The Cost and Benefits of EU Membership

A lot that has been said about the recent elections to the European Parliament.  (Full disclosure: I am an EU national living in the UK.)  For me, part of the debate in the UK represents a useful reminder of the challenge of cost-benefit analysis.  Not surprisingly, there isn’t an accepted view about the balance between costs and benefits of EU membership.  Here is an illustration of the range of estimates (as of 2013) from a research paper of the UK Parliament:

I reviewed some of what has been written and have also read with interest Hugo Dixon's recent book - 'The in / out question'.  I thought that rather than develop another cost-benefit analysis, I would set out the main considerations to take into account if you choose to read one of them to form your own views.

It seems uncontroversial – I think – that the economic benefit from EU membership is the access to supply products and services to a market of 510 million consumers and an economy the size of the US.  Hugh Dixon quotes an estimated benefit of the order of 4% to 5% of UK GDP.  If you accept this, then the key questions are whether: 

•  the costs to the UK of achieving that benefit offset it; and  
•  the benefit can be achieved through an alternative arrangement. 

To consider this, a cost-benefit analysis must set out the ‘counterfactual’, i.e. what would happen in the absence of EU membership, and identify what is incremental as a result.  However, there are a number of options.  The ‘do nothing’ option means trading with the EU based on the UK membership of the World Trade Organisation (WT0).  This does not mean free-trade; it will entail custom duties for certain products such as cars.  There are also other options as represented by the cases of Norway, Switzerland and Turkey.  The bottom line is that you cannot seriously consider the costs and benefits of EU membership without taking an explicit view on an alternative from the very beginning.

If so, here are a number of questions and answers to identify what is incremental (including the benchmark of EU membership).  A "smiley" indicates that the change (or lack of it) is a positive development from a cost-benefit perspective.

A couple of points to note about the table.

Firstly, UK manufacturers exporting to the EU will need to comply with EU product regulations.  They are likely to end up manufacturing to UK and EU product regulation standards so (at best) cost savings would be limited. 

Secondly, the distinction between goods and services in the table is the reality of “free trade”, which does not usually apply to services, such as financial, business and legal services.  They represent 78% of the UK GDP. 

The table suggests that being outside the EU could be cheaper on a ‘cash’ basis.  However, none of the options would appear to replicate the benefits of a single market.  Norway replicates many of the benefits at a reduced cost.  However, note that they are bound to follow EU legislation without having a saying on it – an interesting view about sovereignty! 

Overall, I struggle to see how the UK would be able to replicate the economic benefit of the single market in products and services outside the EU. 

However, the real value of cost-benefit analysis is the impetus to focus on increasing benefits and reducing costs.  This means considering how to reform the EU and get the best from a single market of 510 millions of consumers and a GDP that is as large as the US.  Dixon suggestions include cutting red-tape, negotiating trade deals with US, Japan and China.  For me, one of the more interesting suggestions is the potential gains from banking disintermediation and providing long-term finance to industry through capital markets.  As he puts it, the crisis was a banking crisis not a financial crisis.  Something for another post …  

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The Map and The Territory - Alan Greenspan Book

The latest issue of the Central Banking Journal includes my review of the latest book from Alan Greenspan.  It is an interesting book with insights about economics and about the man.  You can read the review here or below.

Book review of ‘The Map and The Territory. Risk, Human Nature and the Future of Forecasting’ by Alan Greenspan, Allen Lane, 2013

‘The Map and the Territory’ is an enigmatic title for a book written by a former Chairman of the US Federal Reserve, which also seeks to cover ‘risk, human nature and the future of forecasting’.  I set out to review the book thinking how long it will take me to understand the rationale for the title. 

The introduction made an impression.  A reasonable acknowledgement that economic forecasting failed in the lead up to the crisis and of the need “to understand how we all got it so wrong”.  I use the word ‘reasonable’ judiciously.  Given the author’s position as Chairman of the US Federal Reserve before the crisis, I was not expecting an acknowledgement that the Fed or the US authorities fell asleep under Greenspan’s watch so “we all got it so wrong” – my emphasis.   Equally, I am not sure if other central bankers have acknowledged that much.  The assessment is usually about bankers going bonkers. 

One of the issues that Greenspan tackles in the book is the extent to which it is appropriate to rely on rationality assumptions for forecasting economic behaviour.   One of the challenges that Greenspan identifies for forecasters is that behavioural responses are unlikely to be symmetric.  For example, the collapse of asset prices would be sharp and, probably, deep while recovery would be gradual.  Overall, Greenspan concludes that economic behaviour is not random and that most economic choices are stable over the long run.  In his own words, ‘we are driven by a whole array of propensities ... but, ultimately, our intuitions are subject to reasoned confirmation.’

This does not mean that errors would not occur.  Greenspan singles out the secular underestimation of tail risks based on the last quarter century of observations.   As for the ability to eradicate those propensities that can give rise to the tail risks, Greenspan dryly note that ‘there was no irrational exuberance in the Soviet Union and none in today’s North Korea’.

It is difficult not to read the book seeking to understand the man – the musician, the economist (or is he a forecaster), the businessman and the economic technician.   Greenspan uses the term economist and forecaster in ways that seem fully synonyms.  I can only wonder how many people in his position would see things that way.  Typically, I guess they don’t but I found it an honest recognition of the main economic role of leading a central bank. 

For Greenspan, there is also small gap between the forecaster and the businessman.  His business, Townsend-Greenspan & Co, was industry forecasting so he had to delve into the details of markets such as oil, natural gas, coal, pharmaceuticals.  I remember learning about price elasticity of demand and about the challenge of estimating it.  As I recall it, the example that Samuelson’s textbook mentioned was the elasticity of the global demand for oil.  Here is someone who saw that challenge from the first row.  Greenspan admits getting his estimates about the oil consumption after the rapid escalation of oil prices in 1973 off the mark.

The interest in the detail of the economic forecaster is evident through the book.  There is a fair amount of slicing and dicing of US statistics to understand the underlying reality.  I was particularly interested on (I believe) his development of an indicator of a time series of maturity of GDP and his use to measure the degree of risk aversion in the economy.  Another example that caught my attention was the use of patent data to measure productivity.  The examples could be particularly useful to any Central Bank analyst looking for innovative ways to analyse the economy.

In terms of banking regulation, Greenspan acknowledges – not surprisingly – that regulatory capital requirements were too low before the crisis.   His analysis suggests an increase of regulatory capital from 10% before the crisis in terms of book value to 13% and 14% in 2015.  Greenspan is also clear that designating banks as “systemic” is simply enhancing their ability to fund themselves at a lower cost.  Greenspan quotes IMF estimates of 40 to 80 basis points funding advantage, which, as he also points out, is a significant advantage in a competitive financial market.

The books also looks beyond financial regulation to wider economic issues around productivity and the rise of entitlements culture, which makes for an interesting reading.  I would recommend it to post-graduates that want to develop an appreciation of the breadth of economic thinking and analytical skills that can be accumulated over a lifetime, even if you do not necessarily share every idea or conclusion.

As I completed reading the book, I still had not found an explanation for the rationale of the ‘map and the territory’.  I had a few hypotheses but nothing.  I was worried that I might have missed something fundamental about the book.   I was reassured to find references to maps in the inside cover of the book. 

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The Godfather of Freakonomics has passed away

Last week it was announced that Gary Becker had passed away.  He formulated his economic career around the application of the tools of economic analysis to broader social issues like human capital, crime, racial discrimination and family.  This wider application of economic analysis makes him the godfather of Freakonomics.  As a recognition for his research contribution, he received the Nobel Prize in Economics in 1992.

Becker’s Nobel lecture provides a good overview of his work and how he extended the traditional analysis of individual rational choice by incorporating a much richer class of attitudes, preferences, and calculations.  In this lecture, he also shared his inspiration to apply the tools of economic analysis to crime.  He was driving to an examination and was late.   He realised that to arrive on time, he would need to park his car and risk a parking fine.  He knew that enforcement was patchy so there was a chance of not getting a fine.   He made a decision to risk a fine.  The private benefits exceeded the costs!     

Understanding these cost-benefit considerations and non-market interactions matters to economic and social policy.   As he aptly said in one of the speeches at the Nobel Prize award:  “the widespread poverty, misery and crises in many parts of the world, much of it unnecessary, are strong reminders that understanding economic and social laws can make an enormous contribution to the welfare of people.” 

Daniel Finkelstein wrote an interesting article in The Times in which he stressed Becker’s contribution to the world of economics, by emphasising that economics is much broader than understanding how money moves in the economy and that it’s about: “understanding people’s incentives, and structuring social institutions in response to them”.  

When I studied economics, I don't think I appreciated the extent of this imbalance. Furthermore, there is a lot to be done and said to address it beyond the scope of this post.  Though I am with Becker that this is not about re-inventing economics and abandoning rationality, or as he put it eloquently: "no approach of comparable generality has yet been developed that offers serious competition to rational choice theory".  The key test is the generality of the predictions that arise from rational choice.   

So the Godfather of Freakonomics is not with us anymore.  Finkelstein summed it up much better:  “The world has lost one of its great thinkers.  Fortunately, we still have the power of his thoughts.”

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More on the ‘C-factor’ in Regulation: Business Model Analysis

Business model analysis (BMA) is one of those terms that are becoming common currency in regulatory discussions, hence the reference to a ‘c-factor’ or common factor in an earlier post (here).  

The PRA published a useful article in the Bank of England March Quarterly Bulletin setting out how they intend to apply BMA to insurance.  It suggests that there are two aspects to a BMA.

Firstly, there is a company dimension, which is obviously not spelt out in great detail for the obvious confidentiality reasons.  In general terms, this would recognise that:

• there is an ‘inverse production function’ in insurance – the fact that insurers collect premium before the service has been delivered and can earn an investment return until claims are paid; and
• insurers must price the product without full knowledge of production costs – hence the ‘experience analysis’ of reserves.

Secondly, there is a market dimension, which recognises that a business model is not static and will respond to changes in regulation, culture, society and technology.  This is evidenced in the article by reference to two developments:

• price comparison web-sites in the UK motor industry; and
• non-standard annuities.

Overall, the PRA sets out a helpful and clear vision about BMA:

‘The PRA’s capital requirements help to make insurers resilient against short-term shocks.  But to be confident that insurers will remain viable over the longer term, the PRA needs to know whether an insurer’s profits are sustainable.  In other words, the PRA will need to analyse the risks of an insurer’s particular business model.’

I found quite remarkable and refreshing to see this level of clarity from supervisors. 

The recent UK budget announcement about removing the requirement for compulsory annuitisation will provide wide ground to test the practice of BMA from a regulatory perspective and, probably, from a company perspective as well.

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Risk and Compliance Management: Horizons for 2014/15

The UK’s FCA published recently its Risk Outlook and its Business Plan for 2014/15.  They provide a useful indication of the breadth of the regulatory challenges and evidence of a top-down approach to address them. 

The structure of the Risk Outlook is similar to last year’s.  The inherent risk factors such as information asymmetries, do not change overnight unlike the economic and market environment.  The main aspects of the changing market environment that caught my attention were:

1.    the continuing household indebtedness reflecting the growth of unsecured lending, mainly credit card, and forecast increasing household leverage (Figures 6, 18 and 19 of the paper);

2.     lenders’ forbearance in the mortgage market, supported by low interest rates; and the FCA concerns about the cost to consumers (fees and accrued interest);

3.     the stable and risky profile of mortgage lending; about 40% of mortgages have high-risk features – LTV in excess of 90%, loan to income ratios in excess of 3.5 and terms in excess of 25 years (Figure 22);   

4.     the differential impact of increasing interest rates (mortgage customers, those accumulating wealth and near retirement and those considering an annuity purchase).

The FCA then translates these observations into statement about risks.  Again, the ones that caught my attention were:

1.     the challenge of making ‘appropriate’ profits; for example, making profits from non-core activities could undermine fair treatment of consumers or financial crime responsibilities; for insurers, this could manifest itself in the response to the Retail Distribution Review and moves to direct sales;

2.     the implications of short term cost-cutting strategies materialise as demand starts to grow and could result in poor management of firms’ back book;

3.     the adoption of technology may not be supported by adequate systems and controls or expertise; this could manifest itself on insufficient spending on existing technology or the use of big data without appropriate controls;

4.     plans to mitigate the risk of failures do not give adequate consideration to conduct implications such as in respect of the changes to terms and conditions in stress conditions.

The Business Plan then identifies priorities for the key sectors.  For life insurance, the priorities appear to be:

1.       suitability of products and services sold;

2.       fair treatment of the back book;

3.       the governance of with-profits funds.  

Interestingly, the FCA business plan also reflects new responsibilities which include supervising 50,000 firms in respect of consumer credit, enforcing competition law, implementing changes to the approved persons regime and the establishing a new payment systems regulator.   

All in all, it’s going to be a busy 2014/15 for everyone.

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Conduct Risk Regulation: the Global Dimension

I wrote a post not so long ago about conduct risk in the UK (here).  In the course of producing that work, I discovered an emerging global dimension to conduct risk and I have been looking into it.  There seems to be three strands to this:

1.  Work on financial consumer protection focusing on credit and coordination with other international bodies by the Financial Stability Board (here).

2.  Principles for financial consumer protection led by the OECD.    The OECD has developed 10 principles of consumer protection (here).  I have summarised them below.  They summarise neatly the extent of the challenge.  The OECD continues its work.  It has issued a draft paper (here) setting out more detail on some of the principles.  

3. Work on financial education through International Network on Financial Education (INFE) coordinated by the OECD.   There is an interesting set of principles developed by the OECD (here) and a web-site listing financial literacy programmes and related research (here). 

I find this interesting for a number of reasons. 

1.  If you believe that regulation can be improved by pooling knowledge and expertise, then there is something valuable here.  Given the domestic nature of retail financial markets, this is going to be an interesting experiment of supervisory design where the challenge will be to articulate workable approaches that can be tailored to national conditions rather than prescriptive solutions.

2.  While financial consumer protection is a good case of a market failure, in the genuine economic sense, not every policy intervention would necessarily pass a cost-benefit test.  If there was scope for an 11^th principle it would be assessing the costs and benefits of policy initiatives.  Interestingly, the principles on national strategies for financial education include impact assessment. 

3.  The explicit recognition in the OECD principles that effective competition in the relevant markets can deliver appropriate outcomes for consumers. 

4.  While the above points together with the underlying market failure add up to a reasonable case for this activity, it is interesting that policy-makers interest on this issue stems from the financial crisis – a feature of G20 summits since 2010.   

The G20 interest together with the OECD endorsement of the principles should give these initiatives momentum.  It would be interesting to see what are the national impacts of these initiatives.   

=================

OECD 10 principles for financial consumer protection

1. Financial consumer protection should be an integral part of the legal, regulatory and supervisory framework. 

2.  There should be oversight bodies explicitly responsible for financial consumer protection with the necessary authority to fulfil their mandates. 

3.  All financial consumers should be treated equitably, honestly and fairly at all stages of their relationship with financial service providers. 

4.  Consumers should be provided with key information about the fundamental benefits, risks and terms of the product, including conflicts of interest where an agent is also involved in the sale.  

5. Financial education and awareness should be promoted by all relevant stakeholders and clear information on consumer protection should be accessible. 

6.  Financial service providers and their agents should have an objective to work in the best interest of the consumer and be responsible for upholding consumer protection. 

7.  Financial service providers should put in place mechanisms to protect financial consumers’ assets from fraud, misappropriation and other misuse.

8.  Personal information should be protection through appropriate control mechanisms. 

9.  Financial consumers should have access to complaints and redress mechanisms that are affordable, independent, fair, accountable, timely and efficient. 

10. Competitive markets should be promoted to provide consumers with greater choice, create competitive pressure on providers to offer competitive products, enhance innovation and maintain service quality.

Negotiating - Practical Lessons from the Creation of the IMF

If you work in risk management or economics, there is a reasonable chance that you juggle between the 'important' and the 'urgent' and that you interact a great deal with colleagues, counterparts and peers.

I recently reviewed the book 'The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White and the Making of a New World Order' by Benn Steil for the journal 'Central Banking'. 

The context of the book is the economic negotiations between the US and the UK in the lead up to the Bretton Woods conference and the establishment of the IMF.  From the perspective of Keynes and the UK, it provides a fascinating account of how the 'important' prevailed over the 'urgent' and how not to negotiate. But the book is more than just that it becomes at times nearly a thriller.  Harry Dexter White was Keynes' US counterpart and it turns out he was also spying for the USSR.

If you are interested you can read my review here or below.

Book notes: The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White and the Making of a New World Order

A fascinating account of the Bretton Woods conference from the point of view of its two main players: John Maynard Keynes and Harry Dexter White

Author: Isaac Alfon

Source: Central Banking Journal | 12 Aug 2013

Categories: Governance

Topics: Bretton Woods

Benn Steil, The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White and the Making of a New World Order, Princeton University Press, 2013, 472 pages

Benn Steil’s book provides a fascinating account of the developments leading up to the Bretton Woods conference and its immediate aftermath, from the point of view of the two main characters involved: John Maynard Keynes and Harry Dexter White. The book is based on extensive archive work, so often the participants speak for themselves, which makes for interesting reading.

It is striking that the US Secretary of the Treasury, Henry Morgenthau, instructed White in December 1941 to “provide the basis for post-war international monetary arrangements” when victory in the Second World War was still not even in sight, even if the underlying intention was to shift the centre of world finance from London to Wall Street. If that foresight about the next steps had become the norm, perhaps today’s geopolitical landscape would also look different.

The book evidences the challenge of being the ideal economist: in Keynes’ own words, “a mathematician, historian, statesman and diplomat”. Despite his academic achievements, Keynes’ record as an economic diplomat is poor and he was described by other UK officials as a “menace to international relations” and “too offensive for words”. Modern central bankers are likely to share with Keynes an involvement in international negotiations. Keynes’ track record provides a few ideas of how or how not to conduct them.

First, understand your principal strategic priorities. One of the main challenges is identifying what is important and what is urgent for your organisation and prioritising accordingly. At that time, the important issue for everyone (not just the UK) was a new system of exchange rates that brought stability, avoided competitive devaluations prevailing before the Second World War and supported international trade. The urgent issue for the UK was indebtedness and the need for short-term finance at a reasonable cost with no political conditions. Keynes’ focus on the important is certainly appropriate. However, as documented in the book, a solution to Britain’s urgent issue, indebtedness, could have been available from US bankers and others and it is surprising Keynes stopped a consideration of this ‘alternative’. As Steil tells us, British prime minister Winston Churchill’s objective for the war was to survive it: the urgent. Not surprising then that, as Steil also notes, there is only one reference to Keynes in Churchill’s five-volume history of the war.

Second, while understanding the logic of your position is a must, fully sharing that with your counterparts may not be in your interest as it may reveal a weakness. One example is Keynes’ clear articulation to the Americans of the necessity of post-war British trade discrimination.

Third, understand your counterparty’s perspective and vision. Steil is clear from his research that the US administration saw the UK as a rival for economic and political power. However, there does not seem to be recognition in the British sources quoted that this might be driving the US negotiating positions. In fact, the opposite may be true: Keynes associates the behaviour of Americans to a supposed lack of understanding that, for example, the lend-lease arrangements put in place to finance the war would have devastating effects on Britain after the war.

Fourth, look after your counterparty. It is easy to make this personal but this is a wider point. Steil notes that “Keynes’s lack of humility appears to have prodded [US president Franklin] Theodore Roosevelt’s advisers to tighten their demands, lest they be caught out by clever arguments down the road”. And fifth, provide accurate progress reports, in particular when your position is weak from the beginning. Steil identifies, for example, the contrast between the gap in the US and UK positions in the lead-up to Bretton Woods and Keynes’ progress reports.

White is unlikely to be as familiar as Keynes, unless one has an interest in spying and the Cold War. White’s progression to the US Treasury is far from straightforward and for most of his time at the Treasury he was a temporary civil servant. The Treasury seemed his natural home given his “mind for economic policy” and “flair for converting economic theory into administrative practice”. Steil sees him as an “idealist who envisioned a future in which world affairs were managed by enlightened technocrats”. It might not be unreasonable to guess that his admiration for the Soviet revolution led to “freelance diplomacy” and evolved over time into spying for the Soviets.

In terms of economics, both White and Keynes share the overall objective of monetary and currency stability. The important differences lie in the role of gold and the US dollar, and the governance of the International Monetary Fund (IMF). The latter reflected the different positions of the UK (a debtor) and the US (a creditor). Not surprisingly, Keynes wanted less power for the IMF and more discretion to member countries and White pushed in the opposite direction. White also turns out to be a skilful tactician who developed a team and carefully orchestrated the negotiations leading up to the conference and at the conference, to successfully enshrine the US dollar as the reserve currency in a system of fixed exchange rates.

Steil highlights how the views of the US and UK on related issues have changed over time: pegging currencies to the US dollar (US, against then), sharing the cost of adjustments as a result of trade imbalances (US, against then), the necessity of preferential trade treatment (Britain, in favour then). This is a very practical reminder of what Greg Mankiw has described as the difference between economics as a science and an engineering/problem-solving discipline. 

The book ends with a chapter where Steil seeks to draw conclusions for today’s market conditions. He brings in Milton Freedman’s views in favour of floating exchange rates and, overall, I have sympathy with the argument that governments should focus on wealth creation, rather than endless negotiations. It is difficult to challenge Steil’s doubts that another “grand design” would fail to solve the current trade imbalances unless the US and China agree about the need for action. 

Welcome to My Blog

I am pleased that you are reading this.  After some thinking and discussions with some people, I have decided to start this blog to share thoughts on what I know - or don't know.  Seriously, I intend to write about what is at a crossroads between enterprise risk management (ERM), financial regulation and economic analysis.

And the name?  Well, my wife came up with the name 'crescendo' for her art business and she has kindly allowed me to use her idea of a name.  If you speak Italian or learnt music - none of which apply to me - you know that crescendo is something that increases in strength.

I hope you enjoy the postings and that they increase our mutual understanding.  Please get in touch with any thoughts and observations.  I would like this to become a two-way conversation.

Isaac