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.

In the light of today’s publication of a report by the Organisation for Economic Co-operation and Development (OECD), a rich country think tank, my spiked essay on inequality is worth rereading. The OECD broadly argues that high and rising inequality damages economic growth whereas I contend that, if anything, causality runs in the other direction. In other words rising inequality in the developed world is in my view a symptom, rather than a cause, of economic weakness.

It is worth noting that much of the media coverage on the OECD study overstates the certainty of its conclusions. The headlines of the report are simply being used to confirm the pre-conceptions of the anti-inequality brigade.

It is sad fact that as the emerging economies have become wealthier the discussion of development has become ever more degraded. Whereas the focus used to be on economic transformation, attempting to turn poor countries into rich ones, the new generation of experts promotes behavioural correctness.

Take a look at the 2015 edition of the World Development Report, the World Bank’s flagship publication, with its focus on “Mind, Society and Behaviour”. Among the interventions it suggests are giving lentils and metal dinner plates to those who have their children immunised, showing inspirational videos on escape from poverty and sending weekly text messages to remind patients to take their HIV medicine. It is a long way from the old orthodoxy where the emphasis was on such projects as building dams, power stations and roads.

The patronising “nudges” favoured by contemporary experts are based on supposed insights gleaned from behavioural finance. Although psychology can throw light on individual behaviour its use by development experts tends to be banal and misleading.

To begin with it identifies three principles of human decision-making: automatic, social and using mental models. The first and third of these are drawn from the work of Daniel Kahneman who won the Nobel prize for economics in 2002, except he refers to system one (fast) and system two (slow) thinking.

Fast and slow thinking are contrasted with the economists’ conception of rational economic man. Individuals often make quick fire judgments and they also use mental models which can sometimes be misleading.

The problem with the behavioural argument is that the notion of rational economic man is made of straw. Few economists would argue that humans act solely as calculating machines when it comes to making decisions. People often do make decisions without much thought and they can indeed be misled by the concepts they use. These are not the great insights that the behavioural finance experts often suppose.

On the contrary, humans have the ability to interact with each other and to reflect on their choices. This provides the opportunity to make important decisions through the clash of ideas in public debate.

Although the World Development Report does discuss social decision-making its conception is exceedingly narrow. The focus is one-sidely on how social pressures can influence people to think in a particular way: “human sociality implies that behaviour is also influenced by social expectations, social recognition, patterns of cooperation, care of in-group members, and social norms.” There is little appreciation of how, through social interaction, it is possible to change society for the better.

The behaviourists have a dim view of the ordinary people of the developing world. Such pundits are so pessimistic about human potential they think progress consists of nudging individuals towards behaviour that the experts deem as correct.

The most positive outcome would be for the nudgers to be ridiculed. Living standards in Asia in particular have risen tremendously in recent years through ignoring the obsession with individual behaviour and promoting economic growth.

This blog post was first published today on Fundweb

The audio recording of my Battle of Ideas 2015 session on “PIGS can’t fly? Surviving austerity” is now available to listen to online here.

 

Two of my articles, a book review  and a feature, are published in today’s Financial Times (free registration may be necessary to read). I will upload the text at a later date.

This article was first published in the December issue of Fund Strategy.

Of all the confusing areas of economics one of the most bewildering is public spending. Despite its centrality to public debate in Britain most people probably shrug their shoulders when they hear it being discussed. Yet its profile is likely to get higher still with the Autumn Statement and next year’s election.

It is not that it is inherently that complicated. The problem is that some basic distinctions get muddled. Sometimes there is deliberate obfuscation on the part of politicians and experts debating the subject. So, in the interests of clarifying a key subject, there follows some key points to bear in mind.

Let us start by taking public spending as a whole – rather than dividing it into constituent parts. There is a pervasive assumption that the Thatcherite wing of the Conservative party wants to slash it and Labour wants it to remain high.

That premise does not stand up to critical scrutiny. Those who want to examine the question in more detail are fortunate to have comprehensive data freely available at: http://www.ukpublicspending.co.uk/ There is also further information on the Office for Budget Responsibility (http://budgetresponsibility.org.uk/ ) and HM Treasury (https://www.gov.uk/government/organisations/hm-treasury ) websites.

One way to measure public spending in real terms over time is to look at it as a proportion of GDP. There was clearly a huge surge in spending during the second world war but in recent decades there has been no clear trend either way. Spending has risen and fallen with the economic cycle but it has fluctuated around roughly the same level.

For example, public spending for 2014 is forecast at about 43.5% of GDP according to www.ukpublicspending.co.uk. That is about the same level as in 1967 and 1968. In the meantime it fell as low as 34% in 1989 and rose as high as 48% in 1975. In other words, despite all the talk of Thatcherism and neo-liberalism there has been no clear trend towards cutting public spending. Indeed one of the sharpest falls, over five percentage points in four years, came during the Labour government of the late 1970s.

However, if spending is measured on an inflation-adjusted basis and per head basis (taking into account the rising population) the trend looks more like one of steady increase. Spending per head in 2013 (the latest available figure) is calculated at just over £10,000 in constant 2005 pounds. That is not far off twice the level in real terms as when Margaret Thatcher became prime minister in 1979.

Both sets of figures beg the question of why there is so much talk about spending cuts. It is clear from the record that, whatever the rhetoric, spending is stubbornly resistant to such initiatives over the long term.

A closer look at the figures over the last few years helps explain recent developments. In 2008, with the economy going into recession, public spending surged. According to the OBR’s figures it increased from 39.9% of GDP in 2007-08 to a peak of 45.3% in 2009-10 (see graph). This was under a Labour government but it is likely that more-or-less the same would have happened under the Conservatives.

The forecasts for the coming years are even more striking. The OBR forecasts public spending to be at 40.2% of GDP in 2016-17 – that is higher than it was in 2007-08 despite all the talk of cuts. It is also worth noting that public spending is forecast to rise this year in real terms compared with last year. Public spending is only being cut relative to its recent, artificially inflated, peak.

So all the figures on total spending show without doubt there is no trend towards a shrinking state. On the contrary, it looks certain that government will continue to play a huge role in society and in the economy. The claim that Britain is a free market – if that is taken to mean a minimal role for he state – is contradicted by the data. It may or may not be a desirable goal but it is certainly not what exists at present nor is it on the agenda for the foreseeable future.

If spending is not being cut in real terms it begs the question of why it is being so widely discussed. One answer is that spending is falling in certain areas even if aggregate cuts are small.

Take the estimated spending of £731bn in the 2015 fiscal year as an example. The Government has said it is going to protect health spending (about 18% of the total), education* (12%) and overseas aid (1.5%).

There are also large areas of spending which are not classified as departmental spending such as debt interest payments (7%), pensions (20%) and welfare benefits (15%).

That means there are areas which are suffering substantial cuts, such as local government spending, but there are others which are not being cut at all. The cuts get most of the attention but such a one-sided focus provides a grossly misleading picture of the overall trend.

It is high time that debate on the subject was better informed.

* School spending in particular is protected.

The biggest challenge facing the world economy is not the difficult economic conditions but what could be called gloomsters. These are the fatalists who think nothing much can be done about economic problems besides tinkering with monetary policy or public spending.

Gloomsters are not what Margaret Thatcher long ago called “moaning minnies” . On the contrary, they can appear on the face of it to be relatively upbeat about economic prospects. But underlying their policy prescriptions is a deep pessimism about the prospects for creating a more dynamic economy.

Gloomsters can take Labour and Conservative forms. Labour politicians tend to argue that a little less austerity is in order until the economic cycle turns. Conservatives, on the other hand, say a tighter squeeze on public spending is necessary. But neither has much of a clue about how best to promote economic restructuring. Raising investment levels and bolstering productivity plays little part in their discussions.

Take the prime minister’s recent claim that the “red lights are flashing on the global economy”. The thrust of David Cameron’s argument was that the British economy is doing well but the coalition government has to stay on course with spending cuts because of global economic weakness. Essentially it was an exercise in complacency. Britain may be forecast to growth more strongly than other developed economies this year but its medium and longer-term record is poor. The prime minister prefers not to put Britain’s record into its proper context as he is a gloomster: he believes that little can be done to tackle it.

Mark Carney, the governor of the Bank of England, takes a similar view to Cameron. In a recent speech  he echoed Karl Marx and Friedrich Engels when he noted that “a spectre is haunting Europe”. Only Carney was not talking about a communist revolution but economic stagnation. He then went on to argue that Britain is doing better than continental Europe. After that he talked narrowly about inflation and monetary policy.

Of course monetary policy is the Bank of England’s remit. It should be up to elected politicians rather than central bankers to devise a broader economic strategy. Unfortunately there is little sign of this broader debate anywhere.

The trend towards gloomsterism is even stronger in Japan. From late 2012 onwards the Japanese prime minister, Shinzo Abe, pursued an approach that became known as Abenomics . This consisted of three “arrows”: monetary policy, fiscal policy and structural reform.

In the event the Japanese government promoted an expansionary monetary policy and a looser fiscal policy, at least in the short term, but only limited structural reform. The basic weaknesses of the productive economy were left intact. It should not therefore have come as a surprise that the economy contracted in the third quarter to fall into its third recession in four years. Japan is facing yet another election as a result.

It is time that gloomsters of all stripes were challenged. There is a desperate need for a focus on promoting dynamic growth rather than tinkering with monetary policy and fiscal deficits.

This is my latest blog post for Fundweb.

Sabine Beppler-Spahl has interviewed me on Israel and anti-semitism in the latest edition of Novo magazine (in German). The text is not available online but the publication can be ordered here.