Rationale Magazine 2014 (LSE Economics)

RATIONALE LSESU ECONOMICS SOCIETY

MICHAELMAS 2014 EDITION

in a world without reason, turn to economics

BEHAVIOURAL ECONOMICS WHAT HAVE WE LEARNED?

WITH A SPECIAL FEATURE ON CLIMATE CHANGE

CarRoll 1865

Kahneman +Tversky 1979

Cover Art: Melanie Friedrichs

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Content >>> PAGE 11

03 Letter from the Editor 04 The Team 06 The State of Behavioural Economics

The Pitfalls of Measuring Subjective Well-Being Professor Paul Dolan on Behavioural Science The Happiness Manifesto Risk, Uncertainty, & Behaviour in Economic Thought Off the Beaten Path

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14 Applications of Behavioural Economics

The Interstice of Behavioural Economics & Public Policy The Role of ‘Irrelevant’ Alternatives Even Professionals Bury their Heads in the Sand How loss aversion affects investment choice What Drives House Prices in China?

Bulls, Bears and Lemmings: Herding in Financial Markets Should the Eurozone be Aiming for Japan’s ‘Lost Decade’?

Why Your New Year’s Resolutions Won’t Last

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27 Global Issues

European Carbon Trading: Better than Nothing Building Dams in Africa Impact of the Trans-Pacific Partnership Youth Unemployment in Southern Europe The Illusion of Independence The Pope and Piketty Editor’s Review: “Zero to One” The Long-Run Consequences of Environmental Catastrophe

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40 Economics Society Research Project How to Successfully Secure a Job or Internship

PAGE 2

Letter

from the

Editor

Dear Reader, Since I joined the LSE and this magazine in Michaelmas Term last year, I have felt lucky to have experienced one of the most intellectually fertile periods of my life. By the time I graduate in 2015, I suspect it will seem like no time has passed due to the whirlwind of ideas and events around me. So I hope it will be for you, dear Reader, and it is in this spirit that I proudly present the Michaelmas 2014 edition of Rationale.

The theme for this issue is behavioural economics, which is rarely taught at an undergraduate level, but nevertheless has many interesting insights into how real humans differ from their perfectly informed and rational neoclassical counterparts. As our cover suggests, we may feel like Alice, lost in a Wonderland of neoclassical assumptions and results that feel at best, counterintuitive, and at worst, deliberately misleading. Behavioural economics may provide directions that can help get us out of these obfuscated woods.

Our writers have a lot to say about behavioural economics. Ole Agersnap, Yedda Yuan, and Benjamin Aw explore facets of decision making under uncertainty, bringing some classic results up to date. I myself look at herding in financial markets, while Chen Qiu applies ideas from behavioural economics to the Chinese housing market. Christine Farquharson and Simon Loschnauer bring the discussion closer to home by looking at bounded rationality in student choices, and the irresistible appeal of instant gratification. Those interested in public policy implications should check out Sugandha Srivastav’s article, while Melanie Friedrichs traces the role of uncertainty in the history of economic thought. Finally Viktor Rehart and Matthieu Glotz tinker with the philosophical notions of utility, welfare and happiness. Of course, no issue of Rationale would be complete without commentary on global affairs; in our last section, Navreen Sandhu and Mari Magnussen-Landsem examine dimensions of monetary policy, and Tim Dobermann and Maarten Hage discuss one of the defining issues of our time: climate change. Regional policy issues are also represented: Alberto Martelli covers youth unemployment in southern Europe, Mai Mahmoud writes on the impact of the Grand Ethiopian Renaissance Dam, and Avision Ho discusses the Trans-Pacific Partnership.

For the first time, we will be presenting a study by the Economics Society’s research division, on a topic that might be particularly relevant for many students: strategies for finding a job.

We also invite you to provide direct feedback in the form of “Letters to the Editor.” We will publish letters of less than 200 words sent to rationalemagazine2014@gmail.com in the Lent term issue.

It is time for me to leave you in peace with the magazine, but before I do, I would like to gratefully acknowledge everyone who helped make this possible - the Economics Society for sponsoring us, the editorial team for reviewing all the content, the design team for the immense amount of production work, the writers for all of our fantastic content, and finally you the Reader, for being our market’s demand.

Economically yours, Honglin Jiang Editor-in-Chief, Michaelmas Term 2014 PAGE 3

The Team Honglin Jiang | Editor-in-chief

Honglin Jiang is studying for an MSc in Economics at the LSE. He previously worked as a derivatives trader in Sydney, Australia, where he also gained a BSc/BA in Statistics and History from the University of New South Wales. He is interested in financial markets, monetary economics, and asset pricing. | Contact: h.jiang9@lse.ac.uk

Melanie Friedrichs | Editor

Melanie Friedrichs is an MSc Economics student at LSE. She was a member of the first class of Venture for America, a two-year fellowship that seeks to revitalise cities through entrepreneurship by matching graduates with startups, and holds a BA in Economics from Brown University. | Contact: M.Friedrichs@lse.ac.uk

Tim Dobermann | Editor

Tim Dobermann is studying an MSc in Economics at LSE. He is most interested in analysing the interactions between environmental and development economics, notably the role climate change will play in our future economy. His focus is applying economics to the design of policies structured around achieving a more equitable and sustainable society. | Contact: tdobermann@gmail.com

Viktor Rehart | Editor

Viktor Rehart is a MSc Econometrics and Mathematical Economics student. He holds a BA in PPE from the University of York. He is particularly interested in game-theory and time-series econometrics. | Contact: v.rehart@lse.ac.uk

Sugandha Srivastav | Editor

Sugandha Srivastav is an MSc Economics student at the LSE. She previously worked at the Indian Council for Research on International Economic Relations and holds a BSc. (Hons) in Economics, Politics and International Studies from the University of Warwick.. | Contact: S.Srivastav@lse.ac.uk

Fiona Tan | Designer

Fiona Tan is a first-year BSc Economics student in LSE. She is interested in the fields of macroeconomics, but has yet to find a specific field of specialisation. In her free time, she enjoys taking photos, sketching or scrapbooking. | Contact: f.tan2@lse.ac.uk

Eunice Tse| Designer

Eunice is a second-year BSc Philosophy, Logic and Scientific Method student. Her main interests are existentialism, languages, education, figure skating and food. | Contact: y.tse3@lse.ac.uk

Krzystof Zaremba | Writer

Krzysztof Zaremba is head of the reporting team in the Research Division of the LSESU Economics Society. After studying at Sciences Po Paris, he spent a year at the LSE as a General Course Student. Currently, he is reading economic and social sciences at the Bocconi University in Milan. | | Contact: krzysztof.zaremba@onet.pl

Navreen Sandhu | Writer

Navreen Sandhu is a 2nd year BSc Economics student She is particularly interested in research in monetary policy and its implications. | Contact: n.k.sandhu@lse.ac.uk

Benjamin Aw | Writer

Benjamin Aw, a second-year undergraduate in Economics, tries to live a life of rationality.

He lives in eternal servitude of his remembering self, which explains why a camera follows him almost all the time. When he’s not planning his next travel destination, he can be found musing over cadences of languages.

PAGE 4

Mai Mahmoud | Writer

Mai Mahmoud is an MSc Economics student at the LSE. She studied for a BSc Banking and Finance with the University of London International Programmes. She is interested in Development Economics, Political Economy and Middle Eastern Studies. | Contact: m.mahmoud2@lse.ac.uk

Mari Landsem | Writer

Mari Landsem is an MPA candidate in Public and Economic Policy. She also holds a BSc in International Business and Politics from Copenhagen Business School and is interested in global capital markets and monetary policy. | Contact: m.magnussen-landsem@lse.ac.uk

Matthieu Glotz | Writer

Matthieu Glotz is one of the (too many) French students at LSE, currently in MSc Economics. He likes discussing public policies and criticising mainstream economics. He dislikes cold and rain. He is the current president of the MRLSEPDW, or Movement to Relocate LSE in a Place with Decent Weather.

Simon Loschnauer | Writer

Simon Loschnauer is studying BSc Mathematics and Economics. He is interested in how mathematical models can be applied to explain economic behaviour. | Contact: s.loschnauer@lse.ac.uk

Chen Qiu | Writer

Chen Qiu is studying MSc in Econometrics and Mathematical Economics. He is interested in asset pricing, financial econometrics and real estate. | Contact: c.qiu@lse.ac.uk

Christine Farquharson | Writer

Christine is an MSc candidate in Economics. Her interests include public economics, applied microeconomics, and public policy. She has previously worked in the Cabinet Office of the Government of Ontario, Canada.

Ole Agersnap | Writer

Ole Agersnap is a student in the two-year MSc programme in Econometrics and Mathematical Economics. He has previously completed a BSc in Mathematical Economics at Aarhus University and also worked as a Teaching Assistant. | Contact: o.agersnap@lse.ac.uk

Avision Ho| Writer

When not beavering away for his BSc Mathematics and Economics, second year student Avision Ho, can be seen sipping tea or advancing the agenda of video games as a serious art medium. His interest lies in the continuing relevance of regulation and the new approaches it can take to be effective.

Alberto Martelli | Writer

Alberto Martelli is a second year BSc Economics student. He is interested in monetary economics and in the applications of economic theory to finance. He is also interested in labour economics and in the interconnection of economics and politics. | Contact: a.martelli1@lse.ac.uk

Maarten Hage | Writer

Maarten Hage is a MSc candidate in Economics. He formerly studied Applied Physics in Delft, The Netherlands. He is especially interested in environmental and energy economics.| Contact: m.hage1@lse.ac.uk.

Yedda Yuan | Writer

Yedda Yuan is an MSc candidate in Finance and Economics from China. She is interested in financial economics, especially behavioural implications on asset pricing. | Contact: y.y.yuan1@lse.ac.uk

PAGE 5

State

of

Behavioural Economics

THE PITFALLS OF MEASURING SUBJECTIVE WELL-BEING

By Viktor Rehart

PAGE 6

Subjective well-being as a concept has a strong theoretical appeal. Measures of subjective well-being aim to go beyond objective statistics such as GDP per capita to gain an understanding of how happy or satisfied people are. Economists such as Paul Dolan of the LSE argue for the introduction of a ‘happiness index’, in addition to national income measures, to assess well-being on a sovereign scale.

While progress has been made towards measuring subjective well-being, there is still much ground to be covered.

The most obvious approach towards measuring subjective well-being is that of Contingent Valuation. This approach holds that if policy makers are interested in psychological states of those affected by their policy, they should just ask them.

Contingent Valuations involve surveying individuals on the relevant metric, such as how their happiness has changed since

the implementation of a certain policy.

Sadly, the results of Contingent Valuation are often neither very robust nor reliable. In the field of environmental policy, studies have shown that individuals value saving 1000 birds similarly to saving 100,000 birds which is a a highly counter-intuitive result. Furthermore, there seems to be a general tendency towards loss aversion in the human psyche.

That is, the pain of losing something is much larger than the pleasure of gaining the same thing. Therefore, survey responses are highly sensitive to the way the questions are phrased.

Perhaps people’s actions say more than their words? Building on this logic, the Hedonic Pricing Method (HPM) attempts to measure subjective well-being by directly observing the market. For example, the safety premium paid to workers in more risky jobs is interpreted as the

value workers attach to the increased risk they face. Since individuals naturally incorporate their mental states into their decision-making, the HPM seems to be a good measure of subjective well-being. However, one could argue that the HPM requires strong assumptions regarding utility-maximising behaviour and perfect competition.

The attempt to infer psychological states from actions can be problematic.

Consider the example of a positional good, which is a good that is valued more highly if not possessed by others.

For example, countries compete to have the tallest building in the world.

While the tallest building may not provide more value at the margin than an ordinary building, it is still coveted because of its ‘positional good’ status.

‘Happiness’ is derived from this good because one is the sole possessor of it.

To analyze the distortions caused by the good, consider an economy with the following characteristics: 1) The economy consists of two rational individuals, with symmetrical preferences 2) The individuals can both choose between a safe job, paying $x and an unsafe job paying $(x+50) 3) The individuals have perfect job mobility and full information about each other’s preferences and the payoffs resulting from each job 4) They value safety, that is, working in the safe job, at $100 5) Income is a positional good. They

value it another $100 higher, if theirs is higher than that of the other individual 6) They also value their income another $100 lower, if the other individual earns more Using game theory it can be shown that both individuals will choose the unsafe job, which pays $50 more than the safe job.

The public policy maker now tries to determine how much the individuals value job safety.

He observes that the unsafe job pays $50 more than the safe job and that both individuals choose it.

He would now conclude that they both value the additional safety at less than or equal to $50, since they receive compensation of $50 for the unsafe job. But as we have seen above, this is wrong. Even in this highly stylised example, HPM infers the wrong result.

This example demonstrates a large class of problems arise once interdependence between individuals is introduced.

A natural step forward would be to combine the two approaches. Combining Contingent Valuation and HPM should yield more desirable results.

For example, knowledge of the posi-

tional good in above example, obtained through Contingent Valuation, would lead to the correct result.

To remedy the above problems, a number of procedures have been designed. One example is the Ecological Momentary Assessment. The Ecological Momentary Assessment is, in a nutshell, a sophisticated Contingent Valuation technique. Originally published by Stone in 1999, the Ecological Momentary Assessment involves repeated sampling of accounts of welfare at randomised points in time in non-laboratory settings. Individuals record their well-being for the current period of time. This makes the results much more robust, as individuals do not have to “recall” their emotions, preventing distortions of the results by recall-bias. The large sample size furthermore smoothes the results, making it easier to filter out biases caused by the phrasing of questions.

While the Ecological Momentary Assessment seems promising as a method of measuring subjective well-being, collecting large samples of randomised data is time-consuming and costly.

However, if policy makers are serious about understanding the subjective well-being of citizens, this is an investment they should be willing to make.

■

[ ] “... a large class of problems arise once interdependence between individuals is introduced.”

An attempt at measuring subjective well-being: A geographical visualisation of the Satisfaction with Life Index

PAGE 7

PROFESSOR PAUL DOLAN ON THE STATE O ECONOMICS, AND HIS NEW BOOK, HAPPINE Paul Dolan is a Professor of Behavioural Science in the Department of Social Policy at LSE and the author of “Happiness By Design,” published in August, 2014. He started his career as a health economist and shifted focus towards behavioural science, working with Daniel Kahneman as a visiting scholar at Princeton from 2004-2005.

He has also applied behavioural science to public policy as a founder of the Centre for Well-being in Public Policy at Sheffield and a member of the Cabinet Office Behavioural Insights Team, better known as the “Nudge” unit. Rationale sat with him to ask some questions about his book, and about his experiences working as an academic, advising policymakers, and writing about behavioural science and happiness for a general audience.

How can purpose be measured from a public policy perspective? What are some of the problems involved with it?

At the moment there is no better way than to ask you. A whole range of contextual factors influence survey responses, such as the question ordering, the wording of the question or the scales that are given to people. Nevertheless, the reports individuals give of their pleasure and purpose at the moment seem to be meaningful. The same does not hold true for questions about life-satisfaction, which are much more challenging to answer and much more susceptible to contextual factors.

How are experience and story related?

In my book, I draw a sharp distinction between experience and story. In reality the difference is more complicated: The stories inform the experiences, which then drive the stories. For example, when I wrote my book it felt purposeful at the time, but my memory of how purposeful it was will be driven by a difference experience—how well it

[ ]

How is the concept of purpose and pleasure introduced in “Happiness by Design” novel? How do these concepts relate to the notion of a utility in economics?’

Purpose has been talked about for thousands of years, but normally as an achievement-focused “story,” i.e., you have a purpose and you check off if it’s achieved or not. My concept of purpose is more experience-based. Economists usually speak of utility in terms of preference satisfaction, but that wasn’t always the case; it used to be a more hedonic account of pleasure and pain. I think the pleasure and pain conception is closer to my own experiential-based account of utility, but combined with the experience of purpose. By adding purpose you can explain more types of behaviour, for example writing an essay because it feels worthwhile when you are doing it, not just on the completion of it.

PAGE 8

“I could probably get you to behave in any way, if I put you in the right environment.”

What role do stories play in how we evaluate our subjective well-being?

In my book, I use an example about my friend who complains about all aspects of her job, her boss, her commute, her colleagues, and then still draws the conclusion that she loves her job. That’s true of a lot of what we do in life, we tell stories about the things that we think should make us happy. Stories get in the way of us paying attention to the reality. The story of achievement and success leading us to being happy is a good example. There may be evolutionary reasons grounding it, but whether this helps our overall “happiness“ is questionable.

Graphic from “MINDSPACE: Influencing behavio practical guide for applying behavioural insights t Institute for Government and the Cabinet Office i Paul Dolan, Michael Hallsworth, David Halpern,

OF BEHAVIOURAL SCIENCE, THE STATE OF ESS BY DESIGN By Viktor Rehart & Melanie Friedrichs sells.

What applications of behavioural science most interest you?

I’m much more interested in the mechanisms that underpin behaviour and that can be applied to any issue, in any area. I do tend to care more about questions related to disadvantaged populations. Everything matters

our through public policy,” a to policymaking, published by the in March 2010 and authored by Dominic King,, Ivo Vlaev.

when you haven’t got very much of it.

There aren’t really any differences between rich and poor people, only rich and poor environments. If you make me teach 50 lectures this week, I’m willing to give up 5 of them to teach 20 next term. I could probably get you to behave in any way if I put you in the right environment. For me, this is the most important message of much of the science.

What balance should economists strike between writing for a general audience, writing for policy makers and writing for other academics?

I’ve done the writing the papers that 5 people read. I’ve done policy advice and perhaps I’ve had some impact. Establishing your academic credibility is hugely important because it gives you the foundation to do the popular publications. Now I’m ready to take some of those messages out to the world; that was part of the motivation for the book.

should be taught more about. The first is behaviour, and by behaviour I mean the real behaviour of real human beings. The second is the philosophical underpinnings of the science. Economic concepts are sometimes taught as if they’re ethics free, morally neutral, but they’re not. You can’t make any substantive claims about anything without first having some philosophical underpinnings.

The greatest strength of economics is its ability to prescribe, which is something psychology doesn’t do; it’s all about description and understanding.

But that is also its biggest weakness, because economics makes mistakes when it prescribes. If we could better understand the philosophical underpinnings and the actions of real people in the real world, then economics could make its advantage less of a disadvantage.

Can we teach ourselves to be happy, or will there be some parts of happiness that are always beyond our control?

I’m optimistic about our ability to change our environment and design our lives in ways that help us be happy.

I’m not confident in our ability to override our heuristics and biases. We are hugely arrogant— as economists often are, frankly—if you think that you can de-bias yourself from millions of years of evolution, in a threeyear degree or a PhD. I’d much rather live with the fact that I’m a reptile. We make 2,00010,000 decisions every day, most of which are unconscious and automatic, and most of which are pretty good. You can design your environment and make behaviours more or less likely, but once you’re in the environment you have to be humble to the fact that you’re going to act like every other reptile.

■

[ ] Should behavioural economics be taught to undergraduates? How would this affect the discipline?

There are two things that economists

“You can design your environment to make behaviours more or less likely, but once you’re in the environment you have to be humble to the fact that you’re going to act like every other reptile.”

PAGE 9

THE HAPPINESS MANIFESTO What should happiness analysis be to economics? Everything.

What has happiness analysis been to economics so far? Nothing.

What does happiness economics ask for? To become Something.

Once upon a time, economists cared about subjective well-being. Jeremy Bentham famously made it a criterion for social choice. Cardinal utility, happiness measured in numerical quantities, was a central concept in the theoretical work of Leon Walras and Alfred Marshall. Nineteenth century economists were aware of the difficulty of measuring pain or pleasure; but the existence of the concept of utility allowed economists to state how society should be organised. This debate, known at the social choice question, is marked with the name of great economists such as Bentham, Nozick, Rawls; but it has now been left to other social sciences.

So when did economics stop caring about it?

It began with a revolution. The ordinal revolution. At the turn of the twentieth century, Vilfredo Pareto, Francis Edgeworth, Irving Fischer, and Eugene Slutsky redefined utility as an ordered set of individual preferences. Unlike cardinal preferences, ordinal preferences cannot be compared from one individual to another, and one could even less so aggregate them to compare societies. A century after Pareto, ordinal utility is still one of the central axioms of classical economics.

Why does this matter?

Thanks to the ordinal revolution, economics has become the science of status quo. Because ordinal utility does not allow the comparison of individual well-being, economists cannot state if a change is desirable, unless it makes at least one person better off and leaves everybody else indifferent. This law, known as the unanimity rule, pushed the question of equity out of the realm of economics; as by definition redistribution must make somebody worse off.

The assumptions economists make about utility are not scientifically neutral. Especially given the influence of economic science on policy makers, assumptions may have contributed to the extent of inequality in current society. GDP growth is now the unique criterion of success of government; the question of redistribution is insignificant as long as production is increased.

Is change coming?

Since the crisis, policy makers have started moving. In 2008, former French president Nicolas Sarkozy convened the Commission on the Measurement of Economic Performance and Social Progress. Chaired by Nobel prized economists Joseph Stiglitz and Amartya Sen, the commission has laid the ground for the creation of a Gross National Happiness index. In the United Kingdom, the Office of National Statistics started measuring national happiness under David Cameron, and many more countries are also starting to systematically measure happiness.

Economic literature on happiness has benefited from new sources of data on happiness. Recent developments in psychology and neuroscience are trickling down to economics as well. Neuroeconomists are now using MRI technology to directly measure satisfaction from individuals’ brains, arriving for the first time at something close to an objective measurement of well-being.

Happiness economics is now one of most dynamic fields of research in economics. It certainly does not pretend to give recipe for happiness; however, by identifying some determinants of well-being, it can guide public policy better toward what makes people happier. In the end, the question boils down to our very vision of what social progress is:

Do we want to live wealthier or happier?

Choose your camp.

PAGE 10

By Matthieu Glotz

RISK, UNCERTAINTY, AND BEHAVIOUR IN THE HISTORY OF ECONOMIC THOUGHT

By Melanie Friedrichs In 1841 the Scottish journalist Charles Mackay published Extraordinary Popular Delusions and The Madness of Crowds, a book that chronicled mass “peculiarities,” including alchemy, witch hunts, and a more recent phenomena—economic bubbles. Mackay’s book is still in print today, largely because of insightful commentary on the South Sea Bubble, the Mississippi Bubble, and the Dutch tulip mania, commentary that would not seem out of place in modern articles on behavioural finance.

While Mackay may have read the work of his famous Scottish predecessor, Adam Smith, Extraordinary Popular Delusions was written long before most of the concepts that today comprise “economics” were introduced.

How did Mackay manage to get it so right, while many modern economists still get it so wrong?

Mackay belonged to an era when there was still little separation between the “economic” study of optimal decisions subject to constraints, and the study of the circumstantial and psychological influences on behaviour.

Many early economists, including Smith, whose second most famous book was of course The Theory of Moral Sentiments, were as interested in these other influences as they were in incentives and markets. In this intellectual setting, behavioural factors naturally played a large role in Mackay’s analysis.

One important early contribution to understanding behaviour in the real world came from Frank Knight in 1921,

[

“Irrationality” in economics goes way back. Image: The South Sea Bubble, by Edward Matthew

who famously differentiated between decisions made under “risk,” when the payoffs and probabilities of future events are known, and “uncertainty” when probabilities and even possible outcomes are unknown. Modeling be-

“How did Mackay manage to get it so right, while many modern economists still get it so wrong?” haviour is difficult when agents have full information about the preferences and production capabilities of other agents, is harder when those models

need to incorporate known risks, and becomes nearly impossible in the presence of “Knightian” or “radical” uncertainty.

It can be argued that John Maynard Keynes was a behavioural economist.

Many of the key insights of The General Theory, written in 1936, relied on fundamentally behavioural assumptions. For example, Keynes considered the tendency for the marginal propensity to consume to decrease as income increases to be a “fundamental psychological law” independent of other constraints or considerations, and noted the importance of many subjective factors, including “pride” and “avarice” in the saving-spending decision. Also present in his work was a deep belief in the importance of uncertainty:

]

PAGE 11

“If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence of a railway, a copper mine, a textile factory…a building in the City of London amounts to little and sometimes to nothing.”

As economics became more formal, many of the behavioural assumptions that underpinned the conclusions of the early great economists were excluded in favour of assumptions that could be applied to economic problems more generally, in different places, times, and situations. A culmination of this movement was John von Neumann and Oskar Morgenstern’s axiomatisation of utility theory in 1947, that for the first time precisely defined “rationality.”

Over the thirty years, Keynesian and other earlier insights continued to lose ground to utility-maximising rational agent models.

This era is the source of many modern criticisms of economics, criticisms that point out unrealistic assumptions about the absence of risk and uncertainty, but also about the preferences of individuals and the completeness of markets. In general, economists of the postwar era seemed less interested in describing the real world than in pursuing Leon Walras’s vision of an economy that functioned like a perfectly frictionless machine.

Even at its most “rational,” economics has always incorporated some ideas about behaviour, risk, and uncertainty.

Concave utility functions, a form much beloved in all branches of economics, also define risk aversion. The concept of “expected utility” given known risks was first employed by Daniel Bernoulli in 1738, and was included in the Von Neumann and Morgenstern theorem.

Nevertheless, treatment of risk and uncertainty remained incomplete; in 1953 and 1961 Maurice Allais and Daniel Ellsberg each noted behavioural paradoxes that challenged the foundations expected utility theory. More importantly, economics remained unable, for the most part, to deliver the types of meaningful insights provided by Mackay.

PAGE 12

Then in the 1970s there were two important advances. The first was George Akerlof ’s paper on “The Market for Lemons: Quality Uncertainty and the Market Mechanism,” which showed how asymmetric information can lead to adverse selection, using the used-car market as an example. The second, of course, were two landmark papers published by Daniel Kahneman and Amos Tversky, “Judgement under Uncertainty: Heuristics and Biases” and “Prospect theory: An analysis of decisions under risk.” Instead of asking how the addition of risk and uncertainty affects the behaviour of utility-maximising agents, as Akerlof had done, Kahne-

man and Tversky asked how, given a world full of uncertainty and risk, agents actually act. Both approaches have inspired extensive literatures, usually labeled as information and behavioural economics, respectively.

Still there are shortcomings. Unfortunately most of the insights from information and behavioural economics are still not taught to undergraduates, who usually learn only the foundations of expected utility theory. Modeling biases, heuristics, and asymmetric information is also difficult mathematically, making insights from their study difficult to communicate to policy makers or the general population. And

Charles Mackay Extraordinary Popular Delusions and the Madness of Crowds, 1865

John Maynard Keynes The General Theory of Interest, Employment and Money, 1936

Frank Knight Risk, Uncertainty and Profit, 1921 John von Neumann & Oskar Morgenstern Theory of Games and Economic Behaviour, 1947

George Akerlof “The Market for Lemons: Quality Uncertainty and the Market Mechanism” , 1970

Daniel Kahneman & Amos Tversky “Judgement under Uncertainty: Heuristics and Biases”, 1976

while economics has gotten better at modeling known risks, the idea of Knightian uncertainty hasn’t progressed much beyond Knight.

One possible place for unquantified bias and uncertainty within in formal economics lies within the the concept of time preference, usually incorporated into economic models in the form of some positive discount factor β < 1. Proposed explanations for time preference vary. John Rae, writing in 1836, noted that “when engaged in safe occupations, and living in healthy countries, men are much more apt to be frugal,” linking time preference to the probability of death. Irving Fisher listed “self control,” “risk” and “habit” as determinants. Monetary and financial economists, who through crisis modeling have been forced to confront irrationality more directly than other disciplines, are also making some progress toward understanding behaviour in the presence of risk and uncertainty.

What then can we say about behaviour, risk, and uncertainty from the history of economic thought?

1. First, risk and uncertainty play a huge role in economic behaviour, and, through heuristics and biases, may continue to affect behaviour even when risk and uncertainty are not present.

Economists should make more of an effort to incorporate ideas about risk, uncertainty, and behaviour into introductory courses.

2. Second, we need to be aware what assumptions we are making about risk, uncertainty and behaviour, and how those assumptions affect our conclusions. Small deviations from full information or changes in the form of the utility function can have large effects on outcomes, in some cases completely overturning or reversing conclusions.

3. Third, there is a lot we don’t understand about uncertainty, risk, and behaviour. When making predictions or policy recommendations, it may be more useful to revert to the more qualitative but broader analysis of the early economists, at least until economics catches up with reality.

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Image by Benjamin Aw

OFF THE BEATEN PATH

By Benjamin Aw

The ‘dismal science’ of economics has often attracted criticism for unrealistic assumptions. In this regard, behavioural economics is no different from any other sub-field of economics; it tries to refine the unrealistic assumptions of earlier models with slightly more realististic assumptions of its own. All this is, of course, is part of an attempt to enable us to make better decisions. But can behavioural economics actually help us make better decisions?

Too many things guide us in the decision making process to list here, but it suffices to say that we are not as cool-minded as we (and mainstream economists) would like to believe. “People are not accustomed to thinking hard”, said Daniel Kahneman, one of the founders of behavioural economics. For example, the availability heuristic causes us to overestimate the probability of getting into a bike accident after watching a television drama with a bike accident, and the representativeness heuristic might lead us to conclude that all LSE students crave a career in investment banking after one friend applies. These simple rules of thumb powerfully influence us our subconscious, and occasionally such reasoning can lead to erroneous thinking.

Though it may be true that each of us is born with a random set of cognitive dispositions, behavioural economics tries to unify these by identifying systematic in flaws human decision-making systems. For example Kahneman and Amos Tversky’s prospect theory asserts that our decisions are greatly influenced by what we have prior to the decision, that we disproportionately emphasise unlikely events, and disproportionately fear losses. If our innate dispositions lead us on a certain path, then learning from the mistakes of our mind can lead us off the beaten path, away from the folly of the masses.

It is neither immediately obvious nor straightforward to teach ourselves not to let emotions or instincts get the better of us. Introspection and self-control may help us make better decisions more than the findings of behavioural economics. Some people may pride themselves in making calculated decisions before every action, but it is probably impossible to find someone whose decision-making system is not flawed in some sense.

Behavioural economics has properly defined some of the most common flaws of our thought processes, and, with the help of many experiments, has shown that these flaws are systematic across individuals and even cultures.

Behavioural economics is a panacea to our cognitive troubles, but by learning where everyone goes wrong, we can better understand our decisions, and possibly make better ones.

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Applications

of

Behavioural Eco

‘NUDGE AND BUDGE’ THE INTERSTICE OF BEHAVIOURAL ECONOMICS & PUBLIC POLICY

By Sugandha Srivastav

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The theory of regulatory economics states that intervention in markets is justified when the price of a good fails to take into account its true social cost or benefit.

Policy-formulation has evolved over time to address this problem through a variety of mechanisms. The age-old neoclassical response to market failure has been to impose a tax on goods which cause societal harm (such as cigarettes) and subsidise goods which carry positive spill-over benefits (such as vaccinations). However, with advancements in behavioural economics, the policy discourse has become more nuanced. Policy-makers are increasingly advocating less interventionist measures and are looking to spur optimal behaviour through more subliminal means that draw upon insights from empirically-observed human behaviour.

An example of this is the ‘nudge’ approach where people are encouraged to donate organs or pay taxes through policies that do not directly interfere with markets. In the case of taxes, a study showed that sending an SMS reminder using a person’s name increases the rate of tax compliance by roughly 30 percent.

Such results can have profound ramifications for countries such as India whose tax to GDP ratio is amongst the lowest in the world (15%). American academics Richard Thaler and Cass Sunstein explain that ‘nudge’ policies advocate a type of ‘liberal paternalism’ in which people retain their liberty since they are not coerced into action by governments.

While conventional economics is powerful, it deals with an abstraction of the human-being that fails to take into ac-

onomics count the fact that humans are social animals whose decisions are affected by circumstances and heuristics. Heuristic decision-making has been largely ignored in mainstream economics until recently because of the perception that it is characterised by too much randomness. However, empirical evidence suggests that all human-beings share certain idiosyncratic traits. One of these is related to how humans value losses more severely than gains of the same magnitude (i.e. Prospect Theory).

Another is the ‘present bias’ which talks about the manner in which humans discount the future. Simple empirical observations such as herd behaviour are a testament to the incompleteness of the neoclassical assumption of a rational, utility-maximising agent.

Results from theories such as Prospect Theory can be applied in ways that are meaningful to both developed and developing nations. Nidhi Khurana from the World Bank talks about improving public sanitation in India through policy schemes that emphasise

losses. One of the major promises that Prime Minister Narendra Modi made in his election campaign was to get the 600 million Indians who currently defecate in the open to use toilets. Modi’s current plan of action is centred on building 111.1 million toilets over the next five years. While construction is a part of the solution, Khurana argues that it is not nearly enough because as past experience shows, toilet usage depends not only on access but also on behaviour. Khurana highlighted that effective sanitisation schemes in Bangladesh exploited the fact that humans are more averse to losses than gains and therefore, devoted more attention to explaining how open defecation would harm communities rather than how toilet usage would benefit them.

While isolating causality is difficult, this approach seems to have worked since Bangladesh has reduced open defecation to a mere 3% (as per 2012 figures).

A criticism of the behavioural approach to policy-formulation put forth by academic Adam Oliver is that it places far too much emphasis on demand-side interventions, and ignores important supply-side issues. Oliver suggests that in addition to ‘nudge’ policies that encourage consumers to act optimally, we should have ‘budge’ policies that encourage firms to act

more responsibly (particularly those selling products with negative societal consequences). Oliver talks about how the payday loan market is driven by a huge ‘present bias’ whereby consumers ‘overweight the immediate pleasures afforded by spending and underweight the longer term pain of repayment.’ He argues that since this market is driven by such innate human irrationality, it is perhaps more effective to ‘budge’ the payday loan companies into compliance rather than solely target consumers. He therefore justifies more regulation in the industry and calls for more visible advertising of interest rates.

It seems that insights from behavioural economics can meaningfully augment the field of regulatory economics. While behavioural policy-making is in a stage too nascent to reach any concrete conclusions, initial results from empirical studies hold promise.

However, as with any new endeavour, caution must be exercised. A particular shortcoming of behavioural economics is that discoveries from the past may not easily generalise into the future as societal circumstances change. Nevertheless, this does not disprove the efficacy of behavioural approaches but rather tempers the idealism with the realism that is often needed for robust policy-formulation.

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‘Economics Man makes logical, rational, selfinterested decisions that weigh costs against benefits and maximise value and profit to himself.

Economic Man is an intelligent, analytic, selfish creature who has perfect self-regulation in pursuit of his future goals and is unswayed by bodily states and feelings…But Economic Man has one fatal flaw: he does not exist.’

– Harvard Magazine

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RECONSIDERING RELEVANCE: THE ROLE OF ‘IRRELEVANT’ ALTERNATIVES

By Christine Farquharson

Traditional economic models assume that more choice can only be good.

But evidence suggesting that choice, and choosing, can be costly has implications for students.

Homo economicus is an extraordinary decision-maker.

When faced with a large or infinite set of options, agents in classical economic models are instantly able to rank the options by their utility and to choose the best of them.

Nor are these decisions influenced by the inclusion of less-preferred options; since the agent is focused on maximising utility, these less-preferred alternatives appear to be irrelevant to the problem at hand.

Assuming the independence of irrelevant alternatives is widespread, powerful, and intuitively appealing.

But it is not innocuous; empirical evidence suggests that a large number of irrelevant alternatives can make it more difficult to make any decision at all.

A 2000 study by Sheena Iyengar and Mark Lepper found that shoppers who visited a display offering free samples of 30 jams were ten times less likely to buy any jam than those who saw a display with only six jams on offer. In the same paper, the authors found that offering students a larger number of essay topics for an optional assignment reduced both submission rates and the quality of the essays – so be skeptical when your professor promises ‘lots of choice’ on an unmarked problem set!

In response to an overabundance of choice, some people decide to abandon the goal of maximising their utility. In-

Image by Fiona Tan

Anywhere else just wouldn’t make sense

stead, they ‘satisfice,’ selecting the first acceptable option they come across.

For example, a shopper might opt for the first acceptable pair of jeans he finds, rather than exhaustively trying

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]

“... offering students a larger number of essay topics for an optional assignment reduced both submission rates and the quality of the essays” on every pair of jeans in London to find the one with the best combination of style, fit, and price.

The distinction between maximising and satisficing behaviour affects weightier decisions as well. Job seekers, for example, face a long list of adver-

tisements and must choose the positions to which they will apply. Users of the LSE jobs board have the option to include filters in their searches, reducing choice overload. However, maximising students might choose to run broader searches lest they miss out on a perfect opportunity.

In a 2006 paper, Iyengar, Rachael Wells, and Barry Schwartz explored the implications of maximising and satisficing during a job search. They contacted final-year university students, asking them how many positions they planned to apply for, how reliant they were on external information such as published rankings of companies, and how emotionally difficult they were finding the job search process.

Following up with the students, Iyengar, Wells, and Schwartz found that those who displayed maximising behaviour during their job search were more successful in finding highly-paid positions. On average, maximisers had

a starting salary $7,430 higher than their satisficing peers. This premium, worth roughly 20 percent, was not associated with the number of interviews or job offers received.

On the other hand, the maximisers were significantly more likely to express regret, disappointment, and other negative emotions both during and after their job search. On a nine-point scale of negative emotion, maximisers’ mean score was 4.5 at the conclusion of their job search. Satisficers placed themselves at just 3.9 on the scale, suggesting that those willing to settle for a less-than-perfect offer avoided some emotional costs.

Even if choice overload is not an issue, irrelevant alternatives can change preferences. In just one example, a 1993

paper found that students were significantly more likely to choose a gift of a fancy pen rather than cash if they were also given the option of a (less-preferred) ugly pen. Similarly, marketers have long known that offering an extra-large size can increase sales of the large size.

This effect can also influence the job search. A student interested in the notfor-profit sector, for example, might decide to apply to a top consulting firm after seeing a large number of other postings for mediocre consulting positions. This could be a positive outcome; perhaps the student hadn’t realised that he had an interest in consulting work.

It could also be negative, if the student went to the effort of applying only to realise that the industry was not a good

fit for him. What is apparent, though, is that the determination of which options can be considered ‘irrelevant’ is trickier and more important than classical economic theory suggests.

Although satisficing behaviour and context-dependent preferences are often dismissed as irrational, they don’t necessarily deserve condemnation.

The student who decides to apply for a consulting job might believe that the numerous consulting advertisements indicate a booming market, and the satisficers may be more aware of the emotional and opportunity costs of seeking perfection. Still, when choice – and choosing – can be costly, previously dismissed alternatives may make a return to relevance.

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REALISATION UTILITY – EVEN PROFESSIONALS BURY THEIR HEADS IN THE SAND By Yedda Yue Yuan In the framework of financial economics, people are assumed to maximise utility received from consumption or total wealth. In a 1985 article, the economists Hersh Shefrin and Meir Statman pointed out that people sometimes base their utility on realised gains and losses, in other words, by comparing their returns with a benchmark only at the end of an investment period. This is the basic idea of realisation utility. In 2012, Nicholas Barberis and Wei Xiong argued that individual investors are more likely than institutional investors to base decisions on realisation utility because the latter are “trained professionals.” This may sound natural to economists who like to believe that more economics you know, the more rational you are. But they have ignored another important reason for this phenomenon: professional investors are forced to face the “paper” loss or gain immediately when it occurs, instead of at realisation.

Realisation utility has two assumptions. The first assumption is that the investors consider their investment process as a series of periods. Individual investors can deny losses and pray for a price rebound in the near future, as long as they are still within the same

period. In the same way, they may not feel safe about gains until they sell the asset and can grasp the notes. Changes in the value of professional investment portfolio have more immediate effects because the value of investment positions are followed closely not only by managers but also by shareholders, creditors, and, sometimes, regulatory authorities. Moreover, if the investment is on behalf of clients and is open-ended, paper losses might trigger fund withdrawal. These factors mean that institutional investors think about investments in continuous time instead of in a series of periods.

According to the second assumption, investors evaluate outcomes by comparing the realised payoffs with certain benchmarks, the simplest of which is the buying price of the asset. Entry-level investors are more likely to make simple judgments like “a gain is good while a loss is bad”, while professional investors tend to have longer term investment strategies and more complex investment goals like diversifying risk, hedging or arbitrage.

Is there some way to distinguish the effects of paper returns and those of professional investment goals? Fortunately,

[ ] “Having immediate effects of paper gains or losses is a crucial factor keeping people from adopting realisation utility”

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Investors might be better off realising their losses instead

venture capital funds, which together with hedge funds have a reputation as the least regulated institutional investors, provide an informative example.

While open-ended hedge funds face pressure from investors to keep paper returns above a certain level, venture capitalists typically invest with money from several partners over a fixed term of 10 years. In other words, they can evaluate performance in terms of periods rather than evaluating paper returns at every point. If the asset managers of venture capital funds show traces of realisation utility, then we can argue that paper returns matter.

Barberis and Xiong show that realisation utility has some observable implications on investment behaviours, including risk seeking and the disposition

effect, the tendency for investors to sell a winning asset too early and a failing investment too late. Venture capitalists obviously seek risk since they invest in businesses that have a high probability of failure. Comparing venture capital backed IPOs with non-venture capital backed ones between 1983 and 1987, William Megginson and Kathleen Weiss found that venture-backed companies went public at a younger age than companies financed in other ways, implying that venture capitalists exit successful investments too early and exhibit the disposition effect.

In drawing conclusions however, we must recognise that venture capitalists often have no way to sell a diminishing business–they can only

[ ] “Managers tend to refuse to recognise that a deal would not work and to postpone pain by letting the deal fail in the post-merger integration phase.”

PAGE 18

watch their investment evaporate.

Realisation utility applies to more topics than asset investment. One possible extension of its application is corporate governance. It is reasonable to suppose that managers evaluate performance in periods because company financial statements are issued discretely. Manager utility is realised when information about their performance is known by shareholders, partners, and the market at large.

Disposition effects are also present in manager decisions. For example, the announcement of a successful acquisition deal can be compared to selling a “winning asset” because it brings a burst of utility by building the manager’s reputation. The counterpart is the announcement of a collapsed deal, which can be compared to selling the “losing asset”. Managers tend to refuse to recognise that a deal would not work and to postpone pain by letting the deal fail in the post-merger integration phase. Studies from Parkwood Advisors show that 70% of successfully closed M&A deals fail to achieve anticipated synergies and that 58% of mergers fail to create substantial returns to shareholders. Thus, even though they are professionals making corporate decisions, managers working on M&A show traces of realisation utility because their performance is evaluated in periods.

These findings show that the immediate effects of paper gains or losses are a crucial factor in preventing the adoption of realisation utility. Paper returns force some investors to evaluate performance in continuous time rather than in periods, violating the first assumption of realisation utility. We can observe implications of realisation utility, including risk seeking and disposition effects, in behaviour of venture capitalists and M&A managers, indicating that professionals, as well as inexperienced individuals, sometimes refuse to face the reality until reality is realised.

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BEATING A DEAD HORSE: HOW LOSS AVERSION AFFECTS INVESTMENT CHOICES

By Ole Agersnap It is common knowledge that most people dislike risk.

This explains why it is possible to earn money by selling insurance, and why riskier financial assets tend to produce higher returns on average. However, the tools that economists use to analyse decisions of risk and uncertainty have traditionally been quite limited and unrealistic.

Classical expected utility theory, which was made popular in the 1940s and 50s, is still the primary way of explaining how people make decisions when there is uncertainty involved. Classical expected utility theory states that our utility of some “lottery” over a set of possible outcomes is given purely by the utility of each possible outcome and their respective probabilities. This theory has often been proven insufficient to explain the choices of real world agents. Economists Amos Tversky and Daniel Kahneman demonstrated in their research that most people’s willingness to take risk is much higher if they are trying to avoid loss. Crucially, even when offered a choice between gambles that yield the same outcomes with the same probability, people make very different decisions depending on how the question is framed. Consider, for instance, the following scenario, taken from the 1984 paper “Choices, Values, and Frames” by Kahneman and Tversky: A disease has broken out and is expected to kill 600 people. However, two programs to combat the disease have been proposed, only one of which can be adopted.

About half of the respondents were presented with the first set of possible choices: Programme A: 200 people will be saved.

Programme B: One-third probability that 600 people are saved, two-thirds possibility that no one is saved.

The other half were given these two options: Programme A: 400 people will die.

Programme B: One-third probability that nobody will die, two-thirds possibility that 600 people will die.

It is clear that the gambles are identical in the two cases.

However, in the first case, the respondents overwhelmingly favoured the safer option A (72%), while in the second case, where the choices were framed negatively, an even larger majority (78%) picked option B instead.

In the latter case, the options more clearly indicated that programme B would offer a small chance of no losses altogether, and this was enough to overrule the risk aversion that we display in most situations.

It is fairly straightforward to imagine how this extends to investment decisions. Investors often show particular reluctance to selling a risky asset after its price has dropped. To avoid what they see as a loss, they become more willing to gamble by holding onto the asset. Conversely, if the price increases, investors tend to sell the asset to “lock-in” gains and avoid the possible disappointment associated with a subsequent fall in prices.

This is known as the “disposition effect” and has been confirmed by many empirical studies. Since asset prices should, in theory, only be affected by expectations about the future and not past developments, this would suggest that investors affected by the disposition effect are prone to make suboptimal decisions. And this can be exploited by those who are more experienced. A reluctance by many investors to sell an asset that has dropped in price could keep the price at an unnaturally high level, in which case the experienced investor would sell. And similarly, when some investors sell their winning stocks, this would give others the chance to buy at a lower price than they would otherwise have to pay.

So is there any evidence to suggest that naïve decisions made by some investors are exploited by others? In short, yes. Bing Han and Mark Grinblatt found evidence that past capital gains are positively correlated with future returns: stocks whose prices have increased are more likely to increase even further in value. A study of Finland’s stock market by Grinblatt and Matti Keloharju showed that domestic investors were strongly affected by the disposition effect - largely selling winners and buying losers. Foreign investors in the Finnish market, who followed the opposite strategy, achieved far higher average returns than the Finns themselves.

However, contrary to what one might believe, it is not necessarily just amateurs who display the disposition effect. Peter Locke and Steven Mann examined trading behaviour of professional Forex and commodities traders and found that all of them displayed the disposition effect to some extent, but that the most successful traders were those least susceptible to it.

For any aspiring investors, it seems that it could be worthwhile to be a bit self-critical. A stock that seemed like a great investment at first, but has since disappointed, might not be worth holding on to, even if you have to sell it at a loss. By holding on to it for too long, you may be risking something much worse.

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WHAT DRIVES HOUSE PRICES IN CHINA?

By Chen Qiu

1975

2000

2014

Chinese housing: reversion to the mean?

[ ]

Chinese people once thought their house prices would never ever stop rising. But now, the tables are turning.

According to China’s National Bureau of Statistics, 69 out of the 70 monitored cities have had price drops. This is surprising as just a year ago people were talking about China’s housing fever.

Indeed, after ten years of high speed growth, China’s house prices are finally declining. The question is, is the current decline a long term structural recession, or just another short housing cycle?

To answer this question we must explore the factors that affect house prices. In essence, houses are both consumption and investment goods.

House prices are determined by the demand and supply of housing services as well as fundamentals in the asset markets. It is difficult to disentangle these two forces. To add to complications, house prices show significant amounts of heterogeneity across regions. It is crucial to discuss what actually drives China’s house prices.

The Goods Market

If we treat housing as a normal conPAGE 20

sumption good, then classical economics tells us that its price should be determined by the interaction of demand and supply. Two elements stand out if we take a look at the demand side of the market. First of all, China’s most

‘The huge influx of migrant workers settling in cities does not just represent a spatial transfer of demand but also the creation of new demand because of associated lifestyle changes from rural to urban living.’

recent baby boomer generation (people born between 1983 and 1990) is creating substantial demand for housing as members of this generation are ready

to marry. After 2005, the number of China’s newly registered couples per year increased at an unprecedented rate and this coincided with China’s housing boom. Many Chinese treat privately-owned houses as a prerequisite for marriage and this contributes significantly to demand.

Another demand-side factor is China’s urbanisation rate which rose from 37% in early 2000 to 52% in 2012. The huge influx of migrant workers settling in cities does not just represent a spatial transfer of demand but also the creation of new demand because of associated lifestyle changes from rural to urban living. These increases in demands are real and not bubbles.

China’s housing market is also affected substantially by supply side factors.

Over the past years China’s local governments have been very active in regulating the housing market. Their stated objective is to smooth the economic momentum as well as the house price cycle. For example, due to an economic surge in 2005, the central bank decided to constrain liquidity. This impacted the housing market as real estate suppliers required a higher price to

make up for the increase in their borrowing costs. To make things worse, local governments have controlled the supply of local land. Through the leasing of public land, local governments secure large amounts of revenues. A very rough breakdown shows that in recent years as much a 40% share of total housing price transforms into some kind of local government revenues, either through taxes or fees, or more direct land leasing revenues.

China’s government tried to cool down the market but this only resulted in a lowering of housing supply due to cost increase. The overall result was a demand-supply spiral: as demand increased, prices rose but this decreased the supply of housing as the government intervened, which further drove up house prices.

The Asset Market What if we treat housing as a class of investment like stocks and bonds?

Equilibrium asset pricing theories tell us that the price of an investment today should be the net future cash flows discounted at their cost of capital. A pro-

Transition of housing and infrastructures in China from 1950s to 2014

ject that has higher capital costs is more risky so its current equilibrium price must be lower. We usually measure cost of capital by CAPM, that is, cost of capital equals risk free interest rate plus a risk premium. Thus, if we try to rationalise the surge in house prices using the framework of the asset pricing model, it must be that as rental income in China increases, capital costs for housing investment decrease. Rental income is a rather localised factor, which relates directly to local economy, infrastructure and amenities. Some old real estate theories in the 60s already tell us that rental income is a capitalisation of local economic development and public expenditures. Indeed, superstar cities like Beijing and Shanghai bear a higher rental income for their economic prosperity and much better amenities compared to other cities. But even in second and third tier cities in China, it’s not surprising to see how housing rental income rises as part of economic development.

China’s financial market is characterised by “long-term financial repression” i.e. a situation in which the risk free interest rates are too low. China’s savings rate barely safeguards against inflation. In this regard, the housing market provides a good hedge against inflation. However, as China’s financial system liberalises, Chinese citizens may find better hedges against inflation in foreign capital markets.

Behavioural Explanations Recently there have been debates on whether behavioural factors play a role in determining house prices. Scholars in Economics are now in consensus that behavioural factors do contribute to housing price momentum. For example, consumers may choose to buy houses at an earlier date if they expect future prices to rise. One of the most classical views on how behavioural factors come into play is regarding the backward expectation hypothesis. Case and Shiller, in their seminal papers in 80s and 00s, have shown that people’s expectations of house price growth are inconsistent with perfect foresight.

Specifically, one possibility is that when forming expectations of future capital gains, agents incorporate capital gains in the past, say, five years.

This is an example of adaptive expectations, which basically means that people predict what will happen in the future based on what has happened recently. Empirical studies show that middle-term backward looking expectations are important in determining past housing booms in the U.S. But in China it is hard to test such hypotheses because of the short history of China’s commercial housing market (China did not formally introduce commercial housing until the late 90s). Nonetheless, we have reasons to believe behavioural issues might have a considerable impact on China’s housing booms.

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BULLS, BEARS AND LEMMINGS: HERDING IN FINANCIAL MARKETS

By Honglin Jiang It is said that the etymology of “bulls” and “bears” as applied to the financial lexicon stems from how they attack: bulls thrust upwards with their horns, while bears swipe downwards with their claws. However, there is another, less glamorous animal that inhabits the markets - the lemming. As in the popular 1990’s video game, they follow the crowd, frequently to their doom. Few investors will ever admit to being one.

The truth, however, is that the spectacular bubbles and crashes of history could not have occurred without them.

Neoclassical economists tend to assume that humans are something akin to independent utility maximising agents. However, the same assumption that lends economic models their mathematical elegance fails to account for the social behaviour that can lead to extreme deviations from predicted equilibria. In particular, the instinct to herd together may be hardwired into us through millennia of evolution. In a leading theory of herding, evolutionary biologist William Hamilton proposed that “rational herding” occurs as individuals band together to minimise the risk of being eaten by predators.

He stresses that it is not the absolute position of the individual with respect to the predator that matters, but the relative position with respect to other PAGE 22

members of the herd. Over time, the individuals who fail to herd are picked off by the predators and removed from the gene pool.

In finance, this type of herding behaviour is paralleled most clearly among fund managers. Crowding into an asset du jour protects them against accusations of professional incompetence by fickle clients. The gains to correctly making a contrarian investment can be

The natural habitat of the financial herd

more than offset by the career and reputational losses of making an incorrect one. Thus, this asymmetry in payoffs and relative loss aversion leads to aggregate dependency over asset allocation decisions.

The relaxation of the assumption of independence among investors has serious implications for financial asset prices, particularly in options. Options, which are contracts that grant the right, but not the obligation, to buy or sell an underlying asset, are very spe-

cial financial instruments because they allow investors to express a view on the volatility of a specific asset. Since they pay off only when the underlying asset crosses a particular strike, options are worth more the higher the volatility of the asset. After all, losses are limited by the premium paid, but gains are potentially unlimited. Theoretically, with investors acting independently, the volatility price of options far out of the money should not be much more than those at the money. This is because large price swings would be muted by rational investors stepping in to prevent prices deviating too far from their fundamental equilibrium.

Such theoretical assumptions were brutally put to the test by the Black Monday stock market crash of 1987. Prior to the crash, traders priced their options according to a standard log-normal distribution - the convention of the time. However, this statistical distribution applied to stock returns dramatically underestimates the probability of very large moves. The model predicts the frequency of a large crash to be roughly in the order of once in the age of the universe. However, recent experience suggests that the actual frequency is closer to once a decade. Following 1987, traders would price their out-of-the money options with a substantial premium to

compensate for the added risk, leading to the market’s distinctive “volatility smile”.

The pre-1987 options pricing models were failed to account for the human tendency to herd. In 1987, it was herding into a strategy of portfolio insurance - itself a flawed theory that stocks could always be frictionlessly traded. In 1999-2000, investors were clamoring for dot-com stocks.

American housing was next in 20052007. Fears over imminent hyperinflation and Eurozone disintegration fuelled a bubble in gold in 2010-2012.

Humans, it appears, cannot escape their evolutionary instinct to seek safety in numbers, no matter how dangerous that may be. If we cannot escape it, can we at least understand it?

Economists have begun devoting effort to developing models which explicitly account for herding. In a seminal 1992 paper, MIT professor Abhijit Banerjee proposed a sequential decision model where agents form decisions based on a combination of unobservable private information and the observed decisions of all previous agents. He illustrated the idea with a hypothetical crowd of 100 people deciding between two restaurants, A and B, where B is superior. 99 people have private information that B is in fact the better choice, but the one person who believes A is better chooses first. Now the second person observes this choice, and believing the two signals to be of equal quality, tosses a coin to decide where to eat.

If he randomly chooses A, then all other 98 people will decide in sequence that A must be the better restaurant, since the weight of public evidence now outweighs their private beliefs. The significance of this cascade is that herding imposes negative externalities through the loss of

Who’s afraid of the big bad wolf?

private information. The incorrect decision of one person, and a little bad luck, results in everyone getting an inferior meal.

The analogy of this model to financial assets seems particularly apt, as fundamental research (the private information) tends to be most easily discarded at the peak of herding. Correlations among assets increase as investors in-

[ ] “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, one by one.”

- Charles MacKay

creasingly frantically scramble to buy or sell whatever other investors are buying and selling. During the dotcom bubble, investors made no distinction between the balance sheets or cash flows of companies, so long as they had “.com” in their name. Similarly,

during the financial crisis, many assets were driven far below their fundamental values, as investors were forced to liquidate en-masse. As in Banerjee’s model, herding in financial markets also imposes negative externalities on the rest of society through this vicious cycle of bubbles and busts. The economic, social and human costs, as we have all observed, can be devastating.

Thus, at least in the financial world, our instinct to herd, far from guiding us to safety, can instead lead us to precariousness. Galloping in the centre of the flock, all we can see are the people around us, blind to the rapidly approaching cliff. In such a context, the value of skeptics and free-thinkers can hardly be overstated. It is said that there is a unit within Israeli Intelligence whose only job is to question the consensus thinking and present alternative viewpoints. Known as Ipcha Mistabra (roughly translated: “on the contrary, the reality appears otherwise”), the unit looks out for the establishment’s blind spots. Perhaps if financiers and bankers were to adopt a similar mindset, they would benefit both themselves and society. Until then, however, the prevailing attitude appears to be that of Citigroup’s ex-CEO Charles Prince: “As long as the music is playing, you’ve got to get up and dance”.

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SHOULD THE EUROZONE BE AIMING FOR JAPAN’S ‘LOST DECADE’?

By Navreen Sandhu

Much has been written on the topic of the Great Recession, and the lasting legacy it could leave. Potentially one of the most significant of these long-term impacts could be the ‘Japanification’ of the Euro and the potential for the Eurozone’s own ‘lost decade’. However, it could be argued that the situation in Europe is much grimmer than any the Japanese ever faced, exacerbated by a lack of decisive monetary policy action. If this is the case, perhaps the leaders of the Eurozone and the ECB (European Central Bank) should not be worried about a ‘lost decade’, but instead should be setting it as a target to aim for in order to prevent something much worse.

The paths of the Eurozone of today and the Japan of fifteen years ago are strikingly similar. Prior to the crises, both economies faced bubbles in real-estate funded by debt and a boom in asset prices, swiftly followed by a deep recession. This collapse in house prices and assets was intensified in both cases by the liabilities that still remained on both households’ and firms’ balance sheets. In Japan, falling collateral and a rise in bad debt put major pressure on banks, many of which had insufficient

capital levels. Much like the situation in the Eurozone, Japanese banks, firms and consumers went through a period of deleveraging, resulting in a period of low investment, a lack of credit and an absence of economic growth.

in aggregate demand was a cycle of depression and deflation which has been uncontrollable for 15 years, the hardest impacts being felt in the labour market. Due to a lack of demand, many firms had to cut costs, with labour costs taking the greatest burden, and as a result of nominal wages actually falling faster than prices, the share of labour in GDP fell dramatically. This fed into the deflationary spiral which has become synonymous with the ‘lost decade’. Falling wages were chasing falling prices, resulting in deflation becoming deeply rooted into the economy. This effect was exacerbated by the lack of business confidence which fed into very low levels of investment. As firms expected prices to fall, there was no incentive to invest as the future cash flows from investment would suffer as a result of falling prices. A lack of investment only causes aggregate demand to fall further, resulting in the downward pressure on prices remaining. This deflationary spiral is self-fulfilling as falling prices, falling wages and falling investment sustain the equilibrium.

This situation is strikingly familiar to that faced by policymakers in the Euro-

[ ]

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“a negative demand shock ... can trigger mechanisms that keep an economy depressed for years after if there is not a serious policy response.”

The most important lesson from the Japanese case is that a negative demand shock, as has just been described, can trigger mechanisms that keep an economy depressed for years after if there is no serious policy response. In Japan, the effect of this fall

zone. Businesses are reacting to a lack of demand by cutting labour costs so they can become competitive again. This is heightened further by the fact that individual European economies cannot become more competitive by devaluing their currency. This has resulted in unemployment rates of almost 26% in some European countries.

However, in Japan, policymakers have finally come to realise that chasing competitiveness is not a viable method of ending a circle of deflation and low growth. Following the recent introduction of ‘Abenomics’, the BOJ is finally attempting to stimulate the economy. It does so by a combination of fiscal stimulus, monetary policy and structural reforms.

This is in contrast to the ECB, where the impact of wage and labour market flexibility has not yet been understood. Mario Draghi, head of the ECB, has been calling for more labour market flexibility by reducing job protection. The most important lesson the Eurozone could learn from Japan is that labour market flexibility only embeds the process of deflation and depression. If the ECB’s labour market reforms are followed through, it is likely that the full threat of deflation will be unleashed on the Eurozone.

Although the Eurozone has not entered a deflationary spiral, it has not fully recognised how close it is to the edge. One recent study suggested it took the BOJ until 2003 to realise it was in the depths of a deflationary spiral, which meant it was too late for decisive policy action. The ECB could be sleepwalking into the same problem. Although publicly admitting the threat of deflation was very real would be self-fulfilling, if they do not act to lower this risk now, they may find it is

too late.

The Bank of Japan have finally fully committed to inflationary monetary policy. Whether the ECB can do the same is another matter. The complexity of the political framework of the Eurozone make standard Quantitative Easing less straightforward to implement. The effectiveness of QE is also questionable as the asset purchases would have to be proportional to the size of each European economy. As the larger economies already have very low yields, the effect of the policy would be limited at best.

The answer for the ECB could take a different form to ‘standard’ QE measures such as those taking place in Japan. Many economists have suggested they should be aiming for higher inflation. This does not necessarily mean raising their target per say, but adjusting the asymmetric inflation target, which is currently obstructing their ability to react to deflationary risks. The ECB’s mandate is to keep inflation “close to but below 2%”,

[ ] “... policymakers have finally come to realise that chasing competitiveness is not a viable method of ending a circle of deflation and low growth.”

which has resulted in them reacting to deflationary pressure much slower than if inflation was sitting at a higher level. Unlike the Fed and the Bank of England, the ECB has actually raised interest rates and cut its balance sheet in response to inflationary pressure in 2011 and 2013. This quick response to slight inflationary pressure has actually caused a bout of very low inflation, which the ECB has been very slow to respond to, possibly attributable to the wording of their inflation target. If the target was reversed, or made symmetric like the Bank of England’s, the ECB may have lowered interest rates faster, or never raised them in the first place, which possibly could have lessened the threat of deflation currently facing the Eurozone.

The similarities between a failure in policy action by the ECB in 2011 and 2013 are comparable to that of Japan’s monetary policy in the 1990s. However, the ECB should consider themselves lucky to have the BOJ as a prime example of the effect complacent policy can have on future decades. If they choose to ignore this example further, they could find themselves sleepwalking into something much worse than a ‘lost decade’.

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Logo of Bank of Japan (Left) and European Central Bank (Right)

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Why your New Year’s resolutions won’t last

By Simon Loschnauer

Ever since the days of Adam Smith and Jeremy Bentham, ecEver since the days of Adam Smith and Jeremy Bentham, economists have viewed consumers as rational decision makers driven by a relentless pursuit of self-interest. This traditional view is now being challenged by evidence from the field of behavioural economics that suggest anomalies in human behaviour. Here is an example: When faced with the choice of a reward of 100 pounds today compared to 110 pounds tomorrow, many people prefer the immediate money. Very few people, however, prefer 100 pounds in 30 days to 110 pounds in 31 days. While there might be a number of valid reasons underlying this behaviour, people still show inconsistencies in their choices over time that cannot be explained by the neoclassical theory of consumer choice. In the above example, people believe that in a month, they will want to wait a day for an extra 10 pounds.

Yet, after a month, many of them will reverse their preferences and now choose the immediate 100 pounds rather than wait a day for an additional 10 pounds.

The above example illustrates what has come to be known as hyperbolic discounting, the tendency for people to choose a smaller, earlier reward over a larger, later reward.

Economist Paul Samuelson first coined the term in 1937 and suggested that the discounting of utility decreases as the delay occurs further in time, conforming to the functional form of a hyperbola. In its essence, hyperbolic discounting seeks to explain why people act impulsively in the short-term but exhibit greater patience in long-term behaviour. This idea is inconsistent with the traditional theory of economics that assumes that people discount a future reward by a fixed percentage for each unit of time, e.g. if the discount rate was ten per cent then a person should be indifferent between 100 pounds today and 110 pounds in a year.

Hyperbolic discounting has been linked to a variety of commonly observed behaviour such as procrastination, addiction or other problems of willpower. With Christmas holidays coming soon, many people will come up with promising New Year’s resolutions. The problem is that even though the rewards from a healthy diet and exercising look promising, the chocolate cake after the next dinner looks even more promising. The focus on the instant pleasure of having a cake or spending the evening in front of the TV rather than going for a run, causes people

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to heavily discount the future rewards of better health. Interestingly, sometimes we even know that we will regret decisions while we make them, but the instant gratification outweighs the future benefits.

Research from neurology revealed that two very different parts of the human brain are involved in processing choices for now and later. While the choice to delay gratification is mostly processed in the frontal system that is associated with reasoning and problem solving, the choice to do something immediately gratifying is processed in the limbic system, which is mainly connected to our feelings of pain and pleasure.

David Laibson, Professor of Economics at Harvard University and speaker of the Lionel Robbins Memorial Lecture at LSE in 2007, has used hyperbolic discounting also to explain why people simultaneously accumulate large credit-card debts and grow pre-retirement wealth at low interest rates. The rewards from buying new clothes today outweigh the discounted displeasure of future payments and leave the consumer with credit-card debt. When thinking about retirement savings, however, people use a much smaller discount rate for delayed rewards. It is thus more attractive to invest in alternatives that provide a higher expected return in the long-term. Generally, hyperbolic discounting suggests that people’s investment behaviour exhibits patience in the long-term and impatience in the short-term, which conforms to many observations in the financial markets.

The empirical finding that a person who discounts the future hyperbolically will not carry out the consumption plans that he makes today has further implications for policymakers in evaluating programs where benefits spread over decades. The abatement of greenhouse gas emissions to slow down global warming, for example, is a current area of research where behavioural economists make use of hyperbolic discounting.

As an integral part of behavioural economics, hyperbolic discounting suggests that humans are less rational than the homo economicus proposed by mainstream economics. The number of scientific papers on the topic has increased over the last decades as research from the fields of psychology and neurology has provided new insights.

Global Issues EUROPEAN CARBON TRADING: BETTER THAN NOTHING

By Maarten Hage

Most of you will be aware that the European Emissions Trading Scheme (ETS), to put it mildly, has not been a breakthrough success. So far it has been a scheme of grand ambition but little impact. Despite this, the European Union views it as the cornerstone to its drive to reduce greenhouse gas emissions.

The scheme, which covers around 45% of the EU emissions, puts a price on carbon and allows firms to trade in carbon allowances. In theory, this encourages firms that can cut emissions cheaply to do so and sell their surplus allowances to firms for whom it is more expensive. On face value, ETS follows sound economic logic: the government completes the market for carbon emissions and forces firms to internalise their negative externality of production.

This all sounds great, so why has ETS made so little impact? Unfortunately, up to now ETS has been a classic example of good in theory, bad in practice.

The scheme started in 2005 and has been implemented in three phases. During Phase I & II, carbon allowances were dis-

tributed based on current emissions. For Phase I, national governments were given the task to estimate national emissions.

Allowances were then calculated based on this. Almost without exception, national governments overestimated their emissions, which resulted in a surplus in the allowance market. This surplus was so staggeringly large that carbon prices fell to the low of 3 cents per ton in 2007 - hardly an incentive to cut emissions. The EU reacted by tightening allowances for Phase II; however, 17 member states still had carbon caps that were higher than their 2005 emissions. Based on past performance, it is hard to see how the scheme will reach the 21% reduction of 2005 emissions in 2020 that the EU predicts.

The great recession has compounded the effect of a slack cap. The reduction in economic output has reduced emissions, thereby enlarging the already oversized surplus. Since emissions went down, it is arguable that we should not care about the surplus, less CO2 is less CO2, regardless of how the reduction was achieved; however, PAGE 27

under ETS firms can ‘save’ unused permits. Less CO2 now therefore means more CO2 in the future. A large surplus thus reduces the effectiveness of ETS in the future. Furthermore, the recession and the euro crisis consumed most of the EU’s political energy, leaving little for the improvement of ETS. Perhaps the worst effect the recession has had on ETS is that it has completely overshadowed its possible effect on emissions abatement. It is exceedingly hard to disentangle the possible abatement caused by ETS from the reduction in emissions that simply resulted from lower economic output. The lack of clear and easily explainable evidence weakens the case for ETS and emboldens its opponents.

On the back of this summary of ETS failures, you may be forgiven for thinking we should abandon the policy altogether. This would be a mistake. It is clear that ETS has so far not delivered on its promise. This however, was to be expected. ETS is by far the largest capand-trade scheme ever implemented.

This alone is reason enough to expect teething problems, let alone that it has been implemented during the most economically turbulent times since the great depression in the most politically sensitive single market in the world.

Phase III, which started in 2013, gives the EU the chance to make use of all the lessons learned in Phases I&II. There is some evidence that lessons have been learned. During Phase III, the allocation of carbon permits is moving from free allowances to auctions. In 2013, 40% of permits were auctioned and this percentage is set to progressively rise. Furthermore, the EU is taking action to reduce the existing number of saved permits by suspending some auctions, forcing firms to use the reserves of allowances. If the EU is able to set the number of permits up for auction at a level that forces firms to reduce emissions, ETS should at least become effective. We have to hope that the EU has learned from past mistakes and does not succumb to industry pressure to set a lax cap.

To make sure ETS is effective, the EU PAGE 28

should set itself some simple rules. It can easily see whether it has set the cap too high or low by following the price at which CO2 permits are trading. Ludicrously low prices like those seen in 2007 clearly imply it is supplying too many permits, whereas very high prices can have an overly punitive effect on industry, perhaps even inspiring footloose industry to relocate: a phenomenon known as ‘carbon leakage’ and something dreaded by the EU. There is a clear trade-off here: higher prices result in more abatement but hurt industry. In deciding on these rules, the EU needs to balance how much pain it is willing to inflict on industry in order to reduce emissions. It should be clear on this. By setting a target price band for CO2 per ton, the EU can ensure the cap level is effective and lower uncertainty for industry.

The effectiveness of ETS should not only be measured in terms of the abatement it incites. The EU should also pay attention to which firms are reducing emissions. There is recent evidence that suggests that the firms who have cheap carbon reduction options are not necessarily the ones reducing emissions.

The introduction of the scheme has led large polluters, who have to buy a large amount of permits, to try and reduce emissions regardless of how easy it is for them to do so. Conversely, smaller firms that do not have to buy a lot of permits, but may be able to cheaply reduce their emissions, are not re-

ducing significantly. The data suggests profit maximisation is taking a back seat to behavioural effects: firms are more sensitive to the ‘loss’ of paying for permits than the potential gains of selling permits that are no longer needed.

The EU should be extremely sensitive to this effect because it goes directly against the goal of ETS: to reduce emissions efficiently. Ultimately, managers are accountable to their shareholders who expect profits; therefore, it is reasonable to expect the behavioural effects to be mostly short term. As carbon markets mature and industry becomes accustomed to them, private expertise in emissions reduction should grow and lead to firms viewing the carbon market more rationally.

ETS undoubtedly is a flawed system; but it is a flawed system with potential.

ETS is in its infancy, hence we should treat it as such. As it learns and grows, we must forgive inevitable missteps.

Whilst it is right to criticise its flaws, we must never forget to encourage it as well. The electorate should be more vocal in its support for the EU’s attempt to reduce emissions in order to counterbalance the powerful industrial lobby. We cannot forget that the problem of global warming is exceedingly complicated and the solution will not be simple. ETS is better than nothing and the focus should be on improving it. The EU has lost some if its shine in recent years, a strong ETS can help the EU regain some of it.

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EU ETS: more than just hot air

BUILDING DAMS IN AFRICA: A CALL FOR STRONGER MULTILATERAL COLLABORATION ON WATER SECURITY

By Mai Mahmoud

According to the International Commission on Large Dams (ICOLD), there are around 58,000 dams in over 140 countries worldwide. The Grand Ethiopian Renaissance Dam (GERD), currently under construction on the River Nile north-west Ethiopia, will represent Africa’s largest dam with 145 metres height. Being developed on the world’s longest river that is shared by 11 countries, GERD has provoked much controversy over the past few years. On the one hand, the dam promises to transform Ethiopia to an East African power hub and contribute to the national economic development plan targeting the eradication of poverty by 2025. On the other hand, downstream countries, particularly Egypt and Sudan, have expressed concerns that the dam will have adverse effects on their water supply.

Since the launch of GERD in April 2011 as the largest engineering project in the country’s history, the dam has been perceived as a unifying force across ethnically diverse and divided Ethiopia. It is argued that the Ethiopian government was successful in moving attention away from national conflicts towards national economic development. Indeed, images of the dam’s finished structure are framed in gov-

ernment offices, splashed across city billboards and broadcasted repeatedly on state television. Ethiopians perceive GERD as a sign of national dignity, a symbolic development for shifting the country’s image away from being a famine-ridden nation reliant on the donor community towards self-sufficiency and economic prosperity.

The dam is expected to generate 6,000 megawatts of power upon its completion in 2017. Thus, it would triple Ethiopia’s electricity generation capacity, contribute to manufacturing growth by solving the problem of constant power shortages, and enhance power trade in the region. Other benefits of the dam include water conservation by minimising evaporation loss as a result of being built in a relatively less humid valley.

The $4.8 billion dam project, which according to the Ethiopian government is now 40 percent complete, is entirely financed by treasury bonds. Despite the fact that Ethiopian civil servants and state-owned banks are forced to buy a big share of the bonds, Ethiopians consider investing in the dam project a display of patriotism. Besides, the current funding strategy seems inevitable, as international donors and finance institutions have been wary about investing

in GERD. Implicitly, the Ethiopian government accuses Egypt of putting pressure on international partners not to participate in financing GERD. Meanwhile, Egypt has repeatedly expressed plausible concerns that such a huge dam with a storage capacity of 70 billion cubic meters will restrict the flow of water and threaten livelihoods in a country that depends almost exclusively on Nile River water resources.

In June 2013, the International Panel of Experts – formed in collaboration with Ethiopia, Egypt and Sudan to evaluate the potential impacts of the project on the two downstream countries – submitted its final report to respective governments. Although the report was never made public, leaked copies of the official report (signed by the 10 panel members) were lately transmitted online. According to the Egyptian Ministry of Foreign Affairs, the report indicates that present Hydrological and Reservoir Simulation Study shows “detrimental impacts” on Egypt’s water supply and the Egyptian High Dam’s hydropower generation. It is estimated that GERD could deprive Egypt of more than 17 billion cubic metres of water a year, and reduce the production of electricity at the High PAGE 29

The shining issue of Africa

Dam by almost 40 percent.

Disputes over the management of the Nile River have a geopolitical history that precedes GERD. Essentially, two regional agreements are of significant importance in this context. The 1929 agreement between Egypt and the United Kingdom, on behalf of Sudan, allocated minimum flows to the two countries and stated that upstream nations had to consult them over construction projects on the Nile basin.

Modified in 1959 by Egypt and Sudan, the existing treaty allocates Egypt 55.5

billion cubic metres of water per year and Sudan 18.5 billion cubic metres per year. The treaty also gives the two downstream countries the right to legal recourse over the development plans of upstream countries in the Great Lakes region. Nevertheless, it is noteworthy that since the treaty modification in 1959, political, economic and demographical changes in the region have put new pressures on the Nile River water resources.

In 1999 Nile Basin countries launched the Nile Basin Initiative as a transition-

al agreement under a shared vision ‘to achieve sustainable socio-economic development through the equitable utilisation of, and benefits from, the common Nile Basin water resources’.

Later in 2010 the Cooperative Framework Agreement (CFA) was introduced to ensure the realisation of the ‘shared vision’ through a permanent agreement. However, the CFA failed to achieve consensus among Nile Basin countries, with strong opposition from Egypt insisting on maintaining its historical rights in the Nile water based on previous agreements.

This lack of basin-wide agreement over the management of shared water resources is in fact dispiriting. Cooperation over water is vital for facilitating development and reducing vulnerability to climate change. This is of special importance to Africa, ‘the continent most vulnerable to the impacts of projected climate change’ according to the UN Intergovernmental Panel on Climate Change. The unilateral decision-making, represented by the launch of GERD in 2011 amid political and socio-economic instabilities in Egypt, does not provide a fruitful route to future water security in the region. ■

THE FUTURE LEGACY AND IMPACT OF THE TRANS-PACIFIC PARTNERSHIP

By Avision Ho

In today’s political environment, Democrats and the Republicans rarely agree on issues. The Trans-Pacific Partnership (TPP) is one such issue which offers President Barack Obama the chance to leave a mark on the world stage.

The TPP is a proposed free-trade agreement designed to “enhance trade and investment among partner countries, promote innovation, economic growth and development, and support the creation and retention of jobs.”

(United States Trade Representative, USTR). Broadly, the agreement aims to achieve these aims through reducing tariffs and removing non-tariff barriPAGE 30

ers. Competition, environment, labour, and intellectual property are all key areas within the agreement.

A significant reason for why the White House and the newly Republican-controlled Congress are pushing through with negotiations on the TPP is because of the benefits it could bring to the US economy. By reducing the barriers to trade, international markets will open up, improving the access of US goods.

Indeed according to a report published by the Peterson Institute in 2012, it is estimated that the US will see an increase in exports of 4.4%, which will amount to an additional $124 billion

to the US economy (Plummer, 2012).

Whilst exact details of the TPP agreement are rare, sections of the agreement have been leaked onto the internet, in particular WikiLeaks’ release of the Intellectual Property Rights and Environmental chapters.

Some of those who have seen the agreement have expressed concerns over the Intellectual Property chapters.

Several US Congresspeople including Representatives Jan Schakowsky, Rosa DeLauro, Jesse Jackson Jr. and Barbara Lee wrote a letter to Ambassador Ron Kirk of the United States Trade Representative, raising their beliefs that the “negotiations would undermine public

health and access to medicines in the Stephen Cornish, Executive Director es such as AIDS and malaria from developing countries negotiating that of Médecins Sans Frontières Canada, reaching the market in developing agreement”. (Jan Schakowsky, 2011) said of the current proposals: “World- countries. (Sell, 2014) These beliefs were centred on US wide, millions of people die each year Mark Grayson, deputy vice presiproposals pursuing “the expansion in because they cannot afford the medi- dent of the Pharmaceutical Research data exclusivity requirements” which cines they need. These numbers could and Manufacturers of America disawould restrict drug safety regulators climb even higher, unless Canada and grees: “[TPP] will do nothing to stop from using current data to give market other Pacific Rim countries involved the distribution of medicines that are approval to generic drugs, even in the in the TPP trade negotiations take de- generic.” Instead, he argues that the absence of a patent. The consequence cisive action to protect global public TPP agreement will be “transformof this is that it will be harder for ge- health.” (Cornish, 2014) ative“ for the countries involved and neric drugs to be produced during the Cornish’s concerns are echoed by will create “a system in which more period of exclusivity held by the pio- Professor Susan Sell of the George than 85% of prescriptions are filled neer manufacturer. (Sharma, 2007) Washington University who having with generics”.

Further to this, there were plans to studied the WikiLeaks documents, Furthermore, these pioneer pharexpand the scope of patentmaceutical companies who reing so that monopolies can be search and develop the drugs extended in countries outside need a return on their investof the manufacturer’s base of ments. When the expenditure operations thereby restricton research and development ing the choice of different is high - recent figures suggest variants available for a speit is $350 million per drug cific patented medicine. The and the success rate of a drug patenting could be extendvery low (around 5%), then ed even in the case of there the security that a patent brings being no substantial benefit in ensuring the commercial to patients. success of a new drug will enAnother component of necourage pharmaceutical comgotiations is the prohibition panies to continue investing in of “pre-grant opposition” new, life-saving drugs. (Herper, which effectively allows in2013) terested parties such as health Interestingly, the governments experts and patients, to presof countries such as Canada, ent information before the Chile, New Zealand, Malaysia patent is issued. The process and Singapore disagree with of consultation and examisome parts of the US position, nation prior to a patent being advancing their own proposals issued thus becomes less into protect their access to medformed and is subject to less icines. As such, they recognise scrutiny. the potential problems that the Source: World Trade Organisation Profiles, 2012 The implications of the TPP agreement could bring, stringent intellectual properand acknowledge how this ty protection for drugs would make said that the controversial section on weighs up against the stringent proit difficult to effectively treat those in intellectual property would protect a tection of intellectual property. Only the developing world. When there is practice known as ‘evergreening’. Ev- time will tell whether the US will get less qualified information available to ergreening is when companies make their way and, if they do, what the judge whether a generic drug is safe, small adjustments to their drugs, with ramifications will be. New Zealand’s individuals and organisations have the aim of re-patenting it to prevent trade minister recently expressed his little choice but to purchase the more rival generic companies from releas- view that “the finish line is in sight”; expensive original drug from the pi- ing copycat drugs. Sell argues that by we might not have to wait long before oneer manufacturer. This choice is re-releasing the drug in a gel cap or we find out. (Davis, 2014) ■ eroded further when monopolies are liquid format, firms will be able reextended and the issuance of patents strict competition and thus prevent a becomes easier as the consultation deflation of prices. As a result, it will process is subject to less scrutiny. prevent cheaper drugs for illnessPAGE 31

YOUTH UNEMPLOYMENT IN SOUTHERN EUR WHATâ&#x20AC;&#x2122;S NEXT FOR THE DISENFRANCHISED Finding a job has become a daunting task for many youngsters in Southern European countries. Youth unemployment has reached unprecedented levels after the financial crisis. As of September 2014, the youth unemployment rate (the rate of people aged 15-24 currently looking for jobs) was 53.70% in Spain, 50.70% in Greece, 42.90% in Italy and 35.20% in Portugal. In a recession, the youth unemployment rate tends to rise more sharply and recover more slowly than the average unemployment rate. This is because firms, faced with financial difficulties, tend not to hire new workers, thus making entrance into the job market harder for many young people. However, this is truer for some countries than others.

For example, several Central and Northern European countries, along

with Japan, have managed to keep their youth unemployment rate below 10%.

In September 2014, the rate was 9.10% in Austria, 7.60% in Germany, 9.80% in the Netherlands, 8.50% in Norway and 7.20% in Japan. Some countries have even managed to decrease their youth unemployment over the last 10 years.

In Germany the rate was over 16% in 2005, while it is only 7.60% now. On the other hand, 24% of the people in the labour force aged under 25 were unemployed in Italy in 2005. That figure has now gone up to 42.90%.

So what is it that makes some countries more likely to experience high levels of youth unemployment? One explanation certainly has to do with the rigidity of the labour market. Rigid labour markets are characterised by the reluctance of employers to hire

If only looks were enough.

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young workers because of high hiring costs or difficulty in firing. Rigidity can result from many different factors, such as high unionisation rates or universal statutory severance payments. In countries like Italy, 35% of workers are unionised, as opposed to only 11% in the United States and 17% in Germany. High levels of unionisation usually lead to stronger Employment Protection Legislation (EPL). This creates benefits for people who are currently employed, and who can enjoy more secure jobs and higher pay. However, unions make workers more expensive for firms, who are therefore less willing to hire during recessions. This is the socalled dualisation of the labour market: older workers have well-paid jobs that are very hard to terminate, whereas young people are hired, if at all, only

ROPE: D OF GREECE ITALY AND PORTUGAL on a temporary basis. For example, universal statutory severance payments induce many employers to hold back on employing new workers. For a tenure of over 20 years, Spain requires a severance payment of 12 months pay, while Portugal requires 20 months pay.

This is in sharp contrast with countries like the Netherlands, where there is no statutory severance payment, and Denmark, where employers are required to pay 3 months wages after a 20 year-tenure. The prospect of high severance payments is obviously not appealing to employers, who then prefer hiring workers with short-term contracts. Usually, it is exactly young people who settle for short-term contracts, resulting in them having lower job protection and gaining less job-specific experience.

Another reason for high youth unemployment is the fact that, in certain countries, the competencies required by employers do not match those offered by students. Nowadays, more and more employers complain that the education system in their respective countries does not provide students with the skills they need in the job market.

Countries like Spain, Greece, Italy and Portugal all lack efficient vocational training systems that could facilitate entrance into the job market. Students tend to receive a very theoretical education, which is detached from the needs of today’s firms. The transition from universities to the job market in these countries is particularly slow, as there is no direct channel such as structured internships or other programmes to prepare students for the workplace.

A worrisome statistic is the number of university graduates who are unemployed after graduation in the European periphery. In Italy, the rate of unem-

ployment amongst recent graduates has grown from 11.5% in 2007 to 26.5% in 2014. Over the same period, real wages decreased 20%, from an average of over €1200 to just above €1000. This means that graduates are now more willing to accept lower-paid jobs, creating a mismatch between their skills and educa-

By Alberto Martelli

their labour markets, making them more flexible and open to entrance to young people. There are many ways to do this: they can make permanent labour more attractive for employers, make collective bargaining agreements more flexible or liberalise certain professions that are dominated by elder people. Spain has already implemented a labour market reform in 2012, as has Portugal. Both countries are starting to enjoy the fruits of these reforms and are experiencing falling unemployment rates.

Italy, on the other hand, has been slower at creating these reforms. The case of Germany is particularly important to understanding the importance of reforming the labour market. Overall unemployment in Germany was at 10% in 2001. The Hartz Reforms of 2002 created a more flexible and open market, abolishing many benefits and establishing effective apprenticeship and internship programmes for young people. These reforms have been painful and were highly criticised by many Germans in the first few years, but they have resulted in the country now enjoying one of the lowest youth and overall unemployment rates in the world.

The German case demonstrates that reforming the labour market is instrumental to decreasing unemployment.

Once the labour market is more flexible and open, policies such as vocational and apprenticeship programmes regulated at the national level can further enhance youth employment. Labour reforms will be criticised and face strong opposition in the periphery at first, but they are the only way to fight unemployment and give young people the job opportunities they deserve. ■

[ ] “More and more employers complain that the education system ... does not provide students with the skills they need in the job market”

tion and the job they are doing Youth unemployment has become a high priority on the EU agenda. The European Commission has implemented many programmes to try and reduce youth unemployment. The Youth Employment Package includes many measures, such as the European Alliance for Apprenticeships. Moreover, the Youth Unemployment Initiative agreed in 2013 to establish a budget of €6 billion to fight youth unemployment within the European Union. The measures taken include policies to foster employability amongst young people, to facilitate the transition from school to work, and to reduce obstacles to mobility. Since the implementation of these measures, youth unemployment has started decreasing in all the countries of the periphery, but still remains at extremely high levels.

Policies implemented at the European level are surely beneficial, but Portugal, Spain, Italy and Greece face deeper problems that need to be addressed at the national level. They need to reform

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THE ILLUSION OF INDEPENDENCE REVISING THE VALIDITY OF THE POLICY TRILEMMA IN AN ERA OF FINANCIAL GLOBALISATION

By Mari Magnussen-Landsem The Impossible Trinity Most students who have taken an introductory course in macroeconomics will be familiar with the policy trilemma that policy makers face when choosing monetary arrangements. The “impossible trinity” may sound like the title of a Harry Potter sequel but is simply the rule stating that countries are limited to choose two of three the following goods: an open capital market, a fixed exchange rate and the ability to conduct independent monetary policy (see illustration 1).

For years this central piece of international macroeconomic theory has influenced policy-makers who have carefully considered the trade-off the trilemma introduces. The benefits of picking two virtuous features must be weighed against the cost of conceding a third. Since the dissolution of the Bretton Woods system in the 70s, most countries have gradually opened up and liberalised their domestic capital markets to foreigners.

At the same time, most countries have abandoned the fixed exchange rate in favor of independent monetary policy. In essence this means that countries will allow their exchange rate to fluctuate, in return for access to foreign capital and the autonomy to use monetary policy to ensure domestic macroeconomic stability (i.e. taming inflation and unemployment).

The Monetary Trilemma

A NICE but Turbulent Era The movement towards this particular corner of the trilemma has been strongly advocated by a number of prominent economists as well as the IMF. In fact scholars have been so content with the performance of the international monetary order in the past 40 years that they in the academic literature mainly refers to it as the “NICE”1 era.

But then there are always those who complain. In the past 40 years of liberalisation and growing cross-border flows of capital, the occurrence of fi-

[ ] “Countries .. allow their exchange rate to fluctuate, in return for access to foreign capital and to use monetary policy.”

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1 Near an Internationally Cooperative Equilibriun

nancial crises has doubled compared to the age of the Bretton Woods gold standard. In particular this applies to developing and emerging market economies that have been subject to a recurrent boom – bust cycle of credit and asset prices in connection with rapid capital inflow surges and disruptive outflows2 . The fact that most of these crises have occurred outside the developed world, have prompted defenders of a liberal financial system to attribute the cause of such occasional “hiccups” to policy mistakes, weak financial systems, and cronyism in national systems of capitalism. Up until recently, this conclusion proved a convenient interpretation for advocates of the current order. Now, the 2008 global financial crisis (GFC) may have brought the alleged virtues of this NICE international monetary order into question.

2 Examples include the 1994 Mexican Peso crisis, the 1997 Asian financial crisis, the 2001 Turkish banking crisis

Unconventional Policies and Inconvenient Spillovers Since the GFC, policy-makers in the major advanced economies (the US, EU, Japan) have attempted to get the economy back on track by pursuing unconventional, highly accommodative monetary policy. The policy that has received most attention in this context is the asset-purchasing program, Quantitative Easing (QE). G7 Central Bank governors and Finance Ministers claim that such monetary measures “have been and will remain oriented towards meeting domestic objectives using domestic instruments”. Meanwhile, their colleagues in emerging markets have complained about adverse spillover effects from the extraordinary monetary conditions in advanced economies. Brazil’s newly re-elected president, Dilma Rousseff, accused the US of creating a “monetary tsunami” that would fuel volatile financial flows into emerging market economies, putting excessive pressure on their currencies and asset markets.

This then begs the question: If the idea of independent monetary policy holds, implying that monetary policy is a purely domestic issue, why are emerging market officials so concerned about the advanced economies monetary stimulus? What is all the fuss about Dilma?

President Rousseff ’s concern is with the volatile inflows of “hot money” allegedly prompted by the highly expansive monetary policy in advanced economies. In the QE policy period from 2009 – 2013, gross capital inflows to emerging markets have increased from $192 to $589 billion.

This form of footloose capital tends to exacerbate the economic cycle in the recipient economy. It generates economic overheating and excessive currency appreciation when flowing in, only to result in crisis when it later retreats home. In connection with the Dehli Declaration presented in 2012, the BRICS countries jointly stated: “Excessive liquidity from the aggressive policy actions taken by cen-

THE POPE AND PIKETTY INTEGRATING ETHICS INTO CONTEMPORARY POLICY

By Sughanda Srivastav and Tim Dobermann In the aftermath of the recent financial crisis, many economists hypothesised that we were on the brink of a ‘Bretton Woods moment’ - a moment when the world’s leaders would congregate and re-design the global political and economic system. Impetus to address systemic risk and coordination failure was palpable. Complaints of a stagnating middle class and shouts of ‘We are the 99%!’ were widespread. The moment for reform was ripe.

However, a dramatic redesigning of the system did not occur. Occupy movements came and went but the changes that followed have been gradual. Basel III, criticisms of ‘too big to fail’ - or, most recently, ‘too big to jail’ - and the symbolic cutting back of bonuses were moves welcomed by the public. However, they do not represent a shift towards a new or augmented framework. The policy discourse still remains neoclassical in nature, and the tensions that this system creates vis-a-vis income inequality have not found recourse in policy debates.

This is where the Thomas Piketty and the Pope have something to say.

Piketty’s research brought to the forefront the fact that income inequality is higher than what most people imagined. He told the Occupy Movement that it is not the 1% who should be the centre of attention, but rather the top 0.1%, who hold 23% of the total private wealth in the the United States.

Inequality is an essential feature of capitalism, as it incentivises hard work and innovation. The levels today, however, are disproportionate, beyond what most people agree can be characterised as exerting a ‘motivating push’.

Enter the Pope. Pope Francis has ushered in a new focus on the lives of the poorest. According to him, the pursuit of economic efficiency has distracted us from social justice. In his words, society has come to view ethics and morality with a ‘scornful derision’, seeing ethics as ‘too human’ and ‘counterproductive’. He calls for the reintroduction of ethics into policy-formulation. Together, Piketty and the Pope have a strong evidence-based argument for changing - or, at least, augmenting - the current economic and political system.

So, what is the norm of current day policymaking and how can it be improved? Paul Krugman notes in his exposition of markets and morality that ‘people believe, wrongly, that there’s something inherently moral about free-market outcomes.’ The Theory of Moral Sentiments was written by Adam Smith seven years before he wrote The Wealth of Nations. For Smith, ethics and morality underpin economic principles. They highlight the values that human-beings possess over and above the popularised ‘rational behaviour’ of economics. A quirk of history resulted in us remembering Smith solely as the advocate of ‘the invisible (but amoral) hand.’ Contemporary issues such as the recent financial crisis and climate change illustrate that inequality, whether between classes or across generations, is a growing concern. Ultimately, if we are to choose to embrace an Aristotelian concept that the institutions we develop should be ones which make us most happy, ethics will have to be re-integrated into the current policy discourse.

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tral banks to stabilise their domestic economies have been spilling over into emerging market economies, fostering excessive volatility in capital flows and commodity prices. (...) We believe that it is critical for advanced economies to adopt responsible macroeconomic and financial policies, avoid creating excessive global liquidity and undertake structural reforms to lift growth that create jobs.”

Impossible Trinity or Irreconcilable Duo? So what does all of this have to do with the policy trilemma? The key point here is the trilemma’s prediction that a country with an open capital market and market-determined exchange rates should be able to set its own monetary agenda to achieve whatever macroeconomic objective it finds suitable.

However, recent research, most notably possibly from LBS professor Hélène Rey, suggests that free capital flows will cause a loss of monetary independence. Somewhat simplified, this is how the argument goes: The main supporting assumption behind a liberal global capital market is that when funds are allowed to flow freely across borders, capital will be allocated to its most productive use. This implies that the economic fundamentals (local investment opportunities and investment climate, local economic conditions etc) are the most important drivers of capital attrition. Rey argues (and proves rather convincingly) on the contrary that global capital flows are correlated with the global financial cycle, which co-varies with a number of factors that have little to do with economic fundamentals. One important factor that drive global capital movement is the liquidity of major financial institutions following the QE asset-purchasing program. This in turn implies that a number of external factors rather than a country’s economic fundamentals determine the capital inflow/outflow in any given period. It is precisely when

Central Bank of Brazil

capital inflows/outflows to an economy are misaligned with economic fundamentals, that they can serve to exacerbate the economic cycle of the recipient economy.

For sake of illustration we return to Dilma Rousseff and Brazil. Brazil is a country that historically has struggled with runaway inflation and macroeconomic instability. It is therefore not a coincidence that they have chosen to prioritise monetary independence to a

zil’s inflation rate hit the upper bound of its targeted band. Since then Brazil’s policy rate has been steadily readjusted upwards towards the double digits.

This suggests, in line with Rey’s argument, that Brazil’s monetary policy is not allowed to focus exclusively on domestic macroeconomic objective, but must also cater to inflow surges. In effect, Brazil faces a dilemma: On the one hand, it can raise interest rates to target domestic inflation targets and control credit growth. On the other hand, it can lower interest rates to reduce interest rate differentials that motivate speculative hot money inflows surges. This clearly demonstrates the implicit contradiction of achieving domestic macroeconomic stability and tackling excessive inflows.

Such trade-offs would not take place if monetary policy were truly independent. Rather, it indicates that the global cycle of capital flows can allow monetary conditions of the major advanced economies to be transmitted globally. On this note, Rey (2013) argues that the triemma is reduced to a dilemma. Completely independent monetary policy is an illusion when a country is integrated into the global capital market.

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“Completely independent monetary policy is an illusion when a country is integrated into the global capital market.”

fixed exchange rate in order to gain the autonomy to target a high interest rate to combat such inflationary pressures.

In 2012 however, Brazil lowered its interest rate to a historic low (7,5 %) in order to discourage large capital inflow surges prompted by speculative carry trade operations. Consequently, Bra-

Editor’s Review

“ZERO TO ONE”

BY PETER THIEL

By Honglin Jiang In “Zero to One”, renowned venture capitalist investor and serial entrepreneur Peter Thiel outlines his philosophy on innovation, startups and technological progress. He explains how progress via copying and iterating on what has been known to work (“horizontal”, or “one-to-n”) is separate and distinct from radically new innovation (“vertical”, or “zero-to-one” progress). Though he writes with authority and credibility, particularly regarding the characteristics of successful startups, some subtleties are obscured in his ambitious grand thesis.

Thiel defines “zero-to-one” progress as binary technological progress; doing something that nobody else has ever done before. He cites examples such as Facebook, which has changed the nature of how we interact socially. However, many of his examples are arguably not truly “zero-to-one” in the binary sense of the concept. In the same way that many business-people overuse the concept of a “paradigm shift”, Thiel is at risk of overstating the frequency of truly innovative technology. Before Facebook, there existed Friendster and MySpace, and a large part of Facebook’s success was built on incrementally capitalising on superior software and business strategy, rather than a fundamental technological discontinuity. True zero-to-one type technological shifts, manifested today, would encompass innovations like nuclear fusion and quantum computing, which could solve problems such as unlimited clean energy and cracking unbreakable cryptographic keys, respectively.

Nevertheless, Thiel has personally made more than a billion dollars making savvy, concentrated investments on promising startups, zero-to-one or not. It therefore does not come as much surprise that he should be exclusively optimistic on start-

ups as the future engine of innovation. He dismisses the possibility of innovation at large businesses and governments as impossible, given their lack of coordination and scientific pessimism. In his view, if innovation cannot happen at small startups, then it cannot happen at all. This seems too pessimistic for at least two reasons. Firstly, governments have financed and performed great feats of innovation before, and with the right environment, should be able to do so again. Think of projects on a grand scale such as the Apollo moon landings or the development of the internet, which have paid technological dividends to rival those of any startup. Secondly, he dismisses progress by incrementalism out of hand, but in fact much innovation is developed in that grey area between zero and one, where scientists and engineers arrive at a confluence of circumstance that enables an invention that was previously impossible. A good example of this is the atomic bomb, where various teams around the world raced each other to capitalise on pre-war developments in nuclear physics to develop the first viable bomb before the end of World War II. All this said, there is much to credit in the book.

Thiel’s boundless “definite optimism” and faith in humanity’s overall ability to overcome obstacles in the way of its progress is a contagiously refreshing counterpoint to a prevailing air of secular stagnation. However, it’s when Thiel discusses his perspectives on startups and venture capital that the book truly shines. With genuine insight into portfolio management, startup culture, market sizing, monopolistic competition, and the distribution of expected returns, Thiel is at his contrarian best.

Whether one agrees with his philosophy on innovation or not, it’s difficult to argue with its application in his empirical success.

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THE LONG-RUN ECONOMIC CONSEQUENCES OF ENVIRONMENTAL CATASTROPHE By Tim Dobermann

Super Typhoon Haiyan – the strongest recorded storm at landfall, and unofficially the strongest typhoon ever measured in terms of wind speed – rattled into the Philippines and Southeast Asia in November of last year. Haiyan was unprecedented, with the highest sustained gusts measuring in at 315 km/h (195 mph). For a country in this region, typhoons are a regular occurrence, but usually they are of a much smaller intensity.

Such storms pose huge challenges for developing countries. Physical capital

and existing infrastructure are devastated. Crops and other sources of livelihood for rural inhabitants are ruined.

On top of all this, there is the social cost: disrupted and lost lives, missed schooling, and psychological damage.

Successive reports by the Intergovernmental Panel on Climate Change, the world’s largest consortium of climate scientists, have left little doubt on the role of anthropogenic or human-induced climate change on extreme weather events. While no single weather event can be directly attribut-

Source: Hsiang & Jina (2014)

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ed to humans, it is clear that warmer ocean surface temperatures make extreme or rare weather events like Typhoon Haiyan more likely. Ocean heat provides energy to tropical storms, enabling them to survive longer and grow in intensity. Upon landfall, rising sea levels increase the areas at risk of storm surges and flooding. According to the literature, the link between human activities – namely, the release of large volumes of greenhouse gases into the atmosphere – and global warming is unequivocal The immediate impact of a tropical storm is akin to a negative shock to the economy. The long-run trajectory an economy takes after a disaster, however, is less clear. The varying success of recovery and reconstruction efforts have spawned several theories about how such events affect long-term income, usually measured as GDP per capita On one side of the spectrum lies a permanent fall in the economic output of a country. The destruction in the wake of a disaster might be so high that even a substantial mobilisation of resources cannot prompt recovery back to

the previous state on a reasonable time scale.

On the other side, disaster may cause a permanent rise in incomes and economic activity through ‘creative destruction’. A large disruption to an economy might create room for new institutions and innovations. On a more tangible level, storms might wipe-out old and unsalvageable infrastructure, to be replaced by new, more productive forms.

To determine which effect dominates, Solomon Hsiang at UC Berkeley and Amir Jina at Columbia used meteorological data to reconstruct the exposure of each country to tropical cyclones from 1950 to 2008. Accounting for cyclones in previous periods, the authors analyse growth rates in the years immediately before and after a storm.

Their results show that extreme events – those which occur at very low frequencies – have long-lasting negative effects on economic growth. A tropical cyclone which falls into the 99th percentile, similar to Super Typhoon Haiyan, reduces cumulative per capita incomes by almost 15% two decades later. This is equivalent to eroding away nearly one decade of income growth.

Whether a country will be more frequently exposed to tropical storms as a result of climate change is contested. However, climate change in effect ‘loads the dice’, making stronger storms more common. The economic cost of a

storm grows exponentially, not linearly, with intensity. For countries most at risk, such as the Philippines, there is a growing concern over future development prospects.

Such is the harsh reality of climate change. Vulnerable countries and remote areas often do not have the necessary infrastructure in place to be resilient against large storms. Factoring in long-run economic consequences, which most current projections of the total cost of climate change do not, creates an even larger gap between neces-

sary and actual expenditure on climate change adaptation and resilience.

Pinning down the costs associated with future risks is tricky. There is bound to be uncertainty. Uncertainty, however, should not be a cause for inaction. Integrating the findings of climate science into economics will help public and private bodies to make necessary investments and changes to both mitigate and adapt to climate change.

If economics is to truly call itself a science, perhaps this is one place to start.

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Global tropical cyclone exposure. Colours represent the average maximum wind speed for all tropical cyclone events during this period.

Source: Hsiang & Jina (2014)

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HOW TO SUCCESSFULLY SECURE A JOB: RESULTS FROM THE LSE STUDENT LABOR FORCE SURVEY

By Krzystof Zaremba

The topic of most of conversations in Michaelmas term is centered around one thing: applications. Writing cover letters, networking through career events and attending assessment center interviews are the bread and butter of an average LSE student. Glancing jealously at friends who have secured their internships, the curiosity arises: what makes them better than other candidates? Every student asks himself/herself at one time or another this important question: which traits distinguish successful applicants from unsuccessful ones and what should one do to succeed?

As members of the research division of the LSE SU Economics Society, we share this curiosity. Therefore, we decided to conduct a research survey examining the topic in a scientific manner. We conducted a survey to find correlates to success at three fundamental stages of the application process:

1

RESEARCH METHODOLOGY 1

Brainstorm potential expanatory factors for career success outcomes

2

Design questionnaire to measure the correlation between factors and outcomes

3

Distribute through several channels, including web & one-to-one interviews

4

Regress outomes on the data obtained to test our hypotheses

TELEPHONE INTERVIEWS Position in a Society: a signal of time management, organisation, and communication

600

+

Gender: interestingly females have a higher chance of successfully passing

2

INVITATIONS FOR ASSSEMENT CENTER

3

JOB OFFERS

Position in a Society, particularly 2nd & 3rd years

Ratio of studying to socialising

Ratio of studying to socialising

Career events attended, particularly for freshmen

Number of career events attended: can help to develop important networks and gain information

responses Number of career events attended: can help to develop important networks and gain information

Work related exprerience, particularly for freshmen

Networking: making new contacts and perhaps skipping application steps

Our study clearly shows the value of networking and attending career events. Interestingly, two factors we considered, passing a gap year and having a part time job, did not prove significant in our analysis. Although we do not claim causality, the logic of our confirmed hypothesis strongly suggests the causal direction from highlighted factors to successful applications. Therefore, this study indubitably contributes to a better understanding of the LSE Students labour force dynamics.

Furthermore, it proves useful by making concrete recommendations on how to increase oneâ&#x20AC;&#x2122;s employability in an extremely competitive atmosphere.

The research also brings into question the efficiency of the hiring process. Are the networking skills really crucial for working? Is the hiring process inefficiently biased in picking up people who are good at networking at the expense of hard working students? Answers to these questions justify the need for further research on this topic.

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