Showing posts with label Rationality in capital markets. Show all posts
Showing posts with label Rationality in capital markets. Show all posts

Tuesday, November 6, 2018

How does skin in the game help solve the Black Swan problem?

As I was reading Skin in the Game, Nassim Taleb’s latest book, the thought crossed my mind that the author might classify me as an IYI (intellectual yet idiot). He puts economists in the IYI category along with psychologists.
Taleb writes: 
Knowing ‘economics’ doesn’t mean knowing anything about economics in the sense of the real activity, rather than the theories … produced by economists”. 
I agree. Some economists know little about the real world.

Despite his low opinion of economists, the author acknowledges that some of the economists I admire, including Friedrich Hayek, Ronald Coase and Elinor Ostrom, had useful insights about the real world. He even suggests that Paul Samuelson made a useful contribution by pointing out that people reveal their preferences in their market behaviour rather than in what they say.

Rather than viewing Nassim Taleb’s offensive anti-intellectualism as evidence that he suffers from SFB, I think economists and psychologists should view it as a clever ploy to attract the attention of their students. I hope Taleb succeeds, and also hope that his book helps students to pose difficult questions for some of their professors.

There is some irony in the fact that Taleb has a low opinion of intellectuals, since Daniel Kahneman views Nassim Taleb as “one of the world’s top intellectuals”. Kahneman, a psychologist, won the Nobel prize for economics, largely for his research on asymmetry in the way people value potential gains and losses in making decisions. Taleb is critical of that research.

The question I raised at the outset was prompted by the following passage:

Skin in the game helps to solve the Black Swan problem and other matters of uncertainty at the level of both the individual and the collective: what has survived has revealed its robustness to Black Swan events and removing skin in the game disrupts such selection mechanisms. Without skin in the game, we fail to get the Intelligence of Time".

It is worth trying to take that apart to understand the reasoning behind it.

Skin in the game is about more than just sharing in the benefits of an activity. It involves symmetry and reciprocity – paying a penalty if something goes wrong as well as sharing in the rewards for risk taking.

Most people who provide us with goods and services still pursue occupations where they have skin in the game. The problem is that many of the people who don’t have skin in the game - for example, politicians, bureaucrats, bankers and university professors - occupy positions where their mistakes can have far-reaching consequences.

The Black Swan problem arises when we ignore extreme events – potential disasters - that occur infrequently. Taleb’s main point is that there are some risks that we can’t afford to take even though there is a low probability that they will occur at any point in time. His book, The Black Swan, was published in 2007 and made him famous following the 2008 financial crisis. Taleb contends that banks and trading firms are vulnerable to hazardous Black Swan events. The bank blow-ups occurred in 2008 as a result of hidden and asymmetric risks in the financial system.

At the level of the individual, skin in the game helps to solve the Black Swan problem because it helps people to focus on their need to survive in order to succeed. Taleb argues for profiting from risk-taking that doesn’t threaten survival. He points out that Warren Buffet made his billions by picking opportunities that passed a high threshold, rather than by applying cost benefit analysis.

At the collective level, skin in the game helps to solve the Black Swan problem because it requires decentralization of decision-making. Under a decentralized system the costs of the mistakes made by individuals are borne by those individuals, without necessarily affecting other participants. Centralized systems are exposed to the Black Swan problem because they can only be run by people who are not directly exposed to the cost of errors.

What has survived has revealed its robustness to Black Swan events. That applies to ideas, institutions, technologies, political systems, procedures, intellectual productions, car models, scientific theories etc. The only effective judge of things is time, because time is equivalent to disorder. The longer things survive, the more likely it is that they will have survived Black Swan events.

Removal of skin in the game disrupts selection mechanisms. When people have skin in the game they are less likely to reject ideas that have withstood the test of time in favour of new ideas that that have been published in peer-reviewed journals. A lot of findings published in peer reviewed journals fail subsequent replication tests.  

Without skin in the game, we fail to get the Intelligence of Time. Time removes the fragile and keeps the robust. The life expectancy of the nonfragile lengthens with time. Taleb writes:
The only definition of rationality that I’ve found that is practically, empirically, and mathematically rigorous is the following: what is rational is that which allows for survival."

I think Nassim Taleb is correct in his view that skin in the game helps to solve the Black Swan problem. Unfortunately, however, when it is comes to consideration of potential Black Swan events that threaten the survival of humanity, the political systems we have inherited do not ensure that political leaders have enough skin in the game for their minds to focus appropriately. Political leaders focus on their survival at the next election rather than on the survival of humanity. It is up to citizens who are concerned about potential Black Swan disasters to initiate appropriate action themselves.

Monday, April 11, 2016

Is Australian housing more than 40% over-valued?

Source: Australian Bureau of Statistics

A recent article in The Economist suggests that “housing appears to be more than 40% overvalued in Australia, Britain and Canada” (“Hot in the city”, April 2, 2016 - possibly gated). This claim is based on the extent that the ratios of prices to disposable incomes and prices to rents are above their long term averages in those countries. By contrast, according to The Economist, housing prices in the United States are currently at “fair value” because those indicators are close to their long run average.

When they talk about “fair value” I guess what the authors of The Economist article have in mind is an equilibrium price that may differ from current market prices.  That raises some thorny conceptual issues, but I am prepared to accept that markets are sometimes affected by the irrational exuberance or pessimism of large numbers of investors.

The Economist has been using the same methodology for quite a few years now to suggest that housing prices are overvalued in countries in which they have risen strongly since the GFC.

When I wrote in 2011 about a previous article in The Economist using this methodology I pointed out that it was unrealistic to expect average rental yields (the inverse of the house price to rent ratio) in Australia to return to its long term average over the period since 1975 because over the first half of that period high nominal interest rates were suppressing demand for housing. As inflation rates and interest rates came down, housing affordability improved markedly during the 1990s, but this led to increased demand for housing, a sharp rise in house prices and a decline in rental yields. What we were seeing was a return to normality rather than the emergence of a house price bubble.

The Economist has published an infographic (ungated) which neatly illustrates how the ratios of prices to disposable incomes and prices to rents are currently above their long term averages in Australia, Britain and Canada. However, their infographic also illustrates the potential for large errors to be made by assuming that long term averages of house price to rent and house price to income ratios represent equilibrium prices. If you look at movements in the ratios of prices to disposable incomes and prices to rents over the whole period 1970 to 2016, you will notice that those ratios for Australia and Canada were well below the corresponding ratios for the US in the 1970s and ‘80’s. The same was true for Britain in the ‘90s. Even if actual price to income and price to rent ratios were currently the same in all four countries, the ratios for Australia, Canada and Britain could still be expected to be above their long run averages.

So, what does a comparison of actual ratios for Australia, Canada, Britain and the United States show? I haven’t attempted a complete assessment, but the latest data from Global Property Guide (GPG) on gross rental yields suggests yields of 4.4% for Australia (Sydney), 4.4% for Canada (Toronto), 3.2% for the UK (London) and 3.9% for the US (New York). The GPG data for the US relates to Manhattan which might be perceived by investors to offer better prospects for capital gains than most other localities in the US. The Economist’s data on price to rent ratio’s for the US implies a much higher gross rental yield for New York (about 7%) and even a somewhat higher yield for San Francisco (about 5%).

Given current and prospective interest rate levels, those comparisons do not seem to provide much evidence of irrationality in housing prices in any of those countries. It seems to me that there is no more reason to think housing investors in Australia, Canada and Britain have been irrationally exuberant in recent years than to think those in the United States have been irrationally pessimistic.  

Sunday, February 28, 2016

Could Larry Summers be half-right about secular stagnation?

When I read ‘The age of secular stagnation’ by Lawrence H Summers (published in Foreign Affairs (March/April 2016) I was pleasantly surprised to find that I agreed with part of his analysis.

I agree that economic growth has been relatively weak in most developed countries in recent years because levels of investment have been low, despite high levels of saving and low real interest rates. That is not quite how Summers puts it; he talks about “excess savings”. He might have reasons for that, but it makes his argument seem convoluted.

I tend to agree with Summers when he writes:
“Absent many good new investment opportunities, savings have tended to flow into existing assets, causing asset price inflation”.
My agreement is qualified because I think the absence of investment opportunities is more about perception than reality. Why I think that will become clearer later.

The solution Summers offers to the problem of low investment is an expansionary fiscal policy pursued through public investment. Writing about the United States he argues:
“A time of low real interest rates, low materials prices, and high construction unemployment is the ideal moment for a large public investment program. It is tragic … that net government investment is lower than at any time in nearly six decades”.

It is obviously problematic to be proposing an expansion in public investment at a time when rising government debt has been imposing a significant burden on later generations. But there may be ways around such concerns. In its article, ‘Fighting the next recession’ The Economist (Feb. 20) gave some prominence to the New South Wales Government model of privatising assets such as ports to fund public investment. I had not previously thought of the efforts of the NSW government to raise some cash for infrastructure spending as a model that might have wider application.

However, there are limits to the extent that additional public sector investment is likely to stimulate further private investment. Additional public investment in most economic sectors competes with private investment. If governments confine their investments to sectors where public investment might have a comparative advantage, they will, before long, end up investing in projects that have no hope of yielding even a modest return on investment. Such misallocations seem more likely to add to secular stagnation than to help overcome it. Japan’s efforts to stimulate economic growth by building roads to nowhere may be a good example of such counterproductive public investment.

Before proposing solutions to the problem of secular under-investment it would be a good idea to try to understand why it is occurring. In his recent article, ‘U.S. secular stagnation?’ Steve Hanke pointed to Robert Higgs’ concept of “regime uncertainty” as a possible explanation of the long term downward trend in net private domestic business investment as a percentage of GDP since the beginning of the 1970s. An index of economic policy uncertainty developed by Scott Baker, Nicholas Bloom and Steven Davis suggests that economic policy uncertainty is currently very high - at similar levels to the 1930s, and much higher than in the 50s and 60s.

An increase in policy uncertainty is also consistent with the observation by Kevin Lane and Tom Rosewall (RBA Bulletin 2015) that the hurdle rates of return that firms use to evaluate investment projects has not declined along with declines in interest rates that have occurred since the 1980s. This implies that profitable investment opportunities are being foregone because of greater uncertainty about future after-tax returns and costs. OECD researchers suggest that policy uncertainty (concerning regulation, macro policy and taxation policy) is one factor causing the hurdle rate that companies apply to capital spending to be higher than that applied by financial investors (Business and Financial Outlook 2015, p 60).

My conclusion is that Larry Summers might be about half right in his observations about secular stagnation. Investment has been too low, but the long-run solution can't lie in increased public investment. Governments should be thinking about how they can make businesses feel confident that regulatory and tax burdens are not likely to be further increased over the lifetime of new investments.

Sunday, November 22, 2015

Why donate through Opportunity International Australia?

It must have been over 15 years ago when I first began making modest monthly donations to Opportunity International Australia. Opportunity is a microfinance organisation that provides small loans to help people in low-income countries break the poverty cycle by starting their own small businesses. It also offers its clients other financial services including savings accounts and insurance.

What attracted me to Opportunity the most was the potential for money donated to be recycled to help more people as loans are repaid. Over the years I have obtained satisfaction from the information that Opportunity has sent me about transformations that have occurred in the lives of individuals who were being helped. There have been many heart-warming stories about donations being used in ways that help poor people, mainly women, to build better lives for themselves and their families.

Nevertheless, the sceptical old economist in me has been muttering that he would like to see such stories backed by more empirical data showing how the economic and social prospects of Opportunity’s clients have improved as a result of the help that they have been given.

The enthusiasm of development economists for microfinance seems to have waxed and waned over the years, but recent research findings suggest that it can be an effective way to expand the opportunities available to people living in poverty who would otherwise be unable to obtain credit (or would have difficulty servicing loans at interest rates reflecting the high credit risks conventionally perceived to be involved). One particular study I have in mind, undertaken by Shahidur Khandker and Hussain Samad for the World Bank, uses over 20 years of panel data for Bangladesh. This study found that microcredit programmes resulted in increases in income, expenditure and net wealth, and increased participation in education. The results suggest that microcredit has been a particularly effective tool for reducing poverty among women.

In terms of global microfinance, the Opportunity International Network is a relatively small player, but a recent Social Performance Report indicates that it now has 3.6 million loan clients and its gross loan portfolio stands at $US 841.6 million. As indicated in the chart below, most of those loans have been made to India and other parts of Asia.

Those priorities seem appropriate from an Australian supporter’s perspective, but I would personally like to see Opportunity also establish a presence in Papua New Guinea.
Information in the Social Performance Report also indicates to me that Opportunity has been fairly effective in targeting assistance to those whose needs are greatest. A high proportion of new clients have been living in poverty, using $2.50 per day as the benchmark; new clients often have had no previous access to loans or savings facilities with a financial institution; and 94% of clients are women.

Information on the impact of loans and other assistance is currently patchy, but efforts are being made to develop appropriate indicators. The Social Performance Report provides evidence of a substantial reduction in the proportion of clients in poverty in the Philippines and of substantial job creation in clients’ businesses in African countries. One statistic which must imply impressive economic performance by clients is the repayment rate of loans – it is reported that 98% of Opportunity loans are repaid.

Rather than rounding off this post with a conclusion that any two-handed economist might be proud of, I want to do something I have never done before. I urge readers to spare $6 or more (hopefully much more) each month to make a regular donation to Opportunity. You might get a warm inner glow by giving money to other charities, but it would be hard to find anything more deeply satisfying than giving a hand-up to poverty-stricken people who seeking to build better futures for themselves and their families.

Sunday, May 17, 2015

Is Bitcoin better than gold?

When suggestions have been made to me in the past that I should write about Bitcoin, I have expressed reluctance on the grounds that I don’t know much about it. Some would say, however, that is also true of some other things I write about on this blog.

Time seems to be running out for me to write about Bitcoin while the topic is still interesting. I keep reading news reports suggesting that Bitcoin is rapidly becoming respectable. Apparently New York State’s top financial regulator has just granted the first license to a Bitcoin exchange. A couple of weeks ago it was reported that Goldman Sachs is making a significant investment in a Bitcoin-focused company.

Anyone looking for a simple explanation of what Bitcoin is and how it works can find a fair amount of information online without much difficulty. The Economist attempted to provide an explanation a couple of years ago, but I found an explanation aimed at five year olds to be more helpful. A couple of months ago Nicolas Dorier referred me to the excellent explanation which Andreas Antonopoulos provided to a committee of the Canadian Senate in October 2014. Mr Antonopoulos also appeared before a committee of the Australian Senate and responded admirably to concerns about use of Bitcoin for nefarious purposes such as funding of drug trafficking and terrorism. He also argued strongly that incumbents in the finance industry should not be allowed to dictate government regulations applying to Bitcoin.

Should we view Bitcoin as money? In order to look at this question it is necessary to consider three functions of money: a unit of account; medium of exchange and store of value. Some economists, including Scott Sumner, argue that the unit of account function is the distinguishing characteristic of money from an economic perspective, and I am inclined to agree. Bitcoin is not widely accepted as a unit of account at the moment - it certainly does not seem likely to displace national currencies in that role in the near future.

However, Bitcoin seems to be proving itself to be very useful as a medium of exchange in international transactions. It is particularly pleasing to see reports of Bitcoin being used to enable guest workers from countries such as the Philippines to send remittances home to their families for a much lower price than is charged by firms such as Western Union. Further innovations are occurring in this area. For example, it has been recently reported that an Australian company, Digital CC, has set out to become the Uber of international transfers by developing a peer-to-peer transacting technology to allow remittance payments to be made via a mobile app.

There is no question that Bitcoin is much better than gold as a medium of exchange, because gold is expensive to store and transport.

It is when we consider the potential for Bitcoin as a store of value that the question of whether Bitcoin is superior to gold becomes harder to decide. A glance at the charts below might suggest that investors in Bitcoin are being optimistic if they think it will soon be accepted as a reliable store of value.

How much attention we should pay to past volatility in the price of Bitcoin in thinking about its potential as a store of value in the future?

The author of an article in Fortune, entitled ‘Gold vs. bitcoin: An apocalyptic showdown’, has suggested:
“Of course, as a new technology, bitcoin is subject to much more volatility than gold. But over the long run, given the fact that no new bitcoins will be mined after the 21-millionth, we can expect it to ultimately serve as a better store of value than gold”.

I feel inclined to agree. However, the more difficult question for me is whether to put my money where my mouth is

Nicolas Dorier has provided the following response:

"There is nothing to to fear about Bitcoin, but like owning gold, if your lose the map where you buried it, you lose everything. So one should be confident in his ability to protect the map. To learn how to do so, one should start training by protecting some pocket money first before burying his treasure.

First, start small, and consider it a learning experiment rather than an investment. Bitcoin is relatively new, and the tools and ecosystem are not as user friendly as they will become. The learning curve might be a little steep. Owning Bitcoin means being responsible for your money, and most people are not responsible of their own computer.

So be careful, you can always try to buy a few (for 10-50 dollars), and play with it by trying to buy stuff, transfer them between addresses, backup them on paper etc, restore them etc. This stuff was easy to learn for me as I am a developer. But it is not for most people. 

Second, never let your bitcoin on fiat/bitcoin exchanges once you bought. You don't own bitcoins if you don't own the private key. Any balance you see on exchanges are just IOU, not bitcoins.

By playing with it you will learn little by little all what you can do with it that you can't with traditional fiat currencies, and all the business opportunities that it opens. But don't rush it, start playing with it first.

Bitcoin is also an hedge against monetary mismanagement and financial oppression, a typical example right now is Argentina.
The value of Bitcoin increases when governments take measures to restrict the movement of other forms of money. As they do everything to restrict it, it forces people to use bitcoin. Not because they believe or use it as store of value, but because, it is easier to transact. (It is for this reason that Bitcoin came to be used first in black markets.)

As the failure of our central banks becomes more and more obvious, they will start to impose capital controls. (War on cash, that you start to see happening everywhere). This is mainly what will ultimately drive the value of Bitcoin."

Tuesday, July 30, 2013

Do I agree with Steve Keen's views about the causes of the GFC and the NAR?

Who is Steve Keen? What is the NAR? And why am I wondering whether or not I agree with Steve Keen?

Steve Keen is an Australian economics professor, author of a book entitled ‘Debunking Economics’. His blog, ‘Steve Keen’s Debtwatch’, is dedicated to analysing ‘the collapse of the global debt bubble’. The NAR refers to the North Atlantic Recession, sometimes referred to as the Great Recession, that followed the GFC. I am wondering whether or not I agree with Steve Keen because of a comment on Jim Belshaw’s blog last Sunday. Jim wrote:
‘The second part of Winton's post focused on Irving Fisher's views is, if I interpret the argument correctly, very similar to views expressed by Professor Keen. Essentially, a key part of the problem was the combination of levels of private debt with income and price variations.’

My immediate response was to question whether it might be possible that I could express views similar to those of Professor Keen. While my views on economics have strayed somewhat from neoclassical orthodoxy in recent years, I still consider that the concept of equilibrium provides a useful starting point for economic analysis. Steve rejects all conventional neoclassical economics.

If my understanding is correct, there are two main elements involved in Steve’s views about the causes of the GFC and the following recession: Minsky’s financial instability hypothesis; and the concept of endogenous money creation.

Minsky’s financial instability hypothesis involves the idea that a growing economy is inherently unstable. Investments are initially conservatively financed, but it gradually becomes evident to managers and bankers that greater profits can be made by increasing leverage. Investors and bankers come to regard the previously accepted risk premium as excessive and to evaluate projects using less conservative estimates of prospective cash flows. The decline in risk aversion sets off growth in debt, growth in investment and growth in the price of assets. The euphoria is eventually brought to an end as rising interest rates and increasing debt to asset ratios affect the viability of many business activities. Holders of illiquid assets attempt to sell them in return for liquidity. The asset market becomes flooded, panic ensues, the boom becomes a slump and the cycle starts all over again. (That is an abridged version, excluding Ponzi elements, of a summary which Steve provides in his paper: ‘A monetary Minsky model of the Great Moderation and the Great Recession’).

The concept of endogenous monetary creation involves the idea that banks create credit in response to demand. If a bank lends me money, my spending power goes up without reducing anybody else’s. So, bank lending creates new money, and adds to demand when it is spent. From this perspective, ‘aggregate demand is income plus the change in debt’. (My training in economics and national income accounting makes it difficult for me to understand why or how that can be so. Nevertheless, let us proceed.) If my understanding is correct, Steve is arguing that quantitative easing does not increase the money supply, because banks don’t increase lending when central banks purchase bonds from them. (See Steve’s article: ‘Is QE quantitatively irrelevant?’).

My objection to the first element arises because I don’t understand why a growing economy should necessarily be unstable.  In my view, it is necessary to introduce into the analysis a ‘too big to fail’ policy, or something similar, to explain why banks have a tendency to take excessive risks. I have attempted to outline the regulatory issues involved in a previous post:
‘Governments seem to have managed somehow to get us into a vicious cycle where fears of contagion have led them to encourage major financial institutions in the believe that they were too big to fail, while the belief that governments would bail them out has led major financial institutions to take excessive risks. If we can't let big financial institutions fail when they become insolvent, perhaps the next best option is to find the least cost way of regulating them to make it less likely that they will become insolvent’.

My objection to the concept of endogenous monetary creation is that it flies in the face of the reality that monetary policy can increase and reduce the rate of growth in nominal GDP (aggregate demand). It would make more sense to explain the fact that money creation through quantitative easing did not result in an immediate increase in bank lending in terms of funds being used to meet demands for liquidity (or repair balance sheets) than to redefine the concept of money in order to claim that the money was not created.
In my view Scott Sumner is on the right track in arguing that nominal GDP level targeting (along a 5% growth rate) in the United States before 2008 would have helped greatly reduce the severity of the Great Recession:
‘One reason asset prices crashed in late 2008 is market participants (correctly) saw that the Fed had no plan to bring the US economy back to the old nominal GDP trend line’ (See: ‘A New View of the Great Recession’, Policy, Winter 2013. The article is gated, but Scott has expressed similar views on his blog.)

The idea of targeting nominal GDP, to bring it back to the old trend line seems to me to be similar to Irving Fisher’s advocacy of reflation, as discussed in my post about balance sheet recessions.

So, coming back to the original question, I agree with Steve Keen that debt is important in explaining the GFC and the NAR, even though I have a very different view about the way economic systems work.

Wednesday, July 17, 2013

Should the GFC be viewed as a 'balance sheet' recession of the kind Irving Fisher wrote about in the 1930s?

I have been feeling a strong urge to write about the economic policies of the former government of our resurrected prime minister, Kevin Rudd. Whenever I begin to write on this topic, however, what comes to mind is my grandmother’s advice that if you haven’t got anything nice to say, perhaps you shouldn’t say anything. It might be churlish of me to attempt to remind people that Kevin – whom so many people seem to revere as much now as in 2007 – has a record of achievement that is somewhat less than perfect.

Fortunately, not everyone has such qualms and some excellent articles about the economic policies of the Rudd government have appeared in the media over the last week or so. The best newspaper article I have read so far is one by Henry Ergas, entitled ‘Rudd’s Real Record’, published in The Australian last Saturday (July 13, 2013). Ergas reminds us, among other things, that in 2009 Rudd mounted a massive scare campaign about the severity of the GFC in an attempt to justify a splurge of poor quality government spending.

I recall how Janet Albrechtsen suggested in The Australian at the time that the GFC provided Rudd and his treasurer, Wayne Swan, with an opportunity that they were only too eager to grasp:
The Rudd Government finds itself at a very fortunate juncture. As Rudd’s treatise in the present edition of The Monthly reveals, he can blame capitalism for the coming government extravagance funded by taxpayers. Prepare for Rudd’s hubris-filled pitch on how he “saved” capitalism and why you had to pay for it.’

Whether we are prepared or not, we are now hearing Rudd’s hubris-filled pitch:
‘As you know, here in Australia, we deployed a national economic stimulus strategy, timely targeted and temporary, which helped keep Australia out of recession, kept the economy growing, and kept unemployment with a five in front of it – one of the lowest levels in the world.’

The hollowness of the claim by Rudd and Swan that the fiscal stimulus pulled Australia though the GFC has been demonstrated many times. For example, in an article entitled ‘Wayne Swan’s legacy of unrivalled incompetence’ in yesterday’s Financial Review (July 16, 2013), John Stone, former secretary to the Treasury, points out that the hubris of Rudd and Swan overlooks the strength of Australia’s fiscal position prior to the GFC, the role played by monetary policy, the underlying strength of Australia’s banks and the growth in China’s demand for our minerals.

John Stone’s article also raised the question I am intending to address here about balance sheet recessions. Stone suggests that the Australian Treasury had erred in seeing 2008-09 as another cyclical recession like that of 1991-92, rather than as a ‘balance sheet recession’ of the kind that Irving Fisher wrote about in an Econometrica article in 1933.

In my efforts to overcome my ignorance about the characteristics of a balance sheet recession I have managed to find an ungated copy of Irving Fisher’s article. Fisher suggested that in ‘great booms and depressions’ … ‘the big bad actors are debt disturbances and price level disturbances’, with other factors playing a subordinate role.
Fisher argued that it is the combination of over-indebtedness and price deflation that causes the depression:
‘When over-indebtedness stands alone, that is, does not lead to a fall of prices, in other words, when its tendency to do so is counteracted by inflationary forces (whether by accident or design), the resulting "cycle" will be far milder and far more regular.
Likewise, when a deflation occurs from other than debt causes and without any great volume of debt, the resulting evils are much less. It is the combination of both—the debt disease coming first, then precipitating the dollar disease—which works the greatest havoc.’

Fisher suggested:
 ‘it is always economically possible to stop or prevent such a depression simply by reflating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged’.

That seems to me to be similar to the rationale for the quantitative easing policies adopted by central banks in recent years, following the failure of fiscal stimulus efforts. Lars Christensen, a market monetarist, has written more extensively about this similarity on his blog.

John Greenwood’s analysis, conducted in the spirit of Irving Fisher, suggests that some balance sheet repair has occurred in recent years in the countries most affected by the GFC, with greater progress having been made in the US than in the UK and least progress having occurred in the eurozone. 

An article by Max Walsh in today’s Financial Review (July 18, 2013), entitled ‘Rudd’s demands could exceed all expectations’, is another excellent article about the implications of the economic policies of the first Rudd government. Walsh refers to Rudd’s essay in The Monthly (February 2009) in which he sought to differentiate the economic ideology of the two major political parties in Australia. As might be expected, Rudd sought to portray his political opponents as extreme proponents of free market ideology, but he also portrayed the Labor party as being wedded to interventionism.

Kevin Rudd wrote: ‘Labor, in the international tradition of social democracy, consistently argues for a central role for government in the regulation of markets and the provision of public goods’. Max Walsh comments: ‘That’s a view that looks to be at odds with the deregulation and privatisation initiatives of the Hawke-Keating years’.

Viewed in that context, it seems to me that the most likely outcome of Kevin Rudd’s recent promise to pursue microeconomic reform ‘with new urgency’ will be further restriction of economic freedom and lower productivity growth. 

Tuesday, April 2, 2013

Would it be costly to require banks to raise equity to 30 percent of total assets?

In their recently published book, 'The Banker's New Clothes', Anat Admati and Martin Hellwig make a strong case that in order to reduce the risk of insolvency in major financial institutions, shareholders should be required to fund their lending and other investments to a much greater extent.

bookjacketThe authors argue that government regulation to reduce the risk of insolvency of major financial firms is desirable because failure of such firms has adverse effects that are analogous to those that can arise from accidents in nuclear power plants. When I discussed that analogy in an earlier post, I accepted (somewhat reluctantly) that it is appropriate. As a result of the interconnectedness of financial markets, it would probably not be possible to avoid major economic disruption if large financial institutions were allowed to fail when they became insolvent. That makes it desirable to find the least cost way of regulating them to make it less likely that they will become insolvent. Governments are thus presented with problems that are similar to those involved in regulating the nuclear power industry to reduce the risk that serious nuclear accidents will occur.

Admati and Hellwig suggest that the best way to reduce the risk of insolvency of major financial institutions is to require them to raise shareholder equity from current levels (which under Basel III can apparently still be as low as 3 percent of total assets) to 20-30 percent of total assets. The higher ratio of shareholder equity to total bank assets would provide greater scope for any future fall in the value of bank assets to be accommodated without insolvency.

The authors suggest that requiring banks to rely more on equity funding would impose little, if any, cost to society. In this post I want to focus specifically on the reasons they give for that view. I encourage readers who are interested in a broader discussion of this important book to read John Cochrane's review.

The authors argue that requiring banks to rely more on equity funding would impose little cost on society because it would offset the bias in favour of borrowing provided by government guarantees and tax systems. Banks and their creditors benefit from explicit guarantees to protect depositors as well as implicit guarantees associated with the 'too big to fail' concept. These guarantees enable banks to borrow on more favourable terms than would otherwise be possible. Tax systems tend to favour borrowing because they make interest paid a tax deductible expense.  (The dividend imputation system in Australia reduces this bias to some extent but, as acknowledged by the Henry Tax Review, there is still a bias in favour of foreign borrowing and Australian banks rely heavily on this source of funds.)

The authors point out that equity ratios of banks were generally much higher in the 19th century, prior to the existence of government guarantees.  In the US, until the middle of the 19th century, equity levels around 40-50 percent of banks' total assets were typical and early in the 20th century it was still common for banks to have equity of around 25 percent. The picture seems to have been broadly similar in Australia. Data presented in an article by Charles Hickson and John Turner shows (apparently) that the average equity to deposit ratio of Australian banks declined from around 60 percent in the 1860s to around 20 percent in 1892. The subsequent depression would presumably have substantially depleted the equity of those banks that managed to remain in business. Adam Creighton, a journalist, implies that the surviving banks re-built their capital ratios following the depression, so that a century ago they maintained capital ratios of between 15 per cent and 20 per cent. (See: 'Time to Force the Big Banks to Hold More Capital', 'The Australian', 23 November, 2012.)

Admati and Hellwig point out that the proposed increase in bank equity would not interfere with core banking functions of accepting deposits and making loans. Given the current structure of balance sheets, the increase in equity levels would tend to displace additional borrowing from sources such as money market funds rather than bank deposits.

The authors point out that bankers' claims that equity is more costly than debt are flawed because they don't take account of the effect of increased equity in reducing the risk of bank failure and thus reducing the rate of return required by shareholders. Equity only seems costly because government guarantees provide an implicit subsidy on debt. The increase in equity could be accomplished without significantly disadvantaging existing shareholders by requiring banks to retain earnings rather than pay dividends, until equity levels have reached the minimum level.  

I am normally sceptical of claims that governments can improve matters when they attempt to offset the adverse effects of previous interventions by adding a further layer of regulation. It seems, however, that Anat Admati and Martin Hellwig have found an instance where the theory of second best provides a valid guide to policy action. There are strong grounds to argue that if governments cannot credibly bring the 'too big to fail' policy to an end, they should take decisive action to offset the effects that policy has had in encouraging banks to become more fragile.  In my view the authors' proposals deserve strong support.

Monday, March 11, 2013

Is the regulatory problem in banking similar to that in the nuclear power industry?

bookjacketIn their recently published book, 'The Banker's New Clothes', Anat Admati and Martin Hellwig suggest that the causes of the global financial crisis were similar in some respects to the causes of the nuclear power disaster in Japan in 2011. In the case of the nuclear power disaster, the authors suggest that corrupted politicians and regulators had colluded with the Tokyo Electric Power Company to ignore known safety concerns. They comment:
'When an earthquake and tsunami occurred in 2011, this led to a nuclear disaster that was entirely preventable.
Weak regulation and ineffective enforcement were similarly instrumental in the buildup of risks in the financial system that turned the U.S. housing decline into a financial tsunami'.

It might seem obvious to just about everyone that government regulation of the nuclear power industry is desirable to prevent outcomes such as those experienced in Japan (even though regulation was spectacularly unsuccessful in this instance) but I feel inclined to step back a little to consider why such regulation is desirable. What is the problem that the regulation is intended to remedy in the nuclear power industry?

The obvious answer is that in conducting their business of providing electric power to their customers, there is a risk that nuclear power firms may accidentally cause harm to other people. But that is also true of many other business activities. Firms have an incentive to take precautions to avoid such incidental harm because they know that potential victims can sue for compensation.

So, why is additional government regulation needed in the nuclear power industry? Leaving aside the possibility of nuclear material getting in to the wrong hands, a need for additional regulation may arise because of the potential magnitude of the harm that might occur as a result of a nuclear accident. The harmful consequences of a nuclear catastrophe might be so great that the responsible firm would be unable to pay full compensation. That would pose a problem for government of whether to step in and help the victims, but it also poses the problem of how to ensure that the managers of the firm have a greater incentive to take precautions to avoid a catastrophe that would bankrupt the firm twice over, than to avoid a catastrophe that would bankrupt the firm only once. So, there might be a case for the government to step in to attempt to ensure that adequate precautions are taken.

Is there a similar case for regulation of major financial institutions? When I looked at this question a few weeks ago I suggested that when the failure of one bank leads to loss of confidence in other banks that have taken similar risks might just reflect a process in which the market is taking appropriate account of new information. For example, if a financial institution becomes insolvent because a decline in property values causes a decline in the asset backed securities in its balance sheet, that information could be expected to bring about a re-assessment of the value of assets of other financial institutions. It should not be surprising that those financial institutions that are considered to be at greater risk of becoming insolvent would suffer from a loss of confidence and have greater difficulty in conducting their business. That is the way an efficient market could be expected to weed out firms that can no longer be trusted to pay their bills. There does not seem to be anything in that scenario that is analogous to the harmful pollution released as a result of a nuclear accident.

Why do the authors argue that major financial institutions ought not be allowed to fail? The main reason they give is contagion, which adversely affects the broader economy. When a major financial institution collapses it is unable to meet its obligations to other institutions, which are also weakened. As more financial institutions anticipate liquidity problems and attempt to sell assets, there is likely to be a further decline in asset values. As financial institutions cut back lending, the broader economy is adversely affected.

Those effects on the broader economy would be dampened, in my view, if central banks were doing a good job of maintaining public expectations of steady growth of aggregate demand. Central banks were slow to use tools such as quantitative easing to do this during the global financial crisis. Even if central banks had made a more determined effort to manage expectations, however, it is doubtful whether they would have been entirely successful in countering fears that failure of several major financial institutions was likely to have severe adverse impacts on aggregate output and employment.

The authors make the point that it would be extremely difficult to allow large complex financial institutions to fail without major disruption when they became insolvent. Proposals that they could be taken over by public authorities until they were placed under new ownership would be difficult to implement because these firms have thousands of subsidiaries and other related entities spread over different countries. Separate resolution procedures would be required for different subsidiaries in different countries. Massive problems of coordination would be involved.

Governments seem to have managed somehow to get us into a vicious cycle where fears of contagion have led them to encourage major financial institutions in the believe that they were too big to fail, while the belief that governments would bail them out has led major financial institutions to take excessive risks. If we can't let big financial institutions fail when they become insolvent, perhaps the next best option is to find the least cost way of regulating them to make it less likely that they will become insolvent. That does present governments with problems that are similar to those involved in regulating the nuclear power industry.

In a later post I will discuss Anat Admati and Martin Hellwig's views of how governments can reduce the risk of insolvency in financial institutions that are too big to be allowed to fail.

I am writing this postscript before I have posted the article because I have had some further thoughts about market failure, a concept that I was tempted to mention above. An earlier post about financial crises led to a discussion with Jim Belshaw about the meaning of market failure. During the course of that discussion I conceded that the concept of market failure is of limited use and made the point (attributed to Harold Demsetz) that the relevant choice is not between an existing imperfect market and an ideal norm of a perfect market, but between real world outcomes under current institutional arrangements and a proposed alternative set of institutional arrangements. My new point (new to me anyhow) is that if some feasible outcome is superior to that which exists at present, then past failure to implement the changes necessary to achieve that outcome should be viewed as government failure rather than market failure.

Monday, February 25, 2013

Should the Australian government continue to guarantee bank deposits?

In a recent post I suggested that government guarantees of bank deposits tend to encourage banks to become highly geared because they make depositors less cautious about depositing their funds with banks that are at greater risk of default. Such guarantees could be expected to make it possible for highly geared banks to obtain access to deposits at lower cost than would otherwise be possible.

A regular reader of the blog, kvd, objected to my reasoning. In his comments he suggested:
 'your acceptance that 'the market' should play any part in the securitisation of depositors' funds (alongside equity participants) offends against my own beliefs. …

I would not seek in any way to regulate or limit the rich investing their money in any way they wish. But government failure to differentiate between the basic needs of their populace, and the desires of a relatively small, select group of players - that I find a complete abrogation of a basic government role - more specifically, a responsibility.

By all means let's limit government involvement and guarantee - but let's first more clearly delineate what it is that government should be obliged to protect.' 

In the subsequent discussion kvd clarified that what offended against his beliefs was the idea that depositors should be expected to take account of differences in the risks involved in placing their funds in different institutions. 

He explained his position further in a later comment:
 'My interest was initially piqued by what I referred to as the 'securitisation' of a significant part of the funds sources available to banking institutions - namely those funds deposited in the ordinary course of getting on with one's life. If you accept my figures, this amounts to somewhere north of 20% of the funds available for them to pursue their objectives.
While I would be the last to suggest any of the 'big four' are in danger of collapse, I do think that in your higher level analysis of 'marketplaces' and 'risk assessment' it begs the question as to just what is represented by the 20+% of unsecured creditors (because that's effectively how depositors' funds are treated; and that's why there were recent queues outside various high street banks and building societies in the UK) which I termed 'transactors'.

My simple point remains that these funds should be regarded more as the old fashioned 'Trust Fund' one sees in any solicitors' practice. Yet that is not where they presently sit in calculation of leveraging. Within that they are subsumed in those funds available to satisfy any higher-secured obligation. Except for shareholders, they are in fact last in the queue, along with any other trade creditor.

When one thinks of such funds, Winton mentions the 'mum and dad investor'; the implication being that the sums are small, difficult to manage, an annoyance really in terms of transaction costs. [Editorial note: I didn't intend to imply that the sums are small or an annoyance to banks.]
But when I think of those funds I'm referring to my working cheque account …  . These funds are sloshing around in the banking system, available (God forbid) at any time for our banks to satisfy secured creditors. Come a crunch, my funds are essentially an unsecured interest free loan to my bank, available for them to pursue (did you term it?) enhanced shareholder returns.
Too much regulation involved to protect such funds? I'd suggest a reclassification of such funds as first charge government backed liability. Would that would necessitate a recalculation of the risk attaching to other funding sources? Yes, and so be it; the market will decide that.'

Before considering the question of bank guarantees, I will first attempt to consider whether it would be possible or sensible to make the status of bank deposits more like that of solicitor's trust funds. I write 'attempt' because my knowledge of the law concerning solicitor's trust funds is rudimentary. My understanding is that solicitor' trust funds remain the property of the client. There is a great deal of regulation about what solicitors can do with those funds but I expect that they would normally be deposited in a trust account at a bank. That would probably be the safest thing to do with them, even though the funds might still be at risk in the event of bank failure. Perhaps that risk might be covered by solicitor's insurance, I don't know.

The underlying point that kvd is making seems to be that, in the event of default, depositors should be accorded the same ranking as secured creditors. My immediate reaction was that it might be difficult to give depositors a lien over a bank's loan portfolio, but further thought led me to the view that there is nothing to prevent bank deposits from being secured by a lien over other bank assets such as holdings of government securities.

The idea of giving a class of depositors a lien over a bank's holdings of a particular class of assets makes a lot of sense to me. In the absence of government guarantees, this could be expected to be most attractive in relation to transaction accounts of those depositors who are most concerned about security. As at present, such deposits would earn little or no interest and transactions charges would apply. The important point is that these deposits could be expected to be fully covered against loss in the event of bank default – unless, of course, shits are trumps and bank default is caused by default by governments (in which case, government guarantees would also be worthless).  

So, let us now consider whether the government guarantee of deposits should remain in place. Some recent history might help.

Banking in Australia functioned without a government guarantee of deposits prior to the global financial crisis. The Wallis report into the financial system (1997) recommended against the introduction of government-backed deposit insurance on the grounds that it 'was not convinced that such a scheme would provide a substantially better approach or additional benefits compared with the existing depositor preference mechanism' (p355). According to Wallis, the depositor preference mechanism 'provides that the assets of a bank shall be available to meet depositor liabilities prior to all other liabilities of the bank' (p 354).

An article on depositor protection by Grant Turner (RBA Bulletin 2011) suggests that the recommendation against deposit insurance by the Wallis inquiry 'reflected concerns that introducing deposit insurance could weaken incentives to monitor and manage risk' (p 49).

In my view such concerns are warranted. I can understand that depositor guarantees were considered desirable in the midst of the global financial crisis, but it would be good to be rid of them as soon as possible. The best way to phase out such guarantees would be to make them unnecessary by ensuring that governments will never be called upon to honour them. Could that be achieved by requiring that the guarantees will apply only to deposits that are secured by a lien on government securities held by deposit-taking institutions?


I have had second thoughts on the question of how the deposit guarantee should be removed.

My further discussion with kvd, see comments below, makes it clear that in the absence of the guarantee, deposits would rank after secured liabilities in the event of bank liquidation. This has become particularly important since the guarantee was made 'permanent' because the existence of the guarantee has been used as an excuse to allow banks to raise funds using covered bonds (i.e. secured liabilities).

It is probably reasonable to expect that if the deposit guarantee was removed, the market would eventually find a way to give demand deposits the highest priority in the event of bank liquidation. However, it might take some time before banks began to see it as in their interests to provide sufficient asset backing to demand deposits to enable that to occur.

It seems unlikely that any government would remove the guarantee unless it considered depositors to be adequately protected. I think that could be achieved by giving demand deposits the priority that is currently accorded to APRA in order to recover funds it pays to depositors under the current guarantee arrangement. As I understand the situation, the Banking Act gives debts and liabilities to APRA the highest priority in the event of bank liquidation.

In my view, legislation should give demand deposits the highest priority in the event of bank liquidation in order to maximize the potential for banks to be able to honour the promises that they make to allow depositors to withdraw such funds on demand. 

Thursday, February 14, 2013

How can governments stop encouraging banks to be highly geared?

A reader of my book, Free to Flourish, is puzzled by a brief comment I made about fundamental weaknesses in the financial system. He asks whether the following passage implies the existence of a fundamental market failure with respect to the financial system:

'The underlying incentives that the system provides for participants to take risks with borrowed funds might even tempt saints to behave imprudently. Another outbreak of gambling with borrowed funds will become increasingly more likely as memories of the recent crisis recede, unless fundamental reforms are introduced. Required reforms include the removal of any implicit guarantees that any financial institutions are 'too big to fail' - by taking action to penalise rather than assist the owners of financial institutions which are at risk of default - and removal of distortions in tax systems which favour debt funding relative to equity funding' (Chapter 8).

I accept that there may be market failure in the financial system. There can be negative externalities associated with bank failures. If the failure one bank leads to loss of confidence in some other banks, there may be a market failure involved. Then again, there may not be. If the failure of one bank leads to loss of confidence in banks that have taken similar risks, leaving other banks unaffected, it would be reasonable to argue that the market is just taking appropriate account of new information. Nevertheless, at an aggregate level, I accept that central banks may be able to play a useful role in sustaining expectations of ongoing growth in aggregate demand when bank failures occur.

However, my concerns about the fragility of the financial system – as it exists at present – cannot be attributed to market failure.

The following hypothetical example might help to begin to explain the nature of the problem as I see it. Let us focus on two banks competing in a free market, without government interventions. Both banks are the same in nearly all respects, but while Bank A is profitable, Bank B is having difficulty competing for deposits. The reason for this is that the level of shareholder equity in Bank A is relatively high and potential depositors feel that the interest rate being offered on deposits in Bank B (the same as for Bank A) would not adequately remunerate them for the additional risks they would be taking. 

There are several options that Bank B might consider to become more competitive. For example, it could offer a higher interest rate to reflect the greater risks involved for depositors; it could reduce the risks in its asset portfolio (perhaps by having a higher proportion of its portfolio in relatively safe government securities); or it could issue more equity capital and become more like Bank A. The optimal level of equity depends on factors such as the riskiness of the bank's asset portfolio and the extent to which depositors require higher interest to compensate for risk.

Is this example plausible? Is it conceivable that it might be possible in a free market for a bank to be profitable with a relatively high level of shareholder equity? Many would argue that the example I have given is unrealistic because an equity risk premium must be paid for access to equity capital. On that basis, it is argued that banks with relatively high equity could be expected to have a relatively high cost of capital and thus to be less profitable than banks with relatively low equity.

Anat Admati and three of her colleagues provided a pertinent response to the suggestion that increased equity would increase funding costs for banks in their paper: 'Fallacies, Irrelevant Facts and Myths in the discussion of Capital Regulation: Why Bank Equity is Not Expensive'.  These authors draw attention to the Modigliani-Miller (MM) analysis which shows that increases in the amount of equity relative to debt financing simply re-distribute risk among investors. The total funding cost is determined by the total risk that is inherent in the bank's asset portfolio and is independent of gearing. In that context, any losses from using less borrowed funds must be offset by the correspondingly lower cost of equity capital.

The essential assumption of the MM analysis - apart from the assumption (discussed below) of no government intervention favouring either debt or equity funding - is that investors are able to take account of portfolio risk and gearing when pricing securities. Admati et al make the telling point that banks make this assumption in managing their risks.

So, what happens if we relax the assumptions of the MM model by introducing a tax system that encourages debt relative to equity, a government guarantee that banks will not be allowed to fail and protection for depositors? We should expect to get banking systems that are highly geared and fragile – like our current banking systems.

How can governments remove those distortions?  The obvious answer is just do it! However, removal of the tax distortions will require major tax reforms in countries that have classical company taxes. The problem in relation to government guarantees and protection of depositors is that announcements  that they will no longer apply are not likely to be credible (except when made by governments that are so heavily indebted already that further bank bailouts would be impossible in any case).

Does that mean that the best option is for governments to regulate bank behaviour to such an extent that bank failure becomes highly improbable? That approach would suggest that if Basel III is not restrictive enough to make bank failure sufficiently improbable, we should be prepared to move on to Basel IV, and then Basel V, and even to nationalisation of banking if necessary.

At that point I begin to see red. If we are not dealing with a market failure, why are we attempting to displace the market? Is it really necessary to put the entire banking system into a regulatory strait jacket, with all the inefficiencies that involves, in order to live with the consequences of past regulatory failure? Would it not be possible for governments to make a credible commitment never to bail out another bank if they were prepared to spell out punitive action to be taken if regulatory agencies assess banks to be at risk of default? For example, why not announce plans for pre-emptive action to install administrators to restructure banks if they are assessed to be at risk of default?  


With the benefit of comments from kvd and Jim Belshaw (see below) it is clear that the line of argument presented above is not as clear as it could be and contains some unnecessary red herrings.

1.      The definition of banks. For the purposes of this discussion, the distinguishing characteristic a bank is that it is a company with relatively low shareholder equity and a relatively high proportion of debts repayable on demand. Later in the post, my focus is narrowed to financial institutions with deposits guaranteed by governments and/or viewed by governments as 'too big to fail'.

2.      The definition of externalities and market failure. The discussion in the paragraph immediately following the quote from Free to Flourish raises issues concerning the technical definition of externalities and market failure that are a largely a red herring from the perspective of the general line of argument I am developing here. All I needed to say was that while I acknowledge that there may be a case for government intervention based on the existence of market failure, that is not the basis for my concerns about the fragility of the banking system. (Nevertheless, the discussion is raising interesting points. There might be something wrong with our definition of market failure if new information about bank solvency that leads to the collapse of the banking system does not qualify as evidence of market failure. The question that kvd has raised about whether there is a case for government guarantees to cover use bank facilities for every day transactions using is alsoof interest to me. I will try to follow that up in a subsequent post.)

3.      My hypothetical example involving Bank A and Bank B. The example seems to have clouded the point I was trying to make, rather than illustrate it. The point the example was intended to illustrate is that in a free market banks would not have an incentive to seek ever-greater leverage. The rate of return on shareholder funds may rise as leverage increases, but depositors and shareholders would have an incentive to take account of the increasing risk of bank insolvency. As leverage increases the cost of borrowing additional funds could be expected to rise (i.e. the interest rate on deposits would need to rise). And at some point the increase in expected return on shareholder's funds will not be sufficient to compensate shareholders for the increased risk of failure of the firm.

4. Should the Australian government continue to guarantee banks deposits? That is the title of a later post in which I discuss issues raised by kvd.

Thursday, May 17, 2012

What is the case for government funding of mitigation research?

I ended a recent post by suggesting that serious consideration should be given to Bjorn Lomborg’s view that mitigation of climate change is likely to require a substantial increase in government funding of relevant research.
That position is somewhat at odds with a view that I have held for a long time that governments should stay out of the business of trying to pick technological winners by funding research and development. I acknowledge the case for public funding of basic research on grounds that it is a public good that would not be adequately supplied via the normal operation of market forces. If someone suggests, however, that governments should become heavily involved in funding of research into alternative energy because the world is running out of cheap sources of fossil fuels, I would regard that as a fairly silly idea. When the world does start running out of cheap sources of fossil fuels the prices of those resources can be expected to rise, providing a strong market incentive for private sector investment in research into alternative energy sources.

So, what grounds are there to argue that carbon taxes and emissions trading schemes that impose a cost on carbon emissions will not have a similar effect on research incentives? I don’t see any. In both cases, as the production of energy through conventional use of fossil fuels becomes more expensive the market should provide adequate incentives for research.

The case for substantial government involvement in funding of research directed toward mitigation of climate change cannot rest on arguments that apply to equally to many other forms of research, even though some eminent economists may think it does. For example, Ross Garnaut argues (in Chapter 9 of his 2011 climate change report) that ‘the carbon price alone will not lead to adequate investment in research, development and commercialisation of new technologies, because the private investor can capture only part of the benefits’. Similar externalities apply, of course, to a wide range of research, development and commercialization activities throughout the economy. Perhaps the existence of such externalities warrants some government assistance to industry, such as allowing capital spending on research and innovation to be treated for tax purposes as a current rather than capital expenditure.  It might also warrant some government involvement in funding of development rather than just basic research, particularly since it is often difficult to draw a line between R and D. But it would be difficult to justify the large increase in tax – and associated economic costs – which would be required to embark on a major program of government funding of research, development and commercialization of new technologies in all sectors of the economy.

It seems to me that the case for substantial government involvement in funding of research directed toward mitigation of climate change must rest on a form of government failure (the difficulty of obtaining international agreement for concerted action) rather than on market failure (or externalities). If governments were able to agree to an appropriate carbon price the case for additional government funding of research would disappear.

Bjorn Lomborg seems to be on strong grounds in arguing that international agreements to invest in research and development are likely to have a greater chance of success than carbon-reduction negotiations. Wealthy countries are less likely to object to making greater research contributions. Agreements to fund more research may also be seen as likely to make it easier to negotiate future carbon reductions by reducing the cost margin between existing fossil fuel technologies and less polluting technologies.

However, there is potential for gradual mitigation to continue to occur even in the absence of international agreements. Governments of countries with high per capita emissions will continue to come under political pressure – from internal and external sources - to reduce greenhouse gas emissions. Perhaps the most likely outcome is that the world will stumble on toward a reduction in greenhouse gas emissions, relative to what would otherwise occur. The climate will nevertheless continue to change. This may impose high costs on some people (those faced with high adaptation costs relative to their current income levels) and benefits to some others. But the general story might be one of successful adaptation.

If that is the most likely scenario, it would make sense to view increased government involvement in research to mitigate climate change as a precautionary measure. It is probably worth doing even though it will, hopefully, not be necessary. Imagine a scenario where climate change accelerates and costs of adaptation begin to rise steeply. My guess is that in that situation, international agreement would be reached fairly quickly by the United States, China and Europe to cut emissions of greenhouse gases drastically and take steps to ensure that other countries do likewise. The economic cost of such reductions in emissions will be very high if there is still a substantial cost margin between energy generated using conventional fossil fuel technologies and cleaner technologies.

So, it seems to me that the case for substantial government involvement in funding of research to mitigate climate change is largely precautionary. It is in our interests to reduce the risk that will be posed to our standard of living if we have to make sharp reductions in greenhouse gas emissions at some later stage.