SOCIETE GENERALE-Global Strategy Team
Popular Delusions: Government hedonism and the next policy mistake
''What you as the City of London have done for financial services, we as a government intend to do for the economy as a whole”- Gordon Brown speech to bankers, Mansion House June 2002.
Behavioural psychology applies to central bankers, regulators and politicians as much as it does to investors. In promising to ‘fiscally retrench tomorrow’, finance ministers are exhibitingthe behavioural phenomenon of overconfidence in their future self-control. The bitter fiscal medicine required to stabilise debt levels won’t become more palatable today relative to tomorrow until the bond market makes it so. It can only do this through higher yields. Thus,Ireland and perhaps now Greece lead the way. For the Japanese it’s too late.
Why should behavioural psychology be seen as something applying only to investors? Behavioural finance is a well defined sub-discipline in its own right. But where is behavioural politics, behavioural central banking, or behavioural regulation? Remember
the Fed policy statements around the end of the 1990s? The ones that kept referring to the technology-enhanced’ rate of GDP growth? Wasn't this herding around a bad idea the very
same herding then fuelling the NASDAQ bubble?
And as the housing bubble inflated, Bernanke in a quite staggering display of logical sloppiness, concluded that the risk of a housing collapse in the future was small because there had never been one in the past. Weren't they then guilty of framing their analysis in a way guaranteed to preclude an uncomfortable conclusion? If you don't expect to see something,you are less likely to see it. Similarly worthy logic was used when sub-prime rolled over,and Bernanke concluded that there was no risk of contagion to the rest of the economy yet ! Wasn' t this over-weighted?
It probably was, and it probably demonstrates that central bankers are as prone to be as systematically silly as the rest of us ! Indeed, just last year a study by Bernanke concluded that “monetary policy was not a primary factor in the housing
bubble”. I don't want to pretend I am any kind of behavioural expert, but isn't this the well documented ''attribution bias''by which people attribute positive outcomes to themselves,
but negative ones to others?
So here we are today, with regulators rounding on investment banks, hedge funds and tax havens, apparently in denial of the reality that the problem was not the regulations but
the regulators ! After all, heavily regulated institutions like Fannie Mae and Freddie Mac were at the epicentre of the crisis (as was AIG, whose financial services business model was the
facilitation of ''regulatory arbitrage'' around Basle capital requirements). Not that it makes any difference. The regulators are merely bowing to pressure applied by politicians whose
understanding today is as flawed as Gordon Brown' s was in the Mansion House back then.
If this sounds like a rant then I apologise it isn' t meant to be one. We are all fallible and policy making is an impossible job. But that means policy mistakes are inevitable, and I believe we are seeing one right now....
Oscar Wilde said he could resist anything but temptation. But doing something you know you shouldn' t is easier if you can convince yourself that this will be the last time you indulge, that
you won't do it again. So we convince ourselves that since we'll be strong in the future, we can still indulge today. Whether it's smoking, eating too much or going to the pub instead of
the gym, we delude ourselves into thinking that we will take the more difficult path next time.
A few years ago, two economists actually looked at the issue using gym membership data. They found that in a club in which non-members could pay a no-strings fee of $10 per visit, people preferred to pay the $70 per month for unlimited access. And since members only
attended 4.3 times a month on average, they ended up paying an average $17 per visit. The authors concluded this to be clear evidence of overconfidence about future self control.
Investors understand the affliction all too well: a stock trades at £10 and we tell ourselves that we are buyers at £8. But how many of us buy when it gets to £8? Some of us do, but most of
us don' t. Most ofus (I can' t be the only one!) convince ourselves that it's going lower still:
“I’ll buy at £7” becomes “I’ll buy at £6” and by the time it's back at £8we're “waiting for a pullback”. Each investor has their own way of circumventing this problem. But at root, such
poor decision-making is a consequence of our fundamental underestimation today of the discipline and even courage we will require in the future.
G7 ''committed'' itself to the path of further stimulus and they presented it as though it was somehow a difficult decision: ''the position for most countries is to support the economies now, and get the budget deficit down as the economy recovers.'' said the UK's Chancellor, Alistair Darling, nodding earnestly. Well, it got me thinking about how much governments need to retrench to stabilise existing debt to GDP levels. And although I consider myself fortunate enough to have forgotten most of the economics I learned at university, one lesson which was useful, or in any case has stuck with me, is of the arithmetic behind government debt sustainability.
There are lots of books containing lots of equations outlining lots of limits and theorems about the dynamics of government debt sustainability, but the basic intuition is that if I am a finance
minister mulling out how much money I should be borrowing, I want my GDP growth (and therefore my tax revenue growth) to pay the coupons on any debt I take on today. If the GDP growth rate equals that interest rate, the incremental revenue flowing into my coffers thanks to the incrementally higher level of GDP covers my coupon payments. I don' t need to borrow any more money and my debt ratios are stable. But if the interest rate is higher than GDP growth, my
incremental tax revenue won' t cover interest payments. I'll be in deficit and I'll have to issue more debt to plug the gap and my debt ratio will rise. The only way I can prevent further debt
growth is by running a primary budget surplus (i.e. a surplus excluding interest payments).
There are nuances and qualifications to this arithmetic, and limitations too, but in essence the fault line between sustainable and unsustainable debt dynamics can be summarised as:
maintaining a stable debt to GDP ratio requires governments to run a primary balance proportionate to the difference between interest rates and GDP growth.But if it is difficult to summon the political courage today, why will it be easier tomorrow?