2001 RES Conference report, by Faisal Islam, Economics Correspondent of the Observer.

Consider these two comments, articulated by non-economists just before the RES conference: 'Economists have never been so powerful,' and 'economics is the ultimate in pragmatism'.

April's three-day festival of economics, hosted by the University of Durham, provided evidence to support both contentions.

If power means the ability to raise billions of pounds of revenue from thin air, then Ken Binmore and Paul Klemperer must count. As the economists behind last year's sale of 3G mobile phone licenses, they will not easily be forgotten, especially by executives in the telecommunications industry.

Two members of the Bank of England's macroeconomic dream team Stephen Nickell, and Charles Bean, were also in Durham, alongside emissaries from the European Central Bank.

But an economist's value isn't just measured by pounds and pence or the number of votes in monetary policy decisions. There are externalities aplenty in the market for economic research. First, its consumption by the mainstream media, which judging by the coverage afforded to the conference, is on the way up. And, perhaps more importantly, a huge proportion of the papers were of direct relevance to policy making. Economists appear to have taken on the role of dispassionate and pragmatic analysts of society. And it is an analysis that is being heard.

This might explain the 'mission creep' in microeconomic analyses of issues that could not be described as heartland economics. The causes of war, the optimal allocation of pocket money, and the effect of firing football managers are a far cry from Say's Law and Pareto optimality.

The macroeconomic research presented in Durham was remarkably well timed. Sessions on the ECB and the 'Greenspan put' greatly illuminated the actions, inactions and overreactions of the world's central bankers in the weeks after the conference.

Not all of the research was quite ready for consumption by the mass media, however, and it would be a tragedy if media coverage became an over-important totem of academic worth.

But behind the quirky headlines, there was a marriage of meaty analysis and creative theorising that worked excellently. And for the purists, there were enough second-order differential equations to scare off any stray sociologists.

EDUCATION and TRAINING

James Heckman's lecture contained sufficient heteroscedasticity, monotonicity and index sufficiency to sort the real economists from the newcomers, such as your conference reporter. The marginal treatment effect of his lecture on this journalist was not high. Then again, it appears that some of Britain's more eminent macroeconomists were also foxed by his mathematical approach to estimating the return to schooling when it varies among individuals.

'I hope this isn't oversimplifying things but this the instrumental variable,' said Heckman before thrusting "E(Y¦Z=Z)=md+¦ D+E(U1-U0¦P(Z)>UD)P" on to the projector.

Stephen Nickell, the new RES President, was seen to offer a hearty congratulations to the warrior of microeconomics who had refused to compromise on his mathematics. Your reporter was confused, though, and sought out Professor Heckman for clarification. Was he, the incumbent Nobel prize-winner for economics, showing evidence that there is little or no point in educating huge swathes of society, because many people have an innate inability to benefit? I suspect my requirement for clarification rather proved that point.

Evidently the institutional structure of the British school system failed your conference reporter. For Ludger Woessmann, from the Kiel Institute in Germany, the structure of the school system, rather than spending, is the most important determinant of academic success.
Woessmann looked at data for more than 250,000 secondary school pupils in 39 countries and examined three factors that might affect student performance: parental background, the resources available, and the institutional framework of the education system. Children from homes where the parents had high levels of education did better themselves. But class size, and the amount of money spent on a school, did not improve performance.
Schools did better if they could choose which teachers to hire and fix their pay. If teachers could choose teaching techniques and buy their own supplies, this improved scores further. On the other hand, if teaching unions influenced the curriculum, performance in maths and science plunged.
"Faced with the policy alternatives of spending increases and institutional reforms, politicians should opt for the latter," said Woessmann.

AUCTION THEORY

But if economists existed with the sole aim of creating policy then one doubts that the Britain's comparative advantage in auction theory would have developed.
Any perspective on the work of Paul Klemperer and Ken Binmore clearly correlates to the extent of that person's ownership of shares in telecommunications companies.
But both offered a clear exposition of how a seemingly obscure branch of microeconomics can have such a radical impact on the economy - raising £22.5 billion almost exactly a year before the conference. Both touched on the principles of good auction design, and offered intriguing explanations as to why the auctions had raised so much in Britain and Germany, but so unceremoniously flopped in Italy and the Netherlands.
'Auction design is a matter of horses for courses and not one-size-fits-all,' as Klemperer argues.

POLITICIANS, MANAGERS AND INCENTIVES

Election fever was notably, but thankfully, absent from proceedings.
The opening lecture by Canice Prendergast of Chicago University suggested that the incentive problems faced by bureaucrats were intractable.
Designing contracts to incentivise best practice is necessarily difficult, not just because of the risk of malfeasance, but because of the 'multitasking' problem.
'Output measures for bureaucrats are normally pretty crumby,' says Prendergast, drawing on the example of past attempts to increase the productivity of the Los Angeles police department. One simple problem of trying to maximise 'police output' is that the 'police will go and arrest everybody'. Furthermore, they will tend to arrest those who are the easiest to arrest, rather than the high-quality criminals.
'Most bureaucrats do not get rewarded by sophisticated contracts,' he says.
Hans Gersbach took this concept a step further.

Politicians are inescapably short-termist and thus incapable of making necessary long-term decisions, for example, investment in transport, or reducing unemployment in Continental Europe. Anyone who arrived in Durham via our great national railway system would have little difficulty in grasping the notion of the politician's minimalist discount rate.
But Gersbach's paper offers the genesis of an innovative solution: the use of incentive contracts for politicians. In his stylised model, when politicians offer financial contracts that become effective upon re-elections, their time horizons become more long term and the efficiency of decision-making more increases. Gersbach stresses the limitations of his model, in some ways an application of the literature on incentivising central bankers to politicians. But given the increasing consumerism of politics, and involvement of the private sector in public services, performance-related pay for politicians has an irresistible attraction.

Football clubs use such financial incentives for players and management alike. But the ultimate incentive to do well is not getting the sack. Ruud Koning finding suggests that football managers are fired too often: on average, a sacking makes no significant difference to the team's results, although defensively the teams do seem to improve by conceding less goals. Koning concludes: 'Since it is not clear that the results on the field improve after a change of manager, it is likely that the board of a team intervenes for other reasons. It is likely that fan and media pressure are also strong determinants of the tenure of a football manager'. Which sounds almost like democracy.

EUROPE, BRITAIN AND THE EURO

'EMU is without the slightest doubt the biggest change in the international financial system since Bretton Woods' said Richard Portes of the CEPR.
Economists will bear an increasingly weighty burden, as the vexed issue of Britain's entry to the euro looms large. The decision to recommend entry is to be made on allegedly 'economic' grounds.
So it was no surprise that the European Central Bank's special session on monetary union after two years proved fascinating. Representatives from the Bank of England and those incessant ECB-watchers, the CEPR, supplemented the analysis. The session included analyses of the popular reasons for the euro's weakness against the dollar, explanations of the minutiae of the ECB's decision-making apparatus, and discussions about the efficacy of sterilised intervention, and Eastern European 'euroisation'.

Why is euro so weak?

Most of the speakers were sceptical about 'simplistic' explanations for euro weakness. 'Interest rate differentials, US growth rate, data on capital outflows, and the weak credibility story cannot explain this. The market doesn't act systematically,' says Richard Portes. Even innovative approaches, such as applying Kahneman-Tversky model of market psychology, or looking at the effect of the black market offer only a marginal explanation of the new currency's prolonged weakness.
'We have no idea what's caused the depreciation of euro, and the appreciation of the dollar,' said Charles Bean, the Bank of England's chief economist.

'The standard stories don't tell us everything. An interest rate story certainly doesn't.'
But what about the 'new economy' explanation of an underlying productivity differential?

'Expectation of future productivity growth in the tradable goods sector could lead to an appreciation today. But you have to believe that the productivity differentials are permanent - and as knowledge is free, you'd expect them to close over time,' said Bean.
And there's been too much uncriticised commentary in the press and in the City about the role of capital flows and foreign direct investment, he said, agreeing with Portes.

'There are counterpart financial flows and the impact on asset markets can be different from the same FDI flows,' argued Bean.
Both Bean and Portes agreed that explanations centred on 'mistrust of the ECB' don't stack up.
The consensus view appeared to be that economic theory could not explain the euro's weakness.

So is there an argument to intervene?

'Private speculation is the equivalent to an unannounced sterilised intervention. George Soros is the ultimate sterilised intervener - though he wouldn't appreciate being described as such,' said Portes, suggesting that intervention to prop the euro up could be justified.
Charles Bean was rather worried about applying work on private agents to the actions of a central bank. He said: 'Private decisions are often made on the basis of expectations, for example when market participants want to get out ahead of an expected depreciation.'
But intervention could be deemed appropriate on a portfolio management basis.
'If the ECB has excessive reserves the sensible time to run them down when euro is at a low time and on a point of turning,' said Bean.

Has the European Central Bank performed well, and how does it compare to the Bank of England?

The flowchart detailing how and when, central bankers, finance ministers, ECB officials, and the ECB governing council exercised influence over the Bank's interest rate decisions was fiendishly complex.
Alongside the description of the ECB's two pillars of monetary policy, it was difficult to escape the conclusion that its entire decision-making apparatus was rather unwieldy and unfathomable.
Having said that, Charles Bean argued that 'interest rate decisions have been pretty much spot on.'
In his eye, the ECB faced three key problems: a major regime shift, discontinuities in statistical information, and establishing credibility. The first and third of these problems were faced by the Bank of England when it gained operational independence in 1997.
But Bean outlined key differences between the two models - the elevation of monetary targeting to the status of a pillar, and the ECB's price stability target as opposed to the inflation-targeting Bank of England.
'I have some sympathy with the CEPR critics. It's perfectly possible to say that money may be an important indicator but there are lots of other indicators. There's a legitimate question as to whether you want to establish it to the status of a pillar - and there is a credibility question too,' he said.

Vitor Gaspar, the ECB speaker, defended that pillar because 'inflation in the medium is a monetary phenomenon'.
But Bean also contrasted the Bank of England's approach to inflation targeting with the ECB's price stability target.
'The lacuna in the ECB model is how the forecasts map into final decision is not as clear as it might be,' he said.
ECB staff produce two forecasts per year, in conjunction with national central banks. The Bank of England issues four inflation reports per year, and crucially, these forecasts are written by the decision makers.
'It's not just an input into the model, but an important communication tool. We're aiming to give a picture of how information is gathered together and feeds into decision making,' said Bean.
'If there is a weakness [in the ECB model] it's in how the inputs are translated into the outputs of decision-making.'

BUBBLE TROUBLE

Patrick Minford's combative appraisal of Macus Miller's paper on the 'Greenspan put' proved entertaining. Minford was not too convinced about the existence of 'irrational exuberance' in the stock market, and even less the notion that that Alan Greenspan's actions and decisions were questionable.
Miller's controversial thesis was that Alan Greenspan's monetary policy decisions have helped inflate a wide-ranging stock market bubble.
The idea is that investors in the United States have come to expect that the Federal Reserve will take decisive action to prevent the market from falling - but not to stop it rising: and they believe the intervention will succeed. So the Fed is apparently providing insurance against the possibility of a market crash.
The effect is like a put option, which protects investors against falling asset prices. But the reality is a bubble, because the put will not exist when it comes to be exercised. Key pieces of evidence for this hypothesis of a 'Greenspan put' are the actions taken by Mr Greenspan in alleviating the effects of the market crash of 1987 and in checking the market fall in the liquidity crunch of 1998. In both cases, he cut interest rates and pumped in liquidity.

Calibrating the model using a range of plausible parameters, Miller found that believing the Fed can prevent the market falling by more than 25% from its previous peak brings the observed risk premium down from 4.5% to about 2% even though underlying attitudes to risk are unchanged. Since the Fed cannot determine the real value of stocks, the resulting asset prices are not rational, so Miller's account involves over-optimism on the part of the average investor.

The central implication is that there will be a market crash when investors realise that Mr Greenspan is not superhuman. There is an alternative, however; a scenario where he gradually brings investors to their senses and the bubble subsides more slowly --- with the market 'moving sideways' for some time, for example. To avoid a crash and restore realistic valuations (by effectively unwinding the Greenspan put) is a delicate operation. 'Mr Greenspan will confirm his status as a great central banker if he can do it', Professor Miller concluded.

Having said that, it did appear that Professor Miller was encouraging an irrational exuberance of his own making. His American Express card number and details were unwittingly left pinned on the conference noticeboard for most of Tuesday evening. Was this some empirical test of the behavioural foundations of economics? Professor Miller's credit card statement was refreshingly free of illicit purchases of holidays and other luxury goods from the Internet.

DATA DEFICIENCIES

Prize for the best joke of the conference undoubtedly goes to James Heckman who had assumed that his Tuesday evening keynote address began at the same time as Monday's.
'The one piece of data I didn't look at was the programme,' he told a patient audience.
Statistical inadequacies came up as a recurring theme across the papers presented in Durham.
Richard Portes argued that analysis of EMU was being hampered by 'urgent data needs'. The ECB's Vitor Gaspar said that addressing this was 'an important priority for Eurostat', and that perhaps the CEPR wanted to help out.
Against this backdrop, it was fascinating to hear speakers from the Office for National Statistics' fascinating session of 'evidence-based policy'. Prabhat Vaze of the ONS explained a raft of new data that will soon be available, and that is tailored to emerging research requirements. So there are additional questions to be asked in household surveys, as well as changes to reflect the growth of e-commerce. The ONS is looking at different types of quality adjustment techniques - hedonics and options pricing - for more accurate productivity and inflation statistics.
And there could be an end in sight for the old anomaly that if one marries one's housekeeper; GDP falls (despite the housekeeper doing the same work as before the marriage). The ONS are developing a raft of household production statistics to supplement environmental and social accounts.
Elsewhere it's clear that economists are making uses of innovative internet-based data sources.
The elusive Simon Peters used data from a website where clients detail the price and quality of the services of prostitutes. By applying 'hedonic' quality-adjustments to the data, Peters showed the determinants of client satisfaction. He also calculated that the government could raise up to £250 million by taxing this industry.
This paper did not feature in the 'evidence-based policy' session.
In a similar vein, the Bank of England's representatives in Durham roundly ignored one piece of data. It was possible to buy a round in the Conference Bar for an all in charge of 25 pence. But Professor Nickell was not sprinting back to Threadneedle Street with tales of deflation. And Collingwood College bar certainly did not feature in the Monetary Policy Committee minutes.

POWER AND PRAGMATISM

Now to return to those opening comments. At the gala dinner your reporter stumbled on to a table with a gaggle of advisers from the Government Economics Service. They presumably returned to Whitehall with plenty of insights for 'evidence-based' policy-making. The long tentacles of microeconomics reached deep into educational reform. There was that study showing that institutional reform was a better determinant of academic performance than higher spending. Another quantified the effect of secondary school quality upon house prices.

And there were a number of papers that should have given ministers food for thought about policies already enacted. The government's abolition of tax credits was shown to have raised the cost of equity financed and reduced business investment. Student grants (abolished by Labour in the UK) raise attendance and completion rates at US universities, according to a study by Susan Dynarski. And the failure to legalise prostitution was calculated to have lost the Exchequer at least £250 million.

Such extreme pragmatism makes economics a language that government policy-makers listen to and make every effort to understand. At the dinner table one government economist said that one of the papers challenged a Whitehall orthodoxy on measuring changes to the labour market. This is why economists are assuming more power, and events such as Durham's conference are so important.

The clues were all there at last year's conference, where it was revealed that all ministers receive training in economics, and the pay scales for government economists are up. Perhaps this explains the Herculean power wielded by the Treasury. And perhaps the foot soldiers of this Treasury revolution are those Government economists.

ENDS

Faisal Islam
Faisal.islam@observer.co.uk

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