Pounds per pixel

I had cause recently to muse on the rather variable cost of a pixel. It's like this.

Pentax has a new digital camera out. It's called the K-7, it is apparently quite nice, and the body will cost roughly £1,200. It will produce images with 15 million pixels. This is fairly typical for a good quality digital SLR.

Now consider the large format camera I bought the other day. It cost £200, and it will take 5x4 film. Even a medium quality flat bed scanner can produce a three hundred million pixel scan from a 5x4 negative. Lenses for the LF camera are roughly the same price as high end digital lenses - a Rodenstock Apo Sironar S 150mm is comparable in price to the Pentax 31mm limited. So I am getting a pixel for 0.000067p, vs. 0.008p for the digital photographer, a factor of over 100 better.

Now of course digital is free once you have the camera, and large format isn't. But the £1,000 I have saved will buy quite a big pile of Fuji Velvia 5x4. Sometimes old technology is cheaper and better than new...

Hoicked from the comments

In a comment on the non-classical cost benefit analysis post of a few days ago (a title, I think you will agree, of gigantic pretention), Dave said:

I agree with your conclusions: that uncertainty and moral hazard can make CBA unreliable and sometimes it is better to rely on qualitative objectives.

But I disagree with your applying these to systemic risk. Firstly, with systemic risk it is the "worst-case scenario" that is important. If regulators had used the great depression as the worst case scenario, they wouldn't have been far wrong.

Often, though, the worst case scenario can be hard to identify. The worst case scenario in much of finance for instance is that all claims are worthless and all liabilities come due immediately. We might as well all go home if that comes true, and barricade the doors. 'Plausible' worst cases have a nasty habit of turning out to be too optimistic: wasn't it David Viniar from Goldman who said that 2008 was much worse than the most pessimistic scenario they looked at?

Secondly, I can't see how systemic risk regulation would cause bankers to take greater risks. So, I don't see where moral hazard fits in.

Fair enough - bankers are not people riding bikes. (Quite literally, usually - Wall Street tends to view cycling to work as only marginally less strange than coming by elephant.) So probably bankers did not take more risk because they were regulated. Some of them did, however, take as much as they could subject to regulation, because that was the way to maximise returns to shareholders.

Thirdly, how do you take a "moral" position on systemic risk? I don't think this gets you very far.

Well, I think that the key idea of Anglo-Saxon capitalism - that the first and only duty of a firm is to its shareholders - is simply immoral. Of course, like any ethical judgement, you can disagree with that. But I also think, and I'd like to think that I can prove, that a system that has a wider burden of responsibilities, including a responsibility to the financial system, would be less likely to go into crisis, cost the taxpayer less over the cycle, and deliver slower but less volatile growth.

Finally, the main impact of systemic risk regulation would be to encourage smaller banking/trading institutions. I would think that this a good thing in itself. And I disagree with James Kwak that "countercylical measures in a boom dampen economic growth". Surely the opposite is true (in the long run).

Absolutely. We need a lot of small banks, not a small number of large ones. The hard part is how we get to there from here.

Sound words on defence spending

Lewis Page writes sharply and well on defence procurement. He's a sample:

defence manufacture brings us a measly billion or two in exports each year – and our arms industry requires the great bulk of the £15Bn defence materiel budget in spending to win us this rather paltry amount of trade.

Put that way, the claim that we need our massive - per capita larger than any other EU state - defence budget to support exports is clearly ridiculous. Does this spending provide credible independent capability? Page says no, and gives detailed examples:

the Prime Minister can fire his American-made Trident missiles without asking Washington frst. But he cannot expect his supposedly ‘Britsh’ or ‘European’ systems to keep operatng through a normal-length war if US support is cut of. No, seriously. The Eurofghter contains so much US equipment that American consent is required for us to export it to Saudi Arabia, for goodness’ sake. EADS tells us openly that “the A400M will beneft from use of American content”. The command system for the Nimrod is being made by Boeing. The Future Lynx uses American engines.

On a day when the shameful truth of defence procurment - that British soldiers are dying because we can't get them the kit they need - is once more emphasised, it is time to face the truth. Defence spending isn't just absurdly high in the UK: despite that, it does not give the ordinary soldier, sailor and flyer what they need and deserve.

If you want to subsidise exports, then support the most efficient exporters. They are not defence companies. If you want capable weapons systems, then buy the best ones that you can afford*. And if you want to send men out to fight, then you have a moral obligation to kit them out properly: that imperitive over-rides any possible national interest in a particular manufacturer or procurement process. We don't just need to cut defence spending: we need to spend smarter and more ethically.

*Subject of course to acceptable 'will they support it' risk. One might like to consider for a moment in this context whether the Sukhoi-30 is a better bet for the RAF than the Eurofighter...

Update. A correspondant with considerable knowledge of the defence industry points out that even when UK defence companies can meet a procurement objective, they are more expensive than their civil equivalents because they cannot meet the same timescales and margins. A combination of the shelter provided by captive defence spending and the overhead (both in cost and in putting off some staff) of security means that they simply are not lean and mean enough. If you want a van, go to Ford or Toyota or Renault - don't go to someone who makes tanks.

Non-classical Cost Benefit Analysis

Remember Schroedinger's cat? Poor moggy is trapped in a box with a radio active isotope. The isotope decays randomly. Let's say that there is half a chance of detecting a beta particle using a detector inside the box during some time interval. If the particle is detected, then poison gas is released and the cat dies. If not, it lives.

This setup is usually used to explain superposition of states: basically until you open the box, the cat is in the superposed state 'dead and alive'. You force it to be one or the other by observing it.

I want to use it to talk about something else, though - cost/benefit analysis. If you like cats, then you will want to save moggy. But there is a cost to opening the box early, a pound say. If you judge the worth of a cat as more than two pounds, then you'd spend the pound and guarantee that the cat is safe. In general, 'classical' cost benefit analysis says that if a bad event has cost x and probability p, then it is worth spending px to prevent the bad thing.

Concretely this is usually expressed with less likely events: a certain kind of brake failure on your car is a one in a million event, and the average cost of an accident if your brakes fail is ten thousand pounds, so it is only worth spending a penny to prevent the problem.

This classical cost benefit analysis makes two big assumptions. First it assumes that the bad events are independent and identically distributed. In many applications, this is not true: making the system safer sometimes encourages people to take more risk (and not fixing an obvious safety issue makes them more careful). There is good evidence for this from the development of ABS brakes, amongst other things: they didn't make cars nearly as much safer as the developers hoped, since drivers absorbed the safety margin by driving more aggressively.

In the cat experiment, you can think of this as moggy learning (perhaps by cat telepathy) that if it gets between the isotope and the detector, the particle is less likely to be detected, and hence it is more likely to live. This changes p from 1/2 to 1/3, say, and now your pound is only worth spending if you think a cat's life is worth three pounds.

The second major problem is that your estimate of the probability of failure for small p, is likely to be wrong. Your estimate of the cost, x, might be wrong too. As James Kwak says:

imagine that the government had considered the idea of systemic risk regulation five years ago. It would have cost money; it would have created new disclosure requirements for banks and possibly hedge funds; it would have required countercyclical measures in a boom that would dampen economic growth. Those are the costs of regulation. And how would anyone have estimated the benefits? No one would have estimated the scenario we face today – trillions of dollars of asset writedowns, 3.3% contraction in the U.S. economy and counting, even more severe damage elsewhere in the world economy. And as a result, the regulation would have died.

... it’s a mistake to think that all policies can be boiled down to cost-benefit calculations when one side of the equation is difficult or impossible to measure accurately, and the last thing we need today is more economics-based overconfidence.

In other words, cost benefit analysis is all very well if you can measure the costs, the benefits, and their probability distribution accurately. But if you can't, as in the costs of financial regulation vs. its benefits, then you shouldn't use spurious theory to try to justify the decision you wanted anyway. If you don't know the probability of the particle being detected, you simply have to fall back on an ethical judgement: killing cats is wrong.

Office decorations

Note to CEOs everywhere. No one, not your shareholders, not your staff, not your clients, thinks you deserve a $87,000 rug. Buying one shows a spectacular failure of judgment. Buy something cheap and inoffensive instead. But don't go too far.

Update. Thain is paying the $1.2M back, according to a letter leaked to FT Alphaville. Good on him.

What are the armed forces for, exactly?

Yesterday's news from the National Archive that Britain's ability to defend itself against an attack from the Soviet Union was so diminished in the late 1970s that the prime minister exclaimed: "Heaven help us if there is a war!" spurs me to write a post I've been mulling for a while on the armed forces.

The first thing to say is that we should be grateful to those who risk their lives for all our sakes; we should equip them properly; and we should grant them generous rights after their service is complete. The saga of the gurkhas does us no credit at all, for instance: no service person should have to live in penury after a career in the military.

Let us be clear, though, about what the armed forces are for. If necessary, they kill people. Of course we hope that the ability to do it makes actually doing it unnecessary. But sometimes those fond hopes are unjustified. So no one should join without an absolute unquestioning willingness to kill if ordered to do so. That is what the armed forces are for.

All power structures generate their own dynamics, their own justifications. Ones with a long history carry a lot of baggage, too. Thus we have the fiction that the armed forces are commanded by the Queen, when in fact they do the bidding of the government. We have traditions -- many Victorian inventions -- designed to emphasise the importance of the military. Good tourist-attracting heritage though some of these may be, but they also support some convenient myths. Perhaps if we remembered that the military are funded by taxes we might be a little less tolerant of their parades, their lavish messes, their Saville Row tailored uniforms, and their expeditions. State school teachers don't get junkets to the Antarctic: why do the Army?

It is the toys that really bother me though. The boats and the planes, the missiles and (especially) the nukes. Just as Wall Street had a whole industry dedicated to justifying unjustifiable executive compensation, so the `defence' (by which we often of course mean `attack') sector has a whole industry devoted to persuading governments to buy weapon systems they do not need. Admirals like shiny new boats, nukes enhance the virility of defence ministers. So we spend tens of billions without effective scrutiny yet keep universities in poverty, schools with leaky roofs, and nurses on indefensibly low salaries.

We can't afford to go on this way, especially in the present climate. Let's cancel the Trident replacement now. Let's stop spending money on high tech goodies for the top brass, and equip the men on the front line with the armour they need instead.

We also need to eliminate the culture that allowed bullying at Deepcut and Catterick. The armed forces are civil servants too. Let's treat them as what they are: valued public sector workers who are not above scrutiny. A pound spent on subsidising the port in the officer's mess is a pound not spent on education or health. Battle honours dating back hundreds of years are no excuse for a culture that destroys some people today. As Rahm Emanuel says, You never want a serious crisis to go to waste. Perhaps with shrinking tax revenues and an end to our presence in Iraq we can try to produce a military that is efficient, appropriately funded, fit for purpose and fit to be part of a modern democracy.

Christmas Post

I shall be away for a few days from today, so this is the last post for a little while. And, perhaps aptly, it is about the Royal Mail.

I have to say first that I cordially loathe the Royal Mail. Deliveries in my area have one of the highest loss rates in the country, and they are among the least timely. Post offices in central London are almost always horribly crowded, Christmas or not. As an organisation, at least as I experience it, the Royal Mail is broken.

However I don't think the answer is to part privatise it or shut it down. And I recognise that Post Offices outside London often offer services that are important to communities, services that it is hard to put a profit or loss figure on, but which we would miss if they were gone. The arguments in favour of privatisation too often measure what is easy to measure and ignore everything else. (Jackie Ashley makes a version of this argument in the Guardian here.) And if we can spare tens of billions for the systemically important banking system in the UK, surely we can spare a billion or two for the socially important postal system. Let's admit that we need the Royal Mail and see what good we can do with it. (Jon Crudas has an idea here.) But above all let's not use biased analysis based on discredited economics to destroy a national institution that is useful and valuable and could be quite a lot better.

The shocking non-call

A deeply scary event for the capital instrument market occurred today. Deutsche did not exercise a call on a lower Tier 2 instrument, the 3.875% sub notes of 2004/2014. From their press release:

Deutsche Bank has decided not to exercise its early redemption option to call the Notes at par because replacement costs would be more expensive than the existing EURIBOR +88 bps step-up coupon. Accordingly, the Notes' early redemption provision at the option of the issuer is not in-the-money.

The entire capital instrument market is based on the principle that banks will call their sub notes at the earliest opportunity - most investors calculate duration on that basis, and few people calculate an option adjusted spread, viewing the option not to call as reputationally too dangerous to exercise. The world has changed: expect the prices of these things to plummet. It will also become significantly more expensive for banks or insurers to issue hybrid capital instruments. This is really really not good.

What do we want from the banking system?

A few desiderata, to assist in the reform process.

Safety, at least for retail deposits. People want to know that their money is safe and available at short notice.

Availability of credit at a fair price. It should be possible for all, individuals and corporates, to borrow at a spread that reflects the risk (in both directions - not too high nor too low). Financial institutions can make profit in this process, but that profit should not be unreasonably high. Therefore we need some measure of competition in lending.

Return requires risk, and that risk should sit with the risk taker alone. If you want a higher return than government bonds, it should be perfectly clear that you are taking a risk to get that return, and hence if things turn sour, you and you alone should bear the consequences of that decision*. Risk takers should not be allowed to take risk in ways that endanger more than themselves - low altitude parachute jumps over uninhabited desert are OK; driving at 100 mph in built up areas is not.

Ummm, I am sure there is more, but aren't those the most important things? Right now I am a bit like the financial system -- suffering and not working very well -- thanks to a nasty coldy flu thing. I hope my recovery will be easier and faster than finance's. And certainly I hope less radical surgery will be required.

* That extra 1% return on an Icelandic bank account came with a risk. Live with it.

Risk and climate change policy

Just before I went away Paul Krugman posted on the economics of catastrophe, and I have been meaning to follow up for a while. Krugman picks up on some research by Marty Weitzman looking at the distribution of outcomes of climate change. The basic idea is to look at the uncertainties and hence come up not just with a single prediction of the path of global average temperatures, but a path of distributions. There is a lot of model risk in this analysis - it is bad enough predicting financial distributions were we do at least have a lot of high frequency data - however the results are interesting. Krugman says:

Marty surveys the existing climate models, and suggests that they give about a 1% probability to truly catastrophic change, say a 20-degree centigrade rise in average temperature.

Twenty degrees would be game over. Even if it is only 0.01% chance, this is an outcome worth hedging. Clearly then it is not just the expected temperature change that we should be concerned with, it is the variance of that change, or more accurately the upside tail of the distribution. As Krugman says, mobilizing people to protect against low probability but catastrophic outcomes is crucial. Hedging far from the money is cheap, but you do actually have to buy those options.

Uncertainty and strategy

A key issue in strategy is uncertainty in the outcome. Unlike financial return distributions, where we at least have some data to go on, and some models (albeit ones which struggle with autocorrelation, fat tails, and regime changes) there isn't much data on corporate strategy because each situation is different. I can't try the same acquisition a hundred times over to get a sense of the distribution of returns or, as Keynes said:

Our knowledge of the factors which govern the yield of an investment some years hence is usually very slight and often negligible

Usually people don't let that worry them too much not least because the downside is bounded at zero: often you cannot lose more than you put in. But there is one area where is glaringly obvious that a consideration of uncertainty is important because the returns are so volatile and possibly highly negative - nuclear power. Today we heard, entirely predictably, that:

[The] cost of cleaning up the UK's ageing nuclear facilities, including some described as "dangerous", looks set to rise above £73bn

In fact we have no reason to believe that nuclear fission has net positive value. The costs of building it, running it and cleaning it up may well exceed, perhaps by an order of magnitude, the value of the power generated. As France's nuclear safety watchdog has ordered EDF to halt work temporarily at its flagship new generation nuclear power station and half a million people were hit by unscheduled power cuts after seven power stations, including Sizewell B in Suffolk, unexpectedly stopped working within hours of each other perhaps the policy makers might like to reconsider their push for a new generation of nuclear power stations.

Update. WTF? Gordon Brown has said the UK needs to increase its nuclear power capacity - raising the prospect of plants being built in new locations. As Sting didn't write, every little thing he does is hurried, ill-advised, and foolish.

Towards a quantitative hedonics

It is possible to support the general theme of a body of work without thinking any particular part of it is interesting or successful. Susannah Clapp captures the phenomenon nicely in a Guardian review of the play Contains Violence at the Riverside studios. Here the audience sit on the roof of the theatre and observe the action in adjacent buildings through binoculars.

In Contains Violence the spectators aren't in the same building as the actors. You make up your own long-shots and close-ups, using their binoculars to zoom in and out at will; the headphones, which are designed to lock you into the action (you hear not just conversation but the slosh of water, the ring of a phone, the crackle of paper, the clink of a keyboard), also protect you from the sound of other audience members and from street noise. You are, weirdly, much further away from the actors than usual but aurally much closer up. Beneath the imaginary acts of violence, as in a dreamlike backdrop, buses pass by silently, pedestrians bustle, and ambulances speed to real emergencies. Occasionally, a non-actor - a cleaner or late worker - gets snarled up accidentally in the action.

So far, so illuminating: this inside-outsideness sets you up to look quite differently at your surroundings - which is not something The Importance of Being Earnest will usually help you do. But the exciting stuff has actually all happened before the show begins: this is a concept, an occasion, not a drama. Contains Violence has contrived the most thrilling of settings, but it doesn't manage to convey a real story or any richness of expression.

In other words, great idea, poor use of it. I feel the same way about quantitative hedonics. The idea of trying to use rigourous (OK, quasi-rigourous) economics to argue about happiness without all the usual moral biases or imposition of arbitrary utility functions is a good one. Most of the work in the area, however, disappoints. A good example is given by Jeremy Waldon in his review of Sunstein's Worse Case Scenarios in the LRB:

[Sunstein] is reluctant to abandon a method of measuring losses by how much people would pay to avoid them, even though it is hopelessly flawed by the fact that poor people would pay less simply because they have less. (We measure the value of a life by asking how much people would pay to avoid its loss, under various scenarios. Now, as a matter of fact, a poor person will not pay $100,000 to avoid a 10 per cent chance of death from cancer, because the poor person has no access to $100,000; so a poor person’s life must be worth less than a million dollars; and so it is not clear how the government can justify imposing taxes for a scheme that spends many millions of dollars to avoid this sort of hazard. That’s the sort of argument this book is inclined to defend.)

On this basis preventing jeering at polo matches is a much more important aim than giving clean water to sub-Saharan Africa since polo players are wealthy and will certainly pay a lot to increase their comfort slightly, whereas the citizens of sub-Saharan Africa are mostly (in dollars a day terms) very poor. So Waldon has a point: cash only works as a measure if we are comparing the happiness of people with roughly the same amount of disposable income. Even percentage of disposable income does not mean much to people who don't have any. So how can we compare two regulations or two pieces of charity or whatever rigourously in terms of their outcomes? That, it seems to me, is an important question for quantitative hedonics.

Why do we keep playing the protectorate game?

The crown dependencies are possessions of the British Crown: the Isle of Man, Jersey and Guernsey are the principal dependencies. The British Government is solely responsible for defense and international representation of the dependencies, although each island has responsibility for its own customs and immigration. All 'insular' legislation has to receive the approval of the 'Queen in Council', in effect, the Privy Council in London, with a UK minister being the Privy Councillor with responsibility for the Crown dependencies.

Acts of the British Parliament do not usually apply to the Channel Islands and the Isle of Man, unless explicitly stated, and even this is increasingly rare. When deemed advisable, Acts of Parliament may be extended to the Islands by means of an 'Order in Council', although normally the agreement of the dependency administrations would be sought first.

(This summary and the following one filleted from wikipedia [1] [2] as a prelude to the discussion that follows.)

In addition (and constitutionally distinct) there are the British Overseas Territories. These fourteen territories - including Bermuda, the British Virgin Islands and the Cayman Islands - are under UK sovereignty, but they are not part of the United Kingdom itself.

Each Overseas Territory has its own legal system independent of the United Kingdom. The legal system is generally based on English common law, with some distinctions for local circumstances. Each territory has its own Attorney General and court system. Defense of the Overseas Territories is the responsibility of the UK. Neither the overseas territories nor the crown dependencies are full members of the EU.

More or less anything to do with the constitutional affairs of these little bits of land is complicated by history, precedent, residual monarchism and colonialism, and the lack of political will for change. None of that however is reason to simply accept the status quo. Between them the dependencies and territories account for many of the world's tax havens. Their financial systems deprive the UK Exchequer of billions of tax revenue, probably hundreds of billions. They encourage tax avoidance, facilitate money laundering, and contribute little in return beyond the occasional friendly harbour for the Royal Navy. Yet we provide these islands with defense and a variety of forms of aid. That is simply illogical. It is clearly not in UK interests to support the dependencies and territories, especially given the other calls on the defense budget and the fact that this budget is smaller than it could be thanks to the tax arbitrage opportunities these very same islands provide. If they want the shield of the UK military and the UK AAA rating then they should pay UK tax. If they don't want to do that then we should cut the tax havens loose without a second thought.

Both practically and legally the UK has the apparatus to enforce a decision on the protectors and dependencies. Some will doubtless prefer to remain British - and in that case we should extend full citizenship and EU membership to them in exchange for their tax revenue: examples here might well include the islands with less developed financial systems such as the Falkland Islands, the Pitcairn Islands and South Georgia. Others such as Jersey or Bermuda may well decide to go it alone. But in that case they should be treated as any other foreign country, their populace denied UK citizenship, and UK citizens living there treated as foreign domiciled. All in all it is high time we applied some cost/benefit analysis to our constitutional arrangements.

Rational Default

(R.I.P. subprime, alt-A, negative am hybrid arms and all those other delightful mortgage market innovations.)

Over on Calculated Risk, Tanta discusses the behaviour of U.S. home owners given the availability of negative amortisation mortgages. (Essentially an option ARM had very low initial payments, so you could buy a large house with one of these even if you didn't have a large income, then if the house went up in value, sell it before the low interest period ended. If it went down in value, you just defaulted and tried again with a different property. The negative am part is that the reason the interest payments were so low was that some interest was capitalised into the loan amount.

It was the policy makers who didn't recognize rampant speculation in the housing market. While we joked about "liar loans" here on Calculated Risk, the policy makers were congratulating themselves on the "ownership society". I'd argue home buyers who used no money down option ARMs were making a rational choice: they were balancing the odds of a big payday with little financial risk - if the property continued to appreciate - with the stigma of a foreclosure on their record. Obviously many home buyers felt the stigma was worth the risk. I see that as [...] a rational choice given the circumstances.

Now this is interesting: undoubtedly some people did behave this way, but was it a common phenomenon? This is a little like the sovereign default problem I discussed earlier: sometimes it is rational to default. However, just as there nations are held back by the stigma of default, so I suspect many people don't default when they rationally should. This is part of risk aversion, a flipside of the phenomenon whereby students don't go to University despite the availability of deferrable student loans whose repayments are based on income: a risk neutral analysis indicates one course of action, but people are not often risk neutral.

Quantitative Hedonics

I'll start with an effective way to create hap- piness. Lays' ketchup flavour crisps and Mouton Rothschild 1985. Yes, I know it sounds like a strange combination but it actually really works. So, if that is practical hedonics, what's quantitative hedonics?

Economists are starting to broaden the idea of cost, in particular talking about the cost of happiness. Quantitative hedonics, then, is an attempt to measure misery or its inverse, joy. The basic idea is easy enough: if you rate your happiness sitting in the garden this morning at 6/10 without an ice cream and 7/10 with one, and an ice cream costs £1, then it costs £1 to increase your happiness 10%.

Nick Cohen in today's Observer discusses an example of this: the cost of aircraft noise. Clearly being overflown makes people miserable. How much should the airlines pay to compensate the people they inflict this on? Obviously one cannot get an unequivocal answer, but even an estimate is interesting.

This view of the world suggests a different way at looking at some problematic modern situations. For instance recently the New York Times had a discussion of babies on public transport. One side took the view that a screaming child make the whole experience miserable for everyone: the other that they had a perfect right to travel with their child no matter how noisy. It would be interesting of debating whether it is acceptable to travel with a screaming infant what the hedonic cost of doing so was. Perhaps if this added onto the parent's ticket their decision to travel might be different?

Hutton on the Transport White Paper

Will Hutton might be less than 100% sound on the capital markets, but he is often excellent on public policy and infrastructure and he has an excellent article in yesterday's Guardian on the recent Transport White Paper:

There isn't an adult in Britain who does not believe that our transport system is overcrowded, unreliable and unfit for purpose...

Last week's white paper on the future of rail maintains the British tradition. There is to be tinkering at the margins ... but the Department of Transport has shrunk from any serious ambition to scale up British capacity.

The heart of the problem is the Treasury's attitude towards public debt and the way it calculates the payback from public infrastructure projects... its approach to infrastructure spending remains in the dark ages - an outlier of 19th-century thinking.

I might quibble with '19th century thinking' - in many ways the Victorians understood the importance of infrastructure spending better than we do now - but otherwise Hutton is spot on. By using a metric for assessing cost/benefit analysis that is hugely skewed (and probably a hang-over from Thatcherite thinking rather than the 19th century), the Treasury is failing the country, holding back economic development and producing more misery. The requirements of tackling climate change and supporting growth require congestion charging over all urban areas, massively increased spending on rail, and a widespread application of the polluter pays principle to transport (which means higher taxes for SUVs and air travel and subsidies to bicycles and buses).

Errors in Cost Benefit Analysis

A recent Bloomberg article referring to the AEI-Brookings Institute paper Has Economic Analysis Improved Regulatory Decisions? made me think again about cost benefit analysis.

The paper condemns both the quality of cost benefit analysis used in determining the impact of regulation and the `tenuous' use made by policy makers of that analysis. Undoubtedly that is partly for political or hegemonic reasons - cost benefit analysis sometimes comes to the `wrong' conclusions - but I suspect it is also partly because the conclusions of a cost benefit analysis are sometimes not believed. The analyst may be at fault here for not stating the margin of error?

Error bars are common in experimental science: the fine structure constant, for instance, is known to roughly one part in a billion, and in any precise discussion we would state not 1/alpha = 137.035999710 but rather 1/alpha = 137.035999710(96) meaning that the reciprocal of alpha could be as high as 137.035999796 or as low as 137.035999624.

In cost benefit analysis this could be a very useful tool, especially as the error bars are much larger. To take the first example that google coughed up, an amusing cost benefit analysis of different law schools (where the cost is the fees and the benefit is the increase in expected salary after going to the school), the problem is that while the costs are fixed, the benefits aren't. Not only do different individuals earn different amounts despite having the same education, speciality counts so that (in the perverse world in which we live) a tax lawyer earns more than a criminal defender. Moreover the reputation of various law schools will change over time effecting not just the earnings of current graduate but also those of past ones.

An even better example is one of the next hits, a discussion of the cost benefit analysis of rebuilding New Orleans after Katrina given its obvious hurricane risk. Here not only is the benefit uncertain, but so too is the cost. Any analysis with error bars would suggest at best 'case not proven': that, rather than 'cost > benefit' or 'cost < benefit' is often the best that we can conclude since it will often be the case that the intervals [cost - possible error in cost, cost + possible error in cost] and [benefit - possible
error in benefit, benefit + possible error in benefit] intersect.

Going nuclear

Tony and Gordon have bottled energy conservation and renewables, and instead see a new generation of nuclear power stations as key to meeting our energy needs. As we already knew over a year ago they would. Just one question. Can we afford them?



After all, despite the expert's protests, we know that nuclear power stations over their life subtract value from the economy: they cost more to build, run and (crucially) decommission than the power they generate is worth. This might change, of course, but buying an out of the money option is a gamble on the underlying going up, and the government doesn't have a hedge.

What I really worry about, though, is the ongoing costs and risks of dealing with the waste. U235 has a half life of 700 000 000 years. For U238 it's 4 billion years, or roughly the age of the earth. The most permanent structure man has made has lasted less than 10,000 years, yet we are taking on liabilities 700,000 times longer. We are going to produce tonnes, perhaps hundreds of tonnes, of material so toxic that ingesting a microgram is likely to be fatal, and it will remain dangerous for billions of years. Put that way is there anyone who honestly believes it's a sensible idea?

Update. The house of Lords clearly have concerns too.

What particularly troubles me about all of this is that fusion research has slowly been making progress and with more funding, goodness knows how quickly we could get there. In the context of the sums at risk from climate change, a few tens of billions on fusion research would be infinitesimal. Yet this is an order of magnitude less than we are spending. That seems like a bad strategy to me.

Cost benefit of non dom

There was a certain amount of fuss in the papers over the weekend over the non dom tax rules which allow rich individuals to spend a lot of time in London without being domiciled here for tax purposes and hence avoid paying a material fraction of their earnings in tax. Now whether you think this is fair or not (and I don't, but that's an opinion) the real question is whether the amount of wealth created by letting these guys live here without paying tax is worth the lost revenue. I'd love to see a proper cost/benefit analysis here. Wouldn't that be the best way of deciding whether non dom makes sense and, if not, how to change it? What policy would maximise the total benefit to the UK?

Cost Benefit and the Government Machine

I have just been reading an interesting post on Marginal Revolution on the benefits or otherwise of Regulation. Tyler Cowen (why does anyone called Tyler always remind me immediately of Tyler Durden?) says in part:

1. Government regulations have a very large aggregate net benefit relative to their costs; rules for clean gas, taken alone, might be more valuable than all the other regulatory costs we bear. If you don't believe me, try visiting Mexico City in November.

2. Many government regulations are simply unnecessary.

3. No one has come up with a good algorithm for weeding out the bad regulations from the good ones. Nonetheless cost-benefit analysis, for all its philosophic flaws, can serve this function.

Which is fair enough. But what do we mean by cost benefit analysis? Consider a very unlikely event with quite a severe impact: say cost $1B and probability 1 in a million. Cost benefit analysis would suggest it is worth spending no more than $10 to prevent this happening, but if you owned a $1B building, you would probably pay more than $10 to insure it against a one in a million earthquake. I certainly would. (And of course the whole insurance industry is based on paying more for protection than it is 'worth' in a pure cost-benefit sense.)

Really then we should perform cost benefit analysis relative to a utility function, and part of the reason we might disagree about regulation is a simple disagreement about what this function should be.