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Undercover Economist

When it comes to banking, can we have too much of a good thing?

In 1980, the econometrician David Hendry (now Sir David) investigated a key economic question: what causes inflation? Hendry looked to the data for insight. He speculated that a particular variable, X, was largely responsible. He assembled data on variable X, performed a few deft mathematical tweaks and compared his transformed X with the path of consumer prices in the UK. Graphing the result showed an astonishingly close fit.
The only snag: X was cumulative rainfall. Since consumer prices and cumulative rainfall both rise over time, Hendry had an excellent platform for finding his spurious correlation. Statistical sleight of hand did the rest.
Hendry wanted to demonstrate just how easy it was to produce plausible nonsense by misusing the tools of statistics. “It is meaningless to talk about ‘confirming’ theories when spurious results are so easily obtained,” he wrote.
All this is by way of preamble, because a hot topic in economics at the moment is the role of finance in the health of the economy. For many years, economists have tended to believe that a larger financial sector tends to be good news for economic growth, with statistical evidence to back this up.
It won’t surprise anyone to hear that this belief is now viewed with some scepticism, and the statistical studies now back up the scepticism too. Several recent research papers have found that finance can be bad for economic growth.
Given this statistical volte-face, Hendry’s conjuring trick comes to mind. Are our statistical studies simply serving as decoration for our existing prejudices?
A recent note by William Cline of the Peterson Institute for International Economics worries that new anti-finance research rests on a statistical illusion. Rich countries tend to grow more slowly than poorer ones. But rich countries also have larger banking sectors. A naive analysis, then, would show that large banking sectors are correlated with slower growth. But, points out Cline, the same statistical methods show that doctors are bad for growth and that telephones are bad for growth and even that research and development technicians are bad for growth. In reality, all that is being shown is that being rich already is bad for further growth.
Cline makes a good point but a narrow one. It’s not particularly helpful to analyse banking like salt in cooking or water on your vegetable patch, and conclude that “some is good, too much is bad”. Unlike salt and water, banking services are complex and diverse. There’s a difference between a mortgage, a payday loan, life insurance, a credit derivative, a venture capital investment and an equity tracker fund. They’re all financial services, though.
More persuasive analyses of the relationship between finance and growth are asking not just whether finance can grow too big to be helpful but what kind of finance, and why.
In two working papers for DNB, the Dutch central bank, Christiane Kneer explores the idea that the trouble with banking is that it sucks talent away from the rest of the economy. Kneer looked at the process of banking deregulation state by state in the US and found that banks hired skilled individuals away from manufacturing, where labour productivity fell. If Kneer is right, too much finance is bad for growth because the banks are gobbling up too many of the smartest workers.
Another possibility, explored by economists Stephen Cecchetti and Enisse Kharroubi, is that large banking sectors aren’t doing their classic textbook job of funding the most productive investments. Instead, they like to lend money to organisations that already have collateral. Mortgages make attractive loans for this reason. Loans to a business that already owns an office block or an oil refinery are also tempting. But lending to a business with more intangible assets, such as an R&D department or a set of strong consumer relationships, is less attractive. Perhaps it is no surprise when Cecchetti and Kharroubi find that larger banking sectors are correlated with slower growth in R&D-intensive parts of the economy. But it is not encouraging.
. . .
Such research reminds us that we shouldn’t simply bash “banking” or “finance” in some generic way, blaming the banks for anything from the weather to the struggles of bees. We need to look at the details of what the financial services industry is doing, and whether financial regulations are protecting society or making things worse.
The truth is that we desperately need a strong banking sector. This entire research literature on finance and growth was originally kicked off by development economists who had observed that poor countries struggled to develop if they didn’t have decent banks. Thorsten Beck, an economist at Cass Business School, first started studying the effects of finance when he worked at the World Bank. “I didn’t care about the UK or the Netherlands. I cared about Kenya, Chile and Brazil.”
Without a strong and sizeable banking sector to lend money to businesses, it is very hard for a poor country to grow. It may well be that we have more finance sloshing around the economy than we can use. That is a big problem — but it is also a first-world problem.

Other Writing

The myth of the robot job-ocalypse

“The number of jobs lost to more efficient machines is only part of the problem . . . In the past, new industries hired far more people than those they put out of business. But this is not true of many of today’s new industries.”
This sentiment, from Time magazine, dates from the early weeks of John Kennedy’s presidency. Yet it would slot nicely into many a contemporary political speech. Like any self-respecting remorseless killer robot from the future, our techno-anxiety just keeps coming back.
Arnold Schwarzenegger’s Terminator was science fiction — but so, too, is the idea that robots and software algorithms are guzzling jobs faster than they can be created. There is an astonishing mismatch between our fear of automation and the reality so far.
How can this be? The highways of Silicon Valley are sprinkled with self-driving cars. Visit the cinema, the supermarket or the bank and the most prominent staff you will see are the security guards, who are presumably there to prevent you stealing valuable machines. Your computer once contented itself with correcting your spelling; now it will translate your prose into Mandarin. Given all this, surely the robots must have stolen a job or two by now?
Of course, the answer is that automation has been destroying particular jobs in particular industries for a long time, which is why most westerners who weave clothes or cultivate and harvest crops by hand do so for fun. In the past that process made us richer.
The worry now is that, with computers making jobs redundant faster than we can generate new ones, the result is widespread unemployment, leaving a privileged class of robot-owning rentiers and highly paid workers with robot-compatible skills.
This idea is superficially plausible: we are surrounded by cheap, powerful computers; many people have lost their jobs in the past decade; and inequality has risen in the past 30 years.
But the theory can be put to a very simple test: how fast is productivity growing? The usual measure of productivity is output per hour worked — by a human. Robots can produce economic output without any hours of human labour at all, so a sudden onslaught of robot workers should cause a sudden acceleration in productivity.
Instead, productivity has been disappointing. In the US, labour productivity growth averaged an impressive 2.8 per cent per year from 1948 to 1973. The result was mass affluence rather than mass joblessness. Productivity then slumped for a generation and perked up in the late 1990s but has now sagged again. The picture is little better in the UK, where labour productivity is notoriously low compared with the other G7 leading economies, and it has been falling further behind since 2007.
Taking a 40-year perspective, the impact of this long productivity malaise on typical workers in rich countries is greater than that of the rise in inequality, or of the financial crisis of 2008. In an age peppered with economic disappointments, the worst has been the stubborn failure of the robots to take our jobs. Then why is so much commentary dedicated to the opposite view? Some of this is a simple error: it has been a tough decade, economically speaking, and it is easy to blame robots for woes that should be laid at the door of others, such as bankers, austerity enthusiasts and eurozone politicians.
It is also true that robotics is making impressive strides. Gill Pratt, a robotics expert, recently described a “Cambrian explosion” for robotics in the Journal of Economic Perspectives. While robots have done little to cause mass unemployment in the recent past, that may change in future.
Automation has also undoubtedly changed the shape of the job market — economist David Autor, writing in the same journal, documents a rise in demand for low-skilled jobs and highly skilled jobs, and a hollowing out of jobs in the middle. There are signs that the hollow is moving further and further up the spectrum of skills. The robots may not be taking our jobs, but they are certainly shuffling them around.
Yet Mr Autor also points to striking statistic: private investment in computers and software in the US has been falling almost continuously for 15 years. That is hard to square with the story of a robotic job-ocalypse. Surely we should expect to see a surge in IT investment as all those machines are installed?
Instead, in the wake of the great recession, managers have noted an ample supply of cheap human labour and have done without the machines for now. Perhaps there is some vast underground dormitory somewhere, all steel and sparks and dormant androids. In a corner, a chromium-plated robo-hack is tapping away at a column lamenting the fact that the humans have taken all the robots’ jobs.

24th of August, 2015Other WritingComments off
Undercover Economist

London’s turning . . . 

‘London’s excruciating price tag is not just a vulnerability but also a sign of success’

What is happening to London? Is the city devouring itself, its street life disappearing as flat-pack apartment blocks metastasise in once-healthy neighbourhoods? Or are we simply witnessing a process of regeneration and renewal? Rohan Silva, a former adviser to David Cameron, recently told architecture magazine Dezeen that London might lose its creative class because of high rents. In The Observer, Rowan Moore wrote that London “was suffering a form of entropy whereby anything distinctive is converted into property value”.

It is natural that journalists find this an urgent topic: surely the gap between the price of a typical London house and the salary of a typical London journalist has never been higher. But the topic is genuinely puzzling, because London’s excruciating price tag is not just a vulnerability but also a sign of success. It is hard to see how the city can be written off when so many people are willing to pay such extraordinary sums to live there.

It’s worth dismissing some disaster scenarios. Many people fret that the infamous apartments of One Hyde Park stand for the future of London: joyless, unaffordable and empty most of the time. But London is not going to become a gigantic holiday park full of second homes for billionaires — there simply aren’t enough billionaires out there to turn a city of more than eight million souls into the equivalent of a weekend hideaway in Cornwall.

Another concern is that international investors will snap up new-build apartments as investments, then leave them empty. But rental property is a much better investment when one actually rents it out, so this makes sense only if one accepts that most international investors are insane.

Nor has London abandoned its social housing sector either — not yet. About a quarter of London’s households live in social rented housing, and many more than that in inner London. The prevalence of social housing has been falling since the 1980s — but slowly. Social housing is still on offer to almost a million households.

The vision of London as a ghost town can be disproved in an instant by the experience of actually being in London. Try to get on the Tube at Clapham Common at 8am, then tell me that London’s problem is underpopulation.

“London’s population is going up,” says Professor Christine Whitehead of the London School of Economics. “And there’s no indication that the new population is the wrong mix.”

“Mix” is an important word here. More than 50 years ago, in The Death and Life of Great American Cities, Jane Jacobs emphasised the merits of variety in city life. If a neighbourhood had a mix of homes, offices, factories, shops and nightlife, then the streets would be interesting, well used and, therefore, safe for many hours a day. More rigorous zoning might look tidy on a city map but would leave streets (and shops) unusably overcrowded at some times and deadly boring at others. Tedious and perhaps dangerous, such a neighbourhood would be fragile. Jacobs also advocated a mix of different industries so that ideas could spread from one to another. Her most famous example was Ida Rosenthal’s invention of the bra after working not in lingerie but in dressmaking.

Fundamental to all this, wrote Jacobs, was a mix of old and new buildings. Leaving aside unusual cases such as Venice, cities need a mix of higher-rent buildings and more decrepit low-rent buildings, because such buildings house different kinds of activity. Experimental projects, in particular, need somewhere cheap — the Silicon Valley garage, perhaps, or the east London warehouse. “Old ideas can sometimes use new buildings,” Jacobs wrote. “New ideas must use old buildings.”

This is London’s challenge: if only hedge-fund millionaires can afford to live there, then even the hedge-fund millionaires will not wish to. Artists, start-up hopefuls and hipster baristas need not only low-rent places to live but low-rent places to work. If London loses such places, then it will indeed lose its creative edge.

Still, London does not yet seem to be short of hipster baristas. Whitehead says: “I’ve heard that argument once a decade for the past 50 years.” It may yet come true — but so far, so good.

The trouble with creative destruction is that it is always easier to see what is being lost than what is being gained. Notting Hill seems pretty dull to me these days but Clapton Pond is on fine form: brothels have been replaced by bars; murderous dives have been replaced by gastropubs; fried-chicken joints have been replaced by coffee shops. The mix is changing but it’s still a mix, and it’s not obvious that the new mix is disastrous.

What would be disastrous would be if the lot were bulldozed to make way for apartment blocks in which nobody wanted to live because there was nothing to do outside. We must guard against the encroachment of such residential deserts, yet they remain rare in London. The city is, of course, a playground for the super-rich. But, for now, it remains much more than that.

Written for and first published at ft.com.

Undercover Economist

How to level the playing field

‘It costs something like a billion quid to turn a bottom-half Premier League club into one of the best teams in Europe’

They have dominated their national football league, winning 17 times in the past 50 years, far more than any rival. Indeed, only 10 other teams have managed to win the league at all since 1965. Can you guess the club?

You might be thinking Real Madrid — but no, Real have won 21 times in the past half century and Barcelona are not so far behind. Juventus would be a better guess — they have won 19 titles in the past 50 years, with rivals AC Milan boasting 10. Manchester United have 14, just ahead of Liverpool with 12.

But no. I am thinking of Havnar Bóltfelag. Affectionately known as HB, they are the Real Madrid of the Faroe Islands. The club is 111 years old — just a couple of years younger than Real — and just as dominant, albeit on a smaller stage. If Havnar Bóltfelag were ever to play Real, the entire population of the Faroe Islands could rattle around inside Real’s Bernabéu stadium with room to spare for some home fans.

The curious thing is that most European football leagues show a similar pattern of dominance. As sports economist Stefan Szymanski explains in his book Money and Football, looking at just the distribution of wins — typically 18-22 for the leading team over the past 50 years, and 11 or 12 champions in total — it is hard to tell the European leagues apart.

There are some exceptions (the French and Irish leagues have been more competitive, and the Scottish and Dutch leagues less so) but the regularity is striking. That might seem surprising given that the average revenue per top-tier club in England, Germany, Spain and Italy is more than $100m, while that in the Faroe Islands and Luxembourg is less than $1m. And, in case you were wondering, Luxembourg fits the pattern perfectly. The Real Madrid of Luxembourg (or should that be the Havnar Bóltfelag of Luxembourg?) is Jeunesse Esch, also just over a century old. It has won 20 titles in the past 50 years.

So what explains this widespread pattern in which one or two teams tend to dominate? Not the cost of fielding 11 players, certainly. As Szymanski points out, there are plenty of football teams around. Running a football club does not demand scale, like a mobile phone network or a nuclear power station. It’s more like running a soft drinks company: anyone can do it at any scale but Coca-Cola somehow manages to be the biggest around. (Coincidentally, Coca-Cola’s global market share is the same as Real Madrid’s share of the past 50 La Liga titles and Pepsi’s is the same as Barcelona’s.)

Here is a hypothetical question that might shed some light: why don’t Havnar Bóltfelag borrow some money and hire superstars such as Lionel Messi and Cristiano Ronaldo? Let’s assume that a sufficiently gullible bank could be found — the nearest banking centres, Reykjavik and Edinburgh, suggest that anything is possible.

The answer is that Havnar Bóltfelag is not the best place to showcase the talents of the world’s most expensive players. Partly this is a question of geography. But partly HB’s problem is its reputation: it doesn’t have one. Until the club had more name recognition, good players would be reluctant to join, and would have to be given extra financial incentives. Sponsors would feel the same. And while football spectators do like to watch big names playing attractive football, they are also loyal to their old clubs. Even if Real Madrid and Barcelona were somehow to become feeder clubs for Havnar Bóltfelag, it would take a while for their support to ebb and HB’s to grow.

Now apply the same logic to smaller clubs in large leagues, and the reason for big club dominance starts to become clear. Clubs such as Rayo Vallecano in Madrid or West Ham in London face no geographical handicap in challenging Real Madrid or Chelsea. But they would have to pay over the odds to attract players, staff and fans while simultaneously earning less from advertisers and global TV rights.

It is possible to bridge this brand-name gap if you are willing to lose enough money. “It costs something like a billion quid to turn a club from a bottom-half Premier League team to one of the best teams in Europe,” says Szymanski. Manchester City, Chelsea and Paris Saint-Germain have been transformed into top-flight clubs. They are all now in a position to make money — or at least, to lose no more money than any other top club — but nobody expects their owners to recoup the cost of that transition, at least not through the business of football.

The clubs with a large fan base, long history and global name recognition are the clubs with the most to gain from spending a lot trying to win football matches. For anyone else to challenge them requires very deep pockets. That is why winners keep winning.

But should we care about this sporting dominance? Szymanski points out that European football with its lopsided leagues has far outgrown American sports, which are carefully engineered to ensure competitive balance. Apparently, the global army of fans of Real Madrid, Manchester United and Bayern Munich don’t mind if they win a lot.

Written for and first published at ft.com.

Undercover Economist

Worming our way to the truth

‘Why does such a large policy push need to be based on a handful of clinical trials?’

It was one of the most influential economics studies to have been published in the past 20 years, with a simple title, “Worms”. Now, its findings are being questioned in an exchange that somehow manages to be encouraging and frustrating all at once. Development economics is growing up, and getting acne.

The authors of “Worms”, economists Edward Miguel and Michael Kremer, studied a deworming project in an area of western Kenya where parasitic intestinal worms were a serious problem in 1998. The project was a “cluster randomisation”, meaning that the treatment for worms was randomised between entire schools rather than between children within each school.

Miguel and Kremer concluded three things from the randomised trial. First, deworming treatments produced not just health benefits but educational ones, because healthier children were able to attend school and flourish while in class. Second, the treatments were cracking value for money. Third, there were useful spillovers: when a school full of children was treated for worms, the parasites became less prevalent, so infection rates in nearby schools also fell.

The “Worms” study was influential in two very different ways. Activists began to campaign for wider use of deworming treatments, with some success. Development economists drew a separate lesson: that running randomised trials was an excellent way to figure out what worked.

In this, they were following in the footsteps of epidemiologists. Yet it is the epidemiologists who are now asking the awkward questions. Alexander Aiken and three colleagues from the London School of Hygiene and Tropical Medicine have just published a pair of articles in the International Journal of Epidemiology that examine the “Worms” experiment, test it for robustness and find it wanting.

Their first article follows the original methodology closely and uncovers some programming errors. Most are trivial but one of them calls into question the key claim that deworming produces spillover benefits. Their second article uses epidemiological methods rather than the statistical techniques preferred by economists. It raises the concern that the central “Worms” findings may be something of a fluke.

Everyone agrees that there were some errors in the original paper; such errors aren’t uncommon. There’s agreement, too, that it’s very useful to go back and check classic study results. All sides of the debate praise each other for being open and collegial with their work.

But on the key questions, there is little common ground. Miguel and Kremer stoutly defend their findings, arguing that the epidemiologists have gone through extraordinary statistical contortions to make the results disappear. Other development economists support them. After reviewing the controversy, Berk Ozler of the World Bank says: “I find the findings of the original study more robust than I did before.”

Yet epidemiologists are uneasy. The respected Cochrane Collaboration, an independent network of health researchers, has published a review of deworming evidence, which concludes that many deworming studies are of poor quality and produce rather weak evidence of benefits.

What explains this difference of views? Partly this is a clash of academic best practices. Consider the treatment of spillover effects. To Miguel and Kremer, these were the whole point of the cluster study. Aiken, however, says that an epidemiologist is trained to think of such effects as “contamination” — an undesirable source of statistical noise. Miguel believes this may explain some of the disagreement. The epidemiologists fret about the statistical headaches the spillovers cause, while the economists are enthused by the prospect that these spillovers will help improve childhood health and education.

Another cultural difference is this: epidemiologists have long been able to run rigorous trials but, with big money sometimes at stake, they have had to defend the integrity of those trials against the possibility of bias. They place a high value on double-blind methodologies, where neither subjects nor researchers know who has received the treatment and who is in the control group.

Economists, by contrast, are used to having to make the best of noisier data. Consider a century-old intervention, when John D Rockefeller funded a programme of hookworm eradication county by county across the American south. A few years ago, the economist Hoyt Bleakley teased apart census data from the early 20th century to show that this programme had led to big gains in schooling and in income. To an economist, that is clever work. To an epidemiologist, it’s a curiosity and of limited scientific value.

As you might expect, my sympathies lie with the economists. I suspect that the effects that Miguel and Kremer found are quite real, even if their methods do not quite match the customs of epidemiologists. But the bigger question is why so large a policy push needs to be based on a handful of clinical trials. It is absolutely right that we check existing work to see if it stands up to scrutiny but more useful still is to run more trials, producing more information about how, where and why deworming treatments work or do not work.

This debate is a sign that development policy wonks are now serious about rigorous evidence. That’s good news. Better news will be when there are so many strong studies that none of them will be indispensable, and nobody will need to care much about what exactly happened in western Kenya in 1998.

Written for and first published at ft.com.

Undercover Economist

The rewards for working hard are too big for Keynes’s vision

The economist was right in that we are better off but at the cost of our free time

Working long hours pays off in monetary terms, but it means there is less time for pursuits

If John Maynard Keynes is looking down upon me now — he might make a good guardian angel for economists — then he is wondering why I am writing this column instead of lounging by the pool.

“Three hours a day is quite enough,” he pronounced in his 1930 essay Economic Possibilities for our Grandchildren. The essay offers two famous speculations: that people in 2030 will be eight times better off than people in 1930; and that as a result we will all be working 15-hour weeks and wondering how to fill our time.

Keynes was half right. Barring some catastrophe in the next 15 years, his rosy-seeming forecasts of global growth will be an underestimate. The three-hour workday, however, remains elusive. (Keynes was childless, but NPR’s Planet Money show recently tracked down his sister’s grandchildren and asked them if they were working just 15 hours a week. They were not.)

So where did Keynes go wrong? Two answers immediately spring to mind — one noble, and one less so. The noble answer is that we rather like some kinds of work. We enjoy spending time with our colleagues, intellectual stimulation or the feeling of a job well done. The ignoble answer is that we work hard because there is no end to our desire to outspend each other.

Keynes considered both of these possibilities, but perhaps he did not take them seriously enough. He would not have been able to anticipate more recent research suggesting that the experience of being unemployed is miserable out of all proportion to its direct effect on income.

Perhaps Keynes also failed to appreciate that there is more to keeping up with the Joneses than conspicuous consumption. We want to live in pleasant areas with good schools and easy access to dynamic employers. As a result, we find ourselves in ferocious competition for a limited supply of desirable houses.

There are subtler explanations for Keynes’s error. As the late Gary Becker observed in an essay with Luis Rayo, Keynes may have been led astray by contemplating the leisured elite of the 1920s. The income flowing to the “1 per cent” was not much different back then, but they owned much more of the wealth. A gentleman in 1920s Bloomsbury drawing income from capital was just as wealthy as a partner at a 21st-century New York law firm billing at a vast hourly rate. Yet it is no mystery that the gentleman spent his time at the club while the lawyer is working her socks off.

A few years ago, the economists Mark Aguiar and Erik Hurst published a survey of how American work and leisure had evolved between 1965 and 2005. Both men and women had more leisure time — although nothing like as much as Keynes had expected. But some people defied this trend. The best educated and the highest earners, both men and women, had less free time than ever. Starting in the mid 1980s, this elite began to drop everything and work ­furiously.

Perhaps the real story, then, is that we are trying to keep up not with the Joneses but with our work colleagues. By pulling the longest hours and taking the least leave, we climb the corporate ladder. It may be no coincidence that the collapse in leisure time began in the 1980s, at a time when inequality at the top of that ladder was surging. The rewards for working hardest are large.

We are still 15 years away from the world that Keynes imagined. If we are to live up to his laid-back expectations, much will have to change. We’ll need plentiful access to nice schools and neighbourhoods, and less of a rat-race culture in the office.

That sounds welcome. But perhaps the fundamental truth is that many of us enjoy working hard on something that feels worthwhile, or aspire to such work. John Maynard Keynes was a wealthy man, but that did not stop him working himself to death.

Written for and first published at ft.com.

Undercover Economist

It’s tough turning ideas into gold

‘If innovators make no money at all, they will end up creating for the love of creation rather than for any financial reward’

Alchemy, the ancient art of turning base metals into precious ones, was built on more than one misapprehension. The obvious error is that it is impossible to turn lead into gold. (Not quite impossible, actually. Chemistry will not do the job but a particle accelerator will, although not cheaply. In 1980, researchers bombarded the faintly lead-like metal bismuth and created a few atoms of gold. The cost was a less-than-economical rate of one quadrillion dollars an ounce.)

But there is a subtler mistake — not a scientific one but a matter of economics. “The alchemist fallacy” is the belief that once a simple method is found for turning lead into gold, gold will continue to be precious. We don’t have to rely on economic theory to refute this conclusion, because we have a fascinating case study of a close parallel.

Twenty-six million years ago, some cataclysmic event in the Eastern Sahara raised the temperature of silica sand to well over 1,000 degrees. The result was a large deposit of a lustrous material the colour of a lemon’s flesh. A fragment of this precious stuff was used to make jewellery for Tutankhamun’s tomb. (The story is well told in Steven Johnson’s book How We Got to Now.) The substance could be quarried but not manufactured.

While alchemists never figured out how to turn lead into gold, other craftsmen did develop a process with much the same economic implications. They worked out how to transform silica sand, one of the most common materials on earth, into the beautiful, versatile material we know as glass. It has an astonishing variety of uses from fibre optics to microscopes to aeroplane fuselages. But while gold remains highly prized, glass is now so cheap that we use it as disposable packaging for water.

When it was possible to restrict access to the secret of glassmaking, the guardians of that knowledge profited. Venetian glassmakers were clustered together on the island of Murano, where sparks from the furnaces would not endanger Venice itself. Venice had less success in preventing the secrets of glassmaking from spreading. Despite being forbidden on pain of death to leave the state of Venice, some of Murano’s glassmakers sought fortunes elsewhere. The wealth that could be earned as a glassmaking monopolist in some distant city must have been worth the risk.

That is the way of new ideas: they have a tendency to spread. Business partners will fall out and set up as rivals. Employees will leave to establish their own businesses. Time-honoured techniques such as industrial espionage or reverse engineering will be deployed. Sometimes innovators are happy to give their ideas away for nothing, whether for noble reasons or commercial ones. But it is very hard to stop ideas spreading entirely.

A few years ago, the economist William Nordhaus tried to estimate just how fallacious the alchemist fallacy is — how much of the social gains from innovation does the innovator manage to keep hold of? If the answer is anywhere near 100 per cent — even 50 per cent — then there is no fallacy at all. But if the answer is near zero, then innovations are swiftly copied, benefiting competitors and above all consumers.

Nordhaus was writing in the wake of the dotcom bubble, and pointed out that the valuations of “new economy” companies could be justified only if they were able to retain about 90 per cent of their value to society. This is a slice of the pie to make the most powerful and sophisticated monopolist dream. Nordhaus, pointing to the rapid demise of many dotcom firms and the tight margins of others, reckoned that the proportion was rather lower than that.

Looking at data from the United States between 1948 and 2001, Nordhaus estimated that corporations were able to keep about 3.7 per cent of the social value of their innovations. The remaining 96.3 per cent went to everyone else, mostly to consumers.

Nordhaus’s estimate is uncertain but has the ring of truth about it. Even a company such as Apple, which has a gift for holding on to a good proportion of the returns from innovation, has seen its iPad, iPhone and MacBook Air relentlessly chased down by competitors.

All this raises a question: should we wish that the innovator’s profit share was higher or lower? There is a balance to be struck. When innovators keep too much money, the benefit of using or recombining new ideas spreads too slowly. But if innovators make no money at all, then they will end up creating for the love of creation rather than for any financial reward. That may be fine for pop songs and poetry but less so for nuclear fusion or an HIV vaccine. Costly research programmes will not be funded.

The right balance depends on the innovation in question, and how expensive it is to develop. We probably need better incentives to create some new medicines. Yet our intellectual property system gives too much protection to ideas that would have been created anyway, such as simple software, business methods and Mickey Mouse. It is no surprise that the Venetian doges tried to keep the glassmakers in Murano. We should be grateful that they failed.

Written for and first published at ft.com.

Undercover Economist

Why wishful thinking doesn’t work

‘Careless nudges are no more welcome in public policy than at a domino-toppling event’

Three years ago, the University of Vermont in Burlington began to experiment with a few nudges towards a healthy, sustainable lifestyle. First, in 2012, campus outlets and the company operating the vending machines were required to make sure that at least 30 per cent of the drinks on offer were wholesome stuff such as vegetable juice, low-fat milk and water. A few months later, selling bottled water on campus was banned outright. The aim, pushed hard by student campaigners, was to encourage students to fill reusable bottles with tap water instead.

So, how did the Vermont experiment go? A study by Elizabeth Berman and Rachel Johnson (of the University’s own Department of Nutrition and Food Sciences) was recently published in the American Journal of Public Health. The researchers found that “per capita shipments of bottles, calories, sugars and added sugars increased significantly when bottled water was removed . . . As bottled water sales dropped to zero, sales of sugar-free beverages and sugar-sweetened beverages increased.”

In other words, the policy backfired with both barrels. Students didn’t switch to tap water, they switched to the likes of Coke and Diet Coke instead. All this would be just an amusing curiosity — one more example of student campaigners who are all heart and no brains — if it weren’t for the fact that more mature policy makers often commit similar blunders on much broader canvases. We would do well to learn some lessons from the University of Vermont’s experience.

The first lesson is that when it comes to saving the planet, people focus on what they can see. Type “environmental impact of concrete” into a search engine and you are likely to see a page filled with scholarly analysis pointing out that the impact is very large indeed, because cement production releases vast volumes of carbon dioxide. Type “environmental impact of bottled water” instead and your search results will be packed with campaigning groups seeking to persuade you to change your ways.

This is understandable: I can’t do much about concrete but I can stop drinking bottled water. But being a logical target for campaigners is not the same as being a logical target for policy action.

The second lesson is that we often struggle to deal with multiple goals. The University of Vermont wanted to reduce the flow of plastic water bottles to landfill but also wanted to encourage students to be healthy. There’s a clear conflict between these goals. Water is as healthy a drink as you can find, yet that was exactly what the University of Vermont was banning from vending machines. Wishful thinking provides a resolution — if everyone just drank tap water then there would be no problem. But wishful thinking is not an excuse for setting no priorities.

We see this sharply in the debate over nuclear power. We want to reduce the greenhouse gas emissions that result from burning fossil fuels. We also want to avoid radioactive waste and the risk of radiation leaks. In response to a genuine policy dilemma, politicians have tended to plump for wishful thinking every time, typically involving wind turbines.

The third lesson is that the much-vaunted notion of “nudging” doesn’t always help navigate a complicated policy maze. Nudging means using default options, information design and similar techniques to achieve policy goals. It can be very successful. But careless nudges are no more welcome in public policy than at a domino-toppling event. If you pick a questionable target (bottled water) and fudge a key policy dilemma (the environment vs health) then nudging isn’t going to solve your problems.

So what can be done? One approach is to try to reach policy goals with the help of market signals. The classic example of this is a carbon tax, levied on fossil fuels to reflect their carbon-dioxide emissions. The advantage of this approach is that it encourages everybody at any stage of production or consumption to take actions that reduce emissions, because those actions will save them money. A truck manufacturer might develop a cleaner engine, a logistics company might find a more efficient delivery algorithm, and the final consumer might decide to consume a little less.

The idea of using the price system to solve environmental problems is widely accepted by economists but, alas, it finds itself stranded in the policy doldrums. Ponder this: the Pope recently argued that climate change was a grave problem but he opposed market-based responses. Meanwhile the US Republican party likes market-based responses but isn’t so convinced about climate change.

One other advantage of using environmental taxes is that people can decide on their own priorities. A lot of what we do has consequences for the planet — including breathing — and so part of the problem we face is deciding what is worth doing anyway.

Perhaps it is time for a confession. I am writing this column on the hottest July day recorded in British history. At my left hand is a glass of chilled sparkling water, and next to the glass is a plastic bottle to top it up. If there had been a tax on that bottle, it is a tax I would willingly have paid.

Written for and first published at ft.com.

Other Writing

George Osborne’s Magic Has Us Fooled, For Now

The chancellor can alter the law but cannot make costly workers worth hiring, says Tim Harford

He has mastered the art of misdirection as well as any stage magician. Everyone knew George Osborne was going to butcher the tax credit system on Wednesday, more or less halving the income at which they begin to fall away. But few expected him to announce a much higher minimum wage, and he did it with such an extravagant flourish that no one clearly remembers seeing him wield the cleaver.
For most of the poorer working households who qualify for tax credits, the combined effect of Mr Osborne’s Budget will be to make them worse off financially, and to push them away from the labour force by raising the effective rate of tax they pay.
Monique Ebell of the National Institute of Economic and Social Research reckons that a single mother working 30 hours a week at the minimum wage will be more than a £1,000 a year worse off in two years’ time than she is today, despite the increase in the wage she must legally be paid.
That assumes, of course, that she keeps her job at all. This is the big question about the minimum wage: will it increase the earnings of low-paid workers, or price them out of the job market entirely? Should we expect to see these workers laid off and replaced with one-touch espresso machines, automatic checkouts and call-centre workers from India? The minimum wage is a delicate balance, and Mr Osborne has put his thumb on the scale.
The chancellor’s aim is to raise the minimum wage for those over 25 beyond £9 by 2020, from £6.50 today. That is dramatic, although not quite as dramatic as it first seems. Mr Osborne is setting the minimum wage where it might be if the economic crisis of 2008, and the long stagnation that followed, had never happened. He is hoping that employment will not suffer. He has a few other countries to look to as a precedent. France is one example, and it is not encouraging. Australia is a more hopeful case.
Mr Osborne’s move would once have been unthinkable from a Conservative chancellor. A quarter of a century ago, the conventional wisdom was that the idea of a minimum wage was absurd at any level. The logic of that position was simple enough. If the minimum wage was below the market-clearing wage — at which employees want to work the same number of hours that businesses want to hire them for — it would be irrelevant; if it was above, it would be worse than useless. Productive workers do not need a minimum wage because they will anyway be well paid. Less productive workers will be harmed by a minimum wage because employers would rather sack them than pay more than they are worth. One does not simply repeal the laws of supply and demand.
The world has moved on since then, and we know that while supply and demand matter, there is more to the labour market than the simple story above.
Some employers have market power and could pay higher wages if they were forced to; the higher minimum wage may simply redistribute from employers to low-paid employees. Another possibility is that if forced to pay higher wages, employers will invest in training and equipment to justify the labour expense. On this view, wages do not need to follow productivity; productivity can be led by wages.
A third explanation is that since many low wage jobs are in non-traded sectors such as retail, employers will simply put up prices, spreading the burden of the higher minimum wage across all consumers, and possibly reducing inequality.
There is also the argument that higher wages can encourage workers to show up more often and smile at the customers. This is true, but in most cases managers will have reached that conclusion by themselves without the need for a legal minimum.
A large body of empirical evidence suggests either that reasonable minimum wages do not destroy jobs at all, or that they do not destroy very many. The evidence is, of course, mixed and contested.
Much of it comes from the US and concerns the experience of teenagers, who — in the words of Alan Manning of the London School of Economics, “represent about 2 per cent of hours worked and 98 per cent of the studies of the minimum wage”. But it is clear enough that if modest increases in the minimum wage were disastrous for jobs, we would know that by now.
Whether the chancellor’s wage rise counts as “modest” is far more questionable. Professor Manning is guardedly optimistic: he thinks that the bold increase in the minimum wage is worth a try. But he is nervous, and so am I. We are at the edge of what the data can tell us. Mr Osborne is about to provide a fascinating new case study.
The best scenario is that the minimum wage helps to drive up British productivity, which has long languished. Employers invest in training, and rather than replacing workers with machines they give them the latest tools to do their jobs.
To the extent that productivity does not rise, employers absorb the costs or pass them on to consumers, equitably bearing the burden of giving hard-working people a decent wage.
A gloomier scenario seems more probable for some sectors, especially social care. The law of supply and demand turns out to matter after all. Faced with a sharp increase in the minimum wage that runs well ahead of what the Low Pay Commission has felt able to endorse, employers lay off many workers and reduce the hours of others. The welfare bill rises and — as so often in the past — it proves much harder to create jobs than to destroy them.
My own bet is somewhere in the middle. We will discover that Mr Osborne has pushed too hard, and that the minimum wage must be allowed to slip back again relative to median earnings. Some jobs will be lost, a lesson will be learned, and Mr Osborne’s political purposes will have been served. He will be hoping to have upgraded his own job to that of prime minister by then, which may be appropriate: he is a masterful politician but has never shown much grasp of economics.

Written for and first published at FT.com

13th of July, 2015Other WritingComments off
Other Writing

George Osborne’s gamble with jobs

My response to the Summer Budget went up on the FT website yesterday:

The sharp hike in the minimum wage in the Budget was a shock, but it was true to form for the UK chancellor of the exchequer: clever politics and dubious economics. It is telling that, where the Low Pay Commission used to consider the evidence and carefully balance the risks and rewards of a higher minimum wage, it must now recommend whatever George Osborne tells it to recommend.

The risk is clear: forced to pay up to £9 an hour, many businesses will find that they would rather find other ways to conduct their affairs — buying robots, offshoring key functions or moving overseas entirely. Bankruptcy is, of course, another option.

 

Mr Osborne’s gamble is that some businesses will simply eat the cost of higher wages (unlikely), or train their workers better and give them better tools so that the higher wages can be justified with higher productivity. It is possible this may work. It is enormously risky, and if the move is the wrong one it will be hard to reverse. The lesson of the 1980s is that, once lost, jobs are not easy to find again.

One might ask why the chancellor is willing to take such risks and to order the Low Pay Commission to do his bidding rather than be guided by evidence. The answer is not hard to find: Mr Osborne needs political cover. He is hacking away at the welfare state, notably the system of tax credits that was designed to encourage people to work rather than stay at home.

One can only guess what Milton Friedman, one of the inspirations behind the Thatcherite revolution, would have made of all this. In place of a carefully designed system of incentives for people to go to work, we are to be offered a wage increase set by a politician’s whim. Friedman knew that, even in the complex market for jobs, one does not simply abolish the laws of supply and demand.

Mr Osborne promised a Budget for working people but reality does not match that sound bite. The biggest tax break was for people inheriting expensive homes from their parents; and, while benefits for the working poor were being squeezed, those for pensioners were — as always — protected. Those who hoped for radical and logical tax reform have been bitterly disappointed.

As for working people, many will thank the chancellor as their wages rise. Others will become unaffordable and will lose their jobs. No doubt they will be scapegoated as scroungers in some future Budget speech. It is possible that Mr Osborne’s gamble will pay off. It is even possible, although unlikely, that it will pay off spectacularly. But it is reckless, and it is not his job that is on the line.

9th of July, 2015Other WritingComments off
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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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