Debate concentrates the mind. It is easy to dismiss opinions you disagree with from the privacy of your own living room. Debating articulate exponents of contrary views is another matter – even more so when the discussion takes place in front of a large audience.
I found myself in the position of having to sharpen up my arguments for a recent debate on behavioural finance at the City of London festival (plugged at the end of my last blog post). An edited version of the debate was broadcast in the Radio 3 Free Thinking slot and is available to listen to online here.
Instinctively I was suspicious of behavioural finance beforehand. I was familiar with respected pundits, such as Dan Ariely and Richard Thaler, who were all too ready to dismiss human beings as scarred by irrationality or condemned by frailty.
Such contentions did not accord with my experience or understanding of humanity. We may not be perfect but it seemed to me that from the long-term perspective of human history we have achieved a huge amount over the years. We have literally moved from living in caves to, at least relatively speaking, hugely more prosperous, technologically advanced and even humane societies. Such progress would not have been possible without the operation of considerable powers of human reason.
However, reading some of the more subtle material, and debating the likes of Greg Davies of Barclays and Frances Hudson of Standard Life Investments, made me realise that the more moderate proponents of behavioural finance have a point. It is not that we are irrational but we do have what could be called cognitive biases.
For example, most people, given the choice, would evidently opt for having £100 today rather than £102 tomorrow. This is despite the fact that – except in conditions of hyperinflation – £102 tomorrow would be worth more.
To my mind this is not irrational but it is significant. We may, for instance, prefer £100 today because we are sceptical about being given it tomorrow. Perhaps the donor will run away or simply forget. Or we may have an urgent spending priority. Preferring the £100 represents a bias on our part but it is overstating the case to condemn it as irrational.
This example may appear trivial but there are many others that could be given. For instance, the common human preference for avoiding losses over making equivalent gains; or our underestimation of the effect of compound interest on investments.
Nevertheless it still seems to me that what might be called the strong form of behavioural finance is fundamentally flawed. In our debate this perspective was represented by Adrian Wooldridge of the Economist. His approach was essentially to run through a catalogue of financial bubbles over the years as a way of demonstrating innate human irrationality.
To me this approach is deeply ahistorical and superficial. It ignores the specific factors driving each bout of volatility and simply asserts that human irrationality was to blame.
In any case the debate, or at least edited highlights, are available to listen to on the BBC website so you can judge for yourself.
This blog post was first published today on Fundweb.
I will be debating whether emotion or reason dictate the financial markets on the Free Thinking programme on BBC Radio 3 at 10pm this evening (subsequently available on the internet). The event was recorded at the recent City of London festival (see 7 July post).
This is the full text of my spiked review of Fred Siegel’s The Revolt Against the Masses.
Liberalism is one of a select band of troublesome political concepts that has multiple meanings. Indeed, ‘liberalism’ as used in one context can be the opposite of what it means in another.
The attitude of liberalism to freedom provides a prime example of these contradictory meanings. Classical liberalism, which was to the fore in the eighteenth and nineteenth centuries, typically placed a heavy emphasis on the importance of individual autonomy and liberty. In sharp contrast, contemporary liberalism tends to be deeply intolerant and elitist.
Fred Siegel, a senior fellow at the Manhattan Institute, a conservative think tank based in New York, has provided an enormous service with his innovative history of modern American liberalism, The Revolt Against the Masses. It helps put many of the most retrograde trends in the US into their proper context. It also helps shed light on parallel developments in other countries, including Britain, even though they are outside Siegel’s remit.
For Siegel, a defining feature of modern liberalism is its attachment to what he calls the clerisy – a technocratic elite which he identifies with academia, Hollywood, the prestige press, Silicon Valley and Wall Street. Despite its professed attachment to equality of opportunity, this elite holds the mass of the American public, what Siegel refers to as ‘the middle class’, in contempt. The clerisy sees itself as superior to the rest of the population on meritocratic grounds.
As the reach of the state has burgeoned, the clerisy has taken on an increasingly important social role. Over the years, American government has grown vastly, commanding more resources and employing more people, than ever before. As Joel Kotkin, one of the sharpest observers of contemporary American politics, has pointed out: ‘Since 1990, the number of government workers has expanded by some five million to some 20million. That’s four times the number who were employed by the government at the end of the Second World War, a growth rate roughly twice that of the population as a whole.’ Members of the technocratic elite present themselves as impartial experts, but their interests are closely tied to the fortunes of this vast state apparatus.
Siegel’s revisionist starting point is to argue that modern liberalism emerged in the pessimistic years following the immediate aftermath of the First World War. Its leading figures were writers and thinkers such as Randolph Bourne, Herbert Croly, Sinclair Lewis and HL Mencken. Their goal was to build a new American aristocracy that would distance itself from the perceived debasement of modern commercial society.
This early part of Siegel’s work often parallels John Carey’s 1992 study of Britain from 1880 to 1939, titled The Intellectuals and the Masses. Both works portray an intellectual elite that loathes the mass of the population. Indeed, HG Wells, better known today as a science-fiction writer, was a prominent political influence on both sides of the Atlantic in the early twentieth century. Siegel accurately describes American liberalism of the 1920s and onwards as a ‘cousin’ of British Fabianism.
Siegel’s identification of the 1920s as the time when modern liberalism emerged puts him at odds with conventional studies. Many authors argue that it was in the 1930s, with the New Deal of President Franklin Delano Roosevelt (FDR), that liberalism was born. Others point to the Progressive era, which reached its peak in the early years of the twentieth century, as the starting point of liberalism.
But Siegel argues that modern liberalism was fundamentally at odds with progressivism. The progressive movement was a bipartisan and largely middle-class Protestant movement that wanted to outlaw alcohol, gambling and prostitution. It also wanted to curb the power of big business and to create what it saw as a better life for the middle class. Siegel argues that liberalism represented a decisive cultural break from progressivism as it saw the American democratic ethos as a threat to freedom at home and abroad.
In the 1930s, many liberals admired the Soviet Union under the leadership of Joseph Stalin. At the same time, they took the view that the American middle class, stifled by smalltown conformity, was proto-fascist. It Can’t Happen Here, a novel by Sinclair Lewis on the dangers of homespun American fascism, was widely praised by liberal commentators.
Liberalism gained increasing political influence under FDR’s presidency, although he did not go as far as many liberals would have liked. In the early 1930s, Roosevelt established a Brain Trust, a group of academic advisers, to help develop his economic programme. Although this might seem an unremarkable move, in retrospect it was innovative for its time. It was an early example of technical experts playing a leading role in the formation and implementation of policy.
FDR also played a leading role in the popularisation of the idea of ‘economic rights’ – more accurately called entitlements. In his 1944 State of the Union address, he proposed a Second Bill of Rights that included such elements as the right to a useful and remunerative job, the right to adequate food, and the right to protection from unemployment. The president rightly contrasted these entitlements to classical political rights such as free speech, a free press and freedom of worship.
Although the idea of economic rights might sound positive, it in fact laid the basis for a system where different interest groups competed for access to resources from a rapidly growing state. For example, by the 1960s a framework of state-sponsored mobility gave a select number of African-Americans work in a profusion of anti-poverty, anti-discrimination, housing and social-services agencies. These bureaucracies provided jobs for a minority of educated black Americans and gave white radicals an outlet to rail against a wider society they condemned as irredeemably racist. Yet, at least in Siegel’s telling, this development angered most whites while at the same time undermining the prospects for most blacks.
There are many twists in Siegel’s tale, but an important turning point was the early 1970s and the emergence of what he calls gentry liberalism. This was a form of modern liberalism that was hostile to the ideas of progress and mass affluence. It stood in contrast to earlier generations of modern liberals who generally supported the idea of progress.
To be sure, there were green elements in the earlier years. HG Wells, for instance, was a proponent of population control and eugenics. But the primary target of gentry liberalism, as a new form of Malthusianism, was mass culture and mass consumption rather than the poor having numerous children.
Siegel presents Barack Obama as at the apex of the new liberalism. Obama himself is a graduate of the machine that has dominated Chicago politics for decades. His administration is predominantly staffed by a small number of credentialed experts who overwhelmingly hail from a few big cities. Despite all the talk of opportunity, this administration looks down with disdain on the mass of the population. Racial and political authenticity is held up as more important than policy accomplishments. It is also worth noting that this political grouping has substantial support from America’s most wealthy.
A final element of Siegel’s study of modern liberalism might surprise some British fans of John Stuart Mill. In an appendix, he points to Mill, the mid-nineteenth century British thinker, as a key inspiration for modern American liberalism. Mill is better known as an eloquent defender of individual autonomy, particularly in his essay ‘On Liberty’. But Siegel points out that Mill was an ambivalent figure who also held up the idea of a clerisy or ‘endowed class’ whose wisdom and intelligence put it above the average person. This idea of a superior intellectual elite later reappeared in numerous guises, including what HG Wells referred to as the new ‘Samurai’.
The main weakness of The Revolt Against the Masses is Siegel’s conflation of criticism of the American authorities with disdain for what he calls the middle class. For example, he does not clearly distinguish between criticism of authoritarian trends in American society and the view that the general public is proto-fascist. It is indeed true that these two trends are often fused in the minds of American liberals, but that need not necessarily be the case. It is quite possible to oppose on principle American authoritarianism while rejecting the notion that the mass of the population is inherently anti-democratic.
To make the distinction between the two liberalisms clear, it is necessary to breathe new life into two other key concepts from the political lexicon. First, upholding moral equality – the notion that no individual is intrinsically worth more than any other – provides a way of undermining the undemocratic claims of the technocratic elite and its supporters; and second, upholding the idea of freedom, in the classical liberal sense of individual autonomy, is essential to resisting the overwhelming authoritarian impulse of modern liberalism.
My latest spiked book review, on Fred Siegel’s Revolt Against the Masses, is available here. I will post the full text at a later date.
You can hear me discussing liberal elitism on the first ever Spiked Review of Books podcast alongside Rob Killick on Rod Liddle’s new book and Helene Guldberg on Saving Normal.
This is the main text of my recent Fund Strategy cover story on behavioral finance. For a related box see below.
Insights into investment behaviour sometimes come from unexpected directions.
Daniel Kahneman, who won the Nobel prize for economics in 2002 for his work on behavioural finance, has described what for him was a eureka moment. It happened in the mid-1960s when, as a psychology lecturer at the Hebrew University in Jerusalem, he was teaching a course to air force flight instructors. After he had cited studies showing reward is a more effective teaching tool than punishment, one of his students stood up to contradict him.
“With respect. Sir, what you’re saying is literally for the birds. I’ve often praised people warmly for beautifully executed manoeuvres, and the next time they almost always do worse. And I’ve screamed at people for badly executed manoeuvres, and by and large the next time they improve. Don’t tell me that reward works and punishment doesn’t. My experience contradicts it.” (Quoted in Kevin McKean, Decisions, Decisions, Discover Magazine, July 1985.)
Kahneman later recalled this as a “joyous moment of insight”. He concluded that the instructor’s observation was right but his reasoning was completely wrong. The behaviour the student was describing was in fact mean reversion. In other words, performance tends to revert towards the average after periods of outperformance. For example, if a footballer performs particularly well or badly in a game they are likely sooner or later to move back towards their average level.
It was not long before Kahneman related this story to Amos Tversky, another psychology lecturer at the same university. The anecdote helped to spark off an immensely productive three-decade collaboration. Their joint project was to study how people made decisions in conditions of uncertainty. Tversky died in 1996 but Kahneman went on to win the Nobel prize for his work in developing behavioural finance.
Although finance was not their original concern, it became clear that their work had implications in the investment arena. The phenomenon of mean reversion is even apparent in equity price movements. Shares that perform spectacularly tend to revert to the mean sooner or later. Looking at how decision-making happens in practice has many implications from a practical investment perspective. It is therefore not surprising that many investment professionals have taken it up.
The financial crisis that started to emerge in 2007, along with the subsequent turmoil, strengthened interest in the approach still further. Greg Davies, the head of behavioural finance at Barclays, says: “The advent of the financial crisis made a lot of people aware that there is a strong psychological and emotional component to good investment decision-making.”
This article will examine the uses of behavioural finance as well as considering its possible limitations. It will start by sketching the intellectual background to the discipline before discussing its practical uses. Proponents of the field argue it can shed light not only on investment behaviour but on that of corporate executives and investment analysts. The article will finally consider whether behavioural approaches can help to explain the financial crisis of recent years.
Behavioural finance is often defined by what it is not. It tends to be counterposed to the idea of rational economic man – that is, the idea that human behaviour tends to be motivated by narrow self-interest. This concept is also known by many other names including Econ (as opposed to Human), homo economicus (economic human) and Max U (short for Maximum Utility). Sometimes Mr Spock, the character from the original Star Trek series, is held up as the archetypal rational individual.
Even from this basic contrast it begins to become clear how mainstream and behavioural approaches to investment can differ. The rational investor reacts like a calculating machine to each new piece of information that appears in the market. He is impervious to emotions such as greed and fear. The behavioural approach sees investors as prone to a wide range of cognitive biases (see box). In this model the investor is a long way from his rational counterpart.
But although this counter-position provides a way of contrasting the two approaches it should be remembered that the discussion is often more sophisticated. At the highest level, each side has a more nuanced understanding of the topic than is sometimes acknowledged.
For example, Daniel Kahneman draws back from arguing that human behaviour is inherently irrational. “Irrational is a strong word [original emphasis], which connotes impulsivity, emotionality, and a stubborn resistance to a reasonable argument,” he says. “Although Humans are not irrational, they often need help to make more accurate judgments and better decisions, and in some cases policies and institutions can provide that help.” (Thinking, Fast and Slow, Penguin 2012).
It is in this spirit that many of the more sophisticated practitioners of behavioural finance operate. In their view behavioural finance can act to complement the conventional approach rather than necessarily contradicting it. Greg Davies of Barclays says: “I’m very resistant to the notion that the two have to be seen as in competition.”
Frances Hudson, global thematic strategist at Standard Life Investments, uses the metaphor of a toolbox to show that the two approaches can work together. In her view, behavioural finance “addresses part of the market where some of the other analytical tools perhaps do not work so well”. She argues it is particularly useful over the short run. “If you look in the short term, the things that are driving markets are nearly all to do with behaviour,” she says. These include the flow of funds to investors and the reaction to news flow. It is over the longer term, from two to three years, that conventional tools come into their own.
To be sure, there are experts willing to argue bluntly that human behaviour tends to be irrational. Dan Ariely, a professor at Duke University in New York, argues that “we are not only irrational, but predictably irrational”. (Predictably Irrational, HarperCollins, 2009.) “Our irrationality happens the same way, again and again,” he says.
For their part, the proponents of rational economic man often claim that the behaviourists caricature them. The rationalists argue that their idea of rational individuals is more sophisticated than the behaviourists contend. For example, Gary Becker, another Nobel laureate, argued in his 1992 prize lecture: “The economic approach I refer to does not assume that individuals are motivated solely by selfishness or gain. It is a method of analysis [original emphasis], not an assumption about particular motivations. Along with others, I have tried to pry economists away from narrow assumptions about self-interest. Behaviour is driven by a much richer set of values and preferences.”
He went on to claim that “the analysis assumes that individuals maximise welfare as they conceive it [original emphasis], whether they be selfish, altruistic, loyal, spiteful, or masochistic”.
The differences between the two schools cannot be resolved here but it is worth nothing that Kahneman’s approach rests on the premise that humans have two ways of thinking. System 1, or fast thinking, works automatically and quickly, with little sense of voluntary control. System 2, or slow thinking, involves mental efforts that demand a lot of effort and concentration.
The latter system is usually associated with reasoned choices, but the power and importance of System 1 is often under-appreciated.
If humans are prone to behavioural biases, it follows that a wide range of actors are affected. The effects are not confined to investors, whether they are private individuals or professional fund managers. Investment analysts and the executives of companies are also prone to behavioural influences. Even experts in behavioural finance typically acknowledge that they are not themselves immune to bias.
Most of the work of Barclays’ Davies and his team is focused on advising high net worth individuals (HNWIs). In his view this is not a question of making them aware of a long list of possible biases. It is rather a matter of helping them to understand their financial decision-making better.
For Davies this task has two key elements. First, examining whether investors are making the right financial decision for their financial objectives. Second, asking whether they are sufficiently comfortable with their decisions at any given time.
“It’s about people making better decisions through a combination of self-knowledge and a knowledge of how that plays out in their actions and their interventions in various ways,” he says.
An important element of this approach is for its clients to do a Financial Personality Assessment.
This involves measuring their attitudes in relation to six dimensions: risk tolerance, composure, market engagement, perceived financial expertise, desire for delegation and belief in skill.
In practical terms, he says, this means his team can serve its clients better. For instance, during the Wall Street crisis of September 2008 those clients with low composure – those in particular need of emotional security – were contacted first.
For fund managers the challenge is more about how to better run their portfolios rather than providing clients with a framework for investing. JP Morgan has had a large team specialising in behavioural finance since the 1990s.
Jonathan Ingram, a manager on the team, says: “Like any active manager we believe there are anomalies in the market that we believe we can exploit. What behavioural finance really does is give us a framework with which to understand what has caused those anomalies.”
The JP Morgan team, consisting of 44 people, uses behavioural tools to examine a universe of about 2,000 stocks in Britain and the rest of Europe. However, he is keen to emphasise that the approach is not simply about applying behavioural tools in a mechanical way. “The model’s not a substitute for common sense,” he says. “If it was purely a machine making decisions there wouldn’t be 44 people employed.”
Ingram acknowledges that his own team, like any other investors, could in principle be prone to behavioural biases. It tackles the problem by having safeguards in place. “You have to have a very rigorous control around your decision-making process,” he says.
Ardevora is, at least in terms of the size of its operation, at the other end of the scale from JP Morgan’s team. Yet behavioural insights are also central to its investment approach.
Jeremy Lang, one of four partners, is keen to emphasise that he harnesses behavioural insights, rather than referring to his approach as behavioural finance. “We head off in a slightly different direction,” he says.
By this he means that the focus is on the behaviour of corporate executives rather than on investor psychology. “Our view is that they are quite different in personality types and in incentivisation structures and in the environment they face than investors,” he says. “They are prone to different types of biases”. In particular, he sees corporate executives as particularly prone to an overconfidence that can “border on the sociopathic”.
This leads Lang to adopt practices that are in some cases the opposite of mainstream. For example, his first priority is to avoid companies that take undue risks, rather than finding those that offer the highest potential rewards. “It’s not about trying to find the good companies,” he says. “It’s much more about trying to find the environment where executives are more likely to behave in a sensible way.”
Lang also makes a point of avoiding face-to-face contact with corporate executives. This is because he wants to avoid subconsciously identifying with those managers he meets. “I’m recognising my own biases here,” he says. “I don’t want to get too close to them. I don’t want my view twisted by personal contact.”
Instead the emphasis is on learning about the companies and inferring lessons about corporate behaviour from “the boring old balance sheet”. Lang also trawls through written statements made by executives.
Behavioural finance may offer insights into the behaviour of individual actors but it does not necessarily follow that it can explain how markets work overall. Nor can it necessarily explain how the causes of crises.
David Adler, the author of Snap Judgment (FT, 2009), says the approach is useful in some areas but not in others. “Behavioural is very good at finding different anomalies in prices in equities,” he says. “And it’s extremely strong and powerful in looking at individual behaviour.”
However, the New York-based expert says it does not help to explain the Wall Street crisis of 2008-09. “The problem is that the recent crisis occurred predominantly in institutional markets that were not exactly filled with naïve traders.”
In his view, behavioural finance is much better at explaining the behaviour of ordinary investors than that of highly skilled professionals.
The problem in 2008, in his view, lay with a poorly structured market and, in particular, the shadow banking system. “Markets went crazy but it was not because the participants were crazy,” he says. “It was because of poorly structured markets that got into these liquidity spirals.”
This is in contrast to the technology boom of the late 1990s and the subsequent bust in the early 2000s. The focus back then was much more on the equity markets. “The whole field of inquiry is deeply irrelevant to the current situation,” says Adler. “It was fine during the tech boom.”
It is also important to note that the conventional behavioural approach tends to downplay or even ignore the importance of the underlying economy. The emphasis is focused tightly on individuals and their cognitive biases. This precludes the possibility, for example, that surges of liquidity from the real economy can play a role in the emergence of bubbles. Inflated asset prices are not necessarily the result of investor psychology or any form of conscious decision-making. If anything, investors may be simply reacting to the circumstances they find themselves in.
It is widely accepted that behavioural factors can play a role in explaining investor behaviour and that of other market actors. Some financial institutions are willing to expend considerable resources on harnessing such insights. The application of these tools to explain market behaviour or even financial crises is a more contentious area.
This box was part of my recent Fund Strategy cover story on behavioural finance.
Although behavioural finance owed much to modern psychology it also has other antecedents. Often they run parallel to discussions about irrational crowd behaviour.
In the 1970s, at about the same time as Daniel Kahneman and Amos Tversky were starting to develop their ideas, the first edition of Charles Kindleberger’s famous study of Manias, Panics, and Crashes was published. This is essentially a study of the history of financial crises including the Kipper- und Wipperzeit (tipper and see-saw) hyperinflation in central Europe from 1619-1622, the South Sea and Mississippi bubbles of the early eighteenth century and Tulipmania in the Netherlands in the 1630s. From an analysis of these events he develops a theory of crises and discusses the best way for the authorities to tackle them.
Kindleberger himself acknowledges the influence of other notable works in developing his framework. One is the famous study by Charles Mackay, a Scottish journalist and author, on Extraordinary Popular Delusions and the Madness of Crowds (first published in 1841). He also refers to a work by Gustave LeBon, a French author, on The Crowd (1895). LeBon was preoccupied with the dangers of political unrest but many have drawn parallels between unruly behaviour and market mania.
Perhaps the most surprising figure to find in the list of behavioural thinkers is Adam Smith. The eighteenth century author of The Wealth of Nations (1776) is often thought of as the originator of the idea of rational economic man. Indeed the rationalists of today often claim him as their own. This is perhaps not surprising since his seminal economic text contains one of the most famous statements on the importance of self-interest: “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.”
However, it is too often forgotten that Smith wrote two great books rather than just one. The focus of his Theory of Moral Sentiments (1759) is much more on the actual behaviour of individuals than his economic work. It is therefore not surprising that some authors have pointed to psychological insights in his work and one article has even dubbed him a “behavioural economist”. For example, an article in the Summer 2005 edition of the Journal of Economic Perspectives points to Smith as identifying the concept of loss aversion. Of course Smith used eighteenth century language rather than modern psychological terms: “Pain…is, in almost all cases, a more pungent sensation than the opposite and correspondent pleasure. The one almost always depresses us much more below the ordinary, or what may be called the natural state of our happiness, than the other ever raises us above it.”
Smith also wrote, among other things, of the tendency to overconfidence or in his words the: “over-weening conceit which the greater part of men have of their own abilities”.
It would be a mistake to read too much into the contemporary parallels with Smith’s thinking. The focus of the Theory of Moral Sentiments was on relationships between individuals rather than markets or the economy. But it is worth noting that contemporary behavioural insights are not always as path breaking as some of its proponents suggest.
This is my column for the July issue of Fund Strategy.
Those who work in investment are more guilty than most of being too ready to accept the authority of numbers. Words can be doubted but numbers are often seen as virtually sacrosanct.
Indeed, financial news often revolves around numbers. An index is down by X over the day’s trading and another index is up by Y. One currency has moved by a certain amount against another. Why those who invest with a time horizon of several years should be expected to be preoccupied with day-to-day price movements is seldom explained. This is the classic error of short-termism. The problem is not that the numbers are incorrect but that they are the wrong tools for the job.
Of course, numbers can be useful but they should be handled with care. It is only when their pitfalls and limitations are understood that they can come into their own.
The recent row over Thomas Piketty’s best-selling book on inequality, Capital in the Twenty-first Century, illustrates one pervasive problem: confirmation bias. When it emerged that the French economist had made some data errors, many of his critics claimed triumphantly that his arguments had been discredited. When Piketty, acknowledging some small mistakes, defended his overall thesis, his supporters condemned his opponents as inequality deniers. The to and fro more resembled chanting between rival football fans than reasoned debate. It is likely that few had examined the data closely.
One common error is to confuse correlation with causation. Although anyone who has done a statistics course can probably recite the difference between the two they are often confused in practice. Once again, the inequality debate provides a clear example. Arguments along the following lines all too frequent:
A: Inequality widened in the run-up to the economic crisis of 2007-08.
B: The world then plunged into an economic crisis.
Therefore A must be the cause of B.
There are so many problems with such reasoning it is hard to know where to start. Just because two phenomena track each other it does not necessarily follow that one causes the other. It could be a coincidence or there could be another factor driving both trends. For example, blue eyes and blond hair frequently coincide but that does not prove one causes the other.
The pitfalls of confusing correlation and causation are wittily illustrated in the Spurious Correlations website (www.tylervigen.com/). Tyler Viglen, a doctoral student at Harvard Law School, has mined numerous data sets to find unlikely correlations. Who would have thought that the number of people who drowned by falling into a swimming pool correlates with the number of films Nicholas Cage appeared in?
However, confusing causation and correlation is not the only error embodied in the example of widening inequality and the economic crisis. Another is known as cherrypicking: selecting the data that supports your case but ignoring other data. Inequality, in fact, has widened by some measures but not by others.
According to one popular gauge, the Gini coefficient, household income inequality in 2010-11 was at about the same level as in the early 1990s. Yet according to some other measures, particularly those that focus on the top of the income distribution, inequality had widened. Both sets of data are correct as they both measure different things.
But perhaps the most tempting error is what could be called mathematical correctness. The challenge is to find the best available numbers to make a case. But sometimes there is no correct mathematical answer. For example, whether or not inequality is regarded as a problem is ultimately a political question. Some will view it as an inevitable part of the human condition while others might see it as a damning indictment of society.
In such cases the right answer cannot be worked out simply by getting the maths right.
Given the unpopularity of those who work in financial services it was perhaps appropriate that there was a constant hissing sound in the background. Only this time around the source of the hissing, at least in the main, was a noisy air pump rather than the audience.
The venue was the Bowler Hat – a large inflated tent serving as a pop-up theatre – in London’s Paternoster Square. Just to the north was the nondescript London Stock Exchange building and not far to the south was St Paul’s Cathedral. So it was almost literally sandwiched between god and mammon.
It was also a strangely suitable place to be debating whether the City is socially useful in a session that was part of the annual City of London Festival. On the critical side of the panel were Tony Greenham of the New Economics Foundation and Aditya Chakrabortty of the Guardian. On the other side, not entirely uncritical but broadly pro-City, were Marc Sidwell of CityAM and Louise Cooper. Angus Kennedy of the Institute of Ideas was in the chair.
Although all of the panel scored some points in the debate no one landed a killer blow. For Greenham the City has become a haven for speculation and rent-seeking – but whether there was a realistic possibility of it being any different was unclear from his argument. Chakrabortty spent much of his time blaming the woes of the British economy on the City without explaining the nature of the alleged connection.
On the other side, Cooper focused mainly on the City’s textbook role as a channel for raising capital for those who need it. Later in the debate Chakrabortty, quite rightly, questioned whether this model bears any relationship to reality. Finally, Sidwell discussed what he saw as the many positive attributes of the City while also pointing out that, contrary to Greenham’s claims, there was a strong regulatory regime in place before the crisis.
It is of course always easy to be wise after the event but it would have been better if the debate had focused on the City’s key role. Does it succeed in channeling capital for productive purposes or not? It seems to me clear that it does not fulfil this rule at present. It certainly is adept at moving capital around but relatively little of it is being used to enhance prosperity. Whether things could be any different should be the nub of the discussion.
This leads to another point that was not raised by any of the panelists. The City’s role has shifted towards redistributing risk as much as about channeling capital. Until this point is appreciated it is not possible to grapple properly with the subject.
Finally, to declare an interest and make a shameless plug at the same time. I will be participating in a debate on does emotion or reason dictate the financial markets in the Bowler Hat on Wednesday 9 July at 6pm. The other panelists are Greg Davies of Barclays, Frances Hudson of Standard Life Investments and Adrian Wooldridge of the Economist. I hope you can make it.
This blog post was first published today on Fundweb.
This is the text of my piece on global inequality from last Friday’s Financial Times.
It is perhaps the ultimate killer fact: Oxfam, the aid organisation, estimates the 85 richest people in the world own as much wealth as the bottom half of the global population. The figure grabbed global media attention and was even cited by Christine Lagarde, managing director of the International Monetary Fund.
Numbers do not speak for themselves, but no doubt many people find the contrast unsettling. In a world still blighted by poverty, how can 85 people have as much wealth as more than 3.5bn others? Only a small minority is likely to feel confident arguing that such a heavily skewed distribution of wealth can be justified morally.
But statistics should not be taken at face value. The first question to examine is whether the estimate is accurate. For one thing the super-rich do not usually disclose the exact value of their vast portfolios of assets.
Even if the figure turns out to be reasonable, any grounds for objection are open to debate. In a properly functioning market economy the rich do not directly expropriate resources from the poor. Any transfer of wealth happens organically as part of its normal operation. Objections to extreme inequality, whether moral or practical, should be spelt out.
Ricardo Fuentes-Nieva, head of research at Oxfam GB, says the idea of compiling the figure came to him when he was reading Credit Suisse’s Global Wealth Databook 2013. It was there that his eye was struck by the sentence: “The bottom half of the global population together possess less than 1 per cent of global wealth.”
So the starting point for his calculation was an impeccably capitalist source. From there, Fuentes-Nieva, along with Nicholas Galasso, a policy adviser to Oxfam America, could start their calculations. From Credit Suisse’s database they could estimate how much wealth the bottom half of the world’s population owned. They could then work their way down the Forbes rich list to calculate how many of the world’s richest individuals owned an equivalent amount of wealth. This was the basis for the headline figure in Oxfam’s report, Working for the Few: Political Capture and Economic Inequality.
Fuentes-Nieva also points out that when Forbes – a publication that calls itself “the capitalist tool” – recalculated the data using the Forbes list for 2014, it concluded that only 67 billionaires owned as much as the world’s poorest half. Since the super-rich had prospered over the year it took fewer of them to match the wealth of 3.5bn people.
As long as it is recognised as a rough estimate, then, the claim that the 85 richest people own as much as half of the world’s population is reasonable. It only represents an order of magnitude rather than a precise number.
The implicit call for redistribution conjured up by the number is, however, open to debate. Deirdre McCloskey, a professor of economics at the University of Illinois at Chicago, argues in her forthcoming book, Bourgeois Equality, that redistributing the $1.5tn collectively owned by the 85 richest people would have a much smaller impact than widely assumed.
She estimates that if it were all redistributed to the poorest half of the population it would only amount to $428 per person. But that would only be a one-off figure – there would be no further transfer in subsequent years. If, instead, the $1.5tn were prudently invested at, say, 5% a year, it would be a perpetual gain of $21.40 a year for each person in the bottom half of the world’s population – good but not that large in the scheme of things.
For McCloskey, the emphasis should be on economic growth rather than redistribution. “Charity won’t help poor people very much,” she says.
“What does help poor people, and has massively helped poor people in the long run, is the massive expansion of income.” In her view, it would be much better to have a society in which the poor have dignity, including political rights and ample resources, rather than material equality.
As it happens, the Oxfam paper does not call for a global equalisation of wealth but advocates redistributive transfers, the strengthening of social protection and progressive taxation. Perhaps even more surprising is Fuentes-Nieva’s insistence that he is not opposed to inequality in itself. “You need some inequality to reward entrepreneurship and to reward talent and merit and hard work,” he says.
Oxfam’s main concern is not inequality itself but plutocracy. As the report’s subtitle suggests, in a world with highly concentrated wealth there is a risk that the super-rich will “capture” the political system for their own use. “With this massive concentration of income and wealth what you see is a bias of political institutions towards the interests of the few,” says Fuentes-Nieva.
McCloskey concedes this is a potential problem but looks elsewhere to resolve it. “The way to solve that is to make the government smaller,” she says. A more limited state has less capacity to interfere in people’s lives in detrimental ways. She also argues that other forces besides the wealthy, such as trade unions, can capture the government to further their own interests.
The claim that the world’s 85 richest individuals own more than the poorer half of the world’s population is certainly an arresting figure. But in itself it says nothing about the best way to free the world of the scourge of poverty.
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