Who remembers the Nudge Unit? It was all the rage and Cameron’s favourite “think tank” in the early days of the 2010-15 coalition government. Originally part of the Cabinet Office, it was privatized in 2014 and now goes under the name The Behavioural Insights Team. Its aim is still broadly the same: to use psychology and behavioural economics to inform policy making.

I was interested to note that Citizens Advice has commissioned this Team to produce a report, published last week, called Applying Behavioural Insights to Regulated Markets. I was keen to read their analysis and recommendations. It covers much the same ground as my blog post Cat and Mouse published last September. The new report is wider in scope than my post, covering energy (gas and electricity), telecoms, personal finance and pensions.

The Two Fallacies

I explained in my earlier post Two Castles (Part 2) that free market fundamentalism – the guiding economic policy for over 30 years – is fatally flawed by two false assumptions:

1. The only motive guiding human behaviour (in buying decisions) is the pursuit of material self-interest;
2. Consumers always make rational, well-informed decisions.

It was encouraging to see the BIT report fully recognizes the second of these two points. The report says: “there is compelling evidence that consumer decision-making systematically strays from what would be expected from a ‘rational actor’ within economic theory. These systematic deviations, termed ‘behavioural biases’, can result in ‘behavioural market failures’, leading to poor outcomes for consumers.”

The Good Bits

The report gives “compelling evidence” of these failures:

• Mobile phone contracts overcharging by £355m a year;
• Energy consumers paying, on average, £300 over the odds;
• Loss of pension income of between £230m and £1bn over the life of a pension, with 80% of private pensioners missing out on the best deal.

The report also quotes insights from psychology, using the terms “type one” and “type two” thinking. This approximates to the decision making processes in each half of the human brain. It includes an analysis of the different types of “behavioural biases”:

• Status quo (inertia)
• Anchors (behaviour affected by suggested examples, e.g. suggested amounts on charity donation websites)
• Choice overload (brain switch-off when presented with too many options)
• Framing effects (how offers are positioned / described)
• Present bias (up-front saving v. cheaper in the long term)
• Timing (consumers more likely to act, e.g. switch supplier, at a key event, e.g. just before going overdrawn)
• Overconfidence (optimistic assessment of ability to pay in the future)
• Vulnerable customers (scarcity mindset: day-to-day scrimping leaves insufficient mental energy to make good decisions)

The report also goes on to make some useful recommendations about the actions regulators can take to address these problems. One example is in consumer education, what the report calls “simple heuristics”. These are simple rules of thumb to aid consumer decision making and which are likely to lead to a pretty good outcome most of the time.

The Black Hole

But there is one glaring omission throughout the report’s 62 pages. It basically assumes that free markets are the ideal paradigm in all cases. Much of what is recommended is about changing human behaviour to make markets work better. That sacred cow has not yet been slain. Which is a shame – and an opportunity lost. Five out of ten, at best then, Behavioural Insights Team.

So we must turn elsewhere. Interestingly, the IMF has just published a paper, Neoliberalism: Oversold?, which is the second publication from them casting doubts on the great god of free market fundamentalism. (I wrote about the previous IMF paper in an earlier post: Inequality Damages Your Wealth.) I’m off to read the new report; it may be worth a future post…

My wife finds it hard to believe, but basically I think I’m an optimist at heart. Despite all the setbacks, humankind will get gradually wiser and we will learn how to make the future better than the past. Over the long term, of course.

I occasionally spot news items which seem to confirm, or deny, this belief. Here’s a couple from last month, on both sides of the argument.

Peak Stuff?

A report from the Office of National Statistics states that there has been a 30% drop in the UK’s consumption of “stuff” between 2001 and 2013. By “stuff” they mean items such as food, fuel, metals and building materials. Some at least of this drop is because we have become cleverer and / or frugal in manufacturing items. For example, much less metal is now used in building a washing machine. Music downloads have replaced vinyl LPs and CDs.

The optimist’s view is that, perhaps, as western consumer societies mature, we choose to buy fewer “things” and instead spend our money on less tangible leisure activities. If this is so, there is a better potential for the sustainability of our lifestyles and more hope for the future of our finite planet. Environmentalist critics say that the ONS figures are flawed as they do not properly take into account how we, as a country, import our environmental damage, for example through imports of manufactured goods from China. Nevertheless, there is at least some evidence of a glimmer of hope for the future.

Beyond Our Means?

To temper my optimism was another story from the same day’s newspaper. The Bank of England reported the biggest rise in consumer borrowing for a decade. Borrowing rose by 9.1% in the 12 months to January. Whilst this has a positive impact on economic activity in the short term, the medium-term implications are more troublesome. A consumer debt spokesman forecast a 17% rise in unsecured debt defaults by 2020. A professional economic forecaster said mortgage-to-income ratios are at record levels. The outlook, when interest rates eventually start to rise, looks decidedly dodgy.

My principal concern is more basic. We Brits are currently living beyond our means. We are repeating the circumstances which led to the 2007-8 crash – only more so. It was excessive consumer debt which got us into this mess in the first place. The resultant bad debts threatened banks and so the government bailed them out, effectively “nationalising” the debt. Britain is uniquely vulnerable to the next global crash. We have an exceptionally lopsided economy. We have too much dependence on financial services – spectacularly so – and too little in other sectors, especially manufacturing. Osborne has done nothing in the last 6 years to correct this imbalance. His policies have, if anything, made matters worse.

Think of the tower in a game of Jenga. If the size of the base represents the size of the national annual economy, our speculative trading in the City would be a tower nearly 160 bricks high. Osborne is ideologically committed to removing as much regulation as possible – like removing the lower bricks, one by one, in Jenga. One small nudge (financial shock) and the whole teetering pile crashes to the ground.

Still Cheerful?

So the good news is that we may have taken the first few steps towards a more sustainable future, at least as far as the world’s resources are concerned. But we’re saddled with a government that encourages a “Jenga economy”. Keep smiling…. through gritted teeth!

The City of London claims to be the biggest and most important financial centre in the world. In strictly numerical terms, I’m sure it’s true. According to Wikipedia, it is “the largest financial exporter in the world which makes a significant contribution to the UK’s balance of payments”.

Finance Sector “Facts”

Financial services account for nearly 10% of GDP (national income) and employ nearly 4% of its workforce. Business services and finance combined have risen from 5% of GDP in 1948 to 32% in 2013. Gross Value Added (GVA) is a net figure of the output of a sector less costs of goods and services consumed. On this basis, finance’s GVA is 8% of the economy as a whole. Half of this amount comes from London. The City employs 415,000 people (2014 figure), up 25% on 2009. Financial services paid – or collected, e.g. income tax – 11% of the government’s tax receipts.

The flip side of this is the decline in manufacturing since World War II. Britain’s manufacturing sector has declined more rapidly than elsewhere – see graph below. The contrast with Germany is particularly striking.

GVA attributable to manufacturing

(The black triangles above represent spot figures for the UK for 1947 and 1977)

The City: A Source of Economic Instability?

My earlier blog post Two Gamblers and a Pint of Lager discussed how City trading has grown out of all proportion to the “real” economy. In his brilliantly illuminating 2010 book 23 Things They Don’t Tell You About Capitalism, Cambridge economist Ha-Joon Chang explains how things have evolved. Here’s a key part of the picture:

• Mortgages are repackaged and resold as Mortgage Based Securities.
• MBSs get repackaged into Collateralized Debt Obligations.
• CDOs get repackaged into a kind of CDO-squared.
• And so on.

As Ha-Joon says, “the same underlying assets (i.e. houses) were re-used again and again to “derive” new assets. A massive tower of financial assets teeter on a tiny foundation of real assets. Financier Warren Buffet calls them “weapons of financial mass destruction”. What we have is potential instability on a massive scale. One small disturbance and the whole pile falls over. And, of course, no one really understands what they’re doing: it’s all a matter of faith.

In an interview following the decision to set up the Women’s Equality Party, Sandi Toksvig spoke of the crisis which brought about the near-total collapse of the banking system in Iceland. Only one Icelandic bank survived. It was set up by two women. One of their policies was to only invest in things they understood.

The City: Centre of a Web of Tax Havens

Much has been written about the tax avoidance activity of multinational corporations and super-rich individuals: the list is endless. Such activity is made possible by a web of tax havens around the world. Places like Jersey and the British Virgin Islands are part of a number of offshore territories linked to the UK. We have more such tax havens than the rest of the world combined. A 2011 article in the New Statesman describes how the City of London Corporation sits at the centre of this web. It is a local authority, but like no other in Britain. It is exempt from many of the laws applicable to the rest of the UK. Businesses can vote in local elections – the number of votes they have in proportion to the business size. The Corporation has its own representative in Parliament and acts as a cheerleader for the finance industry. It’s the last surviving “rotten borough”.

With over 50% of donations to the Tory Party coming from financial institutions in the City, it’s easy to see why this government really means “the interests of the City” when it talks of “the national interest”. Whether through ignorance or isolation from the “real” world, Cameron, Osborne and company conflate the two. The British Government lobbied hard against an EU proposal to introduce a “Tobin Tax” in 2011 because it said it would damage the City. It made an unsuccessful legal challenge in 2014 to the European Court of Justice. The UK failed in its attempt to ban plans by 11 EU countries to introduce such a tax in their own countries. The Tax is designed to reduce instability (euphemistically called “volatility”) and to cut the finance sector down to size. It works by introducing a tiny (typically 0.1%) tax levy on all financial transactions. As we have seen, given the huge volume of such transactions each day, the tax would potentially raise billions of euros (or pounds).

Large Financial Sectors Damage Economic Growth

A detailed study by Stephen Cecchetti and Enisse Kharroubi of the Bank for International Settlements in February this year showed how too big a finance sector damages economic growth. (Their full, rather technical, report can be found here.)

An earlier (2012) paper showed that once finance grows to a certain size*, which in Britain it has, any further growth in the finance sector depresses economic growth. The trend for the past decade is for finance to grow at 5% p.a. So any further growth in the UK’s finance sector will be bad for the economy.

The 2015 paper shows two ways how the finance sector growth suppresses growth in the real economy. The first is a simple “crowding out” argument: finance “steals” from other sectors the best brains coming out of universities. The second is more subtle. The report shows that those countries with large finance sectors invest proportionately more in real estate, creating property “bubbles”. The sectors which suffer most are the R&D intensive industries. The scope for productivity growth in property is small; in R&D-rich industries it is large. As productivity growth is the main long-term driver of increased prosperity, economic growth is depressed.

The performance of the UK economy since 2010 fits this negative pattern exactly. Only two sectors of the economy have prospered. Bankers and financial service workers continue to pocket the proceedings of the government bailouts (“quantitative easing”) and pay themselves bonuses as if the 2008 crash hadn’t happened. And the housing bubble is inflating to the point where more and more younger people cannot afford to get on the housing ladder. Productivity growth has been non-existent. A highly visible example is the trend away from automatic to manual car wash services.

*finance employs more than 4% of the workforce or private debt is over 100% of GDP

The Inequality Engine

My earlier post Chain of Fools explained how most of the innovative “products” introduced by finance over the last thirty years have a common characteristic. They provide a way of enriching the traders in finance at least risk to themselves. They transfer wealth from the majority of the population to those rich enough to have spare cash to invest and to employ the services of financial advisers. A good example is quoted in Thomas Picketty’s 2014 book Capital in the 21^st Century. Harvard University spends $100 million a year on financial advice, far more than any other university. It gets a 12% return on its investments – three times the US average for university endowment funds. Once you’re rich enough, you can’t help but get richer.

The upshot is that financial services provide, in fact, a very powerful engine driving up inequality. Any attempts by national governments at redistributive policies such as progressive taxes are like walking up a down escalator.

Balance of Payments and Exports

The UK’s balance of payments has been in deficit for the past 15 years, although it can be seen below that matters have been going further downhill since 2010.

The 2014 deficit in goods of £124bn was offset by a surplus of £89bn in services. Finance services supplied a useful £39bn of this surplus. This is perhaps not surprising as the UK economy is responsible for 37% of global financial transactions (with 1% of global population).

However, in value terms, financial services are a poor way to export. Goods, despite manufacturing representing only 10% of our economy, produce 19% of our exports. Financial services, also around 10% of GDP, contribute only 4% of exports.

The underlying picture is that we consume far more than we produce. This has been propped up by overseas investors continuing to invest in the UK economy. The “crowding out / poor productivity” effect of finance over manufacturing described above means this position is not sustainable for ever.

Other Perspectives on the Finance Sector

Finally, I will summarize the work of two independent-minded professionals, the first legal and the second a former key player in finance itself.

Critical Legal Thinking

A 2012 report by the above organisation forensically dissects the value of the various ways banks and financial intermediaries make their money.

30% comes from fees, which the report concludes are extortionate: their words “protection racketeering, fraud, and spivvery” to be precise. 10% comes from speculative dealing with clients’ money, often against their interests. The report mentions that Goldman Sachs traders use the affectionate term “muppets” to describe their clients of these services. 30% is called “other operating income”, an obscure basket of activity believed to include help to clients to hide their money in offshore tax havens. The final 40% comes essentially from charging higher interest to creditors than the banks need to pay themselves. Banks “earn” this by making themselves the only route for clients to capital – as the report says, by “simply being banks”.

Howard Davies article

Howard Davies, former chairman of Britain’s Financial Services Authority, deputy governor of the Bank of England, and director of the London School of Economics, is a professor at Sciences Po in Paris. So he is someone in the know. His Guardian article from 2014 is entitled “Does London’s financial centre boost or harm the UK economy? “

He cites a number of sources, including the 2012 BIS report mentioned above. He makes a few caustic remarks: the expected continuing growth of the finance sector should be good for some other parts of the economy. He cites “Porsche dealers and strip clubs” as examples. His overall conclusions appear to be twofold. Firstly, the net benefit of the finance sector is overstated. And net benefit to the economy as a whole is “mixed”. It’s hardly a ringing endorsement from a man who was at the top of finance tree for so long.

Overall Conclusion

And so to my overall conclusions to the original question: the City, paragon or parasite?

Well, it’s clear that financial services and the City of London in particular are a very important part of our economy and employ a large number of (generally well-paid) people. Any major policy changes which had the effect of destroying large swathes of the sector overnight would be damaging in the short term. Although, of course, finance had a very good try at doing just this in the 2007-2008 crash and the bailout by the government was the lesser of two evils. The finance sector does bring in a surplus on our overseas trade – hardly surprising as the sector is proportionately 37 times larger in Britain than for the world economy. This surplus helps to offset our massive trade deficit in manufactured goods.

But look at the other side of the “balance sheet”. Finance is a major source of economic instability, as the 2007-8 crash showed. It facilitates tax avoidance through its network of tax havens. Its growth is damaging to productivity and long-term growth in the economy as a whole. And it repeatedly creates property bubbles instead of investing in productivity-enhancing industries. Finally, it powerfully drives up inequality.

So, overall, that makes it more parasite than paragon. It’s high time we started rebalancing our lop-sided economy before the next crash.

(Sources for this post include: City of London Corporation, Office for National Statistics, House of Commons Library, Bank of International Settlements, The Economist, The Guardian, New Statesman)

Back in 2009, Adair Turner, former head of the CBI and the financial regulator FSA, called much of what the City of London does “socially useless”. In this post, I will explore this assertion, via a few other ideas on the way.

Chain Letters

As a child, I remember receiving the occasional chain letter. In those days, it was an actual letter through the post. They were generally pretty benign. Typically the recipient was asked to do two things. Firstly, to write a letter to the person named at the top of a short list of names in the letter. Secondly, to copy (by hand) the letter to 4-5 friends, deleting the top name and adding your own name to the bottom of the list. By the miracle of the power of arithmetic, you would then receive a large number of letters from far-flung places. Writing 5 letters to the fifth person in the chain should theoretically bring you 3125 (5 to the power of 5) letters in return – if everyone plays the game. At each step, the total number of people needed is multiplied by five.

The problem is, after fourteen rounds, this system requires the entire population of the planet to take part: 5 to the power of 14 is about 6 billion. And then where do you go? So in practice, chain letters might work for a round or two and then quickly fizzle out.

Pyramids and Ponzi schemes

A more sinister version of the chain letter is pyramid selling.

No, no that type. I’m not aware that the Egyptian government has followed Britain’s lead and is attempting to sell off the nation’s assets (usually these days to the Chinese). No, I’m talking about the illegal business practice of selling some spurious goods or service for an up-front fee. The rest of the scheme works much like the chain letter. The same multiplier effects come into play, as those people drawn in then try to sell on to a number of others. In practice, the very few at the top of the pyramid make all the money and a much larger group lose a little each. It’s a zero-sum game.

A Ponzi scheme works in much the same way. It relies on enticing investors into believing they will make unrealistically high returns on their outlays. Again, in practice, it’s usually only those in the know at the start who make any money. Again, the majority lose. A good example is the scheme set up by Max Bialystock and Leo Bloom in Mel Brooks’ The Producers. They sell shares many times over in failed Broadway musicals to rich “little old ladies” susceptible to Bialystock’s seductive(?) charms.

Financial “Products”

Much has been written over the years about the wonderfully innovative financial “products” dreamed up by City types since the sector was freed from too much nasty regulation. But what are these “products”?

Let’s start first with what is at the heart of traditional markets in goods and services: the transaction. This requires two parties – a buyer and a seller – a product or service and an agreed price for exchange. The producer of the product or service has used resources – physical or human – together with skill, organisation and possibly ingenuity to make something which the buyer values. This may be because the buyer does not have the time, resources or skills to make the product or service him/herself. Provided it’s traded at a fair price, both parties gain from the transaction. The buyer gets the benefit (s)he values from the product or service. The seller gets paid for the time and effort gone into producing it. A win-win game.

Compare this to a typical financial “product”. These are investment schemes of one form or another, offering the opportunity of financial gain under conditions specified by the seller. The buyer trusts the seller to use his skills to maximize the prospects of a gain. The seller invariably minimizes his risk by taking his commission or fee up front. The seller then undertakes some form of speculative investment. If he does well, the buyer gets a profit. But where does this profit come from? The seller has used his knowledge to “play the market” to his advantage on behalf of the client. The only way this is achieved is by hundreds or thousands of other people losing a little each, just like in the pyramid selling scheme. These losses may take the form of actual investment losses or in consequential higher costs in other goods and services. No new wealth is created: this time it’s a win-lose game.

Chain of Fools

Who are the winners and losers in this game? The winners are likely to be those with spare cash to invest: mega-rich individuals and large multinationals – and of course the traders. The transfer of wealth from the many to the few doesn’t have to be very much for each transaction. Tiny margins will do, as the process goes round and round repeatedly. Cumulatively, the effect is massive. Remember from my earlier post Two Gamblers and a Pint of Lager that sums equal to the entire annual output of the UK are speculated in the City every day and a quarter.

As Aretha Franklin sang: “Chain, chain, chain… Chain of Fools”. And who are the fools? It’s us. Turner’s “socially useless” is putting it too kindly.

This is the story of two men with gambling habits and a pint of frothy beer. But there might be a bit more to it than that. There’ll be a short quiz at the end, to see if you’ve been paying attention. Read on…

Poker-Face Dan

Dan lives in a country that is neither particularly rich nor particularly poor. He has a job and his total income is £8000 a year. His friends call him “poker face” as Dan is a mean poker player. His gambling is successful and his poker winnings bring in £400 of his annual earnings. His long-suffering wife Maria is deeply troubled by his habit. She has found out that Dan gambles over £120,000 a year on poker games. Dan says not to worry as he is good at the game. Maria thinks his luck will run out one day and bring ruin to his family.

Oliver: “A Bit of a Flutter”

Oliver lives in a much richer country. Also with a job, he brings in a total of £26,000 a year. Oliver’s new girlfriend Amelia really enjoyed the day out at the races they went to recently. But she was a bit surprised by the size of the bets Oliver was placing, including one bet of £5000. Oliver said he likes “a bit of a flutter” on the horses. He told her not to worry: he’s a real expert, studying form and placing his bets with care. In a typical year, Oliver’s betting contributes a useful £3500 to his annual income. Amelia might be a bit more worried if she knew Oliver placed bets totalling £4 million each year – the equivalent of gambling most of his annual salary every day.

The Frothy Pint

A man walks into a pub and orders a pint of lager. He notices whilst it’s being poured that it looks a little frothy. “Beer’s a bit lively tonight” he says to the barmaid. She just smiles and says nothing. The man takes his drink to a table and sits down. He notices his beer still looks frothy. In fact, there’s only two-thirds of a teaspoonful of liquid in his glass; the rest is head. He takes the drink back to the bar and complains. The barmaid shrugs and says there’s nothing she can do: it’s always like that. The man sits down slowly again, still feeling he’s been cheated. (Sorry if you were expecting a good punchline!)

What’s Happening Here?

Well, I confess, this story is not really about Dan, Oliver and the pint of lager. It concerns the global economy in 2015 and financial services in particular. Economic statistics quote numbers so huge – total world income, for example, is around 74 trillion US dollars a year – it’s hard to relate them to anything real. So I’ve scaled everything down to more human-like terms.

Let’s start with the pint of frothy lager. As recently as 1975, roughly 80% of all global foreign exchange transactions involved the real trading of a product or service. Only 20% were speculative, betting on the rise or fall of prices, exchange rates or some such. Since the liberalisation of financial services in the 1980s, the proportion of speculative transactions has increased almost beyond belief. The speculative stuff now accounts for nearly all the activity: only 0.6% of transactions involve something tangible. That’s equivalent to the two-thirds teaspoon (3.4ml) of actual beer in the pint (568ml) glass.

Dan and Oliver represent the global and the UK economies. Daniel is, apparently, a popular man’s name in Peru. Peru comes half-way down the International Monetary Fund’s ranking of 183 national economies, in terms of income per head of population. Oliver and Amelia are the most popular boys’ and girls’ names in Britain, which comes 27^th in the IMF’s rankings.

Dan’s income of £8000 is the average global income per person. £26,000 is UK middle income. Financial services represent about 5% of the world’s income, but 13% for the UK.

Globally, money equal to the entire planet’s annual output (or income) is traded every 14 working days. In Britain, our annual GDP is traded every one and a quarter days.

Compare Britain’s place in the world with these three numbers:

• 1% of the world’s population
• 2.5% of the world’s income
• 37% of the world’s daily financial transactions.

After the 2010 election, David Cameron promised to rebalance Britain’s economy away from an over-reliance on finance. With over 50% of Tory Party donations coming from financial institutions in the City, don’t bet on real reforms any time soon.

A Short Quiz

Think back to the concerns of Maria and Amelia, with their partners’ gambling habits. Considering the state of affairs in financial services in Britain and around the world, do you think the current situation is:

1. perfectly OK as it is,
2. a bit worrying, or
3. stark raving mad?