Tuesday 23 July 2013

Is Economics On the Verge of a Paradigm Shift? David Orrell's Economyths and the Perils of Financial Engineering

Is economics on the verge of a paradigm shift? This is the question raised by David Orrell’s excellent book Economyths, in which he dissects the flaws at the heart of neoclassical economics and argues not only that it is not fit for purpose, but that it is responsible for many of society’s current problems. As a book that sets out to ‘change your world view’ it really fits the theme of this blog. While I had an existing scepticism of the state of economics when I began reading it, the book has really opened my eyes to the breadth and depth of the problems, and did so in a rigorous but also highly readable way.

The book is neatly structured in ten chapters, each of which is focused on different problem with economics. Orrell re-visits the early thinkers from the classical school of economics to tease out where the foundational assumptions of the field came from. It turns out that many of the problems of modern economics can be traced back to the influence of physics, which led to an atomistic and deterministic view of human behavior. This paradigm served us well initially, and led to some useful insights about the nature of markets. But economics has become elevated to the status of mathematics, in which any theorem is deemed to be true as long as it can be derived from the accepted axioms. Few academics at the heart of the economics establishment outwardly question these axioms, and those that do are often marginalized and labeled as ‘heterodox1. In trying to become more like a science, economics has ended up becoming more like an ideology.

Orrell describes a wealth of data that should lead us to doubt the axioms and theorems of neoclassical economics. People are not rational; markets are not efficient; the policy prescriptions drawn from economics aren’t working. He deftly draws on some of the alternative schools of economics (e.g. behavioral economics, ecological economics) and brings in the work of some allied fields that could have major implications for the way we think about the economy (e.g. neuroscience, psychology). Far from being a pessimist, he points towards some areas of scholarship that could be the basis for a paradigm shift in economics, highlighting in particular the fields of network theory and complexity theory2.

Having attempted to summarize the book, I would like to highlight one idea in particular which plays a small role in the book but made a big impression on me. Dwelling on the modern job title of ‘financial engineer’ (people who develop new financial products, such as CDOs, CDSs, etc.) Orrell observes that in every traditional engineering discipline there is a formalized code of practice and a requirement to build a ‘factor of safety’ into the system3. In fact safety-critical mechanical and structural products typically have a safety margin of over 100% (i.e. they can withstand double the load or stress they are designed for before they break). This extra layer of redundancy means that even when the products (whether cars, airplanes, or buildings) encounter extraordinary conditions, outside of their design specification, they will still function. When a product fails, the firm that built it is legally liable for losses and the engineer who designed it can be personally held responsible.

One could well imagine that the effective functioning of the economy might be deemed  safety-critical. A malfunctioning economy leads not just to discomfort but to starvation, deprivation and a rise in the suicide rate. And yet there is no formalized code of practice for modern financial engineers4. They do not have to build in margins of safety into their products. They are not held accountable when the products they develop fail. This observation is not just based on the 2008 financial crisis, in which financial engineering playing a massive part, but in many previous crises such as the junk bond debacle in the 1980s and the bankruptcy of Enron in 2001.

Prompted by Orrell’s comparison, I’ve begun thinking about other sectors in which unorthodox types of ‘engineer’ are involved in developing mass market, safety-critical products. Food engineering is an interesting one: a majority of food we eat in the West has been processed by a big corporation and has been mathematically optimized to be as appealing as possible for the least possible cost to the producer. This is why the foods contain so much Salt, Sugar and Fat (the title of another book I want to read, by Michael Moss). To the companies, the long-term health effects of these products are a secondary concern, and if we get ill it isn't the food companies that will be held liable. How would things be different if food engineers were held to the standards of traditional engineers? Could they build in a ‘margin of safety’ to make it hard for us to over-consume unhealthy ingredients, and easy for us to get the nutritional sustenance that we need?

Economyths is far from the only book out offering a penetrating critique of the financial system, but it is one of the best5. Moreover, by pointing towards possible paths forward it goes further than many other books in the ‘crisis economics’ genre. Orrell shows that the crisis isn’t just with the financial system, but with the intellectual system that underwrites it, and as Thomas Kuhn pointed out, it is a sense of intellectual crisis which acts as a catalyst of ‘scientific revolutions.’ If Orrell is correct, a scientific revolution in economics is already underway.


1 Interestingly Orrell suggests that many economists are unhappy with the current state of affairs, but don’t question it in public for the sake of their careers and credibility.

2 I was pleased to read this as both these fields are close my own interests.

3 Upon Googling 'margin of safety' the first reference I find is to an appropriation of the term in the field of value investing, so while the concept clearly exists in finance it is not part of a financial engineer’s design responsibility.

4 The CFA Institute's Code of Ethics is probably the nearest equivalent, but it is rather narrowly applicable to fund managers, who by all accounts seem to routinely flout it anyway.

5 Another one which I’ve just begun reading is Nassim Nicholas Taleb’s polemic Antifragile – I look forward to reporting on it shortly.

Thursday 4 July 2013

Why David Cameron's Foreign Trade Claims are Flawed

I don’t tend to pick on individual politicians to criticize, but David Cameron’s piece in today’s London Evening Standard newspaper is worthy of some commentary. You can find the article here.

Let’s analyze what he says:

“This country is in a tough global race to succeed… the world does not owe us a living, we have to earn it.” – this much I agree with. We are, indeed, part of a global economy in which countries compete for economic activity.

But the message of Mr. Cameron’s piece is that we are being successful at attracting foreign investment. He trumpets major capital investments from abroad in the UK telecoms and energy industries and in real estate development. He seems to entirely miss the point that the kind of economic competitiveness that matters most is the ability to produce exports.

As a nation, the UK consumes vast amounts of imported goods, mostly paid for on credit, and as long as the country fails to increase its own exports, it will be increasingly indebted to the countries that supply these goods. Imports help people live wealthy-seeming lifestyles today, but then the debts are left over for future generations to pay off.

The three industries mentioned above, telecoms, energy and real estate, are all services sold back to the people within the country. No exports there, I’m afraid. Just highly inflated housing prices in London, as a direct result of foreign investment in the capital’s real estate. Well done, Mr. Cameron, for attracting all of that investment. Kudos.

Something that might benefit the country, and lead to products and services we can export, is innovation activity. And a good way to stimulate innovation is by supporting entrepreneurship.

Maybe Mr. Cameron realizes this, as he says, “the red carpet is rolled out for entrepreneurs.” But for some reason that doesn’t ring true, for example if the would-be entrepreneurs are from outside the EEA and have to jump through laborious hurdles just to get a visa. Last week Theresa May announced a new policy clearly tailor-made to attract thousands of foreign entrepreneurs: a £3,000 bond that must be deposited before visitors from some select countries are even allowed in the country. Cameron, to his credit, had the good sense to quash this one, but in generating so much uncertainty and confusion much damage has already been done. The sudden and arbitrary changes that are regularly being made to the Byzantine student visa and post-study work visa regulations also exemplify the country’s enthusiasm for attracting talented foreigners.

The third thing that irritated me in the article is Cameron’s joke about his most recent trade mission, “Just last weekend I was in Kazakhstan (but I missed out on the camel’s milk).”

I will leave critiques of his sense of humour for another time. Why, I ask, is our Prime Minister visiting Kazakhstan to attract investment, a country that ranks 133rd out of 176 in Transparency International’s corruption perceptions index, and in the bottom 15% of the World Bank’s control of corruption measure? A country that shoots dead protesters who dare to oppose the oil and gas industry? Is it because these unstable, autocratic, petrodollar-backed regimes are the only ones who both need and can afford one of our biggest actual exports, namely weapons?

Cameron has the gall, two paragraphs later, to trumpet the UK’s “stable democracy, where there are property rights and the rule of law.” He clearly cares very dearly about these things. We may as well put out a sign saying, “Billionaire oligarchs from despotic backwaters welcome here!”

Then, finally, comes the Battersea Power Station project, the “jewel in the crown” of the infrastructure investments Cameron cites. This will be backed by an £8bn investment and will “create 15,000 jobs.” Never mind the fact that jobs created on building projects are only ever temporary, and no substitute for sustainable job-creation. The thing that struck me here was the irony of it. The source of the funding – Malaysia.

Maybe Mr. Cameron is not familiar with the history of economic crises, but if he were he would surely stop boasting about foreign investment being the route to riches. Malaysia, Thailand, Indonesia and their neighbours know this well, from their experience of a financial crisis in 1997. Long before the credit crunch showed the Western world that laissez-faire capitalism has its risks, South East Asia experienced a severe currency crisis and long recession due to the aggressive inflow and then flight of foreign capital. Foreign investment is neither a stable nor a sustainable route to economic growth.

Whether the Battersea project will come to fruition remains to be seen, and I don’t have strong opinions either way (I give its odds of success maybe 1 in 3). But its use by Mr. Cameron as a piece of propaganda is entirely disappointing. Economic growth is important (though not nearly as important as most politicians think) and if the UK wants to pursue it the country needs to look for competitive industries inside its borders that create value for customers elsewhere. There is, perhaps, one investment referenced in the article that involves exports: the Tata group’s purchase and expansion of Jaguar-Land Rover. This investment has helped re-juvenate British manufacturing and create long-term jobs. When Mr. Cameron comes back with more of these type of investments to shout about, it might be worth getting excited about.