Tim Harford The Undercover Economist
  • THE UNDERCOVER ECONOMIST STRIKES BACK
    “Every Tim Harford book is cause for celebration. He makes the ‘dismal science’ seem like an awful lot of fun.”
    – Malcolm Gladwell, author of “The Tipping Point”
  • Adapt – Why Success Always Starts with Failure


    “A highly readable argument... Very impressive”
    – Nassim N Taleb, author of “The Black Swan”
  • Dear Undercover Economist
    “Harford has a knack for explaining economic principles and problems in plain language and, even better, for making them fun”
    – The New York Times
  • The Logic of Life
    “Highly readable, funny and daringly contentious... a whopping good time.”
    – The San Francisco Chronicle
  • The Undercover Economist
    “Required reading”
    – Stephen J. Dubner, co-author of “Freakonomics”
Undercover Economist

Economists aren’t all bad

‘Some research on students suggests economics either attracts or creates sociopaths’

Justin Welby, the Archbishop of Canterbury, recently bemoaned the way that “we are all reduced to being Homo financiarius or Homo economicus, mere economic units … for whom any gain is someone else’s loss in a zero-sum world.”

The remarks were reported on the 1st of April, but I checked, and the Archbishop seems serious. He set out two ways to see the world: the way a Christian sees it, full of abundance and grace; and the way he claims Milton Friedman saw it, as a zero-sum game.

Whatever the faults one might find in Friedman’s thinking, seeing the world as a zero-sum game was not one of them. So what do we learn from this, other than that the Archbishop of Canterbury was careless in his choice of straw man? The Archbishop does raise a troubling idea. Perhaps studying economics is morally corrosive and may simply make you a meaner, narrower human being.

That might seem to be taking the economics-bashing a bit far but there is a hefty body of evidence to consult here. (Two recent short survey articles, by psychologist Adam Grant and by economist Timothy Taylor, provide a good starting point.) Several studies have compared the attitudes or behaviour of economics students or teachers with those of people learning or teaching other academic disciplines.

Typically, these studies find that economists are less co-operative in classroom games: they contribute less to collective goods and they act selfishly in the famous prisoner’s dilemma (where two people have a strong incentive to betray each other but would collectively be better off if both stayed loyal). In 1993, Robert Frank (an economist) and Thomas Gilovich and Dennis Regan (both psychologists) surveyed academics and found that although almost everyone claimed to give money to charity, almost 10 per cent of economists said they gave nothing.

Frank and his colleagues also gave hypothetical dilemmas to students. Would they correct a billing error in their favour? Would they return a lost but addressed envelope containing cash? (And what did they think other people would do in these situations?) Those studying traditional microeconomics classes were less likely than other students to give the honest response, and slightly less likely to expect honesty from others. Most students said they would return an addressed envelope with cash in it but economics students were more likely to admit to baser motives.

Reading such research suggests economics either attracts or creates sociopaths – and that should give economics instructors pause for thought.

Yet I am not totally persuaded. Economists did actually give more to charity in Frank’s survey. They were richer, and while they gave less as a percentage of their income they did give more in cash terms.

What about those hypothetical questions about envelopes full of cash? Were economics students selfish or merely truthful? Anthony Yezer and Robert Goldfarb (economists) and Paul Poppen (a psychologist) conducted an experiment to find out, surreptitiously dropping addressed envelopes with cash in classrooms to see if economics students really were less likely to return the money. Yezer and colleagues found quite the opposite: the economics students were substantially more likely to return the cash. Not quite so selfish after all.

Most importantly, classroom experiments with collective goods or the prisoner’s dilemma don’t capture much of economic life. The prisoner’s dilemma is a special case, and a counter-intuitive one. It is not surprising that economics students behave differently, nor does it tell us much about how they behave in reality. If there is a single foundational principle in economics it is that when you give people the chance to trade with each other, both of them tend to become better off. Maybe that’s naive but it’s all about “abundance” and is the precise opposite of a zero-sum mentality.

In fact, some of the more persuasive criticisms of economics are that it is too optimistic about abundance and peaceful gains from trade. From this perspective, economists should give more attention to the risks of crime and violence and to the prospect of inviolable environmental limits to economic growth. Perhaps economists don’t realise that some situations really are zero-sum games.

. . .

Economists may appear ethically impoverished on the question of co-operating in the prisoner’s dilemma but they seem to have a far more favourable attitude to immigration from poorer countries. To an economist, foreigners are people too.

This viewpoint infuriates some critics of economics, to the extent that it earned the famous nickname of “the dismal science”. Too few people know the context in which Thomas Carlyle hurled that epithet: it was in a proslavery article, first published in 1849, a few years after slavery had been abolished in the British empire. Carlyle attacked the idea that “black men” might simply be induced to work for pay, according to what he sneeringly termed the “science of supply and demand”. Scorning the liberal views of economists, he believed Africans should be put to work by force.

Economics puts us at risk of some ethical mistakes, but with its respect for individual human agency it also inoculates us against some true atrocities. I’m not ashamed to be a dismal scientist.

Also published at ft.com.

Marginalia

“An evening with Tim Harford”

…sounds like the world’s worst date, but in fact I’ll be talking about my book “The Undercover Economist Strikes Back”, which I hope will be a lot more fun.

It’s on 24 April, 6.30pm in central London – full details here.

Prospect Magazine is organising and I am afraid there is a ticket price, but it’s a small venue and there will be drinks laid on. Come along if you like that sort of thing!

If you don’t fancy paying money, here’s a FREE video of me speaking about “How to Prevent Financial Meltdowns”.

Undercover Economist

Why long-term unemployment matters

‘Research shows that employers ignore people who have been out of work for more than six months’

“Quantity has a quality of its own.” Whether or not Stalin ever said this about the Red Army, it is true of being out of work. Evidence is mounting that the long-term unemployed aren’t merely the short-term unemployed with the addition of a little waiting time. They are in a very different situation – and an alarming one at that.

Researchers in the US are setting the pace on this topic, because it is in America that a sharp and unique shift has occurred. Broad measures of unemployment reached high but not unprecedented levels during the recent great recession. Yet long-term unemployment (lasting more than six months) surged off the charts. It has been extremely rare for long-term unemployment to make up more than 20 per cent of US unemployment, but it was at 45 per cent during the depths of the recession. In the UK and eurozone, long-term unemployment is pervasive but that, alas, is not news.

As long as there is a recovery, why does this matter? A clue emerges when we look at two statistical relationships that are famous to econo-nerds like me: the Phillips curve and the Beveridge curve. (They are named after two greats of the London School of Economics, Bill Phillips and William Beveridge.)

The Phillips curve shows a relationship between inflation and unemployment. The Beveridge curve shows a relationship between vacancies and unemployment. Both of these relationships have been doing strange things recently: given the number of people out of work, both inflation and vacancies are higher than we’d expect.

What that means is that we can hear the engine of US economic activity revving away and yet the economy is still moving slowly. The gears aren’t meshing properly; economic growth is not being converted into jobs as smoothly as we would hope. So what’s going on?

Here’s a thought experiment: what if the long-term unemployed didn’t exist? What if we replotted the Phillips curve and the Beveridge curve using statistics on short-term unemployment? It turns out that the old statistical relationships would work just fine. We can solve the statistical puzzle – all we need to do is assume that the long-term unemployed are irrelevant to the way the economy works.

A recent Brookings Institution research paper by Alan Krueger (a senior adviser to Barack Obama during the recession), Judd Cramer and David Cho examines this discomfiting thesis in greater depth. The researchers conclude that people who have been out of work for more than six months are indeed marginalised: employers ignore them, bidding up wages if necessary to attract workers from the ranks of the short-term unemployed.

I’ve written before about an experiment conducted by a young economist, Rand Ghayad. He mailed out nearly 5,000 carefully calibrated job applications, using a computer to tweak key parameters. He found that employers were three times more likely to call an applicant with irrelevant but recent employment experience, than someone who had relevant experience but had been out of work for more than six months. Long-term unemployment had become a trap.

In Ghayad’s experiment, the long-term unemployed were identical in every other way to other applicants. In reality, of course, it may be that people also become demotivated after a long spell of looking for work. The “benefits culture” at work? It seems not. Earlier research by Krueger and Andreas Mueller tracked job hunters over time and showed them becoming ever less active in the job market – and ever more depressed. They could not rouse themselves, even when unemployment insurance payments were about to expire. It wasn’t that the people joined the ranks of the long-term unemployed because they were demotivated to start with: the long-term unemployment came first, and the unhappiness and the lack of drive came later.

. . .

There is a silver lining to all this: it suggests that those of us worried about deep, technology-driven weaknesses in the US economy may be wrong. Instead, the US economy has a cyclical problem so serious that it left lasting scars – but they will heal eventually. One can hope, anyway. Experience in Canada and Sweden during the past two decades suggests that it is possible to chip away at long-term unemployment but it takes time.

Is there a policy cure for this challenge? The rightwing intuition is tough love, based on the theory that overgenerous unemployment support merely incentivises people to sit on the sidelines of the labour market until they become unemployable. Leftwingers retort that the long-term unemployed are the victims of circumstance and need our support.

Recent evidence gathered by two economists, Bart Hobijn and Aysegul Sahin, suggests the rightwingers have a point in the case of Sweden, whereas in the UK, Spain and Portugal the labour market has been hit not by overgenerous benefits but by a structural shift in the economy away from construction. The supply of jobs no longer matches the supply of workers.

As for the US, Krueger’s research paints a picture of the long-term unemployed as people who are not very different to the rest of us – merely unluckier.

Also published at ft.com.

Highlights

What next for behavioural economics?

The past decade has been a triumph for behavioural economics, the fashionable cross-breed of psychology and economics. First there was the award in 2002 of the Nobel Memorial Prize in economics to a psychologist, Daniel Kahneman – the man who did as much as anything to create the field of behavioural economics. Bestselling books were launched, most notably by Kahneman himself (Thinking, Fast and Slow , 2011) and by his friend Richard Thaler, co-author of Nudge (2008). Behavioural economics seems far sexier than the ordinary sort, too: when last year’s Nobel was shared three ways, it was the behavioural economist Robert Shiller who grabbed all the headlines.
Behavioural economics is one of the hottest ideas in public policy. The UK government’s Behavioural Insights Team (BIT) uses the discipline to craft better policies, and in February was part-privatised with a mission to advise governments around the world. The White House announced its own behavioural insights team last summer.
So popular is the field that behavioural economics is now often misapplied as a catch-all term to refer to almost anything that’s cool in popular social science, from the storycraft of Malcolm Gladwell, author of The Tipping Point (2000), to the empirical investigations of Steven Levitt, co-author of Freakonomics (2005).
Yet, as with any success story, the backlash has begun. Critics argue that the field is overhyped, trivial, unreliable, a smokescreen for bad policy, an intellectual dead-end – or possibly all of the above. Is behavioural economics doomed to reflect the limitations of its intellectual parents, psychology and economics? Or can it build on their strengths and offer a powerful set of tools for policy makers and academics alike?
A recent experiment designed by BIT highlights both the opportunity and the limitations of the new discipline. The trial was designed to encourage people to sign up for the Organ Donor Register. It was huge; more than a million people using the Driver and Vehicle Licensing Agency website were shown a webpage inviting them to become an organ donor. One of eight different messages was displayed at random. One was minimalist, another spoke of the number of people who die while awaiting donations, yet another appealed to the idea of reciprocity – if you needed an organ, wouldn’t you want someone to donate an organ to you?
BIT devoted particular attention to an idea called “social proof”, made famous 30 years ago by psychologist Robert Cialdini’s book Influence. While one might be tempted to say, “Too few people are donating their organs, we desperately need your help to change that”, the theory of social proof says that’s precisely the wrong thing to do. Instead, the persuasive message will suggest: “Every day, thousands of people sign up to be donors, please join them.” Social proof describes our tendency to run with the herd; why else are books marketed as “bestsellers”?
Expecting social proof to be effective, the BIT trial used three different variants of a social proof message, one with a logo, one with a photo of smiling people, and one unadorned. None of these approaches was as successful as the best alternatives at persuading people to sign up as donors. The message with the photograph – for which the teams had high hopes – was a flop, proving worse than no attempt at persuasion at all.
Daniel Kahneman, one of the fathers of behavioural economics, receiving an award from Barack Obama, November 2013
Three points should be made here. The first is that this is exactly why running trials is an excellent idea: had the rival approaches not been tested with an experiment, it would have been easy for well-meaning civil servants acting on authoritative advice to have done serious harm. The trial was inexpensive, and now that the most persuasive message is in use (“If you needed an organ transplant, would you have one? If so, please help others”), roughly 100,000 additional people can be expected to sign up for the donor register each year.
The second point is that there is something unnerving about a discipline in which our discoveries about the past do not easily generalise to the future. Social proof is a widely accepted idea in psychology but, as the donor experiment shows, it does not always apply and it can be hard to predict when or why.
This patchwork of sometimes-fragile psychological results hardly invalidates the whole field but complicates the business of making practical policy. There is a sense that behavioural economics is just regular economics plus common sense – but since psychology isn’t mere common sense either, applying psychological lessons to economics is not a simple task.
The third point is that the organ donor experiment has little or nothing to do with behavioural economics, strictly defined. “The Behavioural Insights Team is widely perceived as doing behavioural economics,” says Daniel Kahneman. “They are actually doing social psychology.”
. . .
The line between behavioural economics and psychology can get a little blurred. Behavioural economics is based on the traditional “neoclassical” model of human behaviour used by economists. This essentially mathematical model says human decisions can usefully be modelled as though our choices were the outcome of solving differential equations. Add psychology into the mix – for example, Kahneman’s insight (with the late Amos Tversky) that we treat the possibility of a loss differently from the way we treat the possibility of a gain – and the task of the behavioural economist is to incorporate such ideas without losing the mathematically-solvable nature of the model.
Why bother with the maths? Consider the example of, say, improving energy efficiency. A psychologist might point out that consumers are impatient, poorly-informed and easily swayed by what their neighbours are doing. It’s the job of the behavioural economist to work out how energy markets might work under such conditions, and what effects we might expect if we introduced policies such as a tax on domestic heating or a subsidy for insulation.
It’s this desire to throw out the hyper-rational bathwater yet keep the mathematically tractable baby that leads to difficult compromises, and not everyone is happy. Economic traditionalists argue that behavioural economics is now hopelessly patched-together; some psychologists claim it’s still attempting to be too systematic.
Nick Chater, a psychologist at Warwick Business School and an adviser to the BIT, is a sympathetic critic of the behavioural economics approach. “The brain is the most rational thing in the universe”, he says, “but the way it solves problems is ad hoc and very local.” That suggests that attempts to formulate general laws of human behaviour may never be more than a rough guide to policy.
This shift to radical incrementalism is so much more important than some of the grand proposals out there
The most well-known critique of behavioural economics comes from a psychologist, Gerd Gigerenzer of the Max Planck Institute for Human Development. Gigerenzer argues that it is pointless to keep adding frills to a mathematical account of human behaviour that, in the end, has nothing to do with real cognitive processes.
I put this critique to David Laibson, a behavioural economist at Harvard University. He concedes that Gigerenzer has a point but adds: “Gerd’s models of heuristic decision-making are great in the specific domains for which they are designed but they are not general models of behaviour.” In other words, you’re not going to be able to use them to figure out how people should, or do, budget for Christmas or nurse their credit card limit through a spell of joblessness.
Richard Thaler of the University of Chicago, who with Kahneman and Tversky is the founding father of behavioural economics, agrees. To discard the basic neoclassical framework of economics means “throwing away a lot of stuff that’s useful”.
For some economists, though, behavioural economics has already conceded too much to the patchwork of psychology. David K Levine, an economist at Washington University in St Louis, and author of Is Behavioral Economics Doomed? (2012), says: “There is a tendency to propose some new theory to explain each new fact. The world doesn’t need a thousand different theories to explain a thousand different facts. At some point there needs to be a discipline of trying to explain many facts with one theory.”
The challenge for behavioural economics is to elaborate on the neoclassical model to deliver psychological realism without collapsing into a mess of special cases. Some say that the most successful special case comes from Harvard’s David Laibson. It is a mathematical tweak designed to represent the particular brand of short-termism that leads us to sign up for the gym yet somehow never quite get around to exercising. It’s called “hyperbolic discounting”, a name that refers to a mathematical curve, and which says much about the way behavioural economists represent human psychology.
The question is, how many special cases can behavioural economics sustain before it becomes arbitrary and unwieldy? Not more than one or two at a time, says Kahneman. “You might be able to do it with two but certainly not with many factors.” Like Kahneman, Thaler believes that a small number of made-for-purpose behavioural economics models have proved their worth already. He argues that trying to unify every psychological idea in a single model is pointless. “I’ve always said that if you want one unifying theory of economic behaviour, you won’t do better than the neoclassical model, which is not particularly good at describing actual decision making.”
. . .
Meanwhile, the policy wonks plug away at the rather different challenge of running rigorous experiments with public policy. There is something faintly unsatisfying about how these policy trials have often confirmed what should have been obvious. One trial, for example, showed that text message reminders increase the proportion of people who pay legal fines. This saves everyone the trouble of calling in the bailiffs. Other trials have shown that clearly-written letters with bullet-point summaries provoke higher response rates.
None of this requires the sophistication of a mathematical model of hyperbolic discounting or loss aversion. It is obvious stuff. Unfortunately it is obvious stuff that is often neglected by the civil service. It is hard to object to inexpensive trials that demonstrate a better way. Nick Chater calls the idea “a complete no-brainer”, while Kahneman says “you can get modest gains at essentially zero cost”.
David Halpern, a Downing Street adviser under Tony Blair, was appointed by the UK coalition government in 2010 to establish the BIT. He says that the idea of running randomised trials in government has now picked up steam. The Financial Conduct Authority has also used randomisation to develop more effective letters to people who may have been missold financial products. “This shift to radical incrementalism is so much more important than some of the grand proposals out there,” says Halpern.
Not everyone agrees. In 2010, behavioural economists George Loewenstein and Peter Ubel wrote in The New York Times that “behavioural economics is being used as a political expedient, allowing policy makers to avoid painful but more effective solutions rooted in traditional economics.”
For example, in May 2010, just before David Cameron came to power, he sang the praises of behavioural economics in a TED talk. “The best way to get someone to cut their electricity bill,” he said, “is to show them their own spending, to show them what their neighbours are spending, and then show what an energy-conscious neighbour is spending.”
But Cameron was mistaken. The single best way to promote energy efficiency is, almost certainly, to raise the price of energy. A carbon tax would be even better, because it not only encourages people to save energy but to switch to lower-carbon sources of energy. The appeal of a behavioural approach is not that it is more effective but that it is less unpopular.
Thaler points to the experience of Cass Sunstein, his Nudge co-author, who spent four years as regulatory tsar in the Obama White House. “Cass wanted a tax on petrol but he couldn’t get one, so he pushed for higher fuel economy standards. We all know that’s not as efficient as raising the tax on petrol – but that would be lucky to get a single positive vote in Congress.”
Should we be trying for something more ambitious than behavioural economics? “I don’t know if we know enough yet to be more ambitious,” says Kahneman, “But the knowledge that currently exists in psychology is being put to very good use.”
Small steps have taken behavioural economics a long way, says Laibson, citing savings policy in the US. “Every dimension of that environment is now behaviourally tweaked.” The UK has followed suit, with the new auto-enrolment pensions, directly inspired by Thaler’s work.
Laibson says behavioural economics has only just begun to extend its influence over public policy. “The glass is only five per cent full but there’s no reason to believe the glass isn’t going to completely fill up.”

First published on FT.com, Life and Arts, 22 March 2014

Undercover Economist

How investors get it wrong

‘We trade too often because we’re too confident in our ability to spot the latest bargain’

Flip through the pages of this august newspaper and you will often see reference to how particular investments are doing: gold is up, oil is down and the S&P 500 is going sideways.

Yet illuminating as all this might be, such reporting draws a veil across what we might call the Investor’s Tragedy: that the typical investor doesn’t do nearly as well as the typical investment.

This isn’t just because Wall Street and the City of London cream off all the money, although of course there is something in that. (In 1940, the author Fred Schwed invited us to contemplate the yachts of all the brokers and bankers riding at anchor off downtown Manhattan; the title of Schwed’s book was Where Are the Customers’ Yachts?)

No, the Investor’s Tragedy wouldn’t be much of a tragedy if it was all somebody else’s fault. Alas, the fault is not in our stars but in ourselves: we underperform the market because we’re doing it wrong.

Our first tragic flaw is that we buy and sell too often. In 2000, Brad Barber and Terrance Odean studied the trading performance of more than 65,000 retail investors with accounts at a large discount broker. Looking at the early 1990s – happy days for investors – Barber and Odean found that while an index reflecting US stock markets returned 17.9 per cent a year, the investors who traded most actively earned just 11.4 per cent a year – a huge shortfall that becomes even more dramatic after a few years of compounding.

Hyperactive investors paid corrosive trading costs while failing to improve their underlying investment performance. The typical investor traded less and underperformed by 1.5 per cent per year, a substantial margin. The investors who hardly traded at all were rewarded with market-matching investment performance.

Our second tragic flaw is our tendency to buy high and sell low. Apologies if this is all a bit technical but it turns out that buying high and selling low is not the aim of the investment game.

Here’s how the self-deception works. You put $10,000 into the stock market. It promptly doubles, leaving you with $20,000. So pleased are you that things are going well that you double up, putting a further $20,000 into the market. Now the market falls back to its original level. Licking your wounds, you sell half your shares for $10,000. The market promptly doubles again, leaving you holding $10,000 in cash and $20,000 in shares after investing a total of $30,000. The market has, after a rollercoaster ride, risen by 100 per cent – but somehow you haven’t made a penny of profit.

The most influential study of such behaviour was published in the American Economic Review in 2007 by Ilia Dichev, now at Emory University. Dichev found that dollar-weighted returns were several percentage points lower than buy-and-hold returns: the market did better when only a few people were in it. A number of subsequent studies have examined this tendency, and while not all of them reach the same gloomy conclusion, many do.

Dichev’s work makes sense in the light of research on the psychology of investment. Robert Shiller, one of the most recent winners of the Nobel memorial prize in economics, has found that stock markets tend to revert to long-run average valuations. When things are booming a bust is on the way, and vice versa.

Meanwhile Stefan Nagel and Ulrike Malmendier have discovered that stock market returns in our formative years shape a lifetime of investment behaviour. An awful bear market scares a generation of young investors away, just as they are being presented with a buying opportunity.

Two tragic flaws are probably enough but here’s a third: Odean also showed, in 1998, that investors had a tendency to sell shares that had risen in value while holding on to losing investments, despite tax incentives pushing in the opposite direction. In Odean’s sample of investors, this bias pulled down investors’ returns.

Explanations for these shortcomings aren’t hard to find. We trade too often because we’re too confident in our ability to spot the latest bargain. We buy at the top and sell at the bottom because we’re influenced by what others are doing. And we hold on to shares that have fallen in value because to sell them at a loss would be admitting defeat. (Anyway, those shares in Lehman Brothers are sure to bounce back at some point.)

Armed with a diagnosis, a cure is also readily available: make regular, automated investments in boring, low-cost funds and try to sell in a similarly bloodless fashion.

Unfortunately this advice doesn’t really fit the modern world. The default option for financial reporting is to tell us what the market has done in the past few hours and how everyone is feeling about that. It is hard to think of a brand of journalism more calculated to breed a herd mentality.

Meanwhile, it has never been easier to fidget with our investment portfolios. Investment platform providers have every incentive to turn their websites into something like Facebook, constantly poking us for attention.

Our investments would be far healthier in the equity market equivalent of an old-fashioned piggy bank; the sort that needs a hammer to open.

Also published at ft.com.

Undercover Economist

Four steps to fixing inequality

‘As the example of Finland makes clear, it is possible to change income distribution dramatically’

By most measures, and in many countries, income inequality has been increasing for a generation. Some people don’t care, so here’s another way to look at the problem: over the past 20 years, the pre-tax incomes of the poorest 99 per cent in the US grew by just 6.6 per cent after adjusting for inflation. That is a pathetic one-third of 1 per cent per year. Those who aren’t worried about increasing inequality should still be concerned at such widespread stagnation of living standards.

So what is the solution? Here is a modest proposal to fix inequality in four easy steps.

The first step is to be precise. Are we using the Gini coefficient or the share of the top 1 per cent to measure inequality? Wealth, consumption or income? Before taxes and benefits or after?

This last question is often ignored but it makes a big difference. Consider Finland, France and Japan. Looking at pre-tax household incomes, Finland is the most unequal of the lot. But after the tax system has done its work, Finland is the least unequal. (My source here is a database compiled by the political scientist Frederick Solt.)

Finland’s market economy delivers outcomes roughly as unequal as those of the UK and the US but the tax system is far more redistributive. In contrast, Japan is more equal than the UK and US despite a tax system that redistributes less than theirs, because the country’s economy delivers more egalitarian outcomes.

The second step is to look at underlying causes rather than symptoms. As the philosopher Robert Nozick forcefully observed, there is something strange in worrying about income distribution without considering what processes, just or unjust, produced that distribution.

This isn’t just a philosophical argument – there are practical implications. Consider JK Rowling who is extremely rich because every time someone buys a Harry Potter book, she gets a cut – and a very large number of people have bought Harry Potter books. Unless Bill Gates is out shopping, every time a Potter book is purchased income inequality increases.

Rowling’s wealth is underpinned not only by Harry Potter’s commercial success but by copyright laws which ensure she reaps the benefits of that success. Rowling is not yet 50, so with luck she will still be with us in 2050, and her books will continue to generate inequality-increasing copyright revenue for the rights holders until 2120. A different set of rules might have produced a result that was more equitable yet perfectly efficient. Rowling did not need several hundred million pounds to persuade her to tell us what happens to Hermione in the end.

My point is not to single out Rowling for any criticism but to point out that fortunes do not accumulate through skill and luck alone – there is always a particular underpinning of laws and regulations that could, if we wish, be changed. Carlos Slim’s América Móvil and Gates’s Microsoft could have been broken up by antitrust authorities.

Chief executives enjoy inexplicably large – and often opaque – remuneration packages. Oversight could be tightened, shareholders given teeth.

When we look directly at the sources of high incomes we will sometimes discover policies that would be a good idea in their own right and might reduce inequality only as a side effect.

The third step is to reform redistribution. As the example of Finland makes clear, it is possible for a rich and successful nation to change its income distribution dramatically through the tax system. (A recent and celebrated research paper from the International Monetary Fund adds some more careful empirical backing to this intuitive idea – although there are too many imponderables in such an analysis for it to clinch any argument.)

. . .

Not only must we ask how much to redistribute – largely a political question – we must also ask how to do it. Tax codes are riddled with loopholes and special cases, and under the pressure of the deep recession, such tangles appear to be proliferating. The British system has two nationally levied income taxes and in recent years has introduced a new (and gyrating) tax band for high earners; a separate band over which allowances are withdrawn arbitrarily; and a third band over which child benefit payments are withdrawn. Further crenellations are promised if the Labour party is elected.

However much redistribution we might feel is just, it’s certainly clear that we could redistribute for less trouble if our politicians paid more attention to sensible tax design and less attention to crowd-pleasers.

Step four is to remember the small stuff. Inequality is a consequence of countless policy choices too trivial to trouble finance ministers: whether there are good teachers in most classrooms; whether poorer areas of town are safe at night and have access to affordable public transport; whether toddlers are receiving stimulating childcare; whether the pension system encourages savers without making millionaires out of slick middlemen. We should gather better evidence on such questions and act on that evidence.

A final, fifth piece of counsel: don’t for a moment think this is a problem that can be solved in four easy steps.

Also published at ft.com.

Other Writing

Economic quackery and political humbug

British readers will be well aware that the UK Chancellor George Osborne unveiled his budget statement on Wednesday. Here was the piece I wrote that afternoon:

Has there ever been a chancellor of the exchequer more entranced by the game of politics? Most of George Osborne’s Budget speech was trivial. Some of it was imponderable. The final flurry of punches was substantial. Every word was political.

Consider the substantial first: in abolishing the obligation for pensioners to buy annuities, Mr Osborne has snuck up behind an unpopular part of the financial services industry and slugged it with a sock full of coins. (No doubt he will tell us they were minted in memory of the threepenny bit and in honour of Her Majesty the Queen.) This is a vigorous but carefully calibrated tummy rub for sexagenarians with substantial private-sector pensions.

Nobody else will even understand what has been done. The benefit to pensioners is immediate and real. The cost comes later – but Mr Osborne will be long gone by the time the media begin to wring their hands about some poor pensioner who blew his retirement savings on a boiler-room scam.

His other significant moves were equally calculated. A meaningless and arbitrary cap on the welfare budget is no way to rationalise the welfare state but it is a splendid way to tie Labour in knots. A new cash Isa allowance of £15,000 will benefit only the prosperous, and has political appeal while delivering no real benefit – and no real cost to the Treasury – until long after the 2015 election.

Next, the imponderable. Mr Osborne devoted substantial time to the forecasts of the Office for Budget Responsibility, and no wonder: at last the news is good. But while the OBR is independent it is not omniscient. Like other economic forecasters, it has been wrong before and will be again. Mr Osborne forgot this and spoke of growth in future years being “revised up”. This is absurd. The OBR does not get to decide what growth in future years will be. We can draw mild encouragement from its improved forecasts, nothing more.

Finally, the trivial. Any chancellor must master the skill of announcing policies that have little or no place in the macroeconomic centrepiece of the political calendar. Mr Osborne showed no shame. The news that, for example, police officers who die in the line of duty will pay no inheritance tax is appealing but irrelevant. Police deaths are blessedly rare and, since police officers are usually young and modestly paid, inheritance tax is usually a non-issue even in these rare tragedies.

So let us applaud Mr Osborne for playing his own game well – a game in which economic logic is an irritation, the national interest is a distraction and party politics is everything.

You can read this comment in context at FT.com

Undercover Economist

The business of borders

‘The economic dividing line in the UK does not run along the Scottish border, it circles London’

This Sunday, the Ukrainian region of Crimea will vote over whether to become the Russian region of Crimea.

The circumstances are far grimmer, and hastier, than Scotland’s independence vote later this year, yet both votes are a reminder that national boundaries can be arbitrary things. They spring up, evaporate or move around based on popular votes, brute force or – as may happen in Ukraine – both.

Looking back 70 years, the broad trend is for borders to appear rather than disappear. There were 76 independent countries in the world in 1946; today the US recognises 195. The diplomatic definition of an independent country does not always accord with common sense: a beautiful district in Rome is on the list but Taiwan is not. Nevertheless, the story is indisputable: the world is home to more and more independent countries. Colonies have won independence from old empires and countries have been carved into smaller pieces. Mergers, as between East and West Germany, are rare.

The curious thing about nation states is that they aren’t economic units at all but political ones. We forget this because economic statistics are compiled on a national basis but a country is an unnatural unit of economic analysis. (This point was made forcefully by Jane Jacobs in her book Cities and the Wealth of Nations.) Far more sensible is to think about the economies of major cities and the regions that supply them. Barcelona and Madrid are separate economies. The economic dividing line in the UK does not run along the Scottish border between Berwick and Gretna – it circles London, taking in Oxford, Cambridge and Brighton. London is the true economic outlier in the UK. The reason it remains part of the country is because political boundaries are determined by politics, not economics.

Yet economics matters, at least at the margin. No purely economic theory could account for the simultaneous existence of China (population: 1.35 billion) and the Vatican City (population: less than the average British secondary school). But economic theories can explain some of the changes we have seen since the second world war.

The world economy is far more integrated now. Some of this globalisation is independent of national borders – the internet and the shipping container would make long-distance trade easier whether the world had a single nation or a thousand – but much of it is a function of lower tariffs and fewer non-tariff barriers.

In a world of high trade barriers it was expensive to be a small nation, because being a small nation meant having a small market. The historian Eric Hobsbawm tells us that the British prime minister, Lord Salisbury, admonished the French ambassador in the late 19th century, “If you were not such persistent protectionists, you would not find us so keen to annex territories!”

Trade barriers have fallen steadily since the end of the second world war while the number of nation states has risen – a pattern documented in the American Economic Review by three economists, Alberto Alesina, Enrico Spolaore and Romain Wacziarg.

There is some circularity here: smaller states are keen to lower trade barriers while low trade barriers enable smaller states to flourish. Scottish nationalists have, over the years, argued that the United Kingdom is unnecessary because an independent Scotland could prosper within the European Union and that trade would be easy because Scotland could use the euro or the pound. Unionists in the UK – and in Spain, which faces secessionist pressures of its own – have argued the reverse.

It is ironic that the pro-union side is so keen to talk about barriers to integration and the separatist camp is eager to portray a borderless economy. Still, the economic logic on both sides is clear enough.

So is there an ideal size for a nation? That depends on whose ideal we consider. Alberto Alesina distinguishes between the democratic equilibrium and the “Leviathan’s equilibrium”. A democratic equilibrium is what might result if any region could secede by popular vote. The Leviathan’s equilibrium is the outcome of a process in which larger countries may find it convenient to absorb smaller ones.

The Leviathan’s equilibrium has fewer and larger sovereign states because dictators do not much care about regional self-determination but they love the military strength that comes with scale. This is something Russia’s neighbours well understand. Smaller nations can form alliances but these are an imperfect substitute for having your own aircraft carrier. San Marino, the Holy See and doubly landlocked Liechtenstein are reliant on the indulgence of their neighbours for their existence.

Yet here, again, there is more at play than pure politics. As the world economy becomes ever more intangible, there is less to be gained from seizing territory by force. France could occupy Monaco before breakfast, if it so chose. But leaving aside history, law and simple good manners, what would be the point? An occupied Monaco would not be Monaco any more.

So smaller states are a consequence of democracy, of peace, and of free trade. Let us hope they continue to thrive.

Also published at ft.com.

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Undercover Economist

Let’s have some real-time economics

‘It would have done the Fed no harm to have had more people with a habit of making snap decisions’

What would it take to make economics more useful in a crisis? Not more rigorous or more realistic – although that would be nice – but simply better equipped to deal ad hoc with the financial equivalent of a burning building?

It’s sobering to read the recently published transcripts of the Federal Reserve’s Open Market Committee meeting held on September 16 2008, the day after Lehman Brothers filed for bankruptcy. Fed chairman Ben Bernanke and his colleagues knew AIG was also in trouble but not that the worst recession since the 1930s was under way.

The transcripts induce, at times, the frustration of watching Titanic. The ship is doomed, yet our heroes suspect nothing! The Fed committee raises the possibility of a sharp cut in interest rates but inertia wins out. They are unwilling to act until the dust settles.

The rearranging-the-deckchairs moment comes as the committee discusses the right words to use in its press release. Should it say it is watching developments “closely”, or “carefully” or just watching? Nobody really knows.

In retrospect, the Fed was slow to act – as subsequently evidenced by three later, large rate cuts in an attempt to catch up. But it would be unfair to suggest that the committee was clueless. The meeting begins with a crisp discussion of the impact so far of the Lehman collapse. That’s followed by an agreement to swap currency, without limit, with other major central banks.

The overwhelming sense, however, is of a group of men and women who are rooted to the spot in the face of uncertainty. One of the staff economists, Dave Stockton, presents a detailed economic outlook before admitting, “I don’t really have anything useful to say about the economic consequences of the financial developments of the past few days.” With hindsight, what that meant was that he didn’t really have anything useful to say at all.

Bernanke himself sums up the mood perfectly as he reflects on the rapidly evolving bank bailouts and the risk of moral hazard: “Frankly, I am decidedly confused and very muddled about this.” There is wisdom there – but not of a very reassuring sort.

Hindsight is a wonderful thing and nobody should envy policy makers in such a situation. But is there a better way to conduct emergency policy? I have three suggestions.

First, increase diversity. Despite the reputation of the US for having a revolving door between big business and government, the Fed’s board looked weighted towards government insiders such as Timothy Geithner, then head of the New York Fed, and academics such as current Fed chairwoman Janet Yellen and Bernanke himself. Not many board members had high-level business experience. A variety of perspectives tends to generate a more honest conversation, and it would have done the Fed no harm to have had a few more people with a habit of making snap decisions.

Second, overhaul the economic data available. The Fed was flying blind: it knew surprisingly little about who was exposed to a collapse of Lehman and, immediately after that collapse, a vast tangle of contracts sat in limbo while the picture was slowly sorted out.

In a speech in New York two years ago, Andrew Haldane of the Bank of England argued that financial regulators and risk managers should draw inspiration from the development of supply-chain standards. These standards turned the humble barcode into a way of tracking products as they moved around the world. Because firms could follow products through the production and logistics system, bottlenecks could be bypassed and supply crunches spotted in advance.

What we need now are barcodes for financial products and companies – and they are on the way. The Financial Stability Board, which tries to co-ordinate financial policies across borders, has been developing the building blocks of a system designed to identify specific financial products and legal entities. That last point sounds trivial but it isn’t. Lehman Brothers was a Gordian knot of corporate vehicles. An up-to-date network map of who owned whom would have been invaluable.

Once better data are available, they also need to be displayed in a clear, robust and timely manner. Emery Roe of UC Berkeley, author of Making the Most of Mess, studies high-reliability systems such as electricity networks, whose operators must keep the system up and running despite a constantly evolving set of constraints and setbacks. Roe argues that one key feature of such systems is a clear visual display of trustworthy information. Electricity network operators have this but finance is way behind. The ultimate goal should be for regulators to glance at a computer display and spot stresses and vulnerabilities in the financial system, in real time – not easy.

Perhaps we should also treat such endless firefighting with more respect. In economics, ecology and other disciplines, Roe argues, those making tough decisions in the field are disparaged as practising “agency science”. Yet somewhere there is an ecologist who needs to decide how to respond immediately to the latest toxic spill, and there is an economist who needs to decide how to respond immediately to the latest bankruptcy.

We need people with the art of real-time economics – an art that shouldn’t be dismissed just because it cannot match the rigour of the ivory tower.

Also published at ft.com.

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Tim Harford is an author, columnist for the Financial Times and presenter of Radio 4's "More or Less".
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