RES Annual Conference - 2010

The Society’s Annual Conference was held this year at the University of Surrey, from 29th to31st March. John O’Sullivan of the Economist prepared this report.

The University of Surrey hosted the annual Royal Economic Society conference for a second successive year in 2010. In addition to the 70 or so general sessions devoted to a range of subjects, from health economics to charitable giving, the conference offered three lectures, as well as three special sessions, where delegates had to choose between four separate (and equally enticing) seminars. What follows is an account of some of the big set-piece lectures and sessions to give a flavour of the conference.

Many of the conference events focused on issues relating to the global financial crisis. But one of the most interesting seminars was devoted to ‘The Economics of Criminal Behaviour’. The session, organised by Steve Machin of UCL, teased out two of the big themes in the economics of crime: deterrence (what it is that prevents crime?) and incentives (what it is that makes for law-abiding citizens?).

To start, Philip Cook of Duke University unveiled a study of Business Improvement Districts (BIDs) in Los Angeles. BIDs are not-for-profit bodies that provide services, such as private security guards and sanitation, on behalf of local firms. These are public goods that are supplied privately. The trick is to get the beneficiaries to pay for them. A change to Californian law in the 1990s addressed this problem by forcing all businesses to join a collective scheme if enough local firms had signed up to it.

The study compares crime rates in 30 BIDs set up after 1995 with those in neighbouring districts. Each $10,000 spent by an average BID resulted in 3.4 fewer crimes per year. To work out whether this was money well spent, a cash value was put on each crime prevented. People were asked whether they would vote for a scheme that reduced a particular crime by 10 per cent at a particular cost in tax dollars (the range of ‘offers’ varied from $25 to $225). The responses were used to assign a social cost to different crimes. The results suggested that every $10,000 spent by the average BID bought some $200,000-worth of crime prevention.

A 20:1 benefit-to-cost ratio is impressive-a ‘slam dunk’ in the words of Prof Cook. It seems clear that private security is good value for society as a whole. So good, in fact, that it might be that some of the costs were missed by the study. Perhaps crime was not stamped out but merely shifted elsewhere. Or perhaps BIDs work so well because they draw on extra support from the police. In fact, establishing a BID leads to fewer arrests and so reduces the cost of policing. Nor is there evidence that crime increases in neighbouring districts. If anything, crime nearby falls.

Why is private security apparently so cost-effective? One reason is simply that guards are paid less than police officers. Another is they are dedicated to a single district and are directly responsible for making it safe. Guards can specialise. They know which shifty characters to look out for and which policing works best in their area. Unlike policemen, they are not called away to supervise a parade or protect a dignitary.

The research shows how effective ‘target hardening’ (ie, self-protection against crime) can be. In a similar vein, a paper presented by Ben Vollaard of Tilburg University argued that newly built homes are harder to burgle. Homes put up after a change in the Dutch building code in 1999 were 26 per cent less likely to be broken into than those built beforehand. To comply with the code, builders had to fit high-quality locks and burglar-proof windows and doors. They may only delay a break-in by three minutes but ‘three minutes is an eternity in burglar time’, said Prof Vollaard. Is this a cost-effective policy? The estimated costs of complying with the code are $430 per home. The benefits are only a little higher at $460. But there is a big dead-weight loss: the code reduces a risk that is already fairly low and it does so in a crude way.

Are there ways to prevent people from becoming criminals in the first place? There is plenty of evidence that links a lack of education with criminal behaviour. Studies of America’s jail population in the 1990s showed that most inmates had not finished high school. But few studies have established that less education is a cause of crime.

A third paper, presented by Olivier Marie of Maastricht University, uses a clever instrument to find a causal link between low education and crime. The paper’s authors looked at the crime rates of a cohort of British school-leavers, some of whom were forced to stay in school for longer because of a legal change to the school-leaving age. This group was less likely to engage in criminal behaviour than an earlier cohort. One year of extra education reduces property crimes by 1-2 per cent. What is more, the cost of the extra schooling is outweighed by the benefits of reduced crime.

The Economic Journal lecture
This year’s Economic Journal lecture was given by Carmen Reinhart of Maryland University, co-author (with Harvard’s Kenneth Rogoff) of This Time is Different, a widely-cited history of financial crises. Her lecture was based on work with Prof Rogoff that finds a common pattern in history and across countries: large increases in private debt burdens are followed by banking crises and then by sovereign defaults.

The conference organisers made the most of Professor Reinhart’s presence. She gave a second presentation, with husband Vincent Reinhart at a session on ‘International Capital Flows’, organised by Hélène Rey of London Business School.

Some economists believe that the deeper cause of the global financial crisis of 2007-09 was ‘global imbalances’ — the pattern of large and persistent current-account deficits in America, Spain, Britain and some other rich countries, matched by surpluses elsewhere, notably in emerging Asia, but also in Germany and Japan. The Reinharts' paper looks back over history and finds that big external deficits — what they call ‘capital-flow bonanzas’ — usually spell trouble.

Mr Reinhart likened the issue of payments imbalances to the scene in the funhouse at the end of a 1940s film noir. What seems real depends on where you are looking from. A country’s current-account deficit is its capital-account surplus. It is also someone else’s current-account surplus. He defined a capital-flow bonanza as a current-account balance in the bottom fifth of the distribution as a percentage of GDP. The really big payments deficits (or capital-flow surpluses) tend to occur in low-income countries.

Bonanzas are clustered: there are many countries that have them at the same time. We’ve just been through such an episode, said Mr Reinhart. There was a smaller bonanza cluster in the run-up to the East Asian crisis in 1997-98. The last really big one was in the early 1980s just before the Latin American crisis. A typical bonanza lasts 2-4 years. The biggest predictor of bonanzas is low real US interest rates in the four or five years prior. Mr Reinhart did not openly blame the Federal Reserve’s low-interest rate policy in 2001-03 for the financial crisis we have just lived through but the implication seemed plain.

Carmen Reinhart set out the study’s results, which showed that the ‘maturing’ phase of a bonanza increases the probability of crises-bank failures, a collapsing currency and so on. Bonanzas bolster government finances, at least for a while. Policymakers believe they are geniuses: they receive bumper tax revenues and then extrapolate these into the future. Then the revenues suddenly disappear. This historical pattern fits with the recent experience of Spain and Ireland, noted Mr Reinhart. These countries whose public finances looked strong until the crisis hit and are now struggling with huge budget deficits.

Next up, James Feyrer of Dartmouth College addressed another issue related to global imbalances: what happens to global savings when one big country saves more? One motivation for the research was Ben Bernanke’s idea that America’s run of large current-account deficits was a response to a global ‘savings glut’. To test this idea, Prof Feyrer examined the global response to fiscal shocks in America, and asked the question: when US fiscal policy changes, where does the money go?

There are three possible responses to such a shift. Private savings might change in the opposite direction to public savings — what Prof Feyrer called ‘hard Ricardian equivalence’; or private investment is crowded out (or in) by bigger (smaller) budget deficits; or the shift in the budget balance is reflected in the current account balance.

The results support the idea that a saving glut in one part of the world can crowd in investment elsewhere. Each dollar change in public savings induces a 17-cent change in US investment and a 37-cent change in private savings. So there is clearly some Ricardian equivalence: a tax cut would lead to higher savings in the expectation of future tax increase. But it is also true that if America saves more then other countries respond by saving less. A change to the fiscal balance changes the current-account balance by 46 cents. Overall, there is a roughly symmetrical crowding in of investment in the rest of the world when US taxes rise: about half of the tax savings get transmitted abroad. The net effect is an increase in world savings.

The Frank Hahn lecture
Two of the big set-piece lectures at the conference drew on theory rather than empirical research. Robert Hall of Stanford University gave the Frank Hahn Lecture. The subject of his paper was the impact of financial frictions on economic activity. This work built upon his previous research on tax frictions. The financial sort work in a similar way. Taxes are a ‘wedge’ between employers’ costs and workers’ take-home pay. Financial frictions are the gap between what borrowers pay and savers receive.

A well-capitalised financial system, said Prof Hall, is largely free of such frictions. The essence of the financial crisis was a loss of faith in assets that were backed by real estate of uncertain worth. That uncertainty introduced financial frictions. Banks were holders of these dubious assets and general concerns about their solvency raised the cost of credit within the banking system. The real-economy effects of these frictions were so large because credit is needed to finance big-ticket spending. Recessions are driven by falling spending on goods that yield a service over a long period-consumer durables, housing, machinery, and so on. The rest of GDP is unaffected.

Prof Hall set out a model of how financial frictions raise the cost of investment and then of output and produce ‘a scaling down of the economy’. His approach helps explain why conventional monetary policy was powerless. Cuts in policy rates had little impact affect on the interest rates paid by private borrowers-indeed they rose. ‘The notion that interest rates function to cushion shocks fell down in this crisis’ said the author. By and large, low interest rates were not transmitted to private borrowers.

How much of the increase in borrowing costs reflected an increase in default probability — which is not a friction but a rightful benefit to lenders — is hard to say. Prof Hall also conceded that his model helps explain the size of the economic shock but not its persistence. Credit spreads in America are now closer to more normal levels but the unemployment rate is much higher than its pre-crisis level.

The Denis Sargan lecture
In his Denis Sargan Lecture Jean-Marc Robin, of UCL and Sciences Po, Paris, set out a theoretical model that seeks to explain why shocks lead to such volatility in unemployment. His answer is that differences in workers' abilities act to amplify the initial disturbance. His model can also explain another labour-market phenomenon: the increase in wage inequality in downturns, ie why wages at both tails of the distribution vary with business cycle more than median wages do.

In the Robin model, all firms are identical but the productivity of workers varies. Workers and firms are paired to form productive units. These matches form or break at the start of each period and depend on the state of the economy-more precisely whether it has just endured a positive or negative productivity shock. Each match generates a surplus in excess of what firms/worker could achieve separately. When the surplus turns negative (because of a fall in aggregate productivity), workers are laid off . A fraction of layoffs are matched with a new employer after a fresh wage bargain. There are only two possible negotiated wages: ‘starting wages’ (after leaving unemployment) and ‘promotion wages’ (in the event of a jump in productivity).

Prof Robin showed that his model could generate results that fit reasonably well with the business-cycle variations in unemployment and wage dispersion. A fall in aggregate productivity need only make a small share of workers unprofitable for the shock to generate a fairly big increase in unemployment. What is more, high and low earners are more likely to see their wages adjust to changes in business conditions. High earners are more likely than average to become unprofitable when the economy turns down. Low earners are more profitable than average when the economy recovers. At all times, median wages are likely to be best matched to business conditions.

‘The Crisis and Developing Countries’ was the theme of a session organised by Nauro Campos of Brunel University with three well-known speakers. To start, Professor Alan Winters of the University of Sussex assessed how well recent trends sit with our understanding of the main drivers of migration. The archetypal migration crisis is the 1840s potato famine in Ireland. Rapid growth in Ireland’s population growth went sharply into reverse following the famine, partly because of outward migration. This episode gave rise to the idea that migration responds readily to sudden changes in economic conditions. In fact, migration is a long-run phenomenon. Migrants move if they have well-established networks abroad. This was true for post-famine Ireland.

Indeed there is a weak relationship between GDP growth and outward migration. Nor is there much evidence of large-scale reversals in migration due to recession in host countries (though there are exceptions). Migrants tend to stick around and are hit hardest by recession. The rise in unemployment rates in the recent downturn was greater for foreign-born workers than for indigenous workers. That effect is only partly explained by the collapse in construction industries (much of the building work during the housing booms in America, Britain and Spain was done by migrants).

If migrants are not pushed abroad by a feeble economy, are they pulled by a strong one? Here the evidence is more visible. Prof Walters noted some link between the strength of the US economy and the flow of migrants, as measured by migration rates from the source country.

There have been some extra restrictions introduced on migrants since the crisis broke, said the author. For instance, Russia has halved the number of work permits for immigrants. Australia has cut the quota for skilled migrants, as has Spain and (in an indirect way) Britain. In Asia, there have been tighter immigration policies in South Korea, Thailand and Malaysia. For all that, there is no strong evidence of broader backlash. Where there has been tighter immigration policy, it is often a continuation of a trend that started before the crisis.

By and large, developing economies suffered less in the crisis than rich ones. One consequence of this relative resilience is that firm have become more keenly interested in investing in emerging markets. Saul Estrin of the London School of Economics noted an important milestone: in 2009, foreign direct investment from rich to poor countries overtook that between rich countries, when measured in dollar terms. Prof Estrin described some of the (mostly positive) implications of this.

He first set out some stylised facts about corporate governance and industry structure in developing countries. First, the costs of monitoring firms' managers are even higher than in rich countries because enforcing contracts in courts is expensive. One response to this problem is a concentration in ownership. A second problem is that poorly developed capital markets mean it is hard to diversify risk. That is why conglomerates (where one firm spreads its operations and risk across a range of industries) are common. A third feature is lots of foreign ownership of firms-a channel by which new technology flows from rich countries.

Foreign ownership is also an important route to better corporate governance, argued Prof Estrin. His research shows that sales of state assets to foreign owners raises the efficiency of firms by more than sales to domestic owners does. Foreign ownership is best though domestic private ownership is improving. Contrary to some claims, privatisation programmes in developing countries have not failed but they work best where there is foreign investment.

The role of foreign ownership was a theme picked up by Thorsten Beck, who talked about the agenda for financial reform in sub-Saharan Africa. The region has a high share of foreign-owned banks, with investment often coming from richer African countries or from China. This carries risks but there is little alternative in most low-income countries. Finance is needed to spur economic growth but local banking is expensive. That is in part because African banks lack scale. It also reflects a lack of competition. Financial exclusion is widespread.

The financial crisis had little direct impact on African banks. They did not hold ‘toxic’ foreign securities of dubious value (since there were profitable loans to be made at home). There are few debt-laden households because most bank lending in Africa is to enterprises. And the linkages between troubled banks and the rest of the banking system are generally weak. The links with rich-country bank are tenuous, too.

That means the regulatory challenges in low-income countries are very different to those in the developed world. The G20 group of mostly-rich nations is wary of cross-border banking (it is harder to bail out or wind up failing banks when they operate in many countries). But in Africa, any restriction of foreign banks only reinforces rent-seeking and political capture in the financial sector. Scams are a bigger worry than derivatives so consumer protection is a more pressing issue than financial regulations.

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