Back in July, I was invited to give a keynote speech at an international conference we hosted in Cambridge. In it, I took the opportunity to look back at Cambridge economics a hundred years ago; 1920s Cambridge economics means Keynes, of course. The 1923 book “A Tract on Monetary Reform” contains the memorable “in the long run, we are all dead.” Well, not a message that an emeritus professor wants to read, so instead I focused on the extraordinary achievements of the remarkable Frank Ramsey.
Ramsey arrived as a student in Cambridge in 1920, joined Keynes at King’s in 1924, and was appointed a lecturer in 1928. He made seminal contributions in philosophy, mathematics and economics, and provided the first English translation and critique of Wittgenstein – as an undergraduate! Ramsey worked on formal logic (Ramsey sentences). In mathematics he made contributions in combinatorics and number theory (Ramsey Numbers) and, relevant to this piece, major breakthroughs in probability theory and Bayesian statistics; he saw himself as a philosopher and mathematician. But he also made highly significant advances in economics, some not recognized for decades.
Some economists may have encountered his work on optimal tax structures (the Ramsey Rule) or on the balance between savings and consumption in society; both led to Nobel prizes for others. The significance of those papers goes far beyond their immediate focus: to solve the mathematical optimisation required, Ramsey used an aggregate utility function that many have argued was the foundation for the rational, utility-maximizing quantitative economic models that dominated the second half of the twentieth and the first decade of the twenty-first century. The papers wrestle with the question of discounting, the balance between the welfare of current and future generations – a key issue in economic debates on climate change – and influenced Pigou. His ideas on probability had a profound effect on von Neumann, leading directly to Game Theory.
Amidst these staggering contributions, he was an early recipient of psychoanalysis, was on the fringe of the Bloomsbury set and espoused very liberal ideas for the 1920s – his atheism was a stark contrast to his brother Michael who became Archbishop of Canterbury! But there is tragedy here, too; he died in 1930, aged just 26. What more might he have achieved? Had he lived a few more years, he would have been Alan Turing’s tutor. I would strongly recommend Cheryl Misak’s recent masterly biography of Frank Ramsey.
While Ramsey provided the foundational insights for mathematical rational utility economics, he may not have accepted its precepts. Assuming a single common utility function for society was a necessary simplification for the mathematical approach he took, but it is evident in his writings that he believed individual utility preferences differed substantially. The same is true of his work on probability. He provided an innovative quantitative route to evaluating probability when faced with uncertainty but, in the context of what we now think of as Bayesian theory, he argued that the prior probabilities that people have about events are formed by their beliefs, even by psychological factors. These priors are adjusted as new information becomes available but act as an anchor on how we assess how likely an event is to occur. And while a rational utility maximising agent will fully process all available information, their initial assessment comes from those beliefs and characteristics, that then shape the adjustment process. We can use this insight to shed light on decision-making in private real estate markets.
Throughout my career, I have been bothered by two features of the commercial property market: the first is that the market develops strong views that seem largely immune to evidence – let us call them myths, beliefs that may have some basis of fact but are believed unquestioningly; second, perhaps itself a myth of sorts, is the elevated status and power given to senior decision-makers in the industry, seen as having exceptional insight and judgment – the gurus of real estate. It is something of a mystery why individuals with a track record of mixed performance, mistiming and failed vehicles reappear and are able to access more capital and command attention as speakers, motivators.
I do not have the space to look at those myths in depth but as examples:
• Real estate is an effective inflation hedge.
• Office rents and values capture real economic growth.
• Leverage improves risk-adjusted returns.
• Major gateway cities offer consistently superior risk-adjusted returns.
• Cap rates are a good indicator of risk.
• The best managers deliver consistent alpha.
Of interest is not how much truth there is in them – generally, not a lot – but why are they believed and why do supposedly informed investors act on them? The same applies to “local myths,” beliefs that are confined to particular time-periods and/or markets, which seem set against financially rational decisions.
It is here that the nature of the market and the role of individuals combine; private real estate is characterised by noise and uncertainty, assets are illiquid, specific risk factors are critical to performance and it is near impossible to diversify that risk away. Unlike most financial markets, real estate lacks synthetic vehicles for arbitrage to remove market inefficiencies. This allow mispricing to persist, but also increases the importance of those individual decision-makers. This emerged clearly in the Investment Property Forum’s “Hurdle Rate” project: for many major investors, not only did decision-making tools not conform to finance principles, but also there was much evidence that senior individuals would override “model” decisions based on market intuition. We have no systematic evidence on the outcomes of those overrides or their impact on performance.
Which brings us back to Ramsey; faced with uncertainty, those prior assumptions and beliefs are powerful forces withstanding contrary evidence. Moreover, industry structures provide strong reinforcement mechanisms; risk-taking, rewarded deal-making, deal makers acting as role models for junior staff, recruitment processes seeking out those fitting the profile of “gurus” to act as opinion-formers and belief shapers. It is a powerful echo chamber. This might allow mispricing to persist, to allow behavioural biases to embed in a major asset class. A century later, maybe Frank Ramsey’s legacy could provide us with a research agenda?
A transcript of Colin’s speech is available here.
