Economics – Page 7 – We Know Zero

Actuaries and Placebos

09. April 2014 · Write a comment · Categories: Actuarial, Economics, Pensions, Regulation

Source: Wikimedia Commons – Original work of the US Federal Government – public domain

Placebos are medicines or procedures “prescribed for the psychological benefit to the patient rather than for any physiological effect” according to the Oxford English Dictionary. Originating as a way of doctors to clear their consulting rooms of people they did not feel could be helped with real medicine, placebos’ status, as Ted Kaptchuk makes clear, underwent a dramatic fall from acceptability after the Second World War and the general adoption of the randomised controlled trial to establish the efficacy of medical treatments. The lack of research since into the various aspects of treatment collectively called “the placebo effect” (Kaptchuk is a notable exception to this) is bemoaned by Kaptchuk, who feels an important element of successful treatments is not getting the attention it deserves.

This may be changing. After all, the impacts of placebos and nocebos (from the latin meaning “I will do you harm”, these are as mysterious as placebos, but make you feel worse rather than better) can be dramatic. Ben Goldacre does a five minute routine on them here (warning: it’s a bit rude). A recent Horizon documentary also looked at placebos, with the suggestion that they might have had an impact on the UK Olympic Team GB cyclists as well as in more serious cases like those of Parkinson’s sufferers.

Why am I talking about them? Because, in a more general way, to quote Seth Godin: “A placebo is a story we tell ourselves that changes the way our brain and our body work”. Godin asks why, if a placebo can make wine taste better and improve the way your back feels, we should be squeamish about discussing them.

The main reason, of course, is the feeling that it is unethical to promote treatments and products which have no scientific basis. This also explains why people operating within professions – whether medical or otherwise – are so wary of them. Professions see themselves, in the Baconian tradition, as bodies of people with expert knowledge using that expertise scientifically for the benefit of society. Placebos do not fit into this world view at all.

Imagine two pensions actuaries: Actuary A is a very experienced practitioner, known for years by many of his clients and a trusted source of wisdom. Everything he says, which he conveys with a practised seriousness and sonorousness, interspersed with frequent not-completely-discreet stories about the antics of other people he has met in his long career, is accepted by his clients like tablets of stone brought down from the mountain.

Actuary B is a young relatively newly qualified actuary. He has just obtained his scheme actuary certificate after toiling away in the background providing much of the analysis and calculation work underpinning the consultancy provided by the more senior actuaries in the firm, including Actuary A. He is seeking his first scheme actuary appointment, and has been trouping along to trustee meetings behind Actuary A for some carefully selected clients which the firm would like to move from A to B. B realises quickly, confirmed by his first trustee meeting where one of the trustees looks him up and down quickly and tells him that he doesn’t trust anyone with shiny shoes, that these clients have been selected because of their particular reluctance to pay the elevated charge out rate of Actuary A. Unfortunately this does not mean that they are keen to see a cheaper actuary installed on their schemes, quite the reverse in fact. The trustees who are most incredulous about the fees associated with actuarial advice seem also to be those who set most store in the mystical wisdom of Actuary A and his booming voice.

Now if I say that I think there are placebos at work here I do not mean that these clients are not receiving carefully constructed advice, appropriate to their needs and in compliance with all legislative and regulatory standards. What I am saying is that, from the lack of shine on Actuary A’s shoes, to the gravitas (I think it used to be referred to by a different generation as “bottom”) brought to bear on any particular issue by Actuary A, there are many things which do not add anything to the quality of advice (which in some cases has been almost entirely constructed by Actuary B), but which are valued at least as much (if not more, in Actuary B’s view) by the client.

As Simon Carne has pointed out recently, supported by John Reeve in this month’s The Actuary, the physical advice is subject to an ever increasing body of regulation, to the point where some clients might be deterred from even asking an actuary the time. However, everything about the environment in which the advice is conveyed – from the tone of voice; to the way the actuary sits; to the degree of direct eye contact; to the choice of gestures used; to, where meetings are held at the firm, the whole experience of someone entering the building and being led into a room deliberately designed to make an impression – is not. In the same way that a presentation is not just the collection of slides put together on PowerPoint, we need to give more recognition to the fact that the advice that is valued by clients is a lot more than that which is written or even spoken.

Although, judging from the number of times I have had to be the bearer of bad news (with the expectation that that will be the case preceding me and therefore helping me in delivering that message in many cases), perhaps the more usual term for this element of actuarial advice should be nocebo rather than placebo.

Where would you rather be working in your later years: UK or Germany?

08. April 2014 · Write a comment · Categories: Demographics, Economics, Pensions, Prediction, Regulation

As a quick illustration of the differences between how businesses in the UK and Germany approach change this chart from the recent Economist Intelligence Unit research carried out for Towers Watson takes some beating. To UK eyes, an insane proportion (45%) of German businesses are proposing to make physical changes to their workplaces by 2020 to accommodate a greying workforce. There is an even more dramatic contrast when the issue of flexible working hours is raised. Less than half of UK businesses intend to offer more flexible working hours by 2020, compared to over three quarters of German businesses.

Neither are we interested in training our older workers apparently. Only 28% of UK businesses intend to ensure that the skills of their older employees remain up to date, compared to 48% of German businesses.

So where are UK businesses preparing to manage change then? Giving employees more choice over their benefits is cited by 60% of UK businesses, compared to 45% in Germany and the European average of 48%.

But is this the positive step it is presented as? It seems unlikely to me that these UK businesses that don’t want to invest in older workers’ working environments or give them flexibility over hours or location or train them is interested in providing any choice over benefits that doesn’t also cut their costs. There are going to be some battles ahead over exactly how the pensions changes in the Budget are to be implemented. Judging from this survey, they are going to be hard fought.

Freedom for DBdom?

31. March 2014 · Write a comment · Categories: Actuarial, Cartoons, Defined Ambition, Economics, Pensions, Regulation

My father used to regularly paraphrase Benjamin Franklin at me about nothing being certain except death and taxes when I was growing up. However, having spent the turn of the century advising members of small self-administered schemes how to navigate the 6 (some claimed there were in fact up to 13) different tax regimes for pensions which then applied so as to get the maximum possible benefit from them, I was a cheerleader of the tax simplification which the 2004 Finance Act brought in and which demolished all that.

Now it seems that actuaries are no longer going to be necessarily required for members of defined contribution (DC) schemes to get at their savings. In an age of increasing uncertainty about both death and taxes, I find myself cheering this too.

But why stop there? In their consultation document, the Government states that:

With the right consumer guidance, advice and support, people should be able to make their own choices about how to finance their retirement. Everybody’s circumstances are unique and it should not be for the State to dictate how someone should have to spend their savings.

It then adds:

Those who want the security of an annuity will still be able to purchase one. Equally, those who want greater control over their finances in the short term will be able to extract all their pension savings in a lump sum. And those who do not want to purchase an annuity or withdraw their money in one go, but would prefer to keep it invested and access it over time, will be able to purchase a drawdown product.

So the question has to be asked: why are these freedoms and choices not to be extended to defined benefit (DB) members as well?

The reasons the Government have advanced for the change are equally compelling when applied to DB:

There is a lack of choice for people at retirement, which has become more of an urgent concern now that auto enrolment is boosting DC membership. This is even more the case for DB members who are already numerous (although getting less so daily), as their only choices are how much cash to take up to the 25% tax free limit and (up to a point) when to retire. The other freedom DB members have, of course, is to transfer out, although this freedom makes everybody feel very nervous and is possibly about (see below) to be snuffed out altogether.
Current regulations deter innovation. This is, of course, why defined ambition as an idea has been so slow to get off the ground.
Restrictions on cash commutation imply a lack of trust of members to be able to decide how they spend their savings.
The concern that the annuity market has not maximised income for scheme members. This is mirrored by the high cost of de-risking via bulk annuities, which is the ultimate “flight path” for most DB pension schemes, and which many argue has resulted in a big drag on the growth of UK PLC.

All that would be required to extend these freedoms would be to allow DB members to commute as much of their benefits at retirement, whether for cash or income drawdown, as they wanted, with the rest taken as pension as now.

To be fair to the Government, they do acknowledge the logic of extending the freedoms set out in the consultation to DB members in section 6. But then something strange happens.

Firstly, for public sector schemes, as they are mostly unfunded, the Government says it is concerned about the negative cashflows of members transferring out. If 1% of public service workers did so, the joint Treasury/HMRC analysis is that the net cost would be £200 million. This, I think, provides a revealing peak into the world of state funding, where taking on the Royal Mail Pension Plan was seen as positive for Government finances and off balance sheet private finance initiative (PFI) contracts continue to be negotiated offering doubtful value to the state. It doesn’t matter how much things cost over all, it seems, as long as you are only paying out a bit at a time. The Government often behaves in this respect like the victim of a pay day loan shark. Depending on the commutation terms offered, extended commutation has the potential to solve the public sector pension crisis in a way that Hutton’s Pensions Commission didn’t quite manage to.

Not even considering the option of allowing greater commutation from the schemes themselves, the Government has already decided to ban such transfers from public sector to DC. There is to be no consultation on this.

For private DB schemes, the Government says the decision is “finely balanced”. They are worried about all of those currently captive DB pension investments being spent on Lamborghinis. This rather contradicts the earlier declaration of trust in pensioners to make appropriate decisions about their retirement – after all appropriate investment in support of regular income in retirement (which would presumably be recommended by the “guaranteed guidance” to be offered to DC members) should not differ markedly from the equivalent investments in DB schemes. Whether DB schemes invest on a longer-term basis than individuals is, as the Kay Review made clear, uncertain.

However the Government is very concerned about financial markets – they have section 6 of the consultation devoted to nothing else. It is almost as if individuals can be trusted to look after themselves, with a slightly bigger safety net and a bit of advice, but financial markets cannot.

Again, the Government is not consulting on extending commutation of benefits, but solely on the transfer issue. And apparently removing the current right of all members of defined benefit schemes, except in exceptional circumstances, as proposed with public service defined benefit schemes…must be the government’s starting point, unless the issues and risks around other options can be shown to be manageable.

Even if the Government does manage to stop people pouring out of the exits before April next year, this has to be bad policy. To provide more freedom and choice to one group of pensioners and at the same time to remove a longstanding freedom (and one available at the point members joined the schemes) from the other groups is clearly unfair. What is worse, with an election looming, it is likely to be unpopular.

By the way, one of the things that stands out for me in this whole consultation is the use of State with a big S and government with a small g. It is as if typography alone could portray the “State” as big and bad and “government” as on the side of the little guy. I have done the reverse here.

So, if you DB members want to stop the flickering light of Freedom and Choice dying before it even got going, I advise you not to go gentle but to rage, rage and respond in large numbers to questions 9 and 10 of the consultation in particular. You have until 11 June.

Scotland and Oil

24. February 2014 · Write a comment · Categories: Economics

The most interesting figures I have seen so far in all the noise of the Scottish independence debate come from the Government Expenditure & Revenue Scotland report for 2011-12 (the latest figures available). This report compares the effect of various approaches to splitting oil revenues. It does, being a Scottish report, focus on the impact on Scotland. However, extrapolating from their published figures, the impact on the rest of the UK are just as interesting.

The net borrowing in the Public Sector Accounts for the UK as a whole is shown in blue at the bottom next to the Scottish position with no oil revenues, with the deficits of an independent Scotland and the rest of the UK shown both in £ billions and as a percentage of their respective GDPs above under two separate scenarios. One assumes oil revenues are split per capita, the other that they are split by geographical share. I have assumed no change to economic activity in the UK as a whole due to independence, an assumption I admit may be shaky but for which I have seen no authoritative alternative to date.

On this basis, the rest of the UK’s deficit in 2011-12 as a percentage of its GDP would be 7.7% with a per capita split and 8.5% with a split by geographical share, compared to the 7.9% of GDP for the UK as a whole in the Public Sector Accounts. So one measure increases the rest of the UK’s deficit as a proportion of GDP (the approach the Scottish National Party prefers) and the other reduces it.

That is presumably why it was worth the UK Government relocating to Aberdeen for today’s cabinet meeting to discuss the future of the oil industry. There is a lot at stake.

Is there something fractal going on?

12. February 2014 · Write a comment · Categories: Economics

Economists have recently developed a new term, to describe the nature of income inequality in the United States in particular. They call it fractal inequality, although I am unsure whether Benoit Mandelbrot, the inventor of the whole idea of fractals, would be that impressed. He died in 2010, with the application of fractals to financial markets that he presented in his 2004 book The (Mis)behaviour of Markets, still waiting to be fully taken on board by the risk and investment communities even after the 2008 crash.

A fractal is something that looks pretty much the same however much you zoom in or out on it. A cloud is one example. An equally beautiful example is the Mandelbrot Set (shown below), where a remarkably simple formula creates shapes of infinite complexity.

Source: Wikimedia Commons. Created by Wolfgang Beyer with the program Ultra Fractal 3.

The reason it has come up in economics is that people are paid unequally. Very unequally. And even within the 1% of people who are paid unequally from the other 99%, people are paid unequally. To the extent that it starts to look a bit fractal. See what you think of these two graphs, taken from the HMRC personal income by tax year statistics:

So what about increasing inequality between the 1% and the 99%, as discussed from a US perspective in the first link above? In the UK it has certainly increased, but the rate depends on which time periods you compare. The range provided by HMRC is from 1999-00 to 2011-12. In this period of 12 years, the total income 99% of the population live below increased by 52%, compared to an increase of 41% in the median income (ie the total income 50% of the population live below). Compare this to the 7 years from 1992-93 to 1999-00, during which the total income 99% of the population live below increased by 54% (ie more than the 12 years for which records exist since) compared to a 25% increase in the median income.

The message seems to be that it’s getting worse but not as badly as it used to be.

Taxation and the Squeezed

05. February 2014 · Write a comment · Categories: Economics

A little history: less than 80 years ago, in 1938-39, there were only 3.8 million income taxpayers. This was clearly not enough for a nation on the brink of World War 2 and by 1948-49 (statistics were only collected every 10 years in those days) the number had almost quadrupled to 14.5 million, or around 29% of the UK population (estimates are approximate as there was no census in 1948). Today, there are around 30 million taxpayers, or around 47% of the UK population which, even allowing for the 16-17% uplift in the number of taxpayers caused by the move to individual taxation (rather than counting married couples as a single tax individual as previously), represents nearly a 40% increase in the proportion of the population paying tax since the late forties.

The latest Her Majesty’s Revenue and Customs (HMRC) release on income tax paid by percentile of taxpayers has been seized on by others in the continuing political battle over a future 50% tax rate, but I want to focus instead on one of the other political slogans thrown around in the last few years: the Oxford English Dictionary’s word of the year for 2011 (despite the fact that it is two words) the Squeezed Middle. That the middle has been squeezed is not in doubt, as the graphs below will show. But is this a failure of the income tax system? I think the data suggest otherwise.

First of all, if we look at the proportion of earnings subject to income tax that are paid as tax, they are probably a lot lower than you would think. Obviously this does not include national insurance contributions or Council Tax, both of which are considerably more regressive, but as you can see the percentage did not get above 15% until the top 30% of taxpayers in 1999-00 and the top 12% in 2011-12, with the proportion reducing for everyone below the top 10% of taxpayers until you get to the more complicated interaction between tax and benefits for the bottom 15%. The Squeezed Middle has not been squeezed by the tax man.

We need to be a little careful here, as there has been an effort to move people out of tax through increases to the tax threshold above inflation between 1999-00 and 2011-12. However the percentage of the population paying income tax resulting from this has hardly moved (if anything, it has increased slightly since 1999-00 when it was around 46%), so although the comparison may be approximate, in my view it should still broadly hold.

But the Middle has been squeezed, as the following graph (of earnings in excess of consumer price inflation (CPI) by percentile) shows:

Yet even here, the impact of tax has reduced the depth of the squeeze. At the top end, the top 1% do not on average appear to have seen the sort of runaway increases in earnings seen in the United States. To see what has happened at the lowest point of the smile, the median point where exactly 50% of taxpayers earn more and 50% earn less, we can track the median earnings in 1999-00 terms (adjusting for the increase in CPI since then) up to 2011-12 as follows:

It is clear that the squeeze has been an entirely post 2008 crash phenomenon, with real incomes increasing quite reasonably until then. Interestingly, the tax burden as a percentage of income had already started to fall before the crash, with the process accelerating since then.

The Government’s proposal to target a budget surplus by the 2018-19 tax year, to be achieved by spending cuts rather than tax rises, means that this tax burden is unlikely to change if the Conservatives or a coalition they dominate win the next election, according to the Institute of Fiscal Studies, with 60% of cuts in public spending still to come. Labour have also committed to a budget surplus by the end of the next parliament, with a 50% tax rate reintroduced, but only to the top 1% of taxpayers and offset by a reduction in the starting rate for everyone to 10%. So whoever wins the Middle appear to be safe from an increase in income tax at least.

Both parties appear to be depending on increases to incomes (and/or possibly spending unsupported by incomes which could generate more VAT revenues) amongst the Middle so that unincreased tax rates can still meet the gap between their spending plans and the tax take elsewhere. So let’s all hope that the Squeezed Middle start getting paid properly soon.

The difficulties of looking forward

25. January 2014 · Write a comment · Categories: Economics, Prediction, Regulation

We are only six months into the Bank of England’s new regime of giving forward guidance about what circumstances might lead them to adjust the Base Rate and they are already in a bit of a mess with it. Whether forward guidance is abandoned or not is still in the balance, amid much confusion. However, much of this confusion seems to be due to the challenge that events have provided to the assumption that the Bank of England could make reasonably accurate economic predictions.

It turns out that not only did the Bank not know how fast unemployment would fall (not a surprise: the Monetary Policy Committee (MPC) minutes from August make clear that they suspected this might be the case), but neither did they know, when it did fall, what a 7% unemployed economy would look like. The Bank has been very surprised by how fragile it still is.

Back in August 2013, when unemployment was still at 7.7%, the MPC voted to embrace the forward guidance which has now fallen on its face. This said that: In particular, the MPC intends not to raise Bank Rate from its current level of 0.5% at least until the Labour Force Survey headline measure of the unemployment rate has fallen to a threshold of 7%, subject to the conditions below.

The “conditions below” were that all bets would be off if any of three “knockouts” were breached:

1. that it would be more likely than not that CPI 18 to 24 months ahead would be at 2.5% or above (in fact it has just fallen to 2%);

2. medium-term inflation expectations no longer remained “sufficiently well anchored” (the gently sloping graph below would suggest it hasn’t slipped that anchor yet); or

3. the Financial Policy Committee (FPC) judged monetary policy posed “a significant threat to financial stability”. More difficult to give an opinion on that one but, looking beyond the incipient housing market bubble, it is difficult to see that monetary policy is causing any other instability currently. Certainly not compared to the instability which would be caused by jacking up interest rates and sending mortgage defaults through the roof.

Source: Bank of England implied spot inflation curve

So it seems that there has been no clear knock out on any of these three counts, but that the “threshold” (it was never a target after all) of 7% is no longer seen as significant a sign of economic recovery as it had been believed it would only last August.

Fun as it is to watch the illusion of mastery of the economy by the very serious people flounder yet again, as what is an intrinsically good piece of economic news is turned into a fiasco of indecision, I think the Bank is right to believe that it is far too early to raise interest rates. I say so because of two further graphs from the Office of National Statistics (ONS) latest labour market statistics, which were not included in their infographic on the left.

The first is the graph of regional unemployment, which shows very clearly that large areas of the UK are still nowhere near the magic 7% threshold: the variations are so wide and, in austerian times, the resources to address them are so limited that it makes sense not to be overly dazzled by the overall UK number.

The second is the graph of those not looking or not available for work in the 16-64 age group since the 1970s. As you can see, it has recently shown a very different pattern to that of the unemployment graph. In the past (and borne out by the data from 1973 to around 1993) the number not available to work has tended to mirror the unemployment rate as people who could manage without work withdrew from the job market when times got tough and came back in when things picked up. However in the early 90s something new started to happen: people withdrawing from the job market even when unemployment was falling. There has been a steady increase in their number until it finally started to fall only last year. So what is happening?

One of the factors has been a big increase in the number of people registered as self employed, rising from 4.2 million in 1999 to 5.1 million in 2011. However, many of these people are earning very little and I suspect that at least some of them would have been categorised as unemployed in previous decades. There must therefore be some doubt about whether 7% unemployed means what it used to mean.

The Bank of England have shown with their difficulties over forward guidance that it is very hard to look forward with any degree of precision. It should be applauded for admitting that it doesn’t know enough at the moment to start pushing up interest rates.

Some numbers about the EU

16. January 2014 · Write a comment · Categories: Demographics, Economics

The latest figures (January 2014) from the European Central Bank (ECB) statistics pocket book have just been issued, providing comparisons between European Union (EU) countries, both in the Eurozone and outside it, on a range of measures. And some of these comparisons are not quite what I expected to see.

For instance, perhaps surprisingly in view of the current hysteria in the UK about economic migrants from Bulgaria and Romania, we find that unemployment was lower in Romania (7.3%) than it is in the UK (7.4%) for the latest month (September 2013) for which data on both was available (it’s the UK’s that is missing for October and November for reasons unknown).

I have graphed a selection of the data below, Euro countries are to the left:

First to note, which may also surprise some, is that private sector debt in the UK is not particularly big in EU terms: Denmark and Sweden both have considerably higher private sector debt as a percentage of GDP than the UK, as do 7 countries in the Eurozone with Ireland and Luxembourg heading the list.

Government expenditure as a percentage of GDP is the most evenly distributed of all the measures. I have graphed the 2012 data, as the Q2 2013 data omitted France and Germany. The range across all countries is between 36.1% (Lithuania) and 59.5% (Denmark), with the UK’s 47.9% only a little below the Eurozone average of 49.9%. This suggests to me, for all of the political rhetoric we hear, that it is not the total spend which tends to alter much but the distribution of it. Certainly in the UK, there appears to have been a focus on a relatively small section of the welfare budget to make the savings from.

Government debt is much higher as a proportion of GDP in the Eurozone than in the rest of the EU, with no one outside the Eurozone reaching the Eurozone average of 93.4% (although the UK comes closest at 89.8%). There are 5 countries in the Eurozone with debt above 100%: Belgium (perhaps surprisingly), Ireland, Greece, Italy and Portugal. Spain’s debt is actually below the Eurozone average at 92.3%.

Unemployment statistics are unsurprisingly dominated by Greece and Spain, whose unemployment rates are around 50% higher than the next country. Unemployment rates average 12.1% in the Eurozone and 10.9% for the EU as a whole, perhaps demonstrating the advantage of keeping control of your exchange rate during an economic downturn.

The population statistics remind me what an unusual decision it was for the UK to stay out of the Euro. All the other big countries (by which I mean those with populations over 45 million) are in the Eurozone, with the next biggest EU country outside the Euro being Poland at 38.5 million (with the prospect of their joining the Euro receding somewhat last year). Most of the richer countries are too, illustrated by a much higher proportion of GDP (see below) held in Eurozone countries than their relative populations would lead you to expect.

Finally we come to GDP. This looks very differently distributed according to whether you look at amounts in Euros, or per capita, or by capita adjusted for the purchasing power in each country. The first of these is dominated as expected by the big countries of Germany, Spain, France, Italy and the UK. However, the outstanding performer when looking at GDP per capita with or without the purchasing power adjustment is Luxembourg. Eurozone countries have a higher GDP per capita than those outside (€28,500 compared to €25,500, with the gap narrowing slightly when adjusted for purchasing power).

A final thing strikes me about these statistics. As has been pointed out elsewhere, Francois Hollande is having a hell of a time considering that France’s economic performance is not that bad. In fact it is incredibly average: its Government debt sits at 93.5% compared to the Eurozone average of 93.4% and its GDP per capita when adjusted for purchasing power is bang on the Eurozone average of €28,500. France are much more representative Euro members than Germany (remarkable when you consider that the Euro was once referred to as the Deutsche Mark with a few disreputable friends) and, if Hollande’s approval ratings are any indication, the French people seem to hate that.

When things have nothing to do with each other

15. January 2014 · Write a comment · Categories: Economics

I recently came across this post from 2009, showing how total returns companies achieved and the remuneration packages of their CEOs had no obvious relation between them. This kind of article, showing a correlation does not exist, is relatively unusual in my experience.

Far more common are articles like this one, by Eugenio Proto and Aldo Rustichini, purporting to show new evidence about the link between life satisfaction and GDP. Even if you accept whatever methodology they have used to derive their life satisfaction index (I don’t think we can get no satisfaction currently, see my previous blog), you have then to accept them defining a feature of the data entirely created by their regression analysis tool (the so-called “bliss point”) before going on to discuss what the implications of it might be.

The article’s references are stuffed with well-known economists’ papers and I am sure that one of its conclusions in particular, that increases in GDP beyond a certain point may not increase life satisfaction in developed countries, will lead to the research paper underlying the article to be widely cited as this is a politically contentious area. However this kind of thing is really nothing more than an economic Rorschach test: the meaning of the ink spots often depend on what you want to see.

But such studies are not often treated in this way. Why? Well what if one of the interpretations of the ink spots was backed up by some mathematics which could be run very quickly on any ink spot pattern by anyone with a computer? There is nothing biased about the mathematics, after all. This is what regression tools give us.

Regression is taught to sixth formers (I have taught it myself) as a way of finding best fit lines to data in a less subjective way than drawing lines by eye. The best fit straight line in a scatter graph is arrived at by looking at differences between the x and y coordinates of specific points and the average x and y values respectively. For y on x (ie assuming y is a function of x, you usually get a different gradient if you assume x is a function of y), the gradient of the line is the sum of each x value less its average times the corresponding y value less its average, all divided by the sum of the squares of the x values less their average. Or as a formula (the clumsiness of the preceding sentence is why we use formulae):

Now let’s focus again on the graphs in the Proto and Rustichini article (the second graph has excluded Brussels and Paris, on the basis that they are both very rich and very miserable) and their regression-generated lines of best fit.

If we look long enough at these graphs we can almost persuade ourselves that the formula driven trend line (not a linear one this time) shown actually represents some feature of the data. But could you draw it yourself? And, if you did, would it look anything like the formula-generated one? If your answer is no to either of these questions, there is a possibility that the feature identified by Proto and Rustichini would be entirely absent from your trend line. The formula will always give you some sort of result. The trick is identifying when it is rubbish.

As an illustration of this, I constructed a graph where I was confident there was absolutely no correlation between the two things, and then set Excel’s regression tools to work on it.

As you can see, none of the options, starting with the linear regression we discussed earlier and getting more complicated, result in the kind of #DIV/0 and #N/A messages we get to see regularly elsewhere in Excel. By setting the polynomial option to a quintic, Excel is quite prepared to construct a best fit polynomial of order 5 (it has a fifth power in it – the purple wavy curve) to my array of dots. These lines and curves are merely the inevitable result of the mechanistic application of formulae that in this case have no meaning.

There may be nothing biased about the mathematics, but, as Bernard says In Yes Minister, when questioned by Jim Hacker about the impartiality of an enquiry: “Railway trains are impartial too, but if you lay down the lines for them that’s the way they go.”

Many economic research papers contain graphs which are similarly afflicted.

£1,000 a year rise? Probably not

07. January 2014 · Write a comment · Categories: Economics, Pensions, Prediction, Regulation

There has been the usual flurry of misleading headlines around the Prime Minister’s pledge to maintain the so-called triple lock in place for the 2015-20 Parliament. The Daily Mail described it as a “bumper £1,000 a year rise”. Section 150A of the Social Security Administration Act 1992, as amended in 2010, already requires the Secretary of State to uprate the amount of the Basic State Pension (and the Standard Minimum Guarantee in Pension Credit) at least in line with the increase in the general level of earnings every year, so the “bumper” rise would only be as a result of earnings growth continuing to grind along at its current negative real rate.

However, the Office for Budget Responsibility (OBR) is currently predicting the various elements of the triple lock to develop up until 2018 as follows:

The OBR have of course not got a great track record on predicting such things, but all the same I was curious about where the Daily Mail’s number could have come from.

The Pensions Policy Institute’s (PPI’s) report on the impact of abandoning the triple lock in favour of just a link to earnings growth estimates the difference in pension in today’s money could be £20 per week, which might be the source of the Daily Mail figure, but not until 2065! I think if we maintain a consistent State Pensions policy for over 50 years into the future a rise of £20 per week in its level will be the least remarkable thing about it.

The PPI’s assumption is that the triple lock, as opposed to what is statutorily required, would make a difference to the State Pension increase of 0.26% a year on average. It is a measure of how small our politics has become that this should be headline news for several days.

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