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notes_on_real_life

Stansted expansion

A new public inquiry into expansion of passenger numbers and flight slots at Stansted airport opens this morning. The airport won鈥檛 get an easy ride. Opponents of Stansted will argue that providing extra flight capacity is contrary to the goal of limiting greenhouse gas emissions.

Protestors take part in a demonstration against the expansion of Stansted AirportIndeed, my impression is that climate change has moved to the centre of our arguments about airports, above noise and countryside destruction. But airports weren't always so controversial.

The former Labour cabinet minister, the late Douglas Jay, wrote of his life as a civil servant in the war, helping to make one particular decision. He remembered taking a bus up the Strand in London, attending a meeting about post-war planning at which it was decided Heathrow would be London's main civil airport, and then he went back to his office again by bus. Job done, at a cost of a one penny or so on bus fares.

It鈥檚 quite a while since we were so casual about airports. We now set more demanding criteria.

But before we let climate change become the dominant issue in decisions about airport expansion, we need to make an important decision. Assuming we want to reduce aviation emissions (an argument I won鈥檛 go into) should we constrain airports and runways to discourage us from flying? Or should we discourage flying and see whether that constrains the growth of airports and runways?

Stansted airportIt鈥檚 not an academic question. It is not environmentally irresponsible to restrain aviation to an appropriate atmosphere-protecting size, and then to build as much airport as that aviation comfortably needs (subject to the old arguments about noise and greenspace) rather than using overcrowded airports as a means of restraining aviation.

In essence, the argument comes down to one about what instrument government should use.

And as a first thought on it, most economists would argue that some kind of pricing mechanism, not airport space, is the obvious tool. In other words, if you don鈥檛 want people to fly, make flying more expensive.

Indeed, here's a thought. Suppose we taxed Ryanair like we tax car drivers, for whom two-thirds of the cost of petrol is tax. What would the effect on Ryanair fares be, given that fuel accounts for 40 per cent of the company鈥檚 costs?

The maths is a bit opaque - as indeed Ryanair fares sometimes are. But here鈥檚 my back of an envelope calculation. Ryanair says its average fare is 拢28, but with compulsory add-ons I think it is more like 拢40, and with tax it comes up to about 拢50 (one-way) for the passenger.

With its 10 per cent net margin, Ryanair鈥檚 total costs per average seat should be about 拢36, of which 40 per cent is fuel, which we will call 拢15. Now suppose 鈥 overcoming all the practical obstacles 鈥 we taxed that fuel by 拢30 (so the tax is twice the cost of the fuel). And suppose we applied VAT to the rest of the price of the ticket (raising about 拢5), there is a total tax of 拢35, not 拢10. There would be extra tax of about 拢25. In other words, the typical 拢50 fare would need to rise to about 拢75 for Ryanair passengers and car drivers to be treated the same way.

Treat this as a very ball park kind of figure. But if your goal is to limit air travel - it's an option.

Now, how does this compare to the other option, constraining the amount of runway slots that are available? Well, here鈥檚 a funny thing. If scarce slots really do bite as a constraint on flights, then guess what: airline prices will rise. As demand for flying grows, airlines will not be able to increase capacity, so they'd have to raise prices.

In fact, they'd be silly not to - if they didn't raise prices, they'd have queues of dissatisfied passengers who could never get a seat despite being willing to pay more. So the simple message is, however you constrain airline flight, the passenger will likely pay more.

But there is a big difference between higher taxes, and fewer landing slots. If it's a tax, it's the government which keeps the money. While if runway slots are constrained, the airlines who have runway slots win, because they keep the extra fares they can charge.

It's an important task in thinking about different constraints on flying. Deciding who pays and who keeps the money from any policy.

A similar issue comes up with another policy option: putting airlines into the emissions trading scheme. What this does is put a cap on the emissions of airlines, but it allows them to buy the right to emit more. (They can also sell their rights to emit).

Once the caps bite, this would have the effect of raising prices 鈥 at the margin the airlines would be paying to emit. But of course, the airlines would have the right to emit up to their cap without paying. That would make it quite hard for a new airline 鈥 with no rights to emit at all 鈥 to compete. It would have to pay for all its emissions, whereas those airlines that have a cap will only face a penalty on some.

If it is new airline entry which dictates the ability of existing airlines to exploit us, then the existing airlines will be able to make a handsome profit before any new airline is enticed into the market. Again therefore, the cap-and-trade system has some consequences for the conduct of the market. In fact, it is not surprising that the existing airlines are campaigning for emissions trading to be the chosen way of restraining them.

This is all fascinating stuff. And it is quite complicated.

But whereas we are quite organised in having big planning inquiries into airport policy 鈥 that has moved on since Douglas Jay's day 鈥 our decisions on the tax treatment of aviation seem every bit as haphazard and ad hoc as our war-time decisions about airports.

Maybe, before we open more debates about runway slots, we should have an inquiry into flying.

notes_on_real_life

Value engineering

If you鈥檝e ever stayed at a Hotel, you might have noticed they don鈥檛 have shampoo in the bathroom.

Well, that鈥檚 鈥溾. It is a phrase you might want to remember, as it governs your life more than you know. The concept is perhaps best described by the company鈥檚 own website:

Travelodge reception

    鈥淧ay for things you don't want? That's crazy! Our research shows that most people staying in a hotel simply want a clean, comfortable place to get a good night's sleep, and are happy to forgo the unnecessary "frills" offered in other stuffy, over-priced establishments. So we make sure we provide good quality essentials such as a comfortable bed and a decent quality shower, but get rid of unnecessary extras.鈥

It鈥檚 worth reading , and their justification for not having various specific items in rooms, from hairdryers (answer: most customers don鈥檛 need one) to bathmats (answer: the floors have enhanced slip resistance).

Similarly, if you ever buy a kitchen at Ikea, you might find the cupboard doors a millimetre or two thinner than the doors at the more expensive kitchen suppliers. That鈥檚 also value engineering.

If you鈥檝e sat at a pizza restaurant and found the service a little too efficient, that鈥檚 value engineering of sorts too.

In none of these examples, has the product or service level arisen by chance. In each case, someone has thought carefully about it. They鈥檝e engaged in an exercise 鈥 formal or informal 鈥 called value management to optimise their processes, trim costs and enhance quality.

In big companies they do this in a structured way, engaging consultants in a fairly scientific process using so-called FAST diagrams. In small companies, they do it more haphazardly, maybe sitting in a VE workshop, with key designers and contributors throwing in ideas.

The whole concept of value engineering itself emerged from the American giant, General Electric, during the second world war. Since then it has been dressed up, supplemented and rediscovered in different forms. But at its most ambitious, the broad discipline of value analysis is the task of asking what a company is really trying to achieve, and how it best gets there.

A good example (provided to me by Professor John Roberts, an expert in this area) is that of meeting the objective, 鈥渢o increase profitable capacity in a manufacturing operation鈥. You don鈥檛 just ask, 鈥渉ow do we build more capacity most efficiently鈥; you also ask whether the best way to increase profitable capacity is to stop wasting existing production time on unprofitable lines.

But at its narrowest, value engineering is about paring costs. And that probably remains its most common everyday application: thinking about every aspect of a process and a product to deliver an objective as cost-effectively as possible.

travelodgebedroom2.jpgIt鈥檚 the Travelodge shampoo experience.

I have never sat in a VE meeting, but I know people who have, and it is amazing how much you can save, if you just think about it in a systematic and open-minded way. Indeed, try it yourself next time you want to do some big work around the house: come up with a plan for that new bathroom, and then have a VE workshop with yourself. Ask yourself about all the materials you are using and what they are for. Ask about the schedule of work and whether it minimises costs; ask yourself whether you really need a full length bath, a shorter bath or a shower? Could you save money on tiles by getting a bigger mirror? Do you need tiles or could you paint the wall?

You鈥檒l probably find there are lots of options for saving money 鈥 and some for spending money.

And even if you reject them (the full length bath is much nicer) the exercise may have been instructive. Thinking about big projects constructively is rarely a waste of time.

Note that value engineering is not (in principle) just about delivering the cheap and cheerful.

Upmarket hotel chains will always decide to offer shampoo, but they also need to think about value. Should the bathroom walls be in marble or tile. VE is about delivering the best customer experience for a given cost, so it only involves reducing costs where the saving is bigger than the reduction in value for the customer.

Business loves these kinds of concepts. It can take them, give them initials, and read books about them.

But in truth, value engineering is only a means of implementing a very basic concept of economic welfare: that you improve welfare when what you do costs less than the value someone derives from it. Should a hotel supply shampoo? Yes, if it costs 10p and the hotel customer values it at 11p. No, if it costs 10p and the customer values it at 9p.

This basic intuition is in practice obviously very complicated to implement. We don鈥檛 know what value the customer puts on the shampoo. Not all customers value it, but some value it a lot. If a few value it, couldn鈥檛 we sell it them (which is what Travelodge do)? Or give it to them at the desk? Or can we re-use it so that the cost is actually less than 10p?

But the idea is simple. Cost versus benefit. It should run through every business decision.

Now a lot of people recoil at businesses making things cheaper. They assume that when a hotel cancels the shampoo, or makes the kitchen wood thinner, it allows them to make more profit at the expense of the customer.

But that鈥檚 rarely the case.

It is in the interest of a hotel chain to offer customers all those things they really value. After all, Travelodge would be silly not to offer us shampoo if we valued it at 11p, because they could make more profit and get more satisfied customers by offering it and raising their price by 10.5p.

Similarly, it is in the interests of the hotel chain to offer customers only those things that customers value. After all, they would be silly to offer us shampoo we valued at 9p, if they could make more profit and get more satisfied customers by dropping it, and cutting their price by 9.5p.

In other words, Travelodge has just the right incentive to offer shampoo if customers value it. And removing the shampoo may be a favour to customers rather than a rip-off.

Indeed, often when service is annoyingly low-grade, it is not because a company is incapable of offering high grade service, it is because they have worked out just what their customers really value and want to pay.

And that鈥檚 value engineering for you.

Since I was reminded of the phrase fairly recently, I have found myself muttering it under my breath quite lot; either when I encounter something that has obviously been value engineered 鈥 from an airline meal to the packaging for an electronic device.

Or (less often in fact) where it seems to me something could benefit from value engineering if only they bothered to pursue it.

But be grateful for the modern companies that think carefully about what they鈥檙e doing, even if it sometimes means you can鈥檛 wash your hair when you want to.

vital_statistics

Inflation predictions

The Bank got it wrong last year. It thought inflation was under more control than it was. It's now having to catch up -- and it seems that for that purpose, interest rates .

The Bank's projection for inflation sees inflation coming in on target, on the assumption that rates go up another quarter point or so.

That would be the fifth rise in the latest sequence, and would push base rates to five and ¾%.

As the risks still seem to be "on the upside", we can't rule out the idea that rates may have further to go after that.

For borrowers, it might feel as though the pain is never-ending -- but in recent history, when interest rates have moved up or down, they have done so in cycles that amount to about 1 and ½ percentage points. On that basis, you might expect two further rises if this is an average cycle -- let alone a painful one.

Here is the data of peaks and troughs in recent history -- the average move up or down between the extremes of the cycle is 1.40.

Feb 94      5.25
Dec 95      6.50
June 96     5.75
June 98     7.50
June 99     5.0
Feb 00     6.0
July 03     3.5
August 04     4.75
August 05     4.50

Now this is not particularly helpful in providing exact guidance as to the magnitude of interest rate cycles, as it is hard to decide whether the current interest rate is part of a short cycle that started from the 4.5% trough of August 2005 to 2006. Or whether it is part of a long cycle that started back when rates were 3.5% in 2003. It depends whether you think the 4.50 in 2005 was itself a cycle, or a (probably misguided) digression from an upward swing in rates.

But the point of this data and the argument over the magnitude of cycles is not to predict how far rates will go, but to remind us that rates do move about in a range, and we should not let the recent relatively narrow history of rates limit our horizons as to how broad the range typically is.

People seem shocked by the idea that rates may reach 6%. I think we can say it would be surprising if they went that high, but not shocking. It is quite within the range of possibilities suggested by recent experience.

The real problem though, is that we don't actually know. As the last year has proved, inflation is unpredictable.

Some people think they can (and did) predict it -- but the problem for the rest of us is that we can never be sure their prediction is the right one for us to be following.

The key thing is not to fixate on a particular prediction of rates, but to prepare for realistic scenarios, to which history can be a useful pointer.

notes_on_real_life

Blair's economic legacy

In the 1997 election campaign, the Conservatives ran under a slogan "Britain is Booming. Don't Let Labour Blow it".

They ran a party political broadcast that looked ahead at economic life under Labour, with various people talking from a future under Labour, telling us how their mortgages had gone up, how they had lost their job and how inflation had soared.

It hasn't happened that way.

The economy has grown at an annual per capita rate of 2.4% a year. This is rather better than the average for the last half century, which is 2.1%.

Our overall growth has been 2.8% a year, (slightly) exceeding the average of the developed world, and ahead of the large European nations by an average annual percentage point.

Blair and BrownMeanwhile, inflation has been almost bang on its target. Employment has hit record levels.

If that's all something of a surprise, perhaps more significant is that instead of the government being disrupted by a sterling crisis, Mr Blair is the first Labour prime minister to have endured a currency that is embarrassingly strong, not weak.

Now, it's tempting to dismiss Tony Blair's role in running the macro-economy over the past decade on the obvious grounds that he sub-contracted it all to his Chancellor, Gordon Brown (who in turn out-sourced quite a lot of it to the Bank of England).

And it's true that it is probably not Tony Blair who should be held responsible for big economic decisions, such as making the Bank of England independent, or introducing tax credits.

But aside from the macro-economic management that has not been under the direct control of the prime minister, there have been several important economic developments in the past few years, for which Tony Blair can take a share of responsibility.

He has set an important overall direction for the economy. And it is this direction which is perhaps the biggest surprise of the Labour government of all. For under Messrs Blair and Brown together, Britain has allowed itself to become the most global large economy in the world.

We have allowed our companies to be bought up by foreigners, our manufacturing has been allowed to move off-shore, we have been a more vociferous champion of free trade than our large trading partners. And above all, perhaps the biggest single economic decision of the Blair government's period in office, we have allowed foreign labour to migrate here more freely than most of our counterparts.

The effects may have been deliberate, they may have been accidental; you may view them as positive, you may view them as negative. But the net result is an economy that is rather different to the one Labour inherited.

Business and financial services have become our dominant industries, and manufacturing has shrunk in relative terms far more than anyone could have predicted (from 21% of our economy in 1997, to less than 14% today).

The population has grown by about four per cent - you have to go back a generation to find population growth at that on that scale.

And the foreign cash Britain earns on its investments overseas - at about two per cent of our national income - is higher than it has been at any time since we had an empire.

So it turns out that Mr Blair's natural inclination to project a global role for Britain - obvious in his foreign policy and his promotion of advances in Africa and on climate change - was most forcefully applied to the economy at home.

He didn't get to take Britain into the euro, an international venture to which he was instinctively rather sympathetic, but he did succeed in allowing Britain to cope with a world changing around it.

Perhaps his most important economic legacy is that in a recent international poll, Britain turned out to the the nation most inclined to believe that the emergence of China was beneficial not harmful to its economy.

The UK under Tony Blair has adjusted to the events in the rest of the world with less trauma than most other large countries.

small_change

On interest rates... II

I'm afraid I can't take any particular pride in having made the right call on interest rates yesterday.. as there was no-one making a different call.

Of course, when rates do change, the Bank gives us a short statement of its views - .

The tradition among commentators is to deconstruct the Bank's words for inner meaning. I'm not sure that one needs to. There is a clear recognition that inflation remains a risk, even with it probably falling this year. That leaves open the possibility of further rises in interest rates. Rather than over-intepret the Bank's words though, I would say the argument I outlined yesterday remains valid.

small_change

Foot work

If you were interested in , you might be interested in a post I did last month about the subject.

notes_on_real_life

On interest rates...

The Monetary Policy Committee of the Bank of England has started its monthly meeting to set interest rates. Back in the middle of February, I confidently predicted that rates would rise when the outcome of the meeting is announced tomorrow.

As inflation has risen since I made that prediction, I have no reason to dissent from the unanimous view of the professional pundits that there will indeed be a quarter point rise.

I would put about a ninety per cent chance on that outcome, with a five per cent chance of a half point rise, and a five per cent chance of no change.

As it happens, MPC members will have seen a preview of next week's inflation release. But unless there is an enormous shock contained therein, the committee should not be much affected by those figures, as it takes a medium term view and tries not to react to every twist in the data.

Now my sense at the moment is that interest rate rises are beginning to hurt a portion of the population quite significantly. While any one rise can be dismissed as having only a modest effect (maybe 拢20 a month for each hundred thousand pounds of mortgage), four rises can add 拢80 to the monthly payments and, well, then you are talking about serious money.

Obviously, it's just normal everyday economic life for inflation to go up, for interest rates to follow and for mortgage borrowers to squeal. I could end my blog here, and say there's nothing more to say about where the economy is.

But the position the economy finds itself in at the moment feels more significant than normal.

The problem at the moment is that the economy is arguably in the midst of a mini-boom and incipient inflationary pressure may be worse than it looks. Obviously, the frothy state of the housing market is the most worrying sign.

If one believes that the boom in asset prices generally is a telling indication of overheating, then one might suppose the Bank will have more work to do than one last quarter point rate rise.

And it's easy to imagine that the effect of yet more rate rises could be yet more painful. Instead of mortgage borrowers just finding their monthly payments going up, they might find an economic slump causing their monthly income to go down. And that's when the trouble starts.

Of course, it might be that houses are not over-priced and reflect genuine supply shortage (though it becomes harder and harder to believe that). And it might be that if they are overpriced and soon crash, the economy generally will nevertheless survive unscathed.

But one should entertain the possibility that other, less benign scenarios could occur. At least, this latest decision does seem to come at an interesting juncture.

As it happens, the man who warned about all of this is Mervyn King, who gave an interview to The Times on the day he became governor of the Bank of England almost four years ago.

He told us, "there are plenty of things that could throw up awkward challenges..." And he said, "there will be bigger movements in inflation away from the target... ". He has been right on both prophecies.

He could predict that things might get rough, because the economy has been in a vulnerable position, enjoying strong growth, built on strong consumer spending, fuelled by cheap imported goods and sustained by low interest rates.

It has always been the case that if the ever cheaper goods that have been crucial to holding this formula together stop falling in price, some kind of painful adjustment becomes necessary.

And that might be where we are now.

There was one other thing the governor said in his Times interview four years ago - "The feelgood factor won't be there in the same way...". With interest rates likely to hit five and half per cent tomorrow, mortgage holders probably feel that was his most accurate prophecy of all.

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