Secrets behind interest rates

Last week the Bank of England caught the City by surprise by raising the Interest Rate by a quarter of a point. Not long ago, before Christmas, it also surprised the City by not increasing the interest rate.

This behaviour might be rooted on the “Expectations Theory”. According to this theory, people have some expectations about what somebody else is going to do, and they would act as if those expectations were going to be true. So perhaps the Bank of England was playing with the expectations in order to make them behave as if there were an increase in rates.

What is this behaviour?

Changing the interest rate in order to affect the economy is an idea developed by Milton Friedman. He observed that periods of speculation or situations where there is too much money in circulation lead to increase in prices, what we call Inflation. If the situation gets out of hand, it all can end up in unreal prices. A mix between people not being able to consume anymore because of high prices and a sudden selling frenzy of assets which people think overpriced can trigger a crash, which is followed by a crisis.

In order to avoid it, the Central Bank increases the interest rate. This, on one hand, makes credit more expensive, and people less willing to get them and therefore, less money will be available to keep prices rising.

On the other hand, those who have money will find more attractive keeping it in the bank to get higher interest, with the result, as well, of less pressure on rising prices.

Let’s suppose you expect the Central Bank will increase the Interest rate. You will hold your hand before asking for a credit (above all if rates are variable), or will keep the money just in case you need it in future, because it is better to keep yours than to pay the higher interest in some months. As a result of your expectation, there is less money changing hands. Exactly what the Bank wants to achieve by raising the interest, but without doing it.

Now, the economic data is saying that inflation nearly reached 3% in december, that property prices keep on growing, and growth is expected to be 3%, very high for a developed economy. Facing this data, the Bank could not waste any time and decided to increase the interest to “cool down” the economy.

The other aspect that must be considered when talking about interest rates is the currency exchange, but all the analyses seem to point that it was not relevant in these two decisions.

Why David Beckham’s salary is not an exaggeration

All those who like or just enjoy a bit football (or soccer for this matter) must have noticed that David Beckham has been signed for £128 million. Or in other words, $1 million a week. Excessive as it looks, this amount of money might actually make economic sense.

LA Galaxy, the club that is signing him, is a company. Hence it must have enough revenues to cover its costs. And these costs will rise considerably from April when Beckham starts playing. They must have a plan.

Although his right leg was still one of the best in Europe, Real Madrid, his present club was not signing him from Manchester United to become the new superstar. Beckham had to become a living advert. And he did. There were record sales of shirts, the team got exposure in the whole world. Everyone wanted to see Madrid playing to see Beckham.

LA Galaxy is signing him after a bad performance in the World Cup. He went to Real Madrid to win trophies, and to date, he has won nothing at all. But he is not being signed for being a quality player. He is being signed for being a celebrity-player.

He will boost the name of LA Galaxy around the world (very few people in Europe knew the name of this team until one week ago and now it is everywhere). Thousands of fans will be willing to see him playing, which will fill the stadium. In a moment where the fan base is still being built, this might attract some fidelities to Galaxy. The merchandise sales will soar. There will be a demand to watch the games all over the world, which will turn into TV rights sold. And in a advertising-driven-economy as the USA, advertisers will be pouring millions on the team. Not to mention, obviously, that with such player, LA Galaxy increases the chances to win the championship. And this will attract more fans, more attention, more advertising and more money.

What is hard to comprehend is the amount of money that he will generate now, and above all, in the future. This revenue will make the signing amount small. In that case, if Beckham is generating more money than what he costs, the signing amount is not exaggerated.

We could discuss if it is fair that a single person receives such an outrageous amount of money. That would put us in the realm of ethics, which are not strange to Economics. But leaving ethics aside, it is clear that Beckham is being paid in accordance with his contribution to the revenue of the company, and that is perfectly economics.

Confirmed: Immigration is good and necessary

The Bank of England has published the Bulletin Q4 2006, and it contains a very interesting article that we should rejoice, and not complain, that immigrants are coming over.

The whole article is really enjoyable, written with caution to avoid misleading readers in the wrong direction. And the conclusion leaves many things open to interpretation.

I already wrote about Immigration justifying it from the point of view of pure economics. But I was ending with some questions. One of them was that there is not enough work for immigrants. The Bank of England states clearly:

“Immigrants are employed”

Another of the findings is that there are more immigrants than average both in high qualified jobs and low qualified. An explanation of this might be that the City is atracting brilliant minds, and the economic buzz is also attracting people who is poor at home and go to Britain to find a better life.

“Immigrants also tend to be younger, better educated, and work longer hours than those born in the United Kingdom”

Economically, this is perfect: young people that have not been educated at the expenses of the British public school. It is like suddenly, we have an army of people in the best age to be productive coming from nowhere. And they are willing to work as many hours as necessary to prove that they are good. Wouldn’t you be delighted if you were their bosses? This has a repercussion in the Economy of the country as it has more quality production at the same price. Well, not at the same price.

“The increasing share of “new” immigrants in low paid jobs appears to have led the emergence of a striking wage gap between “new” immigrants and UK-born workers”

Immigrants who come from poor countries tend to be willing to work at any price. And employers take good note of it. Hence, British workers ask for more money to do the same low skilled job. Is this good or bad for the Economy?

The article gives two explanations. Suppose that they are paid less because they work worse. In Leyman’s terms, they are not worth as much as the British. Then we will have worse productivity, as to create the same amount of product, we will need more people doing it, although the cost will be the same because they earn less.

The second view says that they “may have displaced similar or less productive workers”. In this case, they work as well as the British, or even better, but they earn less. Excellent for the economy as more product will be done with less cost.

The article does not indicate whether one view is more real than the other. But it keeps on saying that since immigrants work for less and in any job, unemployment has fallen and more importantly, wages are kept stable. This fact incredibly agrees with theory.

Let’s go back to pure Supply and Demand. If supply is greater than demand, prices will fall, won’t them? If there is more supply of work than workers seeking for a job, potential workers will ask for more salary. But if the gap between Supply of jobs and Demand narrows, the position of job seekers is weaker. Also workers trying to discuss a wage increase will have less power because others will be willing to do their jobs for less money, so insiders will have to accept lower wages.

“Immigration may also have increased the supply potential of the economy by lowering the natural rate of unemployment, either by reducing skills gaps in a tight labour market or by tempering the wage demands of domestic workers, or both.”

The Bank of England suggests that the last wave of immigrants is young, well educated, willing to do the same job as a British do, but for a lower pay, willing to work more hours, and on the top of it, they might even do the job better, displacing nationals that do their job worse, or who are not willing to work for that money, which is not a problem for them because they can live thanks to the subsidies of the Government.

The article hints that immigrants are good for productivity, and are definitely good to keep Inflation down, which at the same time will keep interest rates untouched and ease the fears of a national bankruptcy if the level of credit keeps on hiking and the interest rates increase suddenly.

So what about my questions about immigration. Will they make salaries drop? No, just keep them at the same level. Will they take British jobs? Only those that nobody wants, and those where the British worker is not willing to make an effort to stay. Will they enjoy the services we pay with our taxes? They also pay taxes (unless the employer breaches the law), and they are young and willing to work. They are not a burden to the NHS.

And for the Economy? They are a fabulous present.

Immigration

Romania and Bulgaria are just about to become members of the European Union, which has triggered again the arguments about immigration. In fact, there is no such argument. When analysed from the economics point of view, everything is very clear, even how surprising politicians are.

Let’s supose I have a company in London. I make nice fashionable clothes. The first thing I need is machinery, which I buy in England. Then I need cotton. There are no crops in London. Nor in England. But that is not going to stop me. I will bring cotton from India.

Now I have english machinery and indian cotton. I need people to work and turn the cotton into clothes I will sell in High Street shops. Suppose nobody wants to work for me because everyone is happy with their present situation. I know there are people out there willing to buy clothes. There is therefore demand. I am certain I would make money if I could produce clothes. I will import my workers. The same way I import cotton, I will import the worker.

Let’s now move a bit forward. My workers are already at work and the first supply of clothes is selling very well in the shops. The shops are now selling my products instead of importing stuff from overseas, which means that I am increasing the production of the country and hence, it’s wealth.

So as you see, we need to import people in order to increase the wealth of a country when there are places that are not covered.

Hey, hold on! People are not cotton! And we are not asking them to come, they are coming “en masse” without any request. And they are using the services that we are paying with our taxes.

True that they are not cotton, but it is not that true that we have not asked them to come. They have heard that there is a lot of work here. Check it  youself in any restaurant. And in the fields. There is a demand of people, but we can not expect that companies just ask for 37 workers to be sent over. That’s why they have to come and find the vacancies themselves. After all, they are not cotton.

So immigrants are good for the economy. But, as many will say, they make our salaries drop, they take our jobs, they enjoy services that we pay with our taxes.

Hmmmm… I think this should be treated in another post.

Richard Branson, Rupert Murdoch and the logics of strategy

I have said before that business strategy is like a war, and it is even fir to get hostages. Richard Branson, owner of Virgin, wanted to include ITV, the British Independent TV in his portfolio of Media, recently increased by the cable operator NTL. And then, out of the blue, monopoly concerns appear because the deal is not done. Who does understands this?

Not long ago NTL, soon to be renamed “Virgin Media” was bidding for ITV. And it seemed that everything was done. But then, all of a sudden, ITV rejects the bid saying that from ITV’s perspective there is little, if any, strategic logic for ITV to combine with NTL”.

The deal would be excellent for NTL, because it would include the capacity of producing contents of ITV, apart from the rights in UK for the Champions League. This detail might not look very important, but around the world, football is a major incentive for customers to subscribe to payment TV.

And for ITV? Well, given their recent problems of revenues, being part of NTL would ease this concern. It would give them new platforms to broadcast their content, and also the power of the broadband, which seems to be the future of TV.

So if they were happy with the idea some time ago, and it seems that the merger makes sense, why such harsh statement?

While the decision was taken, Rupert Murdoch increased his ownership of ITV to 18%. Murdoch is the owner of BsSkyB, the satellite broadcaster, owner of the majority of rights to the English football league, and who has recently moved into broadband.

Take this with a grain of salt, because it is just speculation but, what if Murdoch is using the old business strategy of weakening the enemy? Branson and Murdoch are fighting for the hill. Although Murdoch seemed to have it very well controlled, Branson has lately started a battle with new strength. Branson is dealing with a neighbouring tribe that was being neutral until the moment. He want them to join forces. But then, Murdoch manages to have a decisive authority in that tribe and make sure that they remain neutral.

Why is Murdoch not buying ITV himself? That would spread serious concerns of monopoly. But because the deal NTL-ITV makes a lot of strategic sense, Murdoch is making sure that it will not happen. This reassures him that NTL will not grow while he makes further deals to lock his position at the top of the hill.

Milton Friedman

Milton Friedman died last Thursday 16th November 2007. He was awarded Nobel Prize of Economics 1976 and was one of the most important economists of the XX century. I just want to talk here about one single thing of his long list of innovative theories, the management of the interest rate by central banks.

The Economy has cycles. Economists love to use graphics, and line graphs with peaks and troughs are their favourites. Those graphics mean that the economy has good times, when the curve goes up, and bad times, which are the crisis. The task of the economics authorities is trying to make the cycle as flat as possible, that is, to cool down the good times and try to make the bad times less severe.

One of the ways is with taxes and public investment. The trick is that when the Economy is in recession, an injection of money in the form of infrastructures or subsidies keeps the Economy going. This was the theory that worked to help recover from the 1929 crisis, the post-war recovery in Europe and Japan, and was developed by John Maynard Keynes.

The other way is playing with the amount of money available in the Economy. This was one of Milton Friedman’s contributions to the theory of Economics, the Monetarism, and it is normally managed by the central banks.

One of the tools used by Monetarism is the Interest Rate. When the Economy is growing, the movement of money increases, and Inflation becomes a real problem, because people having money in their hands tend to compete for the same goods, and those increase the price, which is the explanation of Inflation. Increasing the Interest Rate makes credits more expensive, and saving more beneficial, so the total amount of money in the economy decreases and so does the risk of Inflation.

On the other side, in periods of crisis, when people has no money or tend to save because bad times are coming, a reduction of the Interest Rate makes borrowing money cheaper and so companies can make investments, people can buy goods and the Economy starts working again.

Obviously this is an oversimplified explanation, but it works, and Milton Friedman was the first to come with the idea.

How Internet Explorer 7 proves that competition is good

Internet Explorer 7 (IE7 or WIE) is being released today for those using Windows XP. But this was never supposed to happen. Back in 2003, Microsoft was planning destroying the market for browsers. So why now we have a new browser from Microsoft? Why did they change their master plan?

Just for reference, a browser is a program that allows us to browse all the information stored in the millions of computers that from the Internet. Without it there would be no way to see webpages, photos, news, etc.

In 1994, the first commercial browser, called Netscape appeared. In a proof of forward thinking, Microsoft thought that this thing of the Internet would never be interesting to users. In July 1995 they released their own browser. That was the beginning of the Browser Wars, which finished around 2002 when more than 95% of browsers were IE.

Then Microsoft took the decision of not releasing any other stand-alone version of IE. From 1995 to 2003, six versions of IE had been released, including some updates and minor improvements. Today is the marks of the first release since then. This means that there has not been any improvement in the browser for 3 years. And nobody can think there was no room for improvement.

Today, IE7 is released. Why is there need for a new one now?

The ashes of Netscape gave birth to a new non-for-profit organisation that released a new browser called Firefox, in September 2004. It was introducing many innovations such as tabbed browsing, pop-up block, search box, the extremely useful extensions, and a download manager. Its use started to grow to the extent that somebody in Microsoft started to get worried.

Then the original plan of not releasing any other IE, and totally integrating it in the next version of Windows, called Vista, was dropped. Today we see the results of that. A brand new IE that includes many of the innovations of Firefox, like tabbed browsing, and other interesting solutions.

If Firefox had never appeared, if the users hadn’t switched to look for the new features it was offering, IE7 with its innovations would have never happened. While Microsoft was enjoying a monopoly situation there was no point to improve, it was a one man race. When a new racer appeared at the end of the street IE had to start running. And it is indeed running! And this is much better for all of us. You can add some excitement by downloading Firefox 1.5 for free and the new IE7 and choosing your favourite. Oh, and just wait couple of months to see the much promising release of the new Firefox 2.0.

Free newspapers in London make sense

The new London free afternoon newspapers have been around for some weeks now. Not by chance, they were launched within days of difference. If in Economics everything is rational, what is rational in giving away your product. And why not simply put a price? Is everybody getting mad?

It is a normal situation throughout Europe in the last years: you arrive to the underground, the train station or get out of it and find your free copy of the morning paper. London is no exception about it, but now, there are also two free papers in the evening, invading the market of the traditional London evening paper, the Evening Standard.

How is it possible that two newspapers, with its costs of paper, printing, computers and above all journalists, can survive giving it for free? The answer is in the Internet. Sites like Google are making vasts amounts of money out of advertising. The idea is that while we are browsing the Internet or reading our newspaper, we see the advert, and then the brand or the product gets “exposure”, meaning that we now know it and are likely to buy it. Luckily for us, advertisers do not know about “ad-blindness”, according to which we have got so used to adverts that our eyes do not see them. Do not ask me to tell you one advert in the paper two minutes after I have binned it. I have no idea.

This is how thelondonpaper has made itself a place in London. Its contents are quite similar to the Evening Standard, the traditional evening London newspaper, with the only difference that you have to pay to get the latter.

A couple of days afte the launch of thelondonpaper, another free paper appeared in the London afternoons. It was delivered by the very same way, by an army of youngsters shouting “free newspaper” at almost every corner, but its approach to news is less serious, creating a differentiated product. The name was London Lite, and were edited by the same company of the Evening Standard.

Some people compare business strategy with war strategy. I can imagine the editors of the Evening Standard with the fresh news on the table that Rupert Murdoch’s company, also editor of the Sun, was planning to launch a free paper that was clearly targeting their evening paper. So they decided to strike back cutting the supplies of the opposite site and forcing them to desist.

It’s been said before that the free paper survives thanks to advertising. The more people see the advert the more exposure the brand gets, and the company is willing to pay more. If there is a second free paper, which also gives a different content, people will prefer one rather than the other. Hence, the readers will be splitted, the exposure will diminish and so will the price advertisers willing to pay. If the income from adverts is not enough to cover the costs, thelondonpaper will have to desist, and the hill of the evening market will have again only one king.

While this explanation might make sense, there is still one loose issue which is that, if London Lite tries to squeeze the profitability of the free afternoon newspapers, then it can not survive itself: the siege is also cutting their supplies. That is true, unless they are happy to run losses. And they could do that by subsidising it with the profits of other newspapers (they are getting supplies through a secret tunnel). Which is a strategy that Rupert Murdoch’s can also follow if his objective is breaking the Evening Standard dominance… Who will be the king of the hill?

Efficiency, market and the responsible use of water

We live in a limited world. Our biggest challenge is dealing with scarce resources. This is what Economics is about. And one of the main points is efficiency, that is, how to do something using as few resources as possible. For example, using a toilet.

I was recently to Vienna, which is a wonderful city, full of History, legends, music, amazing buildings and trams. As I did not want to miss anything, I was wondering around for more than 14 hours everyday. This, and the healthy habit of drinking quite a lot of water led me several times to visit the toilets of the Imperial city.

To my surprise, almost all the men’s urinals, either in palaces, auditoriums, restaurants or bars had an optical sensor. This means that when you leave, it “knows” and then pours water to clean. The toilets had a flush button that allowed you to pour only the amount of water needed, and some had even two buttons, one that released more water, and another for less. All these are methods to use water more efficiently.

This concern about the use of water would be understandable in a country like Spain, well known for its water shortages, but Austria uses only 3% of their annual water supply, so water should not be one of their concerns.

It clashes with the policy in England, another country where water, of which they think there is plenty, has never been a problem. There are no water-saving methods in English toilets. They treat water as if there was an unlimited supply. England has just had the driest year in many months, which has forced the authorities into a hose-ban and some information campaigns. And what is more, the shock of discovering that the water is not unlimited.

Why is the attitude towards water different for the general public of one and another country? The fact that Austria has run some campaigns to make the public concious does not explain the proliferation of expensive gadgets in the restrooms. The answer is in the water bill.

In England, people pay a certain amount of money, and they can use as much water as they want, in the bath, washing the car, watering the garden… In Austria, the households have water meters. The water bill increases with the use of water. So Austrians, private users or businesses, have an incentive to reduce their use. To the extent that furnishing a toilet with expensive items might be costly in the short term, but it pays with savings overtime. I am sure that items like “monoblock” taps or washing machines with water-saving programs, luxurious in England, are an everyday thing in Austria.

England has discussed the use of water meters, strongly opposed by some. But economists know that the market is the best way to allocate resources, and putting a price to something works miracles to make them concious users. Even in toilets.

The success of California lays on the San Andres fault

Everybody knows Silicon Valley or Hollywood. They are the best examples of innovative places and there are hundreds of attemps to copy their success around the world. But these attemps are aiming at the wrong direction, because they can not copy the very reason of the success.

California is nowadays one of the most successful regions around the world, being the cradle and headquarters to companies like Paramount, Cisco, Sun Microsystems or Apple, to mention a few. Economists have rushed to explain what is so special about it. They explain that Silicon Valley is a “Cluster”, a “Technology District”, or “Technopole” among others. All these terms describe a geographic network of suppliers, providers and education centers that can benefit from being phisicaly close in a geographic area: there is a knowledge transference, they have similar needs of infrastructures and supplies, and it creates a network among them.

Having successfully explained what it is, many have been the attempts to copy them. Governments have poured money and financial help to create universities, attract companies and the best brains. But none of them have become as important as the California ones – well, Bangalore and Bolywood in India have done quite well-. This is because what Economists are not aware that there is one factor that they can not reproduce. This factor is what has made of California as it is now and, at the same time, its single major threat.

Iain Stewart, a PhD in geology has an interesting theory. He is one of those scientists turned communicators by the BBC documentaries. I have had the chance to see a few episodes of Journeys from the centre of the earth and Journeys into the ring of fire. They are really worth watching.
In the latter series, he explains that California lays on the San Andres fault. As you know, the surface of the Earth is divided in plates. The fault is the place where two of them join. And the Pacific plate and the American join just underneath California. The movement of these plates creates earthquakes… and it is the explanation for the presence of gold in the Californian mountains.

When in 1848 the “Gold Rush” started, caravans of people travelled to California looking for gold. These were “risk takers”, those who are willing to take risks in order to get a high reward, in opposition to “risk adverse” people, who prefer lower rewards but more secure.

San Francisco was a little tiny town at that moment, and increased its population 30 times thanks to these gold rushers. But also by all the rest who saw an opportunity to do business with those looking for gold, like a guy called Levi Strauss. When the Gold Rush dissappeared, again the rocks gave another incentive for the risk-takers: the moves of the San Andres fault had trapped in the Californian underground another kind of gold, Oil.

When the oil ceased being a source to make money, California had already become home for people willing to take risks in anything that could seem a good opportunity. And this is how somebody decided to invest in cinema and silicon chips.

Obviously, it is hard to argue that today’s success is due to the earthquakes, but the History of California implies that sometimes, the main factors of a successful economy lay on the most unexpected causes. In this case, the risk-takers that first populated California stated an attitude towards business and opportunities. This created an inertia, and still today, anyone who wants to take risks and explore opportunities will consider moving to California. So what makes a difference between these “clusters” and the rest is the attitude of people… and the rocks.

* “Clusters” by Malmberg and Maskell, “Technology Districts” by Storper, “Technopoles” by Castells and Hall