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Bad faith arguments

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One feature of this election campaign is that we are seeing more bad faith arguments. By this, I mean arguments which their advocates cannot sincerely believe, at least not without humungous inconsistency with their other beliefs.

One egregious recent example of this was John Redwood’s claim that Brexit is an opportunity for us to “develop policies to rebuild our self-sufficiency in temperate food.” It is obviously absurd that someone who claims to support free markets – the essence of which is the division of labour – should suddenly favour North Korean-style Juche. But Redwood doesn’t sincerely believe this. He’s looking for an upside to Brexit and is clutching at straws (literally?). It’s a bad faith argument.

Here are some other examples.

“Labour’s call to abolish hospital car park charges is regressive, as it’ll benefit richer people who tend to drive.”

This misses the point. It’s absurd to means-test every transaction: barmen don’t ask to see how much you earn before deciding how much to charge you for a pint. Progressiveness or regressiveness should be judged at the level of the system as a whole, not for individual actions.

Which is why I say it’s bad faith. Those making this claim aren’t saying that, taken as a whole, Labour’s policies are insufficiently redistributive. They are just looking for a flaw in Labour’s policy and missing it.

“Labour shouldn’t scrap private schools: it should raise the standard of state schools.”

Simple maths shows the problem here. Average spending on state secondary school pupils is £6200 (pdf) per head. To raise spending to the level of that at a decent private school (say, Oakham) would need an extra £15,000 per pupil. Across 3.2 million (pdf) pupils, this implies extra spending of almost £50bn a year. That’s equivalent to a raising income tax by a quarter or VAT by one-third. And this is without considering the practical difficulties of giving each state school an Olympic-sized rowing lake as they have at Eton.

Nobody, though, is advocating such a spending increase. Nor are they identifying such massive inefficiencies in the state sector that the elimination of them could get pupils as well educated on £6200 a year as £21,000*. Which is why I say this is a bad faith argument.

“Labour’s plans for worker ownership are the confiscation of shareholders’ property.”

The people arguing this, however, take a very partial attitude to shareholders’ rights. Political uncertainty – about Brexit and Trump’s trade war – is depressing share prices and costing investors’ billions of pounds; we know this because there’s a strong correlation between the Baker, Bloom and Davis index of political uncertainty and equity valuations. If you think Labour is attacking shareholders without being equally vocal about the damage done by Trump and Brexit, you are guilty of bad faith.

“We must respect the will of the people on Brexit.”

The will of the people, however, is to retain free movement.  Which argues for only the softest type of Brexit. Supporters of Johnson’s plan – which he himself doesn’t understand – cannot, therefore, easily invoke the will of the people.

What’s more, the majority of voters favour nationalizing the railways, a wealth tax, worker-directors and higher taxes on top incomes. I haven’t heard Jacob Rees Mogg calling for these. Invoking the “will of the people” when you do it so partially is bad faith**.

“Immigration depresses wages and puts pressure on public services.”

All the evidence, however, is that it has only a tiny effect upon the wages of the low-skilled, and that EU migration is actually a net benefit for the public services. (See this pdf and the references therein.)

I call this a bad faith argument because those who are opposed to immigration aren’t motivated by economic considerations. Almost nobody says: “I was opposed to immigration but having seen the evidence that it does no economic harm I’m now in favour of it.” Instead, such opposition is based on non-economic factors, not all of which are racist. Trying to find an economic justification for tough immigration controls is bad faith: it misrepresents your actual beliefs.

To be clear, I am NOT saying that all arguments here are bad faith. There are valid cases to be made against Labour’s policies on private schools, car park charges and worker ownership, and in favour of Brexit and immigration controls. Not necessarily persuasive cases, but ones that deserve a hearing. So let’s hear them, and not rank dishonesty.

*  Is the Michaela Community School a counter-example to my claim? I don’t know. Its exam results seem good, but can it match private schools for activities such as sport and music?

** OK, so we’ve had a referendum on Brexit but not on a wealth tax. But why not?



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Economy

Cautionary Tales Ep 6 – How Britain Invented, Then Ignored, Blitzkrieg

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Blitzkrieg means “lightning war”, but despite the German name it was not a German invention. Back in 1917 a brilliant English officer developed a revolutionary way to use the latest development in military technology – the tank. The British army squandered the idea but two decades later later Hitler’s tanks thundered across Europe, achieving the kind of rapid victories that had been predicted back in 1917.

This is a common story: Sony invented the digital Walkman, Xerox the personal computer, and Kodak the digital camera. In each case they failed to capitalise on the idea. Why?

Featuring: Toby Stephens, Ed Gaughan and Rufus Wright.

Producers: Ryan Dilley and Marilyn Rust. Sound design/mix/musical composition: Pascal Wyse. Fact checking: Joseph Fridman. Editor: Julia Barton. Recording: Wardour Studios, London. GSI Studios, New York. PR: Christine Ragasa.

Thanks to the team at Pushkin Industries, Heather Fain, Mia Lobel, Carly Migliori, Jacob Weisberg, and of course, the mighty Malcolm Gladwell.

[Apple] [Spotify] [Stitcher]

 

Further reading

Mark Urban’s book The Generals has an excellent chapter on J.F.C. Fuller. Other sources on Fuller include Brian Holden Reid’s J.F.C. Fuller: Military Thinker and Harold Winton’s To Change An Army

Other sources on the development of the tank include Macksey and Batchelor’s TankNorman Dixon’s classic On The Psychology of Military Incompetence and Basil Liddell Hart’s The Tanks.

On modern corporate innovation try Gillian Tett’s excellent The Silo EffectCreation Myth” by Malcolm Gladwell, Clay Christensen’s Innovator’s Dilemma and The Disruption Dilemma by Joshua Gans.

 

The original paper on architectural innovation is:

Henderson, Rebecca M., and Kim B. Clark. “Architectural Innovation: The Reconfiguration of Existing Product Technologies and The Failure of Established Firms.” Administrative Science Quarterly 35, no. 1 (March 1990): 9–30

 

 

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The Fama Puzzle at 40

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Fama (JME, 1984) was published 35 years ago, but the earlier — perhaps the earliest — appearance of the Fama regression is in Tryon (1979). While the puzzle has largely persisted since then, it has seemingly disappeared since the global financial crisis.

Figure 1: Ex post one year depreciation of euro/dollar up to 2007M08 against one year offshore US-euro interest differential (up to 2006M08). 

Recall the puzzle: If the joint hypothesis of uncovered interest rate parity (UIP) and rational expectations –- sometimes termed the unbiasedness hypothesis — held, then the slope of the regression lines (in red) would be indistinguishable from unity. In fact, they are significantly different from that value. This pattern of coefficient reversal holds up for other dollar-based exchange rates, as well as for other currency pairs (with a couple exceptions). The fact that the coefficient is positive in the post-global financial crisis period is what we term “the New Fama puzzle”.

Interestingly, after 2006, the relationship flips.

Figure 2: Ex post one year depreciation of eur/dollar up to 2019M06 against one year offshore US-euro area interest differential (up to 2018M06). 

In a revision to NBER working paper just released (No. 24342, posted 12/11), coauthored with Matthieu Bussière (Banque de France), Laurent Ferrara (SKEMA Business School), Jonas Heipertz (Paris School of Economics), we re-examine uncovered interest parity – the proposition that anticipated exchange rate changes should offset interest rate differentials, with data up to mid-2019.

This is one of the most central concepts in international finance. At the same time, empirical validation of this concept has proven elusive. In fact, the failure of the joint hypothesis of uncovered interest rate parity (UIP) and rational expectations – sometimes termed the unbiasedness hypothesis – is one of the most robust empirical regularities in the literature, vigorously examined since Fama’s (1984) finding that interest rate differentials point in the wrong direction for subsequent ex-post changes in exchange rates.

The most commonplace explanations – such as the existence of an exchange risk premium, which drives a wedge between forward rates and expected future spot rates – have some empirical verification, albeit fragile.

One key development prompts this revisit. First and foremost, the last decade includes a period in which short rates have effectively hit the zero interest rate bound. This point is clearly illustrated in Figure 1 where we plot one-year interest rates for a set of eight selected economies and the US. This development affords us the opportunity to examine whether the Fama puzzle is a general phenomenon or one that is regime-dependent.

Figure 3: One year yields on Eurocurrency deposits.

As shown in Figure 3, more recently — and since the first version of this paper — short rates in the US have risen above the zero lower bound. This allows us to test to the robustness of our findings.

We obtain the following findings. First, Fama’s result is by and large replicated in regressions for the full sample, ranging from 1999 to June 2018 (for exchange rate changes ending in June 2019). However, the results change if the sample is truncated to apply to only the most recent decade, the period for which interest rates are essentially at zero. For that period, interest differentials correctly signal the right direction of subsequent exchange rate changes, but with a magnitude that is altogether not reconcilable with the arbitrage interpretation of UIP. In other words, we obtain positive coefficients at exactly a time of high risk when it would seem less likely that UIP would hold.

The use of survey based expectations — thereby dropping the rational expectations hypothesis — data provides the following insights. First, interest differentials and anticipated exchange rate changes are positively correlated, consistent with the proposition that investors tend to equalize at least partially expected returns expressed in common currency terms (see also Chinn and Frankel (2019) for results 1986-2017).

Second, the switch in the β coefficient at the one year horizon arises because the correlation of expectations errors (defined as expected minus actual) and interest differentials changes substantially between pre- and post-crisis periods. This is important, as can be seen by examining the probability limit of the β’ coefficient in a Fama regression:

s+1 – s = α’ + β'(i-i*) + error

so:

plim(β’) = 1 – [A] – [B] – [C]

Where

[A] ≡ cov(covered interest diff.,i-i*)/var(i-i*)
[B] ≡ cov(risk premium, i-i*)/var(i-i*)
[C] ≡ cov(forecast error, i-i*)/var(i-i*)

covered interest differential = – [(f – s) – (i-i*)]
risk premium = f – ε(s+1)
forecast error = ε(s+1) – s
f is the forward rate for period +1
s is the current spot exchange rate
ε(s+1) is subjective market expectations of the future spot exchange rate (proxied using Consensus Forecasts survey data).

The decomposition for the euro/dollar β’ is shown in the Figure 4 below, for the 2003M01-2018M06 period (defined by the survey data). The components are shown as theoretical β’ + [-A] + [-B] + [-C], so as to add up to the estimated β’.


Figure 4: Decomposition of euro/dollar β’. [A] is brown, [B] is blue, [C] is green; black square denotes estimated β’, line at 1 denotes theoretical β’ under unbiasedness hypothesis. Source: BCFH (2019).

Exchange risk comovement with the interest differential does not appear to be the primary reason why the Fama coefficient has been so large in recent years (although the altered behavior of exchange risk does play a role). Rather, how expectations errors comove with the interest differential appears of central importance — that is the [C] component. This correlation changes because in the pre-crisis period, the dollar depreciated more than anticipated, while that is no longer true post-crisis. The size of the swing is partly due to the fact that interest differentials are now less variable (the variance has shrunk).

So far the change has proved durable despite the liftoff of short rates — at least in the US, Canada and UK. Whether this will continue to be the case remains to be seen.

Ungated version of the paper, here.



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Economy

Bonus Quotation of the Day…

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… is from page 426 of the late Jan Tumlir’s January 1984 speech at the Cato Institute – a speech titled “Economic Policy for a Stable World Order” – as this speech is reprinted in Dollars, Deficits, & Trade (James A. Dorn and William A. Niskanen, eds., 1989):

Indeed the difficulty for the economist may now lie in explaining why the world economy still functions at all, however dissatisfied we may be with its functioning. The answer is, of course, that there is a lot of ruin in any economy with a modicum of freedom. I am sometimes unsure whether it is actually an advantage of the capitalist system that it can take such an enormous amount of beating. If it were in the habit of collapsing more frequently, we would perhaps govern ourselves more prudently (and more cheaply to boot).

DBx: Indeed.

I’ve long argued that the economist’s standard assertion that government intervenes into the economy first and foremost to correct market failures fails spectacularly as a positive theory of government intervention into the economy. It’s far closer to the truth to say that government intervention into the economy is fueled not by market failures (as understood by economists) but, rather by the market’s astonishing success and robustness.

The market’s success at raising people’s standards of living creates the expectation that wealth creation is easy and normal while poverty is out of the ordinary. But of course historically poverty is the norm – and poverty so deep, unrelenting, and overwhelming that few Americans today can begin to imagine a condition so crushing. Because the market makes wealth so abundant and its production appear to be normal and easy to the point of being practically automatic – and because nearly all of the massive number of details of the intricate processes at work at every moment to create wealth are hidden from view – the market’s ‘failure’ to create heaven on earth is believed by many to be an unanswerable indictment of the market.

On top of this ‘problem’ is the market’s mighty robustness: tax it, saddle it with diktats, poison it with easy money, accuse it of being run by and for demons and devils, and the market keeps motoring along, improving the lives even of those who most hate it and who do the most to harass it. The market works less well than it would absent these intrusions, of course, but it still works surprisingly well. As long as, and insofar as, prices and wages are allowed to adjust according to the forces of supply and demand, the market’s robustness is Herculean. (The market is not, however, indestructible. Harass it too much and it will quit working.)

If the market truly collapsed completely more often, giving people a taste of what life is like without it, the world would have in it not only far fewer communists and socialists, but also far fewer “Progressives” and “conservative nationalists.”

The market’s true failure, in short, lies is its incredible capacity to succeed and to keep on keeping on. The market fails to prevent people from taking it for granted.

The post Bonus Quotation of the Day… appeared first on Cafe Hayek.



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