Economics
| The Problems with Performance Related Pay in Finance
I was asked today what I felt about performance related pay in the banking/financial sector and the huge bonuses given to the bankers who are responsible for the financial crisis. To my general thoughts on the topic, I’ll point you towards Tim Harford’s wonderful article in his Undercover Economist column. He talks about some of the adverse incentives created:
Fairly recently, I was invited to participate in a trading simulation and competition run by the bank JP Morgan. It was lots of good fun: we had a simulated market running in the room where everyone could buy and sell shares in technology companies. Everyone was given some virtual money to invest. Throughout the simulation, the ticker would update with news about what was happening in the industry (e.g. earnings reports, new products, etc.) I think there was roughly 40 teams or so participating in the simulation. The top four teams (i.e. the teams which made the most money) won the competition and went through to the next round. My teammate and I were fairly sensible investors: we invested in a portfolio of stock, we knew when to cut our losses and we hedged our risks. I think that would be a good strategy to follow for an investment fund manager: after all you don’t want to lose all of your clients money and you want performance to be pretty stable.
We came about 10th in the competition so we missed out on being in the top four. Anyway, it turned out that the winning teams which won the game had invested larger sums and taken much larger risks than we had. In retrospect, it made sense. Seeing as you wern’t playing with your own money (in this case it was virtual money), the whole game encouraged taking risks. A sensible investor who took fewer risks might make a good return on their portfolio but they would never be able to win it. An investor taking large risks would either come last (in which case, nothing has been lost) or first (in which case they would win the game). The investors who took the most risks – a level of risk which you wouldn’t want to be exposed to if the money was your pension or savings – won the game. The prize is probably an internship or a job or something. I think that illustrates the whole problem with the system of rewards in the financial sector and what caused the traders to take huge risks with our money. | |
| Savers are earning more as real interest rates rise
So lots of my friends have been complaining about interest rates over the last weeks or so. The Bank of England has dropped base interest rates from 5.75% where they were just 6 months ago to 1.0% today. For savers, that also means interest rates have been cut which is bad news for everybody who is saving for a house/college/etc. Right? Not really. The Times discussed this very recently. It’s no good looking at the nominal interest rate which is advertised by your bank or the Bank of England as it is meaningless. What’s important is the real interest rate. Let me explain. Let us take a basket of goods which we define to be representative of your expenditure. The basket of goods has a cost of £100 this year. If we have inflation of 5%, that means the same basket of goods would cost £105 next year. What if you decide, instead of buying a basket of goods today, you choose to put your money in a savings account earning 5%? Well, the £100 you invest will have turned into £105. When you come to spend your money, all you’ll be able to buy is a basket of goods. You’ll have nothing left over. In real physical terms, you haven’t gained anything from saving as the amount you can consume has stayed the same. Hopefully this example illustrates that the important thing is real interest rates. Whilst nominal (advertised) interest rates are at the lowest point in yonks, real interest rates aren’t too bad as inflation is very low. Let’s take a look at nominal interest rates and RPI inflation over the last few years:
We see that it was pretty bad for savers towards the end of 2008 as inflation totally eroded any interest being earnt. However, with inflation now very close to zero, this is no longer the case. This is more clearly illustrated in a graph of real interest rates:
As you can see, real interest rates are climbing back up to around 1.5% where they’ve been for the last couple of years. Conclusions:
| |
| BT line rental increases – Why do paper bills at BT cost so much? The Telegraph reports that line rental for all British Telecom customers will increase by £1/month.
For somebody who receives paper bills, this is a rise from £11.50/month to £12.50/month for those on paper billing. For those on paperless billing (i.e. online), bills will increase from £10.25/month to £11.25/month. According to BT, customers can mitigate the price rise by switching to paperless billing at the same time. This is a fantastic demonstration of price discrimination. On face value, having to pay an extra of £1.25/month for a paper bill seems ridiculous. It is obvious that this £3.75 per quarterly bill charge isn’t there to cover BT’s costs. There is no way that printing, processing and mailing a phone bill every quarter would cost more than 30p. That would leave BT with an additional £3.45 of pure profit per quarter for every paper bill customer. I’ll explain using the old prices of £11.50 for paper billing and £10.25 for paperless billing. The market rate for line rental is £11. BT’s rivals such as Virgin Media charge approx. £11. For BT to be price competitive, it must have a lower line rental than Virgin. If BT generally offered line rental at the paper bill rate of £11.50, it would be extremely uncompetitive against Virgin. However, at the paperless rate of £10.25, BT would be much cheaper than Virgin. But they’d probably make a lot less money as the profit on each line rental would be lower than it could be. Companies get the best of both worlds by charging customers who don’t mind paying more (price inelastic customers), more. Customers which do shop around for line rental and do care how much they pay (price elastic) will pay less.
The costs of paper and paperless billing have absolutely nothing to do with the different line rental charges. It’s simply a way for BT to differentiate between how price elastic customers are. My grandmother can’t be bothered to shop around or to go to the effort of accessing electronic bills. She has paper bills and pays £11.50. On the other hand, somebody like me will shop around to find the best deal. If BT charged me £11.50 as well, I would choose Virgin for a saving of 50p/month. But as BT’s paperless line rental is lower than Virgin’s line rental, I would choose to go with BT and paperless. For me, the cost saving would be worth the small extra effort to check an online bill. By charging different prices to different customers depending on how much they are willing to pay, BT can increase their customer base without cutting their prices for everybody and their profits. It is quite a clever way of operating price discrimination and has a double whammy in allowing BT to proclaim that it is encouraging people to be green. It’s something businesses do a lot and something well worth being aware of. See my previous post , “Why is popcorn at the cinema so expensive?”, for another example. | |
| “Carbon cost” of Google search same as boiling a kettle
The BBC reports today on a study by Harvard physicist Alex Wissner-Gross. Wissner-Gross claims that performing a standard Google search on a desktop computer produces 7g of CO2. A quick session with two searches will produce 14g of CO2 – the same as that from boiling a kettle. From the BBC article:
According to Google Web History, I’ve performed 9,308 Google searches and it’s only counted the searches I’ve performed whilst I was logged on. I’m guesstimating I perform about 40 searches a day; that’s 15,000 Google searches per year (sounds scary when you put it like that). My annual Google carbon footprint would be 105kg of CO2 (0.15 tons). Google have disputed this figure; saying that a search only produces 0.2g of CO2. I’m not able to comment on what I think of the methodoly as I don’t know how either figure was reached. But I think it is important to point out the difference between average cost and fixed cost. As an example, imagine a server farm which was responsible for 100g of CO2 emissions every day. If ten people perform searches, the average carbon cost of a search is 100g divided by 10 searches = 10g of CO2 per search. This is the average cost of the search.
Whereas, the marginal cost would be the CO2 cost of performing one more search. If we then performed an 11th search, the CO2 emissions of the server farm stay the same (we assume it’s running with spare capacity). The marginal cost of performing a search of zero grams of CO2. With eleven searches, you could claim each search had a carbon cost of 9g. But that’s a bit unfair – considering the CO2 output of the server farm if you had made the search and if you had not, you find the CO2 output it exactly the same. Your search had a marginal cost of zero grams of carbon. Whether Wissner-Gross and Google stated the average cost or the marginal cost I don’t know (although I suspect the first may have been the average cost and the second the marginal cost). With Google’s server farms, we know that they will be running regardless of whether we perform searches or not. The important thing then is the marginal cost of a search – this being so close to zero, I don’t think any of us should feel a guilty conscience from using Google. | |
| US Bank Bailout Now More Costly Than World War II
In July, I wrote about what the implications of a hypothetical “economic war” where a country has it’s economy systematically attacked with the aim of causing damage to the country. Perhaps it sounds like a bit of a farfetched idea but I think the recent calculation carried out by an economist, showing that the US bank bailout has already cost more than the US involvement in World War 2, could perhaps add weight to the argument that it should be taken seriously. Frequent CNBC commentator, Barry Ritholtz, writes on his blog:
Let’s take this in contrast (all figures are inflation adjusted):
That’s just really scary. | |
| Sterling Crashes – The effects on gap years and hedging
I received an email from a friend yesterday. She is currently taking a year out and taking on some voluntary work to promote peace in the middle east. It’s such a fantastic thing to do in my opinion and I have a lot of respect for her for doing it! However, it seems like even she can’t avoid the credit crunch which is impacting us all at home. I’ve written about the fall in the value of the Pound before on this blog. £1 would buy you $2.05 at the start of the year, now it would buy you about $1.50. And that’s really, really bad news for anybody who has income denominated in Pounds and costs denominated in dollars. If the gap year cost $8,000 at the start of the year, that would have worked out around £4,000. That cost has now increased to over £5,300. That’s a huge shortfall in funding and now she thinks she might have to cut the gap year short which would be a real shame. My prediction is that we’ll see a bounce in the value of the British Pound soon but obviously the exchange rate is very volatile. That’s a big problem: the cost of everything (accommodation, food, etc.) in terms of your home currency can change dramatically from day to day. The volatility of exchange rates poses extra risks both importers and exporters. Somebody (or some company) buying products in dollars and selling them in pounds will have seen their costs rise by 33% in just the past few months. That could easily make the difference between a healthy profit and a huge loss. Reducing or hedging the risk
So let’s set the scene. I’m an importer of widgets from the US. I import $1 million of widgets per month. The exchange rate is $2 to £1. So my imports cost me £500,000. However, I believe the pound is overvalued. I reckon the UK is going to go into recession soon and the pound is going to be a lot weaker. I go to my bank manager and I ask him to guarantee an exchange rate for the next year. Obviously, my bank manager probably won’t guarantee me a rate of $2 per £1 for a whole year. The reason for that is simple: if the pound does indeed get weaker, he’ll lose out. A more realistic rate he might offer is $1.8 per £1. Providing the pound stays at the $2 level, my bank manager would have made a cut of $0.20 per £1; giving my bank a profit of $100,000. I’m now paying £550,000 for my currency. That’s more than the £500,000 it would have cost me without the agreement, so essentially I’m paying £50,000 for the service of being able to “lock in” my exchange rate for a year. But because I believe the pound will fall in value, I don’t mind. If I could predicted a fall to $1.5 per £1, I would have known my costs would rise to £660,000. So I predict that agreeing a rate for my currency in advance would save me £110,000, in addition to giving a more stable cashflow. What I’ve just described is an “exchange rate derivative” (or a future). The activity is known as hedging. Hedge Funds In amidst the credit crisis, hedging has a bad name and reputation. Imagine my company is publicly floated on the stock market at the price of £2 per share. However, a hedge fund believes that my company is overvalued or expects sales to be poor in the next quarter. The hedge fund makes an agreement with somebody (e.g. a bank) that it will sell shares in my company at the price of £1.80 in one years time. So my bank manager is sitting there and thinking: great! I’m getting a £2 share for the price of £1.80… a profit of 20p instantly! If shares in my company then fell to £1.50, the hedge fund makes a profit of 30p by offloading something worth £1.50 for £1.80.
But here is the moral issue. A hedge fund is making a profit out of the fact that my company is doing badly. In fact, the worse my profits are and the more people I have to make redundant, the more money the hedge fund will make. Isn’t this profiting from somebody elses misery? I hope the similarities between the currency hedge and the company hedge are fairly obvious. Hedge funds make a profit out of the fact that my widget company performs badly. My widget company makes a profit out of the fact that the British economy is doing badly. But whilst there may be a debate to be had over the morals of short selling, it isn’t in doubt that hedging can serve a positive purpose. My friend, who no longer has enough money to complete the gap year she had been planning for a long time, could have avoided being in the situation she is currently in by hedging the Pound. She would have had the knowledge that whatever happened to the British economy and the British Pound, her costs would always be the same. If the Pound fell, she would have made a profit. If the Pound later rose, she would have paid well over the odds for her gap year. But at least the cost of the gap year would be fully known and the risks from currency fluctuates eliminated. | |
| UK cuts VAT to 15%
Everybody who lives in the UK should read about the “exceptional” pre-budget report this year. There are some big tax changes which probably affect you. To sum it up, there is a new 45% band of income tax; VAT is falling to 15% for 13 months; excise duties on alcohol, tobacco and petrol are rising. I wrote about the possibility of VAT cuts two weeks ago. Given VAT is falling from 17.5% to 15%, we should see a fall in the price of goods by 2% from Monday, assuming that the full VAT cut is passed on. In my previous article, I discussed whether retailers are likely to absorb the VAT cuts as extra profit, pass it on as-is or perhaps even cut prices by even more than 2%. Worth keeping an eye on anyway and not making any big purchases of electronics or gadgets quite yet until we see how retailers are going to react. For full details, see the government’s full pre-budget report, “Facing global challenges: Supporting people through difficult times”. | |
| How will UK VAT cuts save you money?
There has been a lot of discussion in the UK lately about a possible cut in Value Added Tax from 17.5% to 12.5%. I’m not sure how likely it is that this will happen – the radio news seems to believe it is inevitable but many other news organisations seem to disagree. A cut in VAT from 17.5% to 12.5% could lead to big discounts on every item sold in the UK. The savings can be fairly substantial – £26 off an iPhone PAYG or £72 on a £1,000 plasma TV. However, it would depend on how and whether those cuts were passed onto the consumer. Retailers could leave prices unchanged. Imagining a £100 product, £17.50 would have previously gone towards the UK government. After the VAT cuts, the government would only take a cut of £12.50 leaving the retailer with an extra profit of £5 per unit.
Retailers can increase their turnover at a time where their costs may be rising but they cannot afford to raise prices for fear of losing customers. But perhaps with retailers knowing that Christmas is coming up, people would buy their product without an additional discount. Hence there would be no need to pass on the VAT cut. Retailers could pass on part or all of the VAT cut. If the entire VAT cut was passed onto the consumer, the £100 product would now cost £92.81. The retailer makes the exact same amount of money they did before; but its great news for the consumer as consumers save a lot of money. In a time when peoples disposable income levels are falling, this increase in demand could ensure retailers get the sales they need. Retailers could discount prices by even more. The retailer may want to cut the price of the product from £100 to £90. However, that might not be too attractive to them – it represents a loss of £10 for every product sold. However, given that the government is absorbing so much of the price cut themselves this may make it a lot more attractive for retailers to cut their prices.
So how does this affect you? I personally believe that if Mr Darling did cut VAT, it would take several weeks, even months for that to filter through to the prices that we pay at the shop every day. Companies have price promises to honour; companies have catalogues which cannot be reprinted immediately, etc. And with Christmas coming up, consumer spending should hopefully pick up anyway. So we would be unlikely to see any big price cuts this year. However, New Year 2009 could be a bumper one for new year sales. If Christmas sales figures aren’t as high as retailers expect, I believe retailers could offer much bigger discounts than in past years. If there are some big purchases you were planning to make, it may well be worth waiting until after the pre-budget report and possibly the new year. | |
| Sterling Falls: Good News for Publishers, Bad News for Advertisers
As a webmaster and publisher, what exactly does the credit crunch and the dramatic falls in the value of the pound mean for you? (This article is primarily targeted at a UK audience). I feel that this is a seldom discussed issue as very few publishers are fully aware of exchange rates and the impact on their ability to make money. In this article, I will discuss the consequences for British publishers of the dramatic falls of the value of the pound and the possible business opportunities here. What’s happened? I’m sure we’re all sick about hearing about the credit crunch… the global financial crisis. I’ve found myself avoiding the news because quite frankly I’ve had enough of hearing about our financial woes. As the chancellor of the UK has just admitted, it looks like the UK will be entering a recession. Economists say a country is in recession if its total economic output (a proxy for quality of life) falls for two successive quarters. Because of the bad news about the UK economy, investors have been rapidly moving money out of the Sterling. This has caused the value of Sterling to plunge. According to Google Finance, Sterling was sitting very close to 2 dollars to 1 pound a couple of months ago. It today plunged as low as 1.53 dollars to 1 pound. And analysts are predicting a further drop down towards 1.4 dollars per pound. What does that mean?
The weaker pound is good news for exporters, and bad news for importers. Web advertising is somewhat unique in that almost all advertising networks trade in dollars. So publishers export advertising to the rest of the world (they sell advertising in dollars) whilst advertisers import it from the rest of the world (they buy advertising in dollars). Let me clarify: A website publisher earning $10,000 per month would have recieved about £5,000 per month. If the value of the Sterling falls to 1.4 dollars, that income increases to £7,140 per month. That equates to £25,000 of extra income every year. However, it’s bad news for advertisers. An advertiser spending $10,000 per month would have to shell out £7,140 per month instead of £5,000 – a price increase of almost 50%. As the audience of this blog tends to include a large number of web developers, especially from the UK, this is good news for you. In fact, if you haven’t thought about monetising your blog or website, it’s well worth doing now. It’s not necessarily good news though…
The more eagle eyed readers will have noticed something. As it’s costing more for British advertisers to place adverts, they’ll place less of them and be willing to pay less money to advertise. So even if the exchange rate of the pound falls, the actual amount of income recieved might not actually go up as much as expected. Right? Kind of. If your website caters for British audiences then it is likely the vast majority of your advertisers will be British companies. If you’re selling advertising to a British company, you’re not really exporting anything – only selling it to a domestic company, but using dollars. If you cater for international audiences and companies, you’ll be a winner. But what else about the financial crisis? Well, regardless of exchange rates, companies are a lot less likely to advertise right now. Given we’re entering a recession, money is tight. Companies cannot be confident about how much money they really have available and whether consumers will respond to their advertising. Like for everybody else, the financial crisis is bad news for exporters too. Whether the fall of Sterling is a long-term correction or just a short-term blip, I can’t say. But what’s important for us to all realise is that the game has totally changed. We need to rethink the way we all spend our money. But in the very short term, I believe there is a big opportunity in the market for British publishers. | |
| A Guide: How to save the Amazon Rainforest and the Environment
It was interesting to open up BBC News and to read the article “Ownership key to saving fisheries“. In brief, essentially scientists have surveyed fisheries across the world and found that giving fishermen long-term ownership of fisheries is the way to keep stocks at a sustainable level. It’s a vindication of basic economics. In this article, I want to discuss the issue of deforestation in the Amazon – one of the biggest environmental issues facing the world. I’ll run through a simple demonstration on how we could preserve the Amazon Rainforest using the exact same principle as that used in the Amazon. The Amazon Rainforest The Amazon Rainforest encompasses 1.4 billion acres (5.5 million square kilometres). In the 10 years from 1991 to 2000, about 500,000 square km of the Amazon was lost to deforestation. It’s been estimated that 17.1% of the Amazon has been lost to deforestation since the 1970. And at the present rate of deforestation, the Amazon Rainforest will be reduced by 40% by 2020. That’s a big problem for all of us. The Amazon is a huge carbon sink – it locks away huge amounts of the greenhouse gas CO2. Deforestation not only reduces the world’s capacity to lock away CO2; it leads to the release of CO2 too. The existence of the Amazon Rainforest has huge benefits for all of us.
Ask a typical person on the street how to solve the problem of deforestation and you’ll get answers such as: prevent illegal logging or ban deforestation of the Amazon. But then put yourself in the position of somebody who lives in or near the Amazon. Obviously, you’ll need to feed your family and make a living. Cut down some trees and sell the timber to make a bit of money. Use the land to farm and to graze cattle and to feed your family. I think it’s extremely unfair for anybody to tell the people who live in the Amazon they can’t do this. I mean, how are they expected to make a living otherwise? Sure, we all lose out from the deforestation because it contributes to climate change. But it’s only fair that the people living in the Amazon should primarily be allowed to look after themselves and their families in the only way they have. The Problem with Al Gore’s Public Commons In 1989, Al Gore said:
Essentially, Al Gore was blaming the Brazilians for cutting what does not belong to them – the Amazon. Here’s the problem of a public commons. It could get a little mathematical, so bear with me. Let us, hypothetically, say that a single acre of the Amazon Rainforest benefits everybody in the world by one millionth of a dollar. Every acre of the rainforest locks away CO2… that’s good news
According to Google, the current world population is 6.6 billion. So the economic value to society of an acre of rainforest would be $6,600. Now, we’ll enter the mindset of somebody living in the Amazon (call him Barack). Just like the rest of us, Barack benefits from lower CO2 levels by one millionth of a dollar. CO2 levels don’t have any local effects so we can make this assumption the benefits are the same for everybody. So the economic value to the private individual (Barack) is $1/1,000,000. Barack could choose to cut down this acre of rainforest. He can sell the wood, and then he can graze his cattle on the cleared land. That’ll probably make him a good $2,000 or so. So Barack has two choices:
It’s quite obvious to see that Barack will cut down the rainforest. He doesn’t care about the rest of us who all lose out by a millionth of a dollar – in fact it’s such a small amount that none of us would really make a big fuss about it. Would you make a fuss about a millionth of a dollar? But look at it from a global perspective: as a global community, we’re all losing out on the rainforest worth $6,000 and getting timber and beef which is only worth $2,000 to us. As a community, we’re made $4,600 worse off by Barack’s decision. We can pay Barack to preserve the rainforest
So here’s a proposal. What if we gave Barack the deeds to that acre of rainforest? He’ll own it and have responsibility to look after it. In fact, we’ll collectively give Barack a sum of $4,000 to preserve that rainforest because we know we’re getting a lot of good out of it. Now Barack has two options:
It’s a no brainer. Barack will preserve the forest. Now look at it from a global perspective. Collectively, the global community is benefiting by $6,600 from Barack’s acre of rainforest. But we’re only paying him $4,000 to preserve it – so we’re collectively made better off by $2,600 by Barack’s decision to save the rainforest. Everybody wins from property rights. To sum it all up… Without property rights: Barack cuts down the rainforest. Barack makes $2,000. The world loses out by $4,600. CO2 levels rise. With property rights: Barack preserves the rainforest. Barack makes $4,000. The world benefits by $2,600. CO2 levels fall. So there we have it. The big environmental issues won’t be solved by telling other people what to do, banning deforestation or giving money to people to plant trees. We don’t need to wait for scientific advances to fix the environment. We just need some open-minded thinking and some basic economics. |
