Are we too complacent on interest rates?

One of the ongoing puzzles in the current conjuncture is why interest rates remain so low, despite the fact that the global economy has turned the corner. Indeed, central banks have recently been subject to widespread criticism for maintaining them at levels consistent with the emergency rates required in 2009 when the economy does not face anything like the same degree of danger. Despite the fact that the Federal Reserve has raised interest rates on three occasions since December 2015, yields on the 10-year Treasury note are still lower than in summer 2014 whilst UK 10-year gilts are trading just above 1% and 10-year Bunds below 0.4%.

Looking at the issue in a longer-term context, the standard approach in the academic literature is to point out that the neutral global real interest rate has fallen over the past three decades. A Bank of England Working Paper published in December 2015 highlighted that the long-term risk free real rate has fallen by around 450 bps in both emerging and developed economies since the 1980s.

The major factors which drive underlying long-term rates are expectations of trend growth and factors which impact on savings and investment preferences. The authors (Rachel and Smith) point out that the impact of a growth slowdown on lower rates is limited, accounting for less than a quarter of the total observed amount, and that the bulk of this can be attributed to changes in savings and investment preferences. Their key finding is that whilst there has been a sharp rise in saving preferences across the globe, desired investment levels have also fallen significantly. This is, of course, fully consistent with the savings glut hypothesis first postulated by Ben Bernanke in 2005. But Rachel and Smith go further by giving some quantitative estimates for the magnitudes of the quantities involved. Thus, they attribute 100 of the 450 bps decline in real rates to slower global growth; 90 bps to demographic factors and 70 bps to lower investment demand. All told, once they account for a number of other factors, they claim to account for 400 bps of the decline in real rates.

As an academic tour de force, this paper is an excellent and comprehensive overview of the factors driving rates lower. But it is not the whole story. A quick look at the data, compiled by King and Low in 2014 (chart), suggests that whilst there was indeed a sharp decline in the global real rate between 1990 and 2008 of around 250 bps, the last 200 bps has occurred post-financial crisis – a period when central banks slashed the short end of the curve to zero at the same time as they were engaged in huge asset purchases. In order to probe a little deeper, it is worth highlighting the concept of the natural rate of interest, postulated by Swedish economist Knut Wicksell at the end of the 19^th century. Wicksell argued that if the market rate exceeded the natural rate, prices would fall; if it fell below, prices would rise. Obviously, we do not know what the natural rate is but a quick-and-dirty method is to measure the difference between nominal GDP growth and the interest rate to assess the extent to which the real and financial sectors of the economy are misaligned.

In the UK, over the period 1975 to 2007, nominal GDP growth was on average within 30 bps of Bank Rate but since 2010 it has averaged a full 300 bps above, and similar deviations have been recorded in the US and the euro zone. This is not proof that interest rates are too low. After all, it is not as if price inflation is a problem for the global economy. But it does highlight the extent to which the interest rate on financial assets is too low relative to returns on real assets, which in turn has helped to propel financial asset prices to stratospheric levels. The concern is clearly that at some point asset markets will turn. But central banks will probably have no choice but to watch the bubble deflate because after having used a huge amount of monetary resources to pump markets up, they cannot realistically deploy more to cushion the fall.

Whilst I understand why central banks have been reluctant to raise interest rates so far – although the Fed is now grasping the nettle – I do detect a slight note of complacency. The fact  that (some) central bankers have justified their low interest rate policy on the basis of lower global equilibrium rates, without fully accounting for the fact that their actions have themselves pushed global rates down, strikes me as distorted logic. I am reminded of the situation a decade ago when many central bankers dismissed rapid growth in monetary aggregates as a problem not worth worrying about, when in fact it reflected the actions of banks to pump up their balance sheets. And we all know how that ended.

In a galaxy far, far away

As the EU starts to get serious about dealing with the prospect of the UK’s departure, this week's events suggested that the two sides are as far apart as ever. I was less than encouraged by the comment from an EU diplomat suggesting that the British “are not just on a different planet, they are in a different galaxy.” German Chancellor Merkel also pointed out in a speech in the Bundestag that some British politicians are still living under the “illusion” that the UK will retain most of its rights and privileges once it leaves the EU.

Theresa May’s response to Merkel’s comments was to pull a line from the Alex Ferguson/Jose Mourinho playbook to suggest that the rest of the EU is ganging up on the Brits (“27 other European countries line up to oppose us”). As if this should somehow come as a surprise when all rational people know that the EU’s objective is to maintain its integrity after Brexit. Indeed, we are now entering the business end of the negotiations, with this weekend’s Brussels summit giving the EU27 the chance to thrash out their line of negotiation. It is increasingly evident that the British are not in a good place and matters have clearly not been helped by the delusional approach taken by the British government.

Ironically, with the Conservatives looking likely to win a landslide victory in the 8 June election, Theresa May will take this as vindication of her government’s stance so far. But the government’s efforts since last autumn have been singularly unimpressive. I find it hard to shake off the suspicion that the government is rather unsure of itself, given the narrow margin obtained by the Brexit supporters in last year’s referendum, and has since spent a lot of time trying to convince the country of the rightness of its Brexit course rather than adequately planning its negotiating position.

The lawyer and blogger David Allen Green has pointed out that rather than getting on with the job of providing “strong and stable” leadership, “there are at least three ways in which May’s government has not got on with the job with Brexit and wasted precious time instead.”  In the first instance, she set up two competing government departments from scratch, resulting in turf wars which ate up a lot of government resources. Second, the government wasted time and effort fighting the attempt by Gina Miller to force parliament to vote on Article 50. As I have pointed out (here) the government could have put a simple bill before parliament in the first place which was worded in such a way as to be virtually impossible to reject – as it ultimately did, but only after a huge amount of time (and public money) was spent in the process. Perhaps worst of all, May has called a needless general election, despite promising not to do so, which in effect will result in the loss of two months of valuable negotiation time.

As a piece of anecdotal evidence to demonstrate how much pressure the civil service is currently operating under, HM Treasury has determined that the monthly survey of UK economic forecasts – to which I contribute – will not take place in May. The Treasury cites the election process as the reason for not conducting the survey. But this is the first time I can ever remember it not being conducted in the more than 20 years since I first contributed – and certainly not for electoral reasons. This is a governmental process under strain.

What is likely to happen over the next few months is that the British government will cry foul over the lack of progress on EU negotiations, with suggestions that the EU27 are somehow trying to punish the UK when in reality it is the UK’s own position which forces the EU to adopt the stance which it does. The Brits want to do a deal on trade but it is clear that the EU will first want to discuss the exit strategy. It is looking pretty likely that no deal will be done quickly. Following last week’s meeting between EU Commission President Juncker and PM May, Juncker was apparently taken aback by May’s unwillingness to compromise, and emerged from the meeting saying that he was ten times more sceptical that a deal could be done than before he went in.

The terrible irony is that all this is panning out as I feared. Indeed, I was contacted by one Brexit voter this week who remarked on my prescience and that I must somehow feel vindicated. But I take no pleasure at all from any of this. Even now, there are deals to be done but I fear we are going to get to the cliff edge far sooner than the British government thinks. Frankly, I do not trust the current government to be able to reach a compromise with the EU – and certainly not unless we see a change of tack from the prime minister. Businesses located in Britain may hope for the best but they are increasingly realising they have to prepare for the worst.

Et maintenant?

With the first round of the French presidential election running exactly to script, the markets today breathed a huge sigh of relief. To recap, Emmanuel Macron and Marine Le Pen made it through to the final run-off, polling 24.01% and 21.3% of the votes, respectively, followed by Francois Fillon (20.01%) and Jean-Luc Mélenchon (19.58%). This was pretty close to what the polls had predicted ahead of the election. With the polls suggesting that Macron will win the final runoff by a margin of around 60-40, the markets decided to get their celebrations in early. On the basis that Frexit will not now happen, the CAC40 posted a gain of 210 points today (4.1%) which is a bigger increase than has been mustered year-to-Friday (197 points). They may be overdoing it!

I have said all along that I did not expect Le Pen to make it to the Élysée Palace, and although we have to wait another two weeks for final confirmation, that looks like a pretty good bet. Assuming that is the case, what happens thereafter? Amidst claims that the French political establishment has been overturned, with neither a traditional left-wing nor Gaullist candidate making the final round for the first time since the establishment of the Fifth Republic in 1958, it should not be overlooked that Macron himself is part of the old establishment. He is a graduate of l’École nationale d'administration (ENA) and a former member of the socialist party who served as Economy Minister between 2014 and 2016, where he pushed through a series of business-friendly reforms. He is also a traditional Europhile who believes deeply in the aims and objectives of the EU (although he has denied that the label is an accurate description of his position).

Indeed, he may be further ahead of the Germans in this regard as he has previously stated that he is in favour of a euro zone budget and the issuance of common euro bonds. Macron is also expected to take a fairly conciliatory approach to Greece’s problems. But for all that he is in favour of economic positions currently not in line with those espoused by Germany, there is a strong sense that he will be in a position to strengthen the Franco-German axis and provide impetus to the flagging EU project. That is, of course, so long as he is secure at home. Macron’s En Marche! movement is not a conventional political party – it was only founded last year – and he may not have enough support in the National Assembly to pursue his domestic agenda.

We cannot write off Le Pen just yet, however, and in a bid to rid herself of the stigma associated with the far right politics of Front National, the party founded by her father, she tonight stepped down as head of FN. Writing in Project Syndicate last week, Zaki Laïdi, Professor of International Relations at Sciences Po, wrote “France has not endured such political turmoil since 1958”. A distrust of elites, fear of globalisation, rising economic inequality and a renewed emphasis among voters on national identity leaves France – along with any other European countries – in a very febrile state. Le Pen taps into the anti-establishment Zeitgeist but although much of the commentary on this side of the channel focuses on her promise to hold a referendum on France’s position in the EU, I suspect that even she will not be able to deliver Frexit.

The bigger problem for both candidates is that neither of them really has a magic bullet to offer the voters. Whoever wins the election will have to make some unpopular choices to make up for the fact that reform progress has been delayed for so long. Outgoing President Hollande’s policies did not move the dial forward. His predecessor, Nicolas Sarkozy, was occupied with the fallout of the 2008 crash whilst the Chirac years of 1995-2007 were hampered by his early failures to push through economic reforms in the face of intense political opposition. France is undoubtedly still a major economic and political power, but like an athlete who has been away for too long, the economy is out of shape and struggling to cope with fitter rivals – locally Germany, and further afield from the rise of China.

Like the UK, France is a proud country with a long history, but it is unable to throw its weight around like it once did. Just as the Brits expressed their frustration by voting for Brexit, so the French have opted to overturn the duopoly formed by the socialists and the centre right. On 7 May, the electorate will thus be faced with a stark choice between an outward-looking Macron and an inwardly focused Le Pen. Whilst the polls suggest that French voters will opt for Macron, if he fails to deliver the prosperity and security that they demand of him, Le Pen and her supporters will continue to ratchet up the pressure. The arguments we will hear over the next two weeks will not end on 7 May – not by a long shot.

Nothing new under the sun

The British Conservative party has torn itself apart over the issue of the UK's EU membership throughout the last 40 years. Indeed, Guy Verhofstadt, the former Belgian prime minister and current MEP who is now lead Brexit negotiator for the European Parliament, remarked recently that the whole Brexit issue was an internal Conservative Party spat that got out of hand. What is less well known is that in the early years of the twentieth century, the Conservatives were similarly split over another economic issue – that of tariffs – which ultimately had disastrous political consequences.

Our story starts at the beginning of the twentieth century in the wake of the Boer War (1899 to 1902) when the limits of British imperial power began to be exposed. The most powerful empire on the planet was forced to use its full military might to defeat an army comprised of farmers, which came as a big blow to national pride and caused a lot of soul-searching at a time when the USA and Germany were beginning to become established as major economic powers.

It was against this backdrop that the Tariff Reform League (TRL) was formed in 1903. The idea was to protect British industry from perceived unfair foreign competition by advocating a policy of Imperial preference in which the British Empire would be transformed into a single trading bloc to compete with Germany and the US. Imports from outside the bloc would be subject to duties which would be channelled towards social reforms, such as the establishment of a universal old age pension scheme. The TRL also claimed that high import duties would allow taxes to be cut in other areas. However, this was a controversial proposition and opponents claimed that such a protectionist policy would raise the cost of goods such as food (especially bread).

Like the Brexit campaign, the TRL was well funded and supported by a range of politicians, intellectuals and businessmen. Moreover, it was popular with the grassroots of the Conservative Party. But politicians were split, and the issue fractured relationships between Conservative MPs and their government coalition allies in the Liberal Unionist Party. As a result, this coalition suffered a landslide defeat in 1906 to the Liberals (not to be confused with the LUP) which advocated Free Trade. Thereafter, the tariff issue appeared to lose momentum. The so-called People's Budget of 1909 was instrumental in introducing a universal pension scheme, undercutting one of the arguments used by the TRL, and by 1914 the league had all but ceased to exist. The Conservative Party also downplayed tariff reform and abandoned a pledge to put the issue to the public in a referendum.

But the coda to this particular piece of history came after WW1 following the official dissolution of the TRL. After comfortably winning the 1922 election with a majority of 78 seats the Conservative prime minister, Andrew Bonar Law, resigned due to ill health. His place was taken by Stanley Baldwin who announced that tariff reform was to become official Conservative policy in order to tackle rising unemployment. Just as Theresa May did this week, Baldwin announced a snap election early in the new term to secure a popular mandate for the new policy. But in the December 1923 election, just 13 months after the previous one, the Conservatives lost 86 seats and although it was still the single biggest party in Westminster, it was unable to overturn a coalition of Labour and the Liberals.

Ironically, the Lib-Lab government failed to hold together and a third election was held in 1924 when the Conservatives won a landslide, helped in part by the infamous forged Zinoviev letter, which was published in the Daily Mail four days before the election. Things got worse for Labour before they got better. The party was blamed for the economic collapse of the early 1930s and polled its worst results at the 1931 election, to which it responded by electing George Lansbury, a left-wing pacifist, as leader.

Whilst history never repeats exactly, the parallels with the British political scene then and now are striking. The Conservatives are split on issues of national economic significance, with Brexit playing the role today of tariff reforms almost a century ago. In addition, the experience of 1923 illustrates that this week's decision to call a snap election is fraught with risks. We should also not overlook the role of the Daily Mail in publishing material whose veracity is open to question. Meanwhile, Labour is repeating its post-1929 convulsions all over again.

As it happens, nobody expects anything other than a thumping Conservative majority following the election on 8 June, so the 1923 experience is unlikely to be repeated. This is partly because, like Lansbury, Jeremy Corbyn is – rightly or wrongly – deemed unelectable. Ironically, Lansbury never actually faced the electorate – he resigned as Labour leader just over a month before the election and the party improved its performance compared to the previous election in 1931 under his successor, Clement Attlee. A Corbyn resignation in the next two weeks is unlikely, but he still has a chance to repeat the rhymes of history.

Perhaps what all this tells us is that there is nothing new under the sun when it comes to politics. The smart leader writers who tell us that the Labour Party is condemned to oblivion really ought to look more closely at history. But it is unfortunate that it is currently unable to mount an effective opposition to a government apparently bent on enacting a ruinous economic policy in the form of a hard Brexit. If there is anything to be learned from the economic and political debates of the interwar period, it is that economic nationalism – for that is what Brexit is about at heart – is a thoroughly bad idea.

Out of the blue

Today’s announcement by Theresa May that she intends to call an election in the UK for 8 June was an Easter surprise that nobody anticipated. From a political perspective, there are many good reasons why the PM would wish to hold an election now. First, the timing is propitious: The economy has withstood the Brexit shock better than most people expected, and although consumers are now being squeezed by the sterling-induced rise in inflation, with the result that real wage growth is now at its slowest since 2014, it has not yet gone on long enough to be really noticeable. It thus makes sense for her to hold an election before the bad news starts to kick in. Although the election was not originally scheduled to take place before 2020, there is a risk that in three years’ time, the economic fallout from Brexit would start to make its presence felt, which could be politically damaging.

Second, although the PM has previously said that the current government would serve its full term until 2020 it is pretty obvious that the manifesto commitments made in 2015 are constraining her room for manoeuvre. As I have pointed out previously (here) the election promise not to “raise VAT, National Insurance contributions or Income Tax" was a howler, which backfired in March when Philip Hammond was forced to rescind his planned increase in National Insurance Contributions for the self-employed following a backbench revolt. Oddly, the same backbenchers did not show any discontent when the commitment to remain in the EU single market was reneged upon (“We say: yes to the Single Market”). It is thus clear that the government realises the manifesto commitments are no longer appropriate in a post-Brexit Britain (so look out for a rise in self-employed NICs in the November Budget).

Third, the Labour Party is down and out. Jeremy Corbyn’s approval ratings are subterranean with three big pollsters giving him a net rating of between -36 and -41 (here). The Conservatives are ahead by 20 points in the polls, but prior to last year’s EU referendum the lead was only 5 points. I would conclude that Corbyn’s failure to speak out in favour of the near half of voters who rejected Brexit, and his decision to go along with the Conservatives’ Brexit timetable, has cost his party dearly. The bottom line appears to be that the Conservatives will win by a landslide with pollsters pointing to a parliamentary majority in excess of 100 seats, compared to 17 today.

As for UKIP, who cares? They appear to be a busted flush with their sole MP having quit the party last month and the party foundering in the absence of the charismatic Nigel Farage. Indeed, a party which existed only to force the UK out of the EU no longer has a raison d’etre. However, they could still damage Labour efforts to win seats in the English north and midlands by siphoning votes away, which can only help the Conservatives. Meanwhile, the Lib Dems are not expected to improve on their poor 2015 showing and the Scottish Nationalists will retain their lockout north of the border.

All this leaves me rather uneasy. The Fixed-Term Parliaments Act 2011 was designed to force governments to serve their full five year term and prevent them from choosing the timing of an election to suit their own purposes. Only twice since 1951 has a government called an election so early in its parliamentary term (1966 and 1974), and on those occasions the majority was either unworkably small (1966, when it was down to 4 seats) or the government was in a minority (1974). We have to go back to 1923 for the last time a government with a workable majority called an election so early. Following the 1922 election which gave the Conservatives a comfortable majority, the prime minister wanted to secure a mandate for tariff reform, which his government supported. In the event its 74 seat majority was wiped out in 1923 allowing Labour to form its first ever government (with support from the Liberals). So beware the lessons of history.

As it happens, sterling ended higher today as (in the FT’s words) “investors bet the prime minister would use the vote to neutralise Tory Eurosceptics and deliver a soft Brexit.” I am not sure it will necessarily turn out like this. Janan Ganesh, also writing in today’s FT, pointed out that the prime minister is not so much bending with the wind to appease the right-wing backbench Conservative MPs as much as she is a conviction politician on a mission. If you buy that version of events, then if the PM is able to secure a much wider parliamentary majority (as is pretty likely), she will then have a mandate to do pretty much whatever she wishes. And as the blog at Another Angry Voice points out (albeit in fairly intemperate language, here and here)  Theresa May has a lot in common with the right-wing of her party. This concerns me because it suggests that far from facing down the Eurosceptics, there is a risk she will be happy to deliver the Brexit-at-any-cost policy which so many of them want.

One thing is for sure: We should never underestimate the prime minister and she certainly does not come across as the type to be pushed around by anyone – especially by those within her own party. As Ganesh pointed out, we should not be fooled by the fact that “on Easter Sunday, one of the least pious societies in the world heard an explicitly Christian message from its prime minister.” As the old joke goes, she may be the clergyman’s daughter, but you couldn’t put anything pastor.

Getting the message across

They say you should never believe everything you read in the newspapers, although in today’s post-truth world I wonder whether you can believe anything. We all suffer from various cognitive biases and tend to believe those elements of the media which affirm our own prejudices. Bearing this in mind, I was gratified to read the headline in today’s Irish Times, pointing out that the “British government realises Brexit is a mistake”. It goes on to quote John Callinan, the second secretary-general at the Department of the Taoiseach, who pointed out that the UK government is now “slowly” beginning to understand that Brexit is “an act of great self-harm.”

Whilst I did point this out last weekend (here) it is gratifying to hear others say what I – and most of the economics profession – have been saying for the past four (and more) years. The worrying thing, of course, is that the article uses the adjective “slowly” to describe the UK government’s dawning realisation of the scale of the challenge. If that is indeed true, it is not the cognitive biases of our elected representatives we should be worried about, but their cognitive processing power. Indeed, there was a total absence of leadership during the referendum campaign with no politician daring to make a coherent statement about the benefits of EU membership which was able to tug at the heartstrings in the way that the Leave campaign managed. There was very much a sense that politicians faced an onslaught from a press which seemed only to be interested in making the case for Brexit. To put it simply, it was as if we lived through a period when rationality broke down.

It is not the first time we have been through this. I was reminded of the article by Chris Dunkley, the Financial Times TV critic in 1997, who described the TV coverage of the funeral of Diana, Princess of Wales by highlighting that the British public had engaged in some kind of collective breakdown. He pointed out that although 60% of the British population tuned in to watch it on TV, that still meant a sizeable minority of 40% did not, but given the way in which it was reported one would have thought that everyone was glued to their TV. Unfortunately I no longer have a copy of the article to hand, so I am quoting from memory, but it got to the heart of the way in which events are distorted by the popular press so that it becomes part of the accepted narrative.

In a similar vein I was struck by a paper I came across recently which looked at the way in which Jeremy Corbyn has been portrayed by the British press. The study, produced last July by Bart Cammaerts, Brooks DeCillia, João Magalhães and César"Jimenez-Martínez of the LSE’s Department of Media and Communications (here), pointed out that “Corbyn was represented unfairly by the British press through a process of vilification that went well beyond the normal limits of fair debate and disagreement in a democracy … He was also systematically treated with scorn and ridicule in both the broadsheet and tabloid press in a way that no other political leader is or has been … The result has been a failure to give the newspaper reading public a fair opportunity to form their own judgements about the leader of the country’s main opposition.”

As one who does not have much time for Corbyn’s policies on the whole, this is a very astute observation. The paper goes on to point out that “UK journalism played an attack dog, rather than a watchdog, role. This is unhealthy from a democratic point of view and poses serious ethical questions as to the role of the media in a democracy, especially when it concerns the legitimate contestation of the Government of the day.” Such behaviour was also evident in the run-up to the 2015 general election, when Labour leader Ed Miliband was portrayed as “Red Ed”, a dangerous socialist who would damage the national interest (not, of course, like the current government whose Brexit policy should in no way be seen as damaging to the national interest).

I have no wish go further into the debate about the role of the media where the likes of Simon Wren-Lewis have discussed it in much detail (here). But we should be very aware of uncritical acceptance of policies such as Brexit (or indeed Trumpism) which make seductive promises which cannot be met. It is incumbent on all of us (politicians included) to act responsibly in the face of some of the wilder policy claims in the press (or indeed social media). Otherwise, it will not just be politicians who have a slow dawning realisation that their positions are untenable. Once voters realise it, they may become even angrier than they are now, and that would definitely not be good for our democracy.

The economics of flight overbooking (or how to avoid a beating)

The recent news that a passenger was unceremoniously hauled off a United Airlines flight because the airline was unable to persuade enough passengers to voluntarily disembark strikes me as an extreme case of market failure. It is well known that airlines routinely overbook flights in order to maximise the chances of a full aircraft, given that a certain number of passengers will not travel for one reason or another. In the event that there are more passengers than seats, the airline must offer some form of compensation to persuade passengers to voluntarily make way. At the same time, the passenger must weigh up whether the price offered is sufficient to compensate them for the inconvenience. It is a classic bargaining situation worthy of further investigation.

Obviously, the aircraft cannot take off until all passengers are seated and it must wait at the departure gate until the supply and demand for seats is in equilibrium. The airline is charged in proportion to the time elapsed over and above the scheduled departure time. According to industry estimates (here), the cost of such delay is around £70 ($87.50) per minute. The airline will know before boarding begins that they are overbooked so it is in their interests to offer compensation before passengers take their seat, although in the recent United case the airline appears to have waited until they were on board, which is a major strategic error.

We can devise a simple model to analyse the choices facing the airline, based on some arbitrary assumptions but it makes the point. If we assume that it takes 10 minutes to remove luggage and repack the hold, then the airline has an incentive to offer compensation of less than $87.50 up to 10 minutes before the scheduled departure time. Between 9 and 10 minutes prior to departure, the strike price rises to $87.50 which is the price of saving another minute of delay. With less than 10 minutes until the scheduled departure time, and no takers for the offer of compensation, the fine will continue to rise in a linear fashion because the airline cannot unload the luggage and still make the slot. The airline will thus have to raise its offer to passengers on the basis that $87.50 has not proved sufficient incentive so far. On the assumption that one of the passengers does not suddenly “crack” during this standoff, the airline will have to engage in a price discovery process in order to tempt one of them to drop their claim for a seat because otherwise the delay will continue indefinitely.

Suppose that for every minute that elapses, the airline raises its offer by $10. Thus, with 9 minutes to go, the airline will face a fine of $87.50 and offers passengers a similar amount. With eight minutes to go, the fine rises to $175 and the passenger payout to $97.50 and so on (see chart for the representation of the cost structure in this case). The total cost to the airline is the fine levied by the airport for missing the departure slot plus the customer payout (we ignore the costs of any overnight accommodation for inconvenienced passengers). If there are still no takers at the scheduled takeoff time, the airline faces costs of $1052 (a fine of $875 and compensation of $177.50). Obviously, this process could go on for a while – in theory up the point at which it becomes cheaper to refund all passengers and cancel the flight (less the cost of unused fuel and any sundry items).

As it happens, one limit to the process is the legal maximum compensation which US airlines are required to pay ($1350). In our simple model formulation, the airline would have to wait two hours before reaching this limit but by that point the airport fines would exceed $11,000. Indeed, as the chart shows, the airline has an incentive to avoid the steeply rising departure fines. A simpler option would be for the airline to decide in advance how much to offer the passenger before it has to pay any departure fines. Thus, more than 10 minutes prior to departure the airline will not be subject to fines but knows that if it waits until the scheduled departure time before finding an agreement, it will have to pay $1052. The sensible option is thus for the airline to offer the passenger an amount up to $1052 which allows it to take off on time without incurring any departure fines; gains goodwill from the affected passenger and still pay an amount which is less than the legal maximum. Note, by the way, that European airlines are less generous. Payouts per passenger depend on the distance travelled and range from a minimum of €250 for short-haul flights to €650 for longer journeys.

The simple model suffers from a number of shortcomings, none of which change the broad picture. It does not deal with multiple equilibria (i.e. if more than one passenger were to accept the offer). A workaround to this problem is to pick a passenger at random and make the offer rather than hold an auction. More problematic would be the case where the airline needs to bump more than one passenger which changes the airline payoff because different people have different preferences, thus making it harder to find a series of market clearing prices.

This raises a question of what would tempt a passenger to accept the airline’s offer of compensation? It all depends on their time preference, or the rate at which they discount the need to be at their destination on time. This will depend on factors such as income and the value they place on their time. If you are a US worker with just two weeks holiday per year and you lose one day due to flight problems, you may set a high value on the cost of delays. If, however, you earn $50,000 per year, you can earn an extra day’s pay ($200) simply by holding out for two minutes beyond the scheduled departure time.

If the model outlined above does not provide a solution, the process can be short-circuited by the drawing of lots to choose who leaves the aircraft – as apparently United did. Unfortunately, the gentleman removed from the United flight was a doctor, who presumably applied a very high discount rate to his time, so it is hardly surprising that he was not best pleased at being asked to leave the flight – let alone the manner of his departure. There are many issues involved here, but perhaps the key takeaway is that airlines are desperate to avoid departure fines so if you have the time to negotiate, chances are you can drive a hard bargain. There again, you might just be hauled off the aircraft …