Forget the real world

26 Feb 2015

Those who see themselves as practical students of the real world are condemned to never understand it.

To grasp how society works demands an entirely different approach. Simply responding to what happens to be in the news is doomed to yield superficial and one-sided results.

The recent calls by economics students for their tutors to take a more reality-based approach provide a case in point. For example, the University of Manchester Post-Crash Economics Society has received a lot of publicity for its campaign for a better economics education. One of its premises was that the way economics was being taught “seemed separate from the economic reality that the world was facing”.

Much of the blame for this alleged unworldliness is pinned on the supposed dominance of free market economics: “Our economics education has raised one paradigm, often referred to as neoclassical economics, to the sole object of study. Alternative perspectives have been marginalised.”

In relation to the latter point the PCES apparently failed to appreciate the implications of its own report’s foreword, entitled “the revolution in economics”. It is deliciously ironic that the author was Andrew Haldane, the executive director for financial stability at the Bank of England, an unlikely revolutionary.

Haldane took the opportunity to assert “the power of economics is that it affects real lives in real ways”. Indeed the inspiration for PCES was a 2011 conference on “Are economics graduates fit for purpose?” supported by the British Government, the Bank of England and the Royal Economic Society. Despite its anti-establishment pretensions it is hard to imagine a more mainstream initiative.

One of the main backers for such projects internationally is the Institute for New Economic Thinking. As I have written before on Fundweb this organisation presents itself as the voice of embattled radicalism, but is itself a bastion of the economics elite.

Its advisory board includes among others five Nobel laureates (James Heckman, Sir James Alexander Mirrlees, Amartya Sen, Michael Spencer and Joseph Stiglitz), two former chief economists at the IMF (Simon Johnson and Kenneth Rogoff), a former economic adviser to the Bank for International Settlements (William White), a special adviser to the secretary-general of the United Nations (Jeffrey Sachs) and Haldane. Its chairman and co-founder is George Soros, a billionaire hedge fund manager.

Indeed the main reason student groups such as PCES have received so much attention is that they reflect the disarray in the economics profession and the policy elite. The professionals’ tools have failed to revive the developed economies from years mired in stagnation so they are desperately seeking alternatives. Only they lack the confidence or ability to produce anything genuinely innovative.

The critics’ goal is not to bury conventional economics but to save it.

This lack of imagination is apparent in the new coreecon project for teaching economics, produced with support from INET. Despite claims to the contrary its approach is not that different to what was being taught previously.

When the mainstream critics of economics call for a reality-based approach they seem to mean several different things:

  • Economic studies should focus on providing a rapid response to recent events. But those seeking to develop a systematic approach should be asking more fundamental questions rather than demanding quick insights into recent developments.
  • An outlook that is orientated towards policy. But looking at the world through the narrow lens of the policymaker tends to detract from understanding the underlying dynamics of the economy.
  • An approach that is “realistic” in the sense of respecting the limits on economic growth posed by such challenges as extreme inequality and climate change. But many authorities from an earlier era, including Adam Smith, were concerned with transcending limits rather than being constrained by them.

Those seeking a genuine alternative should instead read some classic texts rather than paying so much attention to the “real world”.

A useful first step might be to ponder the words of John Maynard Keynes in his General Theory where he took aim at an earlier generation of those claiming to be immersed in the real world. He expressed disdain for “practical men” who “believe themselves to be quite exempt from any intellectual influences, [but] are usually the slaves of some defunct economist”.

Or, even better, follow the advice of Karl Marx in the 1872 preface to the French edition of Capital where he emphasised the hard work needed to develop a balanced view of the world: “There is no royal road to science, and only those who do not dread the fatiguing climb of its steep paths have a chance of gaining its luminous summits.”

Students would benefit enormously from reading the classic works of such Dead White Males rather than adopting the blinkered outlook of policymakers. Systematic study of the past would open the way for a radical step forward in their understanding.

This blog post was first published today on Fundweb.

This is my latest article for spiked.

The sanctimonious war of words against tax dodging embodies a fundamental attack on individual freedom. Although the offensive appears to be aimed mainly at wealthy individuals and multinational corporations, it threatens to undermine liberty for everyone.

Economics is not the real focus of the frenzied discussion of tax in Britain right now. Rather, this is essentially about the arbitrary exercise of state power. By blurring the line between legal and illegal action, this crusade threatens to undermine fundamental freedoms in all areas of human activity. The fact that the debate is framed in terms of tax payment is, in many respects, incidental.

A careful examination of recent developments illustrates the considerable dangers involved.

On 8 February, the Guardian broke the story that HSBC’s Swiss banking arm had helped wealthy customers dodge taxes and conceal millions of dollars of assets. The report was based on files obtained by an international collaboration of media outlets, including the Guardian, Le Monde, the BBC’s Panorama TV show, and the International Consortium of Journalists based in Washington, DC.

Although the files covered the period 2005/07, it was the first time their content had been made public. Hervé Falciani, an IT expert who worked for HSBC at the time, had obtained them by hacking into customer accounts. In late 2008, he fled from Geneva to France, where he was detained but not extradited by the authorities. In early 2010, the French authorities distributed a list of names based on Falciani’s data to their counterparts in several other countries.

Unfortunately, the subsequent discussion muddied the traditional distinction between tax evasion and tax avoidance. It used to be the case that evasion referred to illegal activity while avoidance simply meant the minimisation of tax payments by legal means. So, in a simple example, someone claiming their full entitlement of allowances would be engaging in tax avoidance. Of course, tax-avoidance schemes can also be incredibly convoluted and complex.

This crucial distinction between evasion and avoidance was long embodied in British law. For example, in the 1936 Duke of Westminster case, the judges ruled that no one could be compelled to pay more tax than is required by statute.

The discussion of tax dodging in recent years has removed this key distinction. In the debate about the HSBC case, the two different practices, one legal and the other illegal, were frequently jumbled. For example, Lord Fink, a former co-treasurer of the Conservative Party, was attacked by Ed Miliband, the Labour leader, for having undertaken ‘tax-avoidance activities’. Lord Fink, after initially baulking at the description, went on to argue that ‘everyone does tax avoidance at some level’. In his original statement, Miliband had called David Cameron ‘a dodgy prime minister surrounded by dodgy donors’, but in a follow-up speech Miliband made clear he was not suggesting Lord Fink was dodgy. The Labour leader therefore played a part in blurring the line between illegal and legal activities.

But Miliband was only treading where the Conservatives have gone before. George Osborne, the chancellor of the exchequer, used his 2012 Budget speech to describe ‘aggressive tax avoidance’ as ‘morally repugnant’. The following year, the Finance Act embodied the idea of ‘abusive’ avoidance in law. The legislation created a new anti-abuse rule in which the government outlawed activities that were within the letter of the law.

Such action undermines the traditional liberal notion of the rule of law, which requires laws to be limited, certain and clear. The new ‘anti-abuse rule’ outlaws tax arrangements that ‘cannot reasonably be regarded as a reasonable course of action’. This law is uncertain and unclear and puts considerable discretion in the hands of tax inspectors and courts to determine what is and is not lawful. This empowers the state to stigmatise and punish those by deciding after the event that a form of tax avoidance is deemed unlawful.

It has long been understood, at least from a classical liberal perspective, that widening the scope of laws can undermine individual autonomy. But blurring the line between what is legal and what is illegal can have the same effect, by creating uncertainty as to what the law-abiding citizen can and cannot do.

If politicians want to make certain forms of behaviour illegal, they have the power to do so with clear and specific legislation. If they want to make tax rules stricter in future, they can. But stigmatising legal practices and possibly even making them illegal after the event sets a dangerous precedent. It opens the way to a substantial increase in state power.

The pious war against tax dodging is much more dangerous than any schemes for evading or avoiding tax.

When individuals or corporations act to minimise their tax payments the worst that can happen is that the authorities lose billions in tax revenue. In contrast, the stakes in the sanctimonious offensive against tax dodging are much higher. By blurring the line between legal and illegal activity it threatens to undermine fundamental freedoms.

A careful examination of the discussion over the last few days illustrates the considerable dangers involved.

On 8 February the Guardian broke the story that HSBC’s Swiss banking arm had helped wealthy customers dodge taxes and conceal millions of dollars of assets. The report was based on files obtained by an international collaboration of media outlets including the Guardian, Le Monde, the BBC Panorama programme and the International Consortium of Journalists based in Washington DC.

Although the files covered the period 2005-7 it was the first time their content had been made public. Hervé Falciani, an IT expert who worked for HSBC at the time, had obtained them by hacking into customer accounts. In late 2008 he fled from Geneva to France where he was detained but not extradited by the authorities. In early 2010 the French authorities distributed a list of names based on Falciani’s data to their counterparts in several other countries.

Unfortunately the recent frenzied discussion has muddied the traditional distinction between tax evasion and tax avoidance. It used to be the case that evasion was illegal while avoidance simply meant the minimisation of tax payments by legal means. So, in a simple example, someone claiming their full entitlement of allowances would be engaging in tax avoidance. Of course, tax avoidance schemes can also be incredibly convoluted and complex.

However, in the discussion of the HSBC case the two different practices, one legal and the other illegal, were frequently jumbled. For example, Lord Fink, a former hedge fund manager and also a former co-treasurer of the Conservative party, was attacked by Ed Miliband, the Labour leader, for having undertaken “tax avoidance activities”. Lord Fink, after initially baulking at the description, went on to argue that “everyone does tax avoidance at some level”. In his original statement Miliband had called David Cameron“a dodgy Prime Minister surrounded by dodgy donors” but in a follow-up speech the opposition leader made clear he was not suggesting Lord Fink was dodgy.

The Labour leader therefore played a part in blurring the line between illegal and legal activities but the prime minister has previously done the same. Cameron’s attacks on “aggressive” tax avoidance have played a similar role. The implication of this new category is that legal activity should be outlawed.

If politicians want to make certain forms of behaviour illegal they have the power to do so. If they want to make tax rules stricter in future they can. But stigmatising legal practices and possibly even making them illegal after the fact sets a dangerous precedent. It opens the way to a substantial increase in state power and undermines the rule of law.

This article first appeared today on Fundweb.

It is one of the most bewildering discussions in a confusing area. Deflation is welcomed by some economists but condemned by others as a grave threat. Some basic distinctions are necessary to understand the debate.

Let’s start by outlining recent developments. The eurozone’s inflation rate fell by 0.2 per cent in the year to December according to a flash estimate from Eurostat. For many commentators the drop signaled the possibility that the region was descending into a protracted period of stagnation akin to Japan’s painful experience since the 1980s. For other pundits, particularly in Germany, the slight downturn in prices was no cause for alarm.

Shortly after the eurozone estimate was released the Office for National Statistics in Britain said that the consumer prices index (CPI) had risen by only 0.5 per cent in the year to December 2014 – the lowest level since records began.  In response David Cameron tweeted that: “The fall in #inflation is good news for families. Our long term economic plan is on track and helping hardworking taxpayers.”

Mark Carney, the governor of the Bank of England, said that the dip was nothing to worry about. It was caused by a fall in global fuel and food prices rather than a generalised slowdown of the economy. In his view this sort of low inflation could grease the wheels of economic activity.

The pessimists typically point out that deflation is often associated with stagnation. In other words falling prices and sluggish economic performance often coincide. This phenomenon was common in the western economies in the 1930s and has often prevailed in Japan in recent years. Indeed the term “deflation” is used in two different ways: to simply mean falling prices or alternatively to refer to a downward economic spiral.

Typically the pessimists go on to suggest ways in which falling prices and stagnation could be linked. One popular line of argument is that the economy can get caught in a liquidity trap: consumers are reluctant to buy goods today as prices could be lower tomorrow. Another common claim is that falling prices increase the real burden of debt that economies are suffering.

Deflation optimists, in contrast, often argue that there is no correlation between lower prices and economic stagnation. From that perspective they are challenging one of the key premises of the doomsters.

But the differences between deflation pessimists and deflation optimists are often less than first appears. For example, Carney simply claimed that at present falling prices are confined to niche areas of the economy. If deflation became more widespread, with the overall price level falling, he would no doubt identify it as a problem.

It is also worth noting the all too common tautology used by Carney and many others. He said falling fuel and food prices caused the inflation rate to drop. But this is simply saying that falling prices cause falling prices. It fails to identify the underlying driver.

It would be better to pay much less attention to changing price levels. Instead a more fundamentalist approach to the economy is necessary.

Although it is true that falling prices can coincide with stagnation they can also be a sign of strength. The rapid improvements in information technology in recent years provide an example of the latter trend. Consider how much it costs to buy one kilobyte of computer storage compared with, say, 20 years ago. In effect the price of computers has fallen rapidly. Yet it is a symptom of innovation in this particular sector rather than, on the contrary, a sign of stagnation.

If falling prices can be both a symptom of economic weakness and of strength they have little value as indicators. It is far better to try to discern what is happening in the underlying economy rather than draw illegitimate conclusions from the changing price level.

Analysts should focus on the state of the productive economy rather than the inflation rate. Key statistics to consider include the levels of business investment and productivity growth.

The huge attention paid to the price level – both inflation and deflation – in the past two decades has corresponded with a narrowing view of the economy. Most discussion has focused on relatively superficial questions, including the state of the financial sector, rather than grapple with the underlying dynamics of the economy. It is not that inflation or finance are unimportant but they should be understood in relation to developments in the real economy.

This narrowing of intellectual horizons is the paradoxical effect of the end of the Cold War in the late 1980s. In the earlier era the battle between socialism and capitalism forced individuals to have more fundamental discussions on the nature of the economy. Each side was anxious to prove that their side knew best.

There is no going back to the past but it should be possible to recapture some of the better elements of the earlier discussion. Those who argue the world is facing economic stagnation should start from an examination of the real economy rather than become preoccupied with changing prices.

This column first appeared in the February issue of Fund Strategy.

Although the claim is frequently repeated it is untrue that a debate about economic equality is underway. To those who follow it carefully it should quickly become clear that something else is happening.

Take the recent discussion at the World Economic Forum in Davos. A televised debate involving some of the main protagonists helps make some of the themes clear. The focus was not on equality but on what was regarded as excessive inequality.

A call for income equality would, strictly speaking, suggest that everyone should have the same earnings. But none of the key proponents in the current debate are calling for anything remotely like that. On the contrary, they insist that inequality is both desirable and necessary to provide incentives for people to work hard.

In this respect it was notable that the IMF chief, Christine Lagarde, corrected another panelist in the TV debate who suggested she was advocating equality. The French technocrat protested, quite rightly, that she had said no such thing.

New egalitarians such as Lagarde instead claim that inequality has become too extreme. In their view it has reached the point where it is having damaging social effects. The exact nature of these negative impacts is debated but it is typically claimed that excessive inequality can damage social cohesion and distort the political system. Often the argument is about plutocracy – it is alleged that the rich have too much political power.

This focus on extreme inequality also helps explain why there is such an obsession with the super-rich. To be merely rich is no longer considered noteworthy. The focus is on those at the very extreme end of the income distribution; such as the 85 billionaires who according to Oxfam have as much wealth as the poorest half of the world’s population.

If there is no debate about equality it begs the question why so many people assume it still exists.  This should be understood in relation to the difficulty many people have in breaking from the intellectual landscape of the past.

In relation to the equality discussion it is often those who regard themselves as having a free market perspective who find the discussion most tricky. They are too ready to detect echoes of their leftist opponents of yesteryear when they hear criticisms of extreme inequality. Such free marketeers fail to appreciate how much the discussion has moved on since the 1980s.  The old scripts are of limited use in understanding contemporary anxieties.

It is particularly striking that nowadays it is often the wealthy and the best connected who profess the greatest concern about inequality. At the Davos get-together, which after all is a jamboree for the global elite, complaining about the dangers of the inequality gap has become an annual ritual. The TV panel included not only Lagarde but Mark Carney, the governor of the Bank of England, and Robert Shiller, a Nobel laureate in economics. Winnie Byanyima, the executive director of Oxfam International, was co-chair of the entire conference.

To understand the current obsession with extreme inequality and the super-rich it is necessary to appreciate the discussion is fundamentally different from the debates of the past.

This blog post was first published on Fundweb today.

Supercars for all

14 Jan 2015

The contemporary obsession with the super-rich often combines an intense interest in breathtaking bling with a quiet loathing of those with spectacular wealth. Both ingredients in this peculiar cocktail were on display in BBC2’s recent Meet the Super Rich season of documentaries.

Rich, Russian and Living in London focused on the lavish lifestyle of wealthy Russian expats including an entrepreneur, an art collector and a supermodel. Perhaps their most striking characteristic was a desperate desire to distance themselves from the old stereotype of ostentatious Russian oligarchs. The new generation of wealthy Russians loves fine wine, expensive art, the best British public school education and the glamour of traditional debutante balls.

Next came Billionaire’s Paradise: Inside Necker Island. The programme was essentially a publicity vehicle for Richard Branson’s exotic Caribbean island which doubles as his home base and an exclusive playground for the super-rich. For £40,000 a night the staff of nearly 100 is ready to meet the desires of the exclusive resort’s 28 guests.

The documentary clearly implied that literally every whim of its guests could be satisfied. Those staff who dealt directly with the guests were almost all under 30 and chosen for their good looks. A previous management team which insisted that staff should not share drinks or have “relations” with guests was quickly dismissed. Branson made clear that such restrictions were inappropriate on Necker Island.

Although both documentaries could be enjoyed as lavish spectacles they could also be viewed as outrageous displays of excess. Indeed many viewers probably experienced both emotions: vicariously enjoying the luxury on display while feeling appalled that so few should have so much wealth. The combination of these two elements probably helps explain the popularity of magazines, television programmes and films featuring the super-rich.

The Super-Rich and Us was different in that it purported to be a serious documentary on the topic. However, early indications augured poorly as, according to the BBC’s own More or Less  programme, the trailer made the incorrect claim that the world’s richest 85 individuals own half the world’s wealth. This is a garbled version of Oxfam’s similar-sounding but entirely different contention that the richest 85 own as much wealth as the poorest half of the world’s population.

Episode one overlapped with the other documentaries with numerous examples of conspicuous consumption including Lamborghini supercars, expensive watches and Lear jets. However, it also purported to offer a serious discussion of those it called the “have yachts” as opposed to the “have nots” or the “haves”.

Its central claim – never properly investigated – was essentially that the economy embodies a tug of war between the super-rich and the rest over scarce resources. Free market thinkers such as Arthur Laffer were brought in on the implicit assumption that they were apologists for the ultra-wealthy.

The underlying premise of the programme was that economic activity is essentially a zero-sum game. If some people become extremely wealthy then, so the argument goes, it must be at the expense of the rest of us.

No consideration was given to the possibility that it might be possible to make the size of the overall pie bigger. The population as a whole can benefit from a more prosperous society. Yet, despite persistent inequality, that is broadly the trend of the past two centuries.

The challenge now is to work out how to kick start economic growth. That way it could become possible for everyone to enjoy fine wine, fine art and extravagant cars.

This blog post was first published on Fundweb today.

The last thing I expected to be thinking about after a long and boozy Christmas lunch was economics. However, my first ride in an Uber taxi set me thinking.

For those who have not used Uber, which operates in over 50 countries, it is service that allows users to order taxis using their mobile phone. Gettaxi provides a similar role for licensed cabs.

On Christmas Day I had found myself in Crystal Palace with the prospect of a long and expensive taxi ride to North London looming. Rather than pay a large premium for a minicab, a friend recommended that I use Uber instead. To my surprise the fare was far less than the seasonal hit I had expected.

The taxi driver was more than willing to fill me in with more details on how the service worked. In his previous guise as a minicab driver he would suffer a large amount of “dead time”. For instance, if he drove a passenger from London to Reading he would usually find himself with an empty cab on his way back. In contrast, Uber would generally find another customer who wanted to travel from Reading to London. It is a textbook case of the introduction of technology leading to higher productivity.

The result is lower fares for customers and, at least in the short-term, more revenue for Uber drivers. The service’s efficiency means that drivers can charge less per passenger mile but earn more in total.

Of course there are losers too. Minicab firms and black cab drivers are increasingly finding themselves undercut by Uber drivers. This probably helps explain the backlash with its focus on safety and customer privacy.

Nevertheless it is an example of what economists call creative destruction. The market economy is creating a more efficient way of doing business but at the expense of existing providers.

Whether the incremental increase in productivity justifies its high valuation is another matter. The Silicon Valley start-up was valued at $40bn (£26bn) at the completion of a funding round last month. That makes it one of the world’s largest private companies. A flotation could follow this year.

Despite the benefits for consumers and investors the revolutionary force of Uber and similar apps should not be overdone. The Economist’s claim that such apps will reshape the nature of companies and restructure careers is over the top.

For a start only a tiny proportion of new internet and mobile applications are likely to have anything like the productivity raising potential of Uber. Much of it, such as Angry Birds or Candy Crush, may provide entertainment but it is hard to see it transforming the economy. Some applications, including Facebook and Twitter, could arguably lead to lost output with all the immense amount of time many users expend on them.

In addition, more mundane forces play an important although often underplayed role in economic change. The shift towards greater emphasis on freelance work is in large part a result of the drive of traditional cost cutting.

The hype around Uber and mobile applications more generally is overdone.

This blog post was first published on Fundweb today.

Celebrate cheap oil

20 Dec 2014

One of the great paradoxes of 2014 was the apparent mismatch between falling oil prices and military conflict in strategic regions. Normally fighting in the Middle East and the Ukraine would be expected to push up oil prices. Only this year the price has fallen sharply since June. According to the US Energy Information Administration the price of a barrel of West Texas Intermediate crude fell from almost $108 per barrel in mid-June to below $56 in mid-December.

It would be a mistake to conclude from this discrepancy that geopolitical uncertainty has no effect on the oil price. A more accurate conclusion would be that the forces pushing the price of oil down were greater than those pulling it up. In other words the balance between supply and demand has tilted in favour of the former.

Two key factors on the supply side helped push down oil prices. Together they constitute what the Economist dubbed sheikhs vs shale. The rising production of shale oil, particularly in America, as well as Saudi Arabia’s decision to maintain its crude output both played an important role.

But it would be wrong to underestimate the role of sluggish demand growth, particularly in China and Europe, in reinforcing the downward trend. Although demand for oil is still heading upwards the rate of growth is being called into question. The slowdown in China’s economy in particular will weaken what has been one of the main upward drivers of the oil price for many years.

Of course some of this is subject to change. A low oil price weakens the impetus to invest in the industry and so could lead to curbs on supply growth in the future. Exploration and development that was once profitable may no longer be economical at the lower price.

However, there is a more fundamental lesson that should be learnt from this whole saga. It is not the oil price that drives the state of the global economy. On the contrary, the state of the world economy plays a key role in determining the oil price.

Too many commentators are ready to pin a large part of the world’s economic fortunes on the price of crude. From their perspective low prices boost growth while high prices carry the risk of inflation.

It would be more accurate to see things the other way round. A dynamic global economy should enjoy rising energy demand alongside strong economic growth. It should also show strongly rising supply as investors put their money into developing new sources and better technology. Ideally rising production should outrun increasing consumption and so help to keep prices low.

It is true that over time different sources of energy could come to surpass oil in importance. Indeed coal, natural gas, nuclear and renewables already play a big role in the energy mix. News of the largest ship the world has ever seen, designed for use as a processing platform for natural gas, is a positive sign of determination to develop new supplies.

Nevertheless oil is still a key energy resource and it likely to remain so for some time to come. The rapid development of new sources of supply and better extraction technology should be widely welcomed.

I would like to wish my readers a Merry Christmas and a Happy New Year.

This blog post was first published on Fundweb yesterday.

This is the text of my 4 December feature for the Financial Times

There is an apocryphal tale about an exchange between two of America’s most famous novelists on the nature of wealthy individuals. F Scott Fitzgerald, author of The Great Gatsby, is reputed to have said: “The rich are different from you and me.” In reply, Ernest Hemingway is quoted as saying: “Yes, they have more money.”

As it happens, the quote attributed to Fitzgerald seems to be a corruption of a line in The Rich Boy, his 1926 short story: “Let me tell you about the very rich. They are different from you and me.” Either way, Fitzgerald raises an important question: are the very rich different from everyone else besides the fact that, by definition, they have a lot more money?

Thanks to advances in behavioural finance it has become possible to answer whether the wealthy do indeed think differently from the rest of us.

A rich source of information on the topic is the behavioural finance team at Barclays. It conducts an extensive survey – its Financial Personality Assessment – on 40,000 of the bank’s wealthy clients around the world. The survey goes way beyond the risk tolerance questionnaires that have become commonplace among wealth managers. Instead it questions investors on three dimensions related to attitude to risk – risk tolerance, composure and market engagement – and three on decision style – perceived financial expertise, desire for delegation and belief in skill.

Of course, Barclays conducts the survey in a bid to better serve its clients, rather than out of purely intellectual curiosity. Nevertheless, it provides an interesting peek at how the rich think about risk and investment. In this respect it is particularly fortuitous that it covers the periods of extreme market volatility of recent years.

The survey yields some results that do not conform to the traditional depictions of the wealthy. Greg Davies, head of behavioural finance at Barclays, says that, controlling for other variables such as age, the wealthy only exhibit a slightly higher risk tolerance than the general population.

Entrepreneurs, however, stand out from the rest of the wealthy, he says. “Among entrepreneurs we definitely observe higher risk tolerance and higher levels of engagement with the markets,” Davies says.

Entrepreneurs also display a marked reluctance to hand over the management of their wealth to others. “We observe lower delegation scores,” Davies adds. “These people like to have control over it themselves and are less willing to hand it over to an adviser.”

But although entrepreneurs are willing to take risks to expand their businesses, it does not necessarily follow they are risk-takers in other areas. “We know from academic research that someone’s financial risk attitude may be entirely different from their attitude towards taking risks in terms of health behaviours or participating in dangerous sports,” says Davies.

Perhaps more surprisingly, many entrepreneurs hesitate before investing in the markets because of the perceived risks involved. Davies draws the analogy with a mountaineer. Although climbing a mountain appears risky to laymen, the experts often deny it because of the amount of planning and training they engage in beforehand. Similarly, entrepreneurs often feel they can understand and control risk within their businesses but are less confident about the markets overall.

When such people invest, they often need to create what Davies calls “stories” to provide them with emotional comfort. This could be that they perhaps have a personal connection with a particular firm or they prefer companies from their home country. Often they are reluctant to embrace the conventional view that the best strategy is to have a broadly diversified portfolio.

Hersh Shefrin, a professor of finance at Santa Clara University, draws similar conclusions to Davies about the preferences of the newly wealthy. From his base in Silicon Valley he observes the behaviour of one of the world’s largest concentrations of super-rich entrepreneurs. He has also worked with many ultra-high-net-worth families.

“Wealth acquirers are typically entrepreneurial,” Shefrin says. “That means they set ambitions that are high and they also attach a very high importance to configuring their environment to maximise the likelihood of achieving those aspirations.”

In addition to their strong desire for control, the super-rich tend to exhibit “dispositional optimism” or what a layman might call a rosy outlook. They also typically have good social skills, larger than average families and lower divorce rates.

In psychological terms they tend to emphasise what is often called “system two thinking” rather than “system one”. That means they prefer to ponder difficult decisions slowly, rather than come up with quick answers.

Both Shefrin and Davies agree that what are often perceived as national or cultural differences among the rich tend to reflect this division between old and new wealth. Western Europe and Japan have a higher proportion of inherited wealth, while the US, particularly in Silicon Valley, has more new wealth. Russia, which did not even exist as a market economy until a generation ago, has a particularly high proportion of ostentatious new wealth.

If F Scott Fitzgerald were alive today he might no longer declare that the rich are different from you and me. Instead, he might claim, in terms of behavioural psychology at least, that it is the new generation of wealthy entrepreneurs who are different.

Forging capitalism

12 Dec 2014

This is the text of my recent book review in the Financial Times

Astute observers of capitalism have long recognised there is a tension at its heart. Although the market economy is based on the pursuit of self-interest, its legitimacy depends on benefiting the wider society.

These two contrasting elements were understood as far back as the second half of the 18th century. Adam Smith, viewed by many as the founder of modern economics, famously argued in The Wealth of Nations: “It is not from the benevolence of the butcher, the brewer, or the baker, that we expect our dinner, but from their regard to their own interest.” Less well known is that in his other great book, The Theory of Moral Sentiments, he emphasised the importance of human sociability. Smith saw virtue as necessary to keep the pursuit of self-interest in check.

Capitalism’s subsequent history amply illustrates both the broader benefits of a market economy and the problems that arise when self-interest becomes selfishness. There can be little doubt that popular living standards have increased enormously over the decades. Even the poorest sections of society have access to material possessions that the wealthy of the 18th century would have found unimaginable. On the other hand, there is always the temptation for those pursuing honest profit and self-interest to cross over the line to greed and fraud.

Forging Capitalism is an engaging history of how Britain attempted to negotiate this tension in the century running up to the outbreak of the first world war. The title is a pun. It is a study of the rogues, swindlers and fraudsters who tried to benefit from the market economy through the use of deceit. It is also an examination of how capitalism itself was forged through evolving mechanisms to curb these dishonest tendencies.

Ian Klaus, a member of the policy planning staff of the US state department and a former Harvard academic, includes many colourful rogues. Among them are Lord Thomas Cochrane, who in 1814 attempted to benefit from spreading false rumours of Napoleon’s death. Since the Napoleonic wars were coming to an end such news would have a substantial impact on asset prices. Cochrane quickly sold his holdings in Omnium, a form of government stock, which had risen in price on the false news.

If such stories have a familiar ring it is probably because they provided raw material for some of the most prominent figures in English literature. Novelists such as Charles Dickens, William Thackeray and Anthony Trollope were inspired by some of the same characters and tales.

The other side of Klaus’s story is how different mechanisms evolved to tackle breaches of trust. In the early 19th century the emphasis was on status and virtue. Transactions were typically underpinned by the standing of those involved and market participants were expected to behave virtuously.

By the mid-19th century these notions were giving way to reputation. Although the concept was not new, it became more important and prominent. An increase in literacy and technological developments played an important part. The expansion of the press meant that news about an individual’s reputation could be more easily transmitted to the public.

Finally, in the latter part of the century, there was the shift to what Klaus calls verification. This form of regulation is closer to what exists today, including institutions such as credit rating agencies and the financial media, to check the veracity of transactions. There were also new technologies, such as fingerprints, to verify individual identity. It was during this period that the state came to play a much more prominent role in authenticating information.

The one weakness of Forging Capitalism is that it underestimates the extent to which the market economy was transformed over the century it covers. Klaus sometimes refers to free market capitalism as if it is a system that still exists. Yet by the late 19th century it was already clear the state was playing a central role in supervising and underpinning economic activity. Certainly by the eve of the first world war the role of government was vastly greater than a century earlier.

There is considerable room to debate whether this transition was desirable or even inevitable. But it is striking how few contemporary commentators are willing even to acknowledge it.