Since the days when victorious rulers distributed enemy property among their lieutenants, governments have derived patronage and revenue from the allocation of scarce resources. For modern governments, these opportunities come from technological and social changes, rather than from conquest. The Department of Energy handed out exploration rights in the North Sea. Royalties, petroleum revenue tax and a special corporation tax regime kept the government afloat for two decades. The Independent Television Authority awarded a limited number of broadcasting franchises. When they became a licence to print money the government imposed a levy to shovel the money away. The Gaming Board assigns casino licences on a highly restrictive basis and the Treasury taxes the proceeds.

The traditional mechanism of state allocation of scarce resources is the beauty contest. A selected contestant is given the right to exploit and the proceeds of exploitation are taxed. The auction is a more recent approach. Its origins were ideological – a belief that the market, rather than a government agency should decide the best qualified user of the resource. This belief was quickly shown to be naive. Alexander the Great and William the Conqueror no doubt discovered who made the most extravagant promises of revenues to the king. It was not the hard-working barons who studied husbandry but the loud mouthed braggarts.

Human nature has not changed, and business auctions today suffer from the winner’s curse. The highest bidder is not necessarily the company that will manage the asset most effectively, but the one whose management is most optimistic about its own capabilities, and whose advisers and shareholders are particularly exuberant, perhaps irrationally.

The real attraction of auctions to governments now is not that they reveal the best company for the job, but that they pull in lots of revenue. This works best when the bidders are foreigners. When the state government of Victoria sold its power stations, the successful bidders were those foreign utilities with the most bullish views about the future of Australian electricity prices. Today, these companies are nursing their losses – PowerGen has recently quit after a £500m loss – but Victoria has retired most of its debt.

Like broadcast programmes, mobile phones use radio waves that interfere with each other, so that the spectrum needs to be allocated between different users. This gives the government the opportunity to auction it. Britain’s first big auction of independent television franchises was a fiasco. The mobile phone licence auction was much more cleverly designed.

It is not at all obvious that there is a long term scarcity of radio spectrum. There is not yet much congestion in existing mobile phone networks and the new licences substantially increase the amount of spectrum that is available. If demand for more sophisticated applications of mobile telephone technology really takes off, much more space will be needed. Against this should be set the likelihood that technology will enable us to use spectrum more and more efficiently. No-one knows.

It was the belief that it was selling off radio spectrum, of modest and uncertain value, which provided the basis for the government’s £2 – £3 bn estimates of what its mobile phone licence auction might raise. No-one had anticipated the mad scramble to buy telecommunications stocks that would happen after the auction was announced.

Britain, like most countries, launched its mobile phone industry with limited competition. The duopoly of Cellnet and Vodafone set high prices. They competed on marketing expenditures and handset subsidies. Orange and One2One forced tariffs down, but not by much, because they were barely able to keep pace with the growth of demand. Eventually, as in all other businesses, more new entrants will appear, the market will mature, supply will catch up with demand, and prices will reflect the costs of supply.

But this was not enough for consultants and analysts who believed that the laws of economics had been repealed by new technology. They have projected revenues far into the future on the basis of high tariffs, generating stratospheric valuations for mobile phone companies. It is reasoning of this kind that has made Vodafone Britain’s most valuable company. The government was selling, not just radio spectrum, but the opportunity to have your company’s prospects assessed in this hubristic way.

The same models that have been used to price technology, media and telecoms (TMT) stocks – sophisticated in detail, nonsense in essential structure – have formed the basis of most bidder’s valuations of these new licences. Perhaps rightly so. If mobile phone company shares are worth what the people who use these models say they are, then the same applies to mobile phone company licences. And the market will if asked provide the money to underpin these valuations. Not to bid on the same assumptions that the stock market applies in valuing your company (even if you see that these assumptions are mistaken) is to undermine the value of your shares. You cannot afford not to have these licences. If you live in cloud-cuckoo land, you must live by the laws of cloud-cuckoo land.

Vodafone faces the most difficult problem. It is the largest mobile phone operator in the world and is determined to remain so. Its extraordinary market capitalisation is based on that positioning. That business model compels it to pay whatever is needed to get the largest of the licences available to it. Vodafone has paid through the nose to do so, and BT, understanding Vodafone’s position, has forced it to.

The £22.5 bn that the British government has raised in the auction is not a tax on mobile phone users. Perhaps demand for mobile services will continue to grow more rapidly than supply, and mobile phone tariffs will remain high. In that case, the companies who have paid these prices will indeed recoup their expenditures, and the Treasury has, as it did in the North Sea, simply taxed away company profits.

But it is more likely that supply will catch up with demand well within the twenty year life of these licences. In that case, the government must resist the inevitable pressure to limit competition in the market to enable the winners to avoid the winner’s curse. If the projections of the models of the bidders and the markets are indeed far too optimistic, the government will, with exquisite luck and timing, have raised £22.5 bn of revenue from frenzied buyers of TMT stocks. No juster tax has ever been imposed.

3^rd May 2000

Ponzi schemes

From the earliest days of market economies, there have been financial promoters with a single objective.   To persuade people to give them more money than they intend to give back.

The simplest route to lazy riches has always been to lie.   I can create precious metals from base materials.   There is undiscovered gold in the unexplored wilderness of Indonesia.  Ostriches are a neglected source of delicious meat and nutritious protein.   A few suckers are always attracted to these propositions, but the likelihood of exposure and imprisonment deters most people from advancing them.

The trick is therefore to receive more than you pay out while being honest and open about what you are doing.   This requires redistribution:  some people get more than they put in, others less.   Those who enter the scheme must believe they are likely to be in the category who will receive more, rather than in the category who will receive less.   This cannot, in aggregate, be true.  But the objective is to rely on self deception by the participants, rather than overt deception by the promoters.

Virtually all schemes that have been devised fall into one of three categories – redistribution to the early, redistribution to the lucky, redistribution to the skilful.   These correspond to chain letters, lotteries, and games.  In each case, thoughtful players may understand that taken as a whole they will lose, but can still believe they will not be among the people who do.

Chain letters depend on an ever expanding circle of participants.   Dodgy banks, from the first days of money lending to BCCI in our own times, have always used this principle.   You pay withdrawals and generous interest from the savings of new depositors.   

These activities are illegal because they promise generous interest.   The safer route is simply to create the expectation of high return from the evidence of the success of those who joined the scheme early.   Financial chain letters are now generally known as Ponzi schemes (after Charles Ponzi, who developed a celebrated example in the US in the 1920s) or pyramid selling (after a group of companies who filled the garages of their victims with unwanted detergent in the 1970s).

As Robert Shiller notes in his recent guide to financial speculation, most Ponzi schemes offer some feeble explanation of how they generate their high return.  Mr Ponzi claimed that large profits could be earned from international arbitrage in postal reply coupons. Pyramid sales people were assured that direct distribution was a means of undermining the excessive profits of soap powder manufacturers.   Albanians, whose economy was brought to collapse by an explosion of Ponzi schemes, were told that the transition to capitalism would allow the widespread and effortless accumulation of riches. There are people who believe the same thing today about the internet.

Because Ponzi schemes inevitably end in collapse, governments are anxious to outlaw them. Their counter measures usually rest on tackling the deception in the explanation.   When a company called Titan Business Systems entered Britain with an entirely clean Ponzi scheme – they did not pretend that there was any source of revenue other than an ever increasing number of new participants – it showed that no deception is needed to induce gullible people to take part. The very openness of the scam caused the Department of Trade and Industry difficulty in shutting it down.

Chain letters are possible because players can easily persuade themselves that they are early.  It is almost as easy to persuade yourself that you are skilful. When people are asked to compare themselves to the norm – as drivers, lovers or executives of large corporations – less than half the population rate themselves below average. Some of the optimists are found in betting shops, studying form.   Some of them are in casinos, believing – against reason and experience – that they can predict the movement of a roulette wheel.   

Other optimists are in the trading rooms of banks and large corporations.   Foreign exchange trading, and secondary dealing in fixed interest securities, are  – like roulette and racecourse betting – zero sum games, in which players can only win at the expense of losers.   But in all these activities, a high proportion of participants believe their own dealings are profitable.  Mostly, this relies on systems – whether selective memory or accounting rules – that are more effective at recording gains than losses.

Lotteries are the most transparent and enduring means of persuading people to part with more cash than you intend to return. It is harder to see how people can persuade themselves that they are more than averagely lucky than  more than averagely early or skilful.   But they manage it.   They are also influenced by a psychological trait described as prospect theory.  We focus on improbable outcomes to a degree that is not justified by their low probability.  Economists call this irrational:  but all they mean is that not many economists play lotteries and that running lotteries as a profitable business.

The most sophisticated financial schemes are those that combine elements of all three.  Day trading, for example.   It is a game, at which I am skilful.  It is a chain letter, in which I am an early participant.  In time, other people will ‘get it’, and my holdings can be sold on at a higher price.   And it is a lottery – we all agree that most new economy stocks will fail, but one or two will prove to be immensely valuable. There is one enduring and unvarying feature of all these schemes.  It is better to run them than to participate.

R. Shiller,  Irrational Exuberance Princeton University Press, 2000