RES Conference Report

The Society’s Annual Conference took place this year at the University of Cambridge from 26th-28th March. This report was compiled by Sam Fleming, Economics Editor of The Times.

The ducks are back from their winter retreat, the daffodils are rampant, and punts filled with gaggles of Italian school children are gliding along the chilly river. It must be Cambridge in the springtime. But along with the city’s customary visitors, for three days in March the Backs teamed with flocks of a more exotic feather: economists, gathered for the Royal Economic Society’s annual conference.

Having tired the newspaper’s readers with several weeks of Budget coverage, I was eager to escape London and delve into realms of economics that the national media normally neglect. The RES conference certainly fits that bill: delegates packed into the conference rooms of Robinson and Clare colleges between March 26 and 28 were offered a smorgasbord of presentations ranging from local corruption and coal mining deaths in China, to the impact of cashless systems on free school meal take-up in Essex; from examinations of the impact of the 1918 Spanish flu epidemic, to the de-penalisation of cannabis in the London Borough of Lambeth.

Familiar themes also reared their heads: how do we get the UK growing again? What do we do about the transmission of sovereign debt shocks across the euro area? How do we regulate the banking system in the future? Conveying the full contents of a conference jammed with so much content is — needless to say — impossible. So my account offers a selective and highly biased account reflecting one journalist’s attempt to pick his way through scores of presentations and debates.

One feature that immediately became apparent scanning the programme on the first day was the Society’s pulling power. Delegates were able to listen to some of the super-heavyweights of the economics world, among them Kenneth Rogoff of Harvard, Lorenzo Bini Smaghi, lately of the European Central Bank’s executive committee, and Guillermo Calvo of Columbia University.

The three economists joined for one of the big set piece events of the conference, a debate in the West Road concert hall about the sovereign debt crisis. Bini Smaghi struck the most optimistic tone of the three, perhaps unsurprisingly given his recent position, as he argued that crises such as the one afflicting euroland are a painful but necessary force for change in democracies.

Progress in this case will require among other things a recognition that the region’s imbalances were driven by the private sector, rather than purely being a fiscal matter. One key vulnerability is that the region’s banking systems remain strongly national in nature. The contrast with the US is clear: if a state there goes bankrupt the banking system itself doesn’t go bankrupt as well, because there is no inextricable link between the lenders and the individual state itself. What is needed in euroland is a truly European banking system and resolution system — something that the region’s politicians have belatedly been coming round to in recent months.

A rather more gloomy Professor Rogoff dwelled on the classic critique of the euro — namely it has never been an optimal currency area — before comparing the situation to that of a couple who can’t decide whether to get married. They decide to open a joint account at the local bank, as a way of seeing how things would work out financially. Then they decide to bring in their siblings to share the account too, then cousins, and then second and third cousins they’ve never even met.

Eventually everyone begins to fall out, triggering a barrage of lawsuits. What do they do? The upshot is they have little choice but to get married, solemnizing their commitments in a far more tangible union, and that, according to Professor Rogoff, is what the euro needs to do now. The alternative — a break-up — is simply too painful and expensive to contemplate.

The growth and investment conundrum

Asked in the Q&A about the worries of the US, Professor Rogoff acknowledged that a debt default by the world’s biggest sovereign creditor would be great for sales of his and Carmen Reinhart’s book — This Time Is Different — but was unlikely to happen. One question in the meantime is to consider what damage uncertainty over how America will get to grips with its fiscal woes is doing to the real economy.

In the Hahn lecture, Nance L Stokey of the University of Chicago sketched out a simple model examining the damage that may be resulting. This looked at the impact of uncertainty over the potential for future tax rises, which prompts businesses to delay investment decisions.

A high degree of uncertainty about tax changes increases the option value of waiting to make investments, given they are expensive to reverse. When the uncertainty over tax is resolved, a boom results as companies eagerly pull projects off the shelf. The size of the boom will depend on the ultimate tax rate, with lower rates generating a bigger boom.

The goal is to build a model in which markets in the short term ‘dislike’ uncertainty. The concept could equally be applied to hiring decisions, or to consumers’ decisions on whether to buy a new house, as well as to uncertainty over future financial regulation or energy policy changes. Look at present-day US and the value is clear. Investment plunged in 2009 and has remained low since, despite the large cash surpluses of companies such as Apple.

Meanwhile US deficits have been rising, and the costs of social security and Medicare will only increase in the future as more baby boomers retire. The question marks over how the country’s swelling debt mountain will be tackled may well be short-circuiting an investment-led recovery.

Britain’s own investment outlook is also one of the big disappointments of recent history — and its own fiscal woes may well be part of the picture. A special session on the first day of the conference looked at ways of engineering a growth pickup.

This involved firstly drawing lessons from the Great Depression era. Nick Crafts of the University of Warwick told delegates that the growth strategy of the 1930s was initially driven by efforts to raise the price level, while fiscal policy was tightened. Fiscal policy only became Keynesian in the UK from the mid-1930s onwards, with expansion driven by re-armament. The Defence Loans Act in 1937, under which £400 million was borrowed over five years, may have had a significant effect on GDP, pointing to a high fiscal multiplier.

John Van Reenen, Director of the Centre for Economic Performance at the London School of Economics, looked at more recent history, arguing that the claim that Britain’s pre-2007 growth was all down to a finance boom was simplistic. The UK saw strong productivity growth, with improvements in a range of sectors including business services, distribution and manufacturing. This was thanks in part at least to continued reforms by the Labour government, not just a Thatcherite inheritance.

There are therefore reasons to take a more optimistic view of the evolution of productivity from here too, rather than assuming that massive capacity destruction has left little by way of an output gap. This could lead to the conclusion that there is room for more of a fiscal stimulus by the Government today. It is not, for instance, clear why more investment in schools and roads would terrify the bond markets.

The race to the bottom in tax

As it pursues its austerity agenda, the present Government’s reform efforts have focused on making Britain a more attractive destination for global enterprise – for example with plans to lower the Corporation Tax rate to 22 pence.

Another initiative is the so-called ‘Patent Box’ regime for innovative companies. A lucid presentation from Helen Miller of the Institute for Fiscal Studies left me in little doubt as to how wrongheaded the policy is. The measure (which originates from the last Labour government and has always been looked upon sceptically within the Treasury) will offer a reduced 10 per cent rate of corporation tax for income derived from patents, as Britain follows in the footsteps of Belgium, the Netherlands and Luxembourg.

The trouble with the scheme is that it is poorly targeted, being focused on the income from ideas, not the activity that generates the ideas, so that the research can be located separately from the income. There could of course be other benefits from having a patent filed in the UK, but the patent box structure does not guarantee that the innovation will necessarily happen here.

The research by Miller and her colleagues into firm behaviour shows that introducing a patent box does affect the likelihood of a country clinching more patent holdings, but revenue from that income is likely to fall sharply because the lower tax rate more than offsets the higher number of patents. The Treasury itself has estimated a £1.1 billion revenue loss from the policy.

That does not mean the patent box is bad news all round: a handful of companies are extremely heavy users of patents — including the UK’s top five filers Unilever, GlaxoSmithKline, BT Group, Rolls-Royce and QinetiQ. For some of them, this will no doubt prove to be an extremely welcome innovation.

Perhaps the regime will help convince them to keep some related research activities in Britain. The trouble, of course, is that the UK can’t patent the box itself: Even more countries may feel compelled to follow suit exacerbating the race to the bottom in the corporate tax system.

Crime and punishment

Government policy failures and successes loomed large in a fascinating session on the economics of crime, chaired by Stephen Machin of University College London. This is a growing field of empirical research examining issues such as the costs and benefits of partaking in crime and links with unemployment, wages, age and police practices.

Imran Rasul of University College London presented the results of an examination of the effects of the London Borough of Lambeth’s temporary and unilateral experiment with depenalising possession of small quantities of cannabis between 2001 and 2002. The policy was championed by local police commander Brian Paddick in the hopes that it would free up the police to deal with more serious forms of crime.

The research involved building a data set looking at crime rates for eight types of crime including drugs offenses between 1998 and 2006 spanning the London boroughs. To interpret the evidence, the researchers developed a hotelling-style model of two boroughs, emphasizing the importance of behavioural responses by the police, suppliers and consumers.

Paddick’s initiative didn’t have much of an effect immediately after it was introduced in July 2001. But six months after it began it was announced that it would be extended, and at that point there was a sharp, 18 per cent increase in cannabis possession offenses. The research suggests about half of this surge could be accounted for by individuals moving into Lambeth from neighbouring boroughs, perhaps in response to signals that suggested (wrongly) that the policy would be permanent.

The researchers found little evidence that the policy caused the police to tackle crimes involving harder, Class A drugs such as heroin, crack and cocaine, but there were long-run reductions in five non-drug types of crimes as police attention was diverted away from the world of narcotics.

A year after it was started the policy was reversed amid reports of increased drug tourism into Lambeth and children turning up for school under the influence. Did local people value the policy, however short-lived as it ended up being? The research shows that house prices within the area were 6 per cent lower than might have been expected, suggesting that people put disproportionate negative weight on the increase in cannabis-related crime — despite the concomitant decline in non-drugs offenses.

While the Lambeth research looked at the effect of relaxing the law, a presentation from Rodrigo Soares examined the result of prohibition. This research took us across the Atlantic to Brazil, where the government decided in the 1990s to heavily restrict and then, in 2001, to ban the trade in the rare tropical wood mahogany.

Few outside the furniture and forestry trade would object to the decision in principle: mahogany takes 30 years to mature and its production was doing terrible damage to the rainforests. But the policy was thinly policed and proved to be a disaster. While officially mahogany exports fell, there was an 1,800 per cent spike in exports of a miscellaneous category called ‘other tropical timber specie’ in a single month in 1999, pointing to rampant mis-classification by producers attempting to circumvent government restrictions.

Prohibition also appears to have led to higher deforestation, and, alarmingly, a rise in homicides in regions with a natural occurrence or trade in mahogany as the business was driven underground. From 1995 to 2007, the effect for the state of Para, centre for production of the wood, added up to 1,998 additional deaths due to illegal mahogany activity.

This underscores the dangers of implementing loosely enforced prohibition, which may lead to high levels of illegal activity and violence. When agents operating in illegal markets cannot resort to the regular system of justice to uphold agreements and seek protection from competitors, the result can be violence. As Mr Soares put it, ‘the medicine is much worse than the disease.’ The potential lessons for other countries, including the US with its heavy-handed ‘war on drugs’ are clear to see.

Frontier economics

One of the more newfangled niches in economics goes by the clodhopping name ‘macroprudential regulation’. The Bank of England is trying to establish itself as one of the leading exponents, championing the use of ‘macropru’ via its new Financial Policy Committee in the hopes of preventing a re-run of the banking crash of 2007-09.

The problem is that while the merits of crisis-prevention tools are obvious, the theoretical underpinnings for this branch of central banking are at the seedling stage. To help address that problem, the Bank of England sponsored a session on the final day of the conference to examine the academic state of play.

Javier Suarez of CEMFI led the charge with a discussion of research into the calibration of capital requirements imposed on banks. These may well reduce credit and output in normal times, but they also reduce banks’ systemic risk-taking and therefore the losses caused by systemic shocks.

Getting the requirements right is clearly a hugely complex problem. Suarez’s research with David Martinez-Miera of Universidad Carlos III examines risk-taking in a simple dynamic general equilibrium model. Under their model, optimal capital requirements are quite high, at 14 per cent, and do not need much cyclical adjustment.

Such high capital requirements may well have a sizeable negative impact on GDP, but that is just one yardstick. The social welfare gain from having a 14 per cent requirement rather than 7 per cent is equivalent to a perpetual increase of 0.9 per cent in aggregate net consumption. To account for transitional costs, higher capital requirements should be introduced gradually, according to Suarez.

Charles Goodhart, emeritus professor at the London School of Economics and part-time sheep farmer, followed. Humans, he argued in an entertaining lecture, are rather similar to sheep: they have a tendency to follow a path for no particular reason, and once they are on it they will carry on even if it was not well chosen. That is what regulators did when they set capital ratios under the Basel I and II capital accords. There was no theoretical underpinning for the ratios they demanded at all, nor was there any discussion of sanctions or penalties. But the regulators still gamely plodded along that same path for years.

The world has moved on, having recognized the inadequacy of the old Basel regime, and Basel III has been born. Prof Goodhart argues there is still work to be done. In his view there should be two capital ratios, with a sliding scale of sanctions. The lower ratio would be the point where a bank becomes too dangerous to continue and needs to be taken over. The higher one is a form of holiness— something to which we should all aspire, while accepting we inevitably fall short from time to time. We may want banks to hold a much higher level of capital in general, but we can’t expect them to hold it at all times, Prof Goodhart observes.

Basel III has taken a useful step in the right direction by setting a Conservation Range when the equity ratio falls below 7 per cent but above 4.5 per cent, but Prof Goodhart argues that 7 per cent is too low, while the 4.5 per cent minimum is too high. He also argues that a more sophisticated ladder of sanctions is needed, potentially including Pigovian taxes.

Young talent

Alongside veterans such as Prof Goodhart, the conference was populated with dozens of up-and-coming economists vying for delegates’ attention. In a session called Young Talent, Dutch economist Vincent Sterk put forward research into the impact of house price declines on geographic mobility. A decline in home equity reduces the funds available to homeowners for deposits on new houses, and if the homeowner is in negative equity funds will be needed to pay off the existing home loan. The result is that unemployed homeowners may turn down job offers that require them to move, leading to a higher unemployment rate.

In a separate session exploring African growth and development, two compelling presentations examined the long shadow cast by slavery. The first of these, by Luis Angeles of the University of Glasgow, discussed why Europeans made Africa such a massive exporter of slaves to the Americas, with 12.5 million people displaced by the barbaric trade. The answer, he said, is in part the high price technologically advanced Europeans were able to offer for slaves. On top of this, it was relatively cheap to obtain slaves within the continent: enslaving your people was taboo, but Africa’s cultural fragmentation meant raiders did not have to go far to find villagers from a different background whom they could seize.

Such was the interest in the Africa presentations that it was standing room only in the stuffy little seminar room. Indeed, while previous writers have complained about a large number of nearly empty sessions in past conferences. I found little evidence of this in March. Maybe I was lucky in my choice of presentations, but all of the sessions I attended were both engaging and amply populated — despite the sunny spring sunshine tempting us to decamp to the Backs.

From issue no. 158, July 2012, pp.7-9.

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