behind the theory. Generally, you should be able to understand the world you live in, and how the macroeconomic factors such as interest rates and GDP can affect your livelihood. Therefore, regardless of whether you want to pursue economics as a career or take it up as an interest, I would highly recommend it for everyone as it provides the ability to analyse the logic behind social phenomena and come up with a clear chain of reasoning for a proposition.

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THIS IS A FACT

London and the Rest:

Could HS2 make things worse? H

Left: Evidences of opposition to HS2 can be found in many affected towns

igh Speed 2 will “heal the north/south divide”. These were the words of Nick Clegg last year, similar words were heard from both the leader of the Labour Party and the leader of the Conservative Party. They argue that more jobs and higher economic growth to the ‘underdeveloped’ Midlands and North are the main reasons for HS2, but will it really benefit these regions’ economies? There are valid reasons to suggest that it will. As property and land prices in London’s commuter belt keep rising, footloose industries will look further afield to establish offices, distribution depots and R&D centres. However, accessibility to the capital with its world-class facilities and international airports is still a priority. This is why many corporations have invested in facilities along the M4 and M11 corridors, such as Sony in Bridgend and AstraZeneca outside Cambridge. Many claim therefore that by making Birmingham, Leeds and HS2’s other destinations more accessible from London, more firms will be prompted to invest in these areas, leading to a growth in local employment and thus wealth. If managed effectively, this effect could increase via the process of agglomeration and potentially create hubs of certain industries around places such as Birmingham and the East Midlands. It must be noted however, that fewer business trips will involve overnight stays due to the reduced journey times. After the LGV Sud-Est was built in 1981 between Paris and Lyon (the first high-speed

rail route in Europe), the number of passengers staying at least one night at their destination fell from 74% to 46%. Therefore, there is likely to be less spillover from spending on business trips between HS2’s destinations, although this will likely be outweighed by the effect on businesses relocating to cities on the line, due to the much larger multiplier effect of changing employment rates. The main questionable point is which way the businesses will relocate. Many claim that agglomeration could work the other way, to make the situation even worse for communities outside the Southeast. Businesses – particularly the service industries on which Britain is especially reliant – often find it is efficient and advantageous to locate near to other businesses in the same industry, and the British city with the most of these is almost always London. Britain’s economy is highly dependent on its capital city. London, partly because of this, has the highest productivity of all cities in the UK, as well as large consumer and skilled labour recruitment bases. This, in turn, attracts even more businesses. Building HS2 is a form of liberalisation by taking down boundaries between London and the destination cities. As a result, some businesses currently in the Midlands and the North would have fewer reasons not to relocate to London; they would be able to reap the benefits of being based in London while having quick access to the economic and social factors

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It is questionable whether HS2 is the most effective way to increase regional and national development when there is so much money to play with.

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currently keeping them where they are. In France - another large economy heavily reliant on its capital city - unemployment relative to national levels in the formerly industrial Lille conurbation actually increased after HSR (high- speed rail) routes had been established from Paris, London and Brussels, from 12.4% in 1990 to 14.2% in 1999. The same applies to the wider Nord Department and the Nord-Pas-de-Calais region. A similar trend can be seen in more affluent Lyon. Although a number of Paris-based firms opened regional offices in Lyon, the region has experienced a significant rise in relative unemployment. The Rhône Department, of which Lyon is capital, had an unemployment rate 1.4% below the national average in 1982, rising to 0.1% above the average by 1992. This shows how building HSR links often benefit the already dominant city more than the periphery. In the event, the greatest effect will likely be a movement of businesses to Birmingham (followed by Leeds, Manchester and the East Midlands after Phase 2 is built), not from London, but mainly from less accessible areas, such as Newcastle, Coventry and Stoke. This will probably outweigh any movement into or out of London because HS2 will essentially bring cities like Birmingham into the Southeast labour market. The effect can be observed in many countries with centralised high-speed rail systems. The Tokaido Shinkansen connecting Tokyo and Osaka from 1964 aided an employment increase of 35% in the Osaka Kansai conurbation in 1955-70 - as well as an increase in Tokyo. However employment in Nagoya - between the two cities and not on the line at the time, fell 30% in the same period - highly unusual for a major city in postwar Japan. The only country with a large high-speed network for a significant period of time which did not lead to such results is Germany with its InterCity-Express (ICE). Unlike France and Spain with their HSR routes centred on Paris and Madrid respectively, and Japan before it expanded its Shinkansen network out of central Honshu, Germany has had an extremely decentralised HSR network from its beginnings in 1991. Of course, Germany has had the ‘advantage’ of an already decentralised economy - partly because it was two countries before 1990. But, the destinations of the first HSR routes were deliberately smaller, less prominent cities at both ends (Hannover-Würzburg and

THE BRITISH GOVERNMENT IS NOW CONSIDERING HS3, A NEW

Stuttgart-Mannheim were the first routes). Using a similar technique in the UK, such as building Phase 2 of HS2 (Birmingham to Manchester and Leeds) before Phase 1 to London, or even the recently mooted HS3 proposal across the Pennines, would be a smarter method to revitalise the northern economy and potentially create a “Northern Powerhouse” as George Osborne likes to put it. In this way, the region could develop without constantly depending on London. Such a scheme is not far off - Manchester Airport already serves more destinations than any other British airport and linking it to Liverpool, Leeds, York and Hull via HSR could create a hub to rival Heathrow. It is also highly reported that the benefits of HS2 come with higher short-term costs: the natural environment which the line will pass through will be damaged. The government claims that HS2 may benefit the environment due to fewer motorists and air passengers, leading to fewer greenhouse gases being emitted, but this will almost certainly be outweighed by the effect on local habitats. Blight in villages along the line will no doubt also occur - if it hasn’t already. Burton Green in Warwickshire is already suffering from residents moving away as the line is expected to bisect the village, and house prices are falling fast. Then, there is the ever rising cost to the taxpayer: £43 billion according to the last Department for Transport report. It is questionable whether HS2 is the most effective way to increase regional and national development when there is so much money to play with. The scheme will probably be better news for London than the North in the long term. The way it is structured will centralise larger business towards the capital and smaller ones towards the other stops on the line. However, the hardest hit will no doubt be the tertiary cities not even served by the route.

Below: Are the future HS2 trains worth the money? Bottom: A chart demonstrating the shortened journey times that HS2 could offer

FURTHER READING: ‘Urban Transportation Economics’ by Kenneth Small

HIGH-SPEED RAIL LINK BETWEEN MANCHESTER AND LEEDS

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The

Black Swan Effect

An illustration of people’s overconfidence and irrationality

he term “Black Swan” was once applied by the Europeans to refer to objects that do not exist, because they were certain that every swan in the world was white. The perception was eventually demolished when we discovered the first naturally existing black swan in New Zealand. Years later, the American journalist Nassim Nicholas Taleb captured and analysed this little trivia, which constituted the basis of a well-known principle in explaining the origins of catastrophic events and criticising human behavior – The Black Swan Effect.

The fundamental idea of “Black Swan” suggests that our world (or more precisely, the universe) is guided by random and extreme events that we do not even expect to happen. From the SARS virus crisis, the Indian Ocean tsunami in 2004, the Credit Crunch in 2008, to the ongoing civil wars in the Middle East, none of them occurred as people had anticipated. These catastrophic events all brought devastating impacts to society, which were only exacerbated by mankind’s lack of awareness. These events can be described as Black Swan events.

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THIS IS A FACT

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As human beings, we believe that we have the intellectual capacity to behave rationally and correctly. However, this belief is flawed. Nassim characterises the delusions that we create in our minds when faced with Black Swan events into three categories, and together, they are known as the “human tri-fogs of misperception”. For the sake of the first delusion, let’s assume you and your friend Polly have just been in a geography lesson. Polly claims that she can remember the capital cities of all the countries in the world and recounts a decent number of them based solely on the material learned in the lesson. Nevertheless, there are approximately 200 countries in the world, and as spectacular as it would be, the chances of Polly living up to her claim are minimal. From this, we can conclude that our minds are exaggerating the level of our knowledge, meaning that we think we know more than we actually do. This conclusion creates a divergence between two types of information, conscious and unconscious. Our brain can only process conscious information, the type that we truly possess and understand; it merely creates the illusion that we know more than we do. This asymmetry of information causes us to be unable to predict certain events since we do not have the necessary knowledge to do so, hence creating the Black Swan effect. The second delusion deals with how people react after the occurrence of Black Swan events. The Credit Crisis of 2008 was, without doubt, devastating. However, months after the bubble had burst, (please refer to the article, the Credit Crisis) there were interesting commentaries such as the following: “If we had correctly predicted the extent of our assets being overvalued, we would have certainly avoided this crisis.” Governments, financial advisors, and ordinary investors thought the credit crunch was predictable and preventable. This adds to the unpredictability of future Black Swan events because after the occurrence of one Black Swan event, we immediately conclude that armed with the experience of this one, we will definitely be able to predict future ones. This creates a false sense of security, which further clouds our judgement and impedes our ability to comprehend Black Swan events. Moreover, we are always persuaded to suggest explanations that we consider as logical and sensible to us in order

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“No number of sightings of white swans can prove the theory that all swans are white. The sighting of just one black one may disprove it.” — Karl Popper

Above: A black swan, literally

to justify the occurrence of Black Swan events. For instance, Ross, a chef, took part in a cooking contest and mixed up the wrong ingredients. Years later, when he had become a professional cook, he attributed his poor performance by suggesting that he was being innovative and trying to create a new dish. Even though many knew he was lying, he persisted. There is one thing that is worth noting – he behaves differently before and after he became a cook. This exploits another problem in how we view an event– the excessive reliance on hindsight.

We are usually tempted to suggest explanations after an event has happened, which would serve to justify our decisions during the event. This is especially apparent in unexpected events, where our insight is clouded by cornered acuities. In economics, we assume human behaviour is rational. This is because we are confident in the material we have studied. We seldom consider the limitations of our knowledge. When writing his book, Nassim illustrated the case of news reporters: although they may not share the same opinion, they have, more or less, a similar analytical framework. News reporters comment on a subject with a similar methodology. As a result of this, it becomes nearly impossible for readers to retrieve different information when receiving multiple sources of information. This leads to the third delusion of human perception: we are overconfident about our knowledge to the point that we do not question its validity, quality and accuracy. Black Swan events are often labelled as “unknown”, “uncertain” and “impossible”. In fact, it is simply the reflection of the inadequacies and limitations of our knowledge. Just because we cannot explain or comprehend an event, it does not mean that this particular event is never going to occur. Therefore, instead of asking the question “how can we avoid Black Swan events?”, the real question should be “how can we learn from Black Swan events and learn to predict future occurrences by removing the element of surprise?”. Well, unexpected events are intrinsically associated to risk management (risk is a potential loss incurred in an investment) and high returns. Typically, we tend to select the safer choice when making an investment decision in order to reduce potential risks. Nevertheless, there are always risks lurking on the horizon, and rather than spotting the obvious one and stopping, we should focus more on the unseen risks by collating as much information as we can before making an educated decision. Even so, we cannot mitigate the irrational behavior of the market completely and hence why economics is both a science, as well as an art. FURTHER READING: ‘The Black Swan: The Impact of the Highly Improbable’ by Nassim Nicholas Taleb

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THIS IS A FACT

Left: New York Stock Exchange: a place where many try to beat the market

Can you beat the market? Smart investing in a world of irrational markets.

Well, can you?

f I gave you a £1000 to invest, could you turn a profit? It seems to me that the common answer is yes, which to a certain extent I agree with, but how large? How much of a profit can be made? Theoretically, billions, but is that skilful investment or is it just luck? Most importantly, can you outperform the market? Let’s start off by playing a little game. I’m going to let you pick an asset to invest in: asset A or asset B (very inventive I know). Asset A’s price has been rising steadily for the past 9 years, with an average growth of 8.6% each year. Asset B’s price has been dropping steadily for the past three months, in fact a 10% price drop. Which one would you pick to invest in? Most people would answer asset A, seems logical, right? Well, asset A was a flat in New York just before the great depression; that year, house prices would drop as much as 30%. What about asset B? Asset B was the stock price for Verizon from July of last year to September. In the next month alone, Verizon’s stock prices rose by 10%. It may appear that I’ve just tricked you, by giving you misleading and limited data, and therefore leading you to a ‘wrong’ choice. This is one of the many reasons why people consistently fail to choose the right assets to invest in: misinformation, or the incorrect

interpretation of data. Simply put, some people don’t know what to do with the information given to them, and that will in turn lead to random and ‘irrational’ investments. “But, I’m not some people,” you say. “I’ll invest in what everyone else is investing in, with that many people buying it must be profitable... right?” This has happened again and again in the past, people buying assets simply because others are buying it, just blindly following the examples of others. Few stop and think for themselves: wait, is this group right? When a lot of people start buying something, the price of it will rise, greater demand, greater price (economics 101, you’re welcome). Some may see that rising price as a sign of profitability and before you know it, thousands more have invested and the vicious cycle repeats. The problem is, this irrational demand has skewed the price of the asset away from its intrinsic value - its actual worth. At some point, people stop hopping on the bandwagon, and buying stops; some people realise that prices are unlikely to rise anymore and start selling. The problem is that this selling is rapid; many people don’t end up making a profit, and instead lose money. If it helps, think of it as a party. That is, some people start one, word gets out that it might be a good one, people start turning up, and for a while everyone’s happy. Then, people stop coming, and soon the ones that are still sober (thinking clearly)

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realise the party is pretty lame, and start leaving. People follow suit, and the party’s over. What I’ve just explained is an economic phenomenon known as a ‘bubble’. Granted, it doesn’t always happen. The basic mechanism behind it is the following: herd behaviour, many people buy just because others do, not because of careful choices of assets. The reasons stated above are rather simple, they’re just examples of people, bluntly put, being clueless or reckless. There has to be a deeper answer than ‘people are being dumb’. Well, here is where it will get a little more sophisticated; meet our friend Efficient Market Hypothesis (EMH) developed by Eugene Fama. The basic principle is that the price of any stock always trades at its fair value. How is that even possible? EMH states that stock prices reflect all information available, meaning that the price of a stock should never deviate from its intrinsic value, making it impossible for someone to outperform the market by

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selling stocks at a price that is higher than what it should be. Carefully selecting the right stock to buy and sell doesn’t matter, since you cannot sell it for more than it’s worth. The only way you can earn more under EMH is by taking higher risk investments, and nobody wants that. At this point beating the market may seem like quite a grim prospect. From human mistakes to the idea of EMH, the odds seem pretty stacked against you, right? Looking on the bright side, human mistakes can be minimised, through something that you’re already doing: learning. One of the main reasons that herd behaviour happens is that people aren’t really sure what’s happening to an asset at a given moment. By being educated, especially in economics and business studies, (thank me later economics department), you’ll be better able to make sense of news and trends in prices. Meaning you’ll be less inclined to follow others, and instead make your own choice. Sure you can still make the wrong choice, but at

Left: Eugene Fama, developer of the EMH Right: The housing bubble was one of the most devastating ones yet

AS OF JANUARY 2013, THERE ARE 16 PEOPLE LEFT IN THE WORLD WHO WERE BORN IN THE 1800S.

The problem is, this irrational demand has skewed the price of the asset away from its intrinsic value - its actual worth. least now you’re less likely to. The explanation of EMH earlier was a bit of a white lie, it’s not a law for a reason. There are three sub sections to EMH: weak, semistrong, and strong (inventive I know, guess it’s a trait of economists). All three operate on the principle that asset prices reflect publicly known information. Weak is only when asset prices reflect publicly known information, semi-strong adds the idea that asset prices instantly adjust to new information, and finally strong adds that insider information or hidden information is also reflected in asset prices. There is also one basic assumption that EMH makes: that on the whole investors are ‘rational’ (basically meaning that the actions of these agents fit in with economists’ models or reasoning, even if it deviates from reality). What that means here is that on the whole, people react ‘correctly’ to a piece of information. This allows people to deviate from the ‘right’ decision, but that the majority don’t (in other words, allows for random, independent errors). In essence it means that investors’ choices can be described using a normal distribution curve with respect to the right choice being made. Personally I don’t believe in the EMH. In my opinion, it is one example of how economics has started to stray from reality. For example, one of the proven ways to beat the market: informational time lag (informational asymmetries in technical jargon). Some institutions do this by using supercomputers. They write computer algorithms that check the news constantly, predict how the market will respond and buy and sell accordingly. If semi-strong EMH is true then this shouldn’t even be possible! If true, the prices should have instantly adjusted, and no one should be able to take advantage of this time lag. To conclude, there is no foolproof way to beat the market. If there was, we’d all be rich enough to swim in pools of fifties. You can use

supercomputers to take advantage of time lag, make wise and informed investments; none of them are guarantees. What is guaranteed however, is chance. Even if you randomly select a stock, there’s a chance it’ll outperform the market. In fact, according to a study which simulated monkeys throwing darts at a board to choose a random stock, those monkeys outperformed the market by a margin of 1.7%, when compared to the market average. If a monkey can do it, why can’t you?

Below: Man vs. Monkey - are we better than our evolutionary predecessors?

FURTHER READING: ‘Keynes: Return of the Master’ by Robert Skidelsky

WITH DIVIDENDS REINVESTED, U.S. STOCKS HAVE INCREASED 28,000-FOLD DURING THEIR LIFETIMES.

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The Living Wage A debate of profit and efficiency against social welfare and morality.

ccording to Ed Miliband, there is a ‘cost of living crisis’ within the United Kingdom which threatens to further exacerbate the income gap between the wealthy and the poor. Several policies have been suggested by Miliband in order to tackle this crisis, but my interest lies with the ‘living wage’, a bolstered and expanded version of the minimum wage that we have in place today. And thus, I will discuss several of the pros and cons of the ‘living wage’ and leave it up to you to decide what you think. Firstly, the most compelling argument in favour of the implementation of the ‘living wage’ is that it will be beneficial for society by protecting the lowest socio-economic sections of society from poverty; by enforcing the ‘living wage’ through legislation, the government will be able

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to make it mandatory that employers pay at least £7.65, the figure set out by Miliband. By setting the minimum wage higher, this should reduce the burden upon persons who are currently either struggling or entirely unable to pay for their cost of living through their income on the current minimum wage: £6.31 (at the time of writing). This cost of living crisis is due partly to the fact that the growth in nominal wages had not risen above the rise in the rate of inflation since March 2010, until April of this year, where the growth in nominal wages was 1.7%; inflation was 1.6%. However, the utility of these figures may be slightly limited, as the growth in nominal wages was only 1.7% when the numbers for bonuses were included; without bonuses, the figure was 1.4%, which would suggest that the cost of living is still a major

Above: Many workers have been campaigning for the living wage.

CURRENT MINIMUM WAGE: £6.31

problem within society. Also, supporters of the ‘living wage’ argue that the government needs to increase the minimum wage because they have a responsibility to their citizens to ensure that their standards of living are of a satisfactory level; the government have a moral responsibility to help those struggling simply because their authority as a government rests almost entirely on the consent of the people. Furthermore, advocates of the living wage also suggest that it will have some considerable economic benefits and advantages, mainly concerning productivity. Some economists would argue that by increasing consumers’ disposable income, this will not only increase their happiness, because they are less concerned about potential financial difficulties and are able to spend more on goods and services that they enjoy, it also increases their ability to purchase products that may be beneficial to them from an economic perspective. For example, by increasing their wage, they are able to pay for better medical services, meaning that they are likely to be healthier, and able to increase their productivity, as they suffer from illness less frequently. Alternatively, by simply having more money to spend, consumer expenditure in the economy will most probably increase, boosting short-term growth. However, as is often the case with economics, there is no steadfast rule that this increase in income will actually lead to an increase in consumer expenditure. Whilst interest rates remain at 0.5%, there is no real incentive to save, but this is not likely to last, with reports suggesting that the Bank of England is likely to increase interest rates in the near future. Also, there is a possibility that some people will spend their money on goods that may not be beneficial to increasing productivity, such as goods that are damaging to health or ones that prevent them from working as often or as well, like narcotics. Finally, the notion that by increasing wage spending, and thus productivity, may also be limited because theoretically, it will reduce firms’ profits, due to the higher costs from paying larger salaries, which causes a reduction in the available funds that a firm has to reinvest in capital. This is important because whilst interest rates are low, which would normally incentivise borrowing, the lack of lending confidence of the banks means that firms are relying more on self-made profits to invest, which would be seriously reduced by the

PROPOSED LIVING WAGE: £9.15 (LONDON) £7.85 (UK)

higher costs caused by the implementation of the ‘living wage’. On the other hand, there is the argument that the government should not intervene within the labour market with legislation for a ‘living wage’. This free-market argument is based around the idea that the market is better suited to provide value to a worker rather than an arbitrary and subjective value imposed by the government. The implementation of such legislation would only serve to distort market signals. Not only does the imposition of a value on a worker create the possibility that firms hire below-standard workers

Below: Ed Miliband, advocate of the living wage and enemy of the cost of living crisis

“Supporters of the ‘living wage’ argue that the government needs to increase the minimum wage because they have a responsibility to their citizens to ensure that their standards of living are of a satisfactory level.”

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for higher prices than they would have in the free market, it may also go some way to increasing unemployment. Classical unemployment is generally a result of the market price for labour being forced above the free market equilibrium by legislation, which causes firms not to hire workers because of the excessive costs from the enforced wage prices. This means that workers who could be employed if the government had not intervened, are not due to the interference of the government. However, this argument could be called into account because the rise from the current minimum wage to the ‘living wage’ may not create a great margin and that it is unlikely to overly affect the job prospects of potential workers through higher costs for firms. Finally, the implementation of the ‘living wage’ could also add to inflationary pressures by increasing the costs of production of firms, who have to pay higher wages. This will then translate into higher prices for the consumer, and if the majority of firms within the economy decide to put up prices to counterbalance the effects of the rising costs, then the general price level of the economy will increase, which will cause a rise in the rate of inflation. This cost-push inflationary pressure was seen in 2011: a time in which inflation should have fallen, due to the weak economic

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growth (0.7% in 2011) which caused firms to lower prices in order to attract demand. However, due to rising costs, such as the 19% increase in fuel prices in 2010, firms still increased their prices in order to defer these rising prices onto the consumer, so that they could try and maintain their profit margin; this was a main reason behind why inflation was 5.2% in 2011. The fear of rising inflation, despite being only 1.8% in May 2014, is always a major factor to consider with economic policies, due to its affect on purchasing power. A ‘living wage’ designed to increase consumers purchasing power is all very well and good, but not when its affect are being negated by soaring inflation. In summation, I believe that whether or not the ‘living wage’ is a worthy policy to tackle the cost of living crisis is up to you. Whilst it could be argued that not implementing the living wage would be more beneficial to the UK economy, the social factors must also be considered because, to some, it would be highly immoral to allow the most vulnerable sectors of society to waste away because it’s not ‘economically viable’. This is truly, a debate of efficiency against morality. FURTHER READING: Living Wage Website: www.livingwage.org.uk

Left: Oil prices increased by 19% in 2010 Right: Is Mark Carney, Governor of the Bank of England, likely to raise interest rates?

he idea of animal spirits which was brought forth by Keynes has always interested me. I’ve always felt that not all economic decisions are made based on pure economic rationale and that psychology and behavioural patterns surely play a part. To better understand the concept of animal spirits, I recently read Animal Spirits: Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George Akerlof and Robert Shiller, a fascinating read. There are of course points that I would like to discuss. The main issue addressed is the state of mainstream economics. The authors feel that modern economics has not allowed for the incorporation of animal spirits, which the authors stated to be made up of confidence, money illusion, corruption and bad faith, stories and fairness. One good example of this is their critique of natural rate theory. The theory was developed by Milton Friedman and Edmund Phelps. They believed that the original Phillips curve was incorrect, due to the fact that it allowed for money illusion. Both Friedman and Phelps believed in rational expectations and believed that wage contracts would change to reflect inflation expectations. This would mean that real wages would hold constant, meaning that unemployment should only deviate slightly from a ‘natural rate’ the NAIRU (non-accelerating inflation rate of unemployment). The policy implication of this is very important, any attempt by the government to intervene by demand side policies would only lead to accelerating inflation under this theory, while not actually impacting unemployment. The authors critique this idea with the use of money illusion, showing that wage rates do not respond to inflation rationally. For example only 19% of wage contracts of Canadian workers from 1976- 2000 had COLAs (cost of living adjustments), which would adjust wages according to current inflation. However, even then, COLAs only adjust after a threshold has been reached, in fact, only a third of these contracts experienced levels of inflation that reached their thresholds. This to me, is a good example of money illusion, there are of course others stated in the book, but needless to say at the moment I am very much in favour of the view that animal spirits should be incorporated into mainstream economics. One interesting point was a discussion of a confidence multiplier by the authors. They argued that alongside the usual fiscal and investment

Animal Spirits A discussion of Shiller and Akerlof’s work on behavioural economics. multiplier, there should also be one that relates to confidence. This is not to say that it should be quantified, but the idea that there could be one was important to note. In my opinion what is most important about this concept is that the fiscal and investment multiplier could change drastically according to the confidence multiplier, perhaps it is more accurate to say that the confidence multiplier would have an add-on effect on the others. This has intriguing policy implications, as mentioned before, stimulus would be more effective if first

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the issue of confidence is addressed. Therefore perhaps the most important role of stimulus at any time is to restore confidence, the value of the stimulus should be a secondary concern. Collapse of confidence is argued to be the cause of recessions by the authors. Interestingly the upswing of the economy seems to lay the seeds for this to happen. The authors argue that during the upswing overconfidence leads to investments being made that ultimately will lead to economic losses, similar to the idea of malinvestment, except overconfidence instead of excessive increases in money supply being the cause. The authors also argue that due to the abundance of investments being made there is greater incentive for corruption, which combined with the eventual economic losses will result in a collapse of confidence. To me there is irony in this situation, under this view recessions are when the confidence multiplier is the lowest, hence when fiscal stimulus is the least effective, yet most needed. Fairness is the last element that I would like to discuss. The authors’ idea of fairness has given me a new perspective on the process of setting wages. Previously I had been of the view that employers will always look for a way to employ at the lowest wage possible as to decrease the costs of the firm. However, I neglected to consider the effect that wage has on the productivity of labour. This of course would lead employers to employ at a higher wage than the market clearing wage. This, known as efficiency wage theory, is suggested to be a reason why involuntary unemployment exists. Indeed, it is not that the unemployed are not prepared to accept a lower wage, but employers are not prepared to give a lower one. The authors further develop this idea, purporting that employers not only have to give a wage that will ensure labour productivity, but a ‘fair’ one. There are therefore many factors to consider in wage setting; whether the employee will feel motivated or not, whether other employees at the firm feel that the wage is ‘fair’ and whether the employee will feel loyalty towards his/her tasks. I agree with this proposal. It seems to me that there are real problems when it comes to setting wages, and it is not a matter of freely setting a wage. There are restrictions that employers must abide by in order to ensure the smooth running of a company. The ‘fair’ wage, the authors argue is also one of the main reasons why there is involuntary unemployment. The fair wage

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will simply be higher than the market clearing one, allowing there to be a demand gap in the labour market, thus inducing unemployment. Unfortunately, there aren’t many ideas that I disagree with in this book. It’s always hard to critique something that you agree with. On the other hand, the book proposes a very strong case of how animal spirits should be incorporated into mainstream economics, which I am very supportive of. Looking to the future, I have begun reading Joseph Stiglitz’s Globalisation and its Discontents; look forward to a discussion of that next. FURTHER READING: ‘Animal Spirits: Human Psychology Drives the Economy’ by George Akerlof and Robert Shiller