Sunday, 5 August 2007

No Such Thing As a Free Lunch

Here is what was thought could well appear in the:

Economics Tripos 2008: Economic principles and problems.

1. Should pensions be regarded as a civil right (perhaps subject to employment record) or be determined by the return on a pensioner's past contributions to the pension system?

2. 'Globalisation destroys the very possibility of a domestic economic policy.' Discuss.

3. 'All that counts is the level and growth of national income; distribution can take care of itself '.
What is your response to this statement?

4. 'The market for financial derivatives has no beneficial role in the allocation of resources; it is a pre-announced catastrophe.' Discuss.

5. Consider the case for the repatriation of immigrants with reference to:
i Scottish politicians
ii Polish plumbers
iii those fleeing from hunger and torture.

6. Discuss the proposition that public private partnerships combine the worst possible features of both public and private enterprise and ownership.

7. 'The principle of central bank independence has neither theoretical nor empirical support.' Discuss

8. 'Corporate ethics is an oxymoron, as is market socialism.' Discuss.

9. 'Immigrants' benefits should be regulated by the principle of reciprocity. Migrants should enjoy benefits no higher than those enjoyed by receiving -state nationals migrating to their country of origin.' Discuss with reference to immigration into the United Kingdom from one developed and one emerging economy.

10. You have been appointed Chief Economic Advisor to the Hungarian government. What year, if ever, would you recommend the country should join the Euro, and why?

11. Why was the transition from central planning to the market economy marred - in central eastern Europe - by devastating recession, while China and Vietnam thrived throughout the same process?

12. The welfare state was killed by moral hazard. Illustrate this proposition either - by use of a mathematical model, or - with reference to a west European economy.


Nick Drew said...

I'll take you on 4

hatfield girl said...

Half an hour while I get the dinner on, ND. Back in a mo.

hatfield girl said...

Derivatives do not have goods or services or productive factors as an object but are bets on the price of the above and bets on the price of other derivatives.

The bettor does not have to put up his stake and the bookie doesn't have to commit resources geared to his potential liabilities.

To date the market has been confronted with only minor crises, but the increasing size of the derivatives market and the increased leverage exercised by market operators, the lack of transparency, e.g. operators liabilities in the event of closing their positions vary from minute to minute, and are not known to shareholders (and are easily concealed in balance sheets) is unnerving.

The diffusion of this kind of 'betting fever' now contaminates even formerly respectable operators such as pension funds and insurance companies. Pensions could well not be paid, insurance liabilities to the insured not met (and think of the fields that covers).

Betting on interest rates, prices of commodities, value of bonds and shares, and then betting on the value of bets and so on like the picture on the Quaker Oats box needs consideration.

Equating demand and supply, substituting efficient for less efficient producers and products has no place here. This is Keynes's casino writ large and we are playing without the zero, but with no guarantee of payment of winnings either.

There's an awful lot of weight on the gamblers knowing what they are doing ND. We could end up with a credit crisis, cruel deflation, a collapse in demand, or if central banks imprudently act to bail out those exposed, horrifying levels of inflation.

The managing director of the IMF, De Rato is on my side and, with a few figures I can't look up now as I'm doing the dinner, I'd expect a 2:1.

For dinner I am preparing aubergine casserole, served with pork escalopes char-grilled with ginger and small green peppers (the piquante kind) and garlic, greenery from the kitchen garden, iced fruit, (peaches and nuns' thighs), and a local Serristori chianti.

Scroblene said...

Q. One is an absolute bastard HG.

There's a huge amount of spin coming out on pensions at the moment, and you are right to ask now.

The pain for millions is only a little prick at the moment, and he's only been in the job a few weeks!

hatfield girl said...

Yes, Scrobs, pensions. Got to set the table, back in a mo.

I have opened the Serristori to try, this may not have been a good plan.

Hope hand is not hurting you?

David Farrer said...

1. The second.
2. Hopefully yes.
3. All that counts is that economic (and other) interactions be voluntary.
4. A catastrophe when politicians get involved.
5. I'm Scottish - we don't want Gordon Brown back. Why do you think we sent him down there?
6. "Public enterprise". LOL
7. That's why I've invested in gold.
8. "Ethics" are for individuals. "Market socialism" is an oxymoron.
9. All "benefits" should be earned in the marketplace.
10. 1956. Best get all the bad news out of the way in one go.
11. Chinese universities are stuffed with the works of Ludwig Von Mises.
12. A is A

Caronte said...

Yes, Scrobs, One is an absolute bastard. But only because of its political implications, which are dynamite, otherwise it's very easy to answer.

A system whereby decent living pensions to the aged are paid, as of right and regardless of their employment record, out of the pension contributions of those currently employed, is perfectly feasible - under some circumstances. True, such a scheme resembles one of pyramid banking, a "Ponzi scheme" in which interest is paid out of new deposits, until these dry out and withdrawals begin, and the system collapses. But in this kind of pension system there are always new depositors (those currently employed), while withdrawals are delayed to retirement age and slow thereafter. As long as the number of current employees time their pension contribution is no less than the number of pensioners time their pension, the system can run and run indefinitely without going bust. If we do the accounts properly there is a hidden item of government debt which is the present value of future unfunded pensions of those in current employment, but the day of reckoning - as long as those conditions are satisfied - never comes. Such is the beauty of what is variously called Pay As You Go (PAYG), defined benefits, re-distribution system.

The trouble is that in the last decades life expectancy has increased dramatically everywhere while pensionable age has not. Systems of this kind that used to be perfectly viable now need an increasing government subsidy in order to stay viable. Or you need to raise pension contributions,and/or raise pensionable age, and/or reduce pensions. Otherwise - as the Russians used to say in their painful transition that hit old age pensioners hard - First You Pay Then You Go.

So here comes the Defined Contributions, Fully Funded, Accumulation, alternative pension system. In which you know what you put in, indeed take your pick among pension funds, and you draw out at will sums not exceeding the current value of what you have put in in the course of your employment. Advantages: 1) viability; 2) choice; 3) flexibility (you retire when you like and choose the time pattern of payments); 4) Faster development of financial markets. Disadvantages: 1) risk (what if your pension fund has invested in dot.coms?); 2) probable cost of claims on government subsidies in case of system failure; 3) the unnecessary, large scale cost of moving from PAYG to a fully funded system, which makes an item of public debt, forever submerged, raise to the surface for attention and service.

A better alternative to the second system is one in which the government continues to fund old age pensions out of the pension contributions by current employees, but credits them with their contributions and rewards them AS IF they had been invested in funds of their choice, simply mimicking the functioning of a fully funded system. The pension debt, or quasi-debt, stays submerged.

There is no ideal pension system. Take your pick - according to your age, current entitlement, expectations, including your probably inflated belief of your ability to invest wisely your own pension contributions. There is only a way - as indicated above - of making less painful the transition from PAYG to Fully Funded.

OR: Help the Government! Kill an Old Age Pensioner!

hatfield girl said...

DF, 5? that's outrageous.

hatfield girl said...

Caronts, I think of the nasty bugs in the NHS and I tremble.

Sackerson said...

HG: excellent paper, this should run and run. Not much time at the moment, but here's a start for my answer to 1:

If you don't have a universal basic pension, but are not prepared to see anybody be REALLY poor, you'll have a mean-tested pension, which makes fools of those who saved money for their retirement. We're part way into this situation with Brown's ludicrous Pension Credit and Pension Savings Credit (the latter being effectively a 40% rate of tax on low income).

So: instead, a universal basic pension at whatever level is to be regrded as a decent minimum; no downward adjustment to it if you have additional pension income; abolish the Age Allowance and treat pensioner taxpayers the same as anyone else.

HG, you've opened up, not a battle, but a multi-theatre war here. We may have to cut this into a number of strands.

Steven_L said...

Cool questions. I would fret if those came up in an a proper exam as I've never studies economics. But seen as it's a blog I'll have a go.

1) Both, I'm not in favour of letting old folk starve to death, nor am I in favour of discouraging saving.

2) No, whereas George W has bought some nice guns with the US's borrowed money, our troops have a shortage of nice guns and body armour whilst we have an over-supply of quangocrats, bureacrats, regulators and people employed by the state to lecture us into buying 'fairtrade' coffee. Globalisation did not force the UK to borrow so much money or to expand the size of the state.

3) Not true, distribution is affected by regulation, regulation cannot take care of itself, it requires politics and democracy.

4) I don't know, but it scares me that the B of E will have to weigh up this whole credit crunch vs. inflation thing. They never gave a stuff about the affordability of housing, why shuld they care about people who bought too many credit derivatives?

i) Scots/Welsh/NI MP's hould not vote on devolved issues.
ii) I'm an 'undecided' on EU membership.
iii) I liked Michael Howard's idea that we actually go to places like Darfur and take in our share of refugees, shaming the French keep their share.

6) I hink it does, private greed without the need to be competitive or attract abnd retain customers and public maladministration of money.

7) Theoretical, no, because government sets targets. Empirical, no, because the B of E lowered interest rates before the 2005 election when they should have raised them a quarter point.

8) Corporate ethics is not an oxymoron, in a free market business must match the wants of it's customers, these might include ethical considerations. Market socialism is, socialism is a one party, one-view, pro-centrally planned economy way of looking at things.

9) No, immigartion should be regulated more by potential. The Equalities Review is a useful pointer as to which ethnic groups are the most economically useful. Benefits, execept for the disabled, should be contribution based.

10) I haven't the foggiest. I'd ask them 'Do you want German interest rates in return for not being vuilnerable to some bastard short-selling your currency'?

11) I blame Russia.

12) The welfare state is not dead, it flourishes, it's bigger than ever. We need social reform.

Newmania said...

On 8 Corporate ethics are no more absurd than the ethics of any other group and better than nations as corporations cannot exist except within a climate of honesty between them and others . Market Socialism is based on the idea of Market failure and to deny that it exists at all seems to me to be over egging the pudding. So I think the implied conclusion here is wrong and stems from abstracting s=econiomics from its social and necessarily moral framework. The perfection of the market is a similar un-warranted abstraction

Good one HG

Sabretache said...

Item 4.

I think the 'derivatives' issue is nowhere near as simple as the populist doomsayers paint it. Yep, the big numbers look scary, but that's where the simplicity ends. Derivatives trading is essentially a zero-sum game; one party's gain is his counterparty's loss with the gain contingent on counterparty ability to pay out and remain solvent. The only wider economy double entry is the premium/commission/spread involved in transaction execution. So, the real risk is not in the total notional value of derivatives open interest, but the leverage with which those positions are held - anywhere between 10 - 200 times. However, on the plus side, a high (but admittedly unknown) proportion of the speculative counterparty OI is held by professional marker makers whose primary business is profiting from the spread and whose exposure therefore fluctuates essentially around zero.

I do agree with your 'betting fever' assertion though. At the retail level it is typified by those 'City Index' adverts on Bloomberg and CNBC: Cue husky coquetish female voice with the question: "Which is smarter - investing a pound to make 10p or 10p to make a pound? or "With City Index you could be up when the market is down". The possibility of investing 10p to LOSE a pound or being down when the market is up? - forget it - you're a smart investor aren't you?

The systemic risk, such as it is, is not in the derivative contracts themselves, many of which can be very useful indeed, but in the leverage available - and used - to trade them.



So, the real risk is not in the total notional value of derivatives open interest, but the leverage with which those positions are held - anywhere between 10 - 200 times. However, on the plus side, a high (but admittedly unknown) proportion of the speculative counterparty OI is held by professional marker makers whose primary business is profiting from the spread and whose exposure therefore fluctuates essentially around zero.

Could you please help me/us by explaining the second sentence? The first indicates that people are betting with money they don't have - could you say a bit more fully and/or simply how the second sentence qualifies that?

Scroblene said...


You know your stuff!

I have to admit that I started our risk in a new business, very late, but reckon to have our dues when I'm around 65.

Risk only gets paid for after the worry, but I'm old enough to do this I think.

There is a downside, i.e. no cash splash now, and I'm utterly pissed off with the way banks/insurance cos/ etc are treating people like me.

So I've changed.

If I'm wrong, - sod it!

If I'm right, I'll buy big drinks for people like you and enjoy your company!!!

HG - You're invited as well so keep a date in 2010 free for a big pissup!

CityUnslicker said...

Phew, if I answered all of these in depth it would be time for me to retire.

Re BoE independence. There are hundreds of academic papers which suggest an independent bank makes better long term interest rate decisions.

It really is quite obvious that removing the political decision making from this market process is a public good. No more reductions just before elections etc.

As for empirical evidence, we have had only one slight downtrun since 1997; and this is with a Labour government in power who historically put us into deep recessions within months of getting the keys to no 11.

However, the devil is in the detail and the mandate under which the Bank runs will always be a subject for debate. Currently it seems clear that the use of CPI rather than RPIX means we are over-heating our economy for not good reason. The CPI was drwan up in order that we could join the Euro after all.

Central Bank independece is a public good overall; but not a panacea for a countries economy that has other pressing issues (like immigration, globalisation and rampant government spending)

Nick Drew said...

"The market for financial derivatives has no beneficial role in the allocation of resources"

Dinner sounded excellent, you have your priorites right. But a 2:1 ? Sorry, not this time, I am with Sabretache here.

"Derivatives do not have goods or services or productive factors as an object but are bets on the price of the above ... Equating demand and supply, substituting efficient for less efficient producers and products has no place here"

This is v wrong. Farmers et al rely on derivatives, either directly or indirectly. They know that prices are prone to fluctuate & that's the only reason they need for wanting to hedge (close parallels with insurance & I'm sure you know the Churchill quotation).

A liquid market in hedges can of course be used by others to bet, but a healthy range of contrarian views are vital and they provide liquidity. Still others are, as 'Tache says, market-makers. Betting is only one motivation, and even then, why not? if someone truly believes they have the better understanding of the market.

For technical reasons it is not possible to have a sustainable competitive market in a commodity unless there is a viable forward / futures market in that commodity. We do need competitive markets - in agriculturals, oil, gas, electricity, metals etc etc.

Risk should migrate to those best able to manage it (or in some circunstances, to bear it). Price-signals are required for this. An active market in hedges is a marketplace for rational allocation of risk.

So it is most certainly about the efficient allocation of resources: bold typeface cannot emphasise this enough.

Of course adroit market regulation is appropriate: and widows'n'orphans shouldn't get involved - unless they are farmers !!

hatfield girl said...

C.U. As you well know you have to answer 4 in three hours; 1 down, 3 to go. No wonder undergraduates should be young, the rest of us couldn't take the pace, we're out of training. How older people manage university examinations puzzles me. The level and range of these questions is about right, possibly avoiding the duller stuff, with help from the table. It was, as always, agreed that it's harder to set them than to answer them. Why ever should anyone have called it the dismal science though?

I like DF's answer to 2 on globalisation 'Hopefully yes".

Scrobs and Caronte have given pensions the what for.

For someone claiming to be a non-economist Stephen I is giving some sophisticated instant reactions. Are you sure S_I? Not even a bit of study, ever?

And Newmania, expected Blue in tooth and claw turns in, yet again, a thoughtful measured response and underlines 'abstracting s=econiomics from its social and necessarily moral framework. The perfection of the market is a similar un-warranted abstraction. That's a First

Going to think about the rest after tea.


Nick & HG: On derivatives - Richard Bookstaber (please see my blog's summary/abstract at ) recently explained that for derivatives to work as intended, the market must be liquid and efficient, but in a crisis can turn out to be neither.

hatfield girl said...

Galbraith, on financial crises, says there are two ingredients: leverage and expectations.

Speaking as a farmer (my latest and newest manifestation) I cannot believe that I need to gamble on the price of olive oil using a times 200 margin. That kind of leverage is a well-known, essential ingredient of market catastrophe - from tulips to the South Seas to Enron; times 200 leverage needed for market efficiency is not going to go well with the Archers.

On central bank independence (7) no co-ordination between a cenral bank and an equally independent chancellor of the exchequer costs the UK public more than they should be prepared to pay:
higher interest rates; higher exchange rates; lower competitiveness internationally; less employment via lower net exports and investment. All of this could be avoided, and we didn't even join the Euro.

Caronte said...

Scrobs, thanks for your support on pensions. I look forward to your party in 2010 (God willing), I have great respect for entrepreneurship and you deserve to succeed.