Tim Harford The Undercover Economist

Articles published in August, 2007

Charitable campaign

Dear Economist,

I am an economics student, and intend to run for president of the student union this year. The elections are won on the basis of whose name is seen the most around campus. Given that it is improbable I will win, I am willing to offer a pot of hundreds of pounds to people to help campaign – dependent on my winning. What is the most efficient use of this pot? Hire one person to go flat out? Or spread the money around?

Cheers

J, England

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25th of August, 2007Dear EconomistComments off

Price fighters

What is the perfect rate of inflation? It is the kind of odd question that economists like to ask each other for fun, but which central bankers have to decide for real.

You might think that the answer was, obviously, zero, but nobody has told the central banks. The Bank of England has an inflation target of 2 per cent, the European Central Bank aims to keep inflation below, but close to, 2 per cent, and the Federal Reserve has a “comfort zone” of between 1 and 2 per cent. Japan’s inflation rate is about zero – but when I visited Tokyo in May, one senior official told me: “We envy you your inflation.”

These are only targets: most would concede that inflation is impossible to control perfectly. But why do central bankers aim to keep it above zero, rather than trying to eradicate it?

One reason is that relative prices need to change frequently to reflect changes in the economy: this year, British peas will be expensive because the crop was ruined by floods. But clothes have been getting cheaper for years, thanks to low-cost manufacturers in China. And yet the evidence suggests that it is usually easier to raise nominal prices than to lower them. So a little bit of inflation, which ensures the typical price change is up rather than down, means that those relative price adjustments can happen more quickly and easily. This can have a substantial effect on the real economy.

Professor Peter Sinclair of Birmingham University, when a research fellow at the Bank of England, concluded that moderate inflation could have other benefits: creating more room for policymakers to stimulate the economy if necessary, a steadier banking system and slightly lower average unemployment.

Of course, you can have too much of a good thing. While some inflation may help relative prices to adjust, too much requires such frequent price changes as to become a real burden. According to a credible 1990s estimate from the economist Daniel Levy, the typical American supermarket spent $100,000 a year changing the labels on its products: at high inflation rates it would have spent much more.

At a certain point – which Zimbabwe is well past – hyperinflation renders all prices meaningless. When Robert Mugabe ordered shopkeepers to halve prices in June, one of the most remarkable features of the pointless edict was that it would only have reduced them to their level less than a fortnight earlier.

In such circumstances, it is all but impossible to get a sense of the price of a beer versus a meal versus a shirt. The whole purpose of the price system – to convey information about the relative cost of different items – is lost.

One often hears that during periods of hyperinflation, people switch to barter, trading cigarettes or coffee for other products. That is not quite correct. Instead, during hyperinflations people look for alternative currencies. Cigarettes and coffee are portable and standardised, and so are decent candidates. So while the price of a shirt in terms of Zimbabwean dollars may be hopelessly volatile; the price of a shirt in packets of cigarettes or pounds of coffee is more stable.

Meanwhile, Japan is still trying to work out how to reach the “enviable” inflation the UK enjoys. Another economists’ conversation piece is the helicopter drop: the Bank of Japan could produce inflation by printing billions of yen and showering them over Tokyo.

Self-respecting central bankers try to expand the money supply using more sober methods.

Or do they? Japan has recently been gripped by an epidemic of mysterious cash gifts – bundles of yen left in mailboxes, public lavatories and even raining from the roof of a convenience store in Tokyo. Could the Bank of Japan finally be calling in the helicopters?

First Published at ft.com.

The Wrong Trousers

Dear Economist,

Why is it so hard for me to find a properly fitting pair of trousers on the high street? As a 33-34in waisted, 5ft 11in male, I consider myself of average build. Yet appropriate attire always seems to be out of stock. Can economic theory shed any light on this?

Concerned Trouser Consumer

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18th of August, 2007Dear EconomistComments off

Milton Friedman, meet Richard Feynman

If economics can tell us something useful about crime, marriage or car-pooling – as I believe it can – then other academic disciplines should have something to tell us about economies. Last month, Science published an example that may turn out to be important. Two physicists, Cesar Hidalgo and Albert-Laszlo Barabasi, and two economists, Bailey Klinger and Ricardo Hausmann, have been drawing unusual pictures of economic “space” that promise a deeper understanding of the biggest question in economics: why poor countries are poor.

There are many explanations, but some are easier to test than others. One very plausible account of why at least some poor countries are poor is that there is no smooth progression from where they are to where they would be when rich. For instance, to move from drilling oil to making silicon chips might require simultaneous investments in education, transport infrastructure, electricity and many other things. The gap may be too wide for private enterprise to bridge without some sort of co-ordinating effort from government – a “big push”. That is an old and intuitive idea in economics, but as an informal argument it leaves a lot to be desired. For a start, while plausible, it might not be true. If it is true, it might be far more so for some kinds of economy than for others. And if there is to be a big push, in which direction should it go?

Continued at ft.com, subscription free.

Online upgrade

Dear Economist,

I have just joined a dating website in the hope of finding true love. Friends of mine have started dating someone they met online, only for a “better offer” to arise on the website. If this happens, what should I do?

Duncan, London

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11th of August, 2007Dear EconomistComments off

Scarce tactics

Let others worry about the oil price or China’s current account surplus. On this page, I am celebrating a vintage summer for the economist as personal improvement guru. The “Dear Economist” column, first penned by Alan Beattie and Chris Giles (now FT trade and economics editors, respectively), has celebrated its fourth anniversary. Then Esquire magazine, of all places, was persuaded to publish my full-length feature on what economics could teach its readers about getting a date.

Now Tyler Cowen, an economics professor and prolific blogger at marginalrevolution.com, has published a self-help book called Discover Your Inner Economist.

I have myself long harboured a shameful desire to write a self-help book based on the basic principles of economics, but Cowen got there first. (One of those basic principles is that money doesn’t get left lying in the street for long.) I recommend his book very highly to anyone who enjoys reading this page: it’s relentlessly creative and I loved reading it.

Still, the economics of self-help is a difficult business. This is not for the obvious reason, which is that economics appears to be a narrow subject focused only on money. Economics is far broader than that: two decent definitions of the subject are that it is the study of scarcity (and what could be scarcer than Mr Right?) or that it is the study of rational behaviour.

It’s this second definition that hints at trouble…

Continued at ft.com, subscription free.

What have cities ever done for us?

My wife grew up in the countryside. To the extent that I have ever grown up, I did so in a series of small towns. Now we live in London and we are always dithering about whether to stay put with our young family, or move out to the countryside.

It is a decision for us, of course, but it is a decision that affects others – and is affected by the mixed signals provided by the government’s involvement in schools, infrastructure and the planning system. To the extent that governments get involved at all, they should be defending cities, strengthening their infrastructure and allowing them, within reason, to grow. In the UK and to some extent the US, they seem determined to do just the opposite.

Most people would prefer to live in cities. We know that because they currently accept a big financial penalty for doing so. Once you strip out the effect of the higher cost of living in cities – chiefly housing and tax – average city wages are lower than those in the countryside and small towns. Daniel Gross, the New York writer, recently totted up the purchasing power of the New York dollar: a mere 61 cents; and higher New York wages compensate for less than half the difference. The Harvard economist Edward Glaeser finds that a similar pattern holds across the US: real wages are lower, not higher, in the bigger cities. I don’t propose to shed a tear for New Yorkers or Londoners here, just to point out that we are not in it for the money.


Continued on ft.com, subscription free.

10th of August, 2007Other WritingComments off

Mr Market’s capers are not so silly

Mr Market has been getting a pasting from my learned FT colleagues recently. John Authers compared him to Wile E. Coyote. John Kay warned against personifying the market – but called him a silly old fool anyway.
The criticism seems reasonable enough. Credit spreads, bond prices, equities and currencies have all been dancing an insane caper. At times like this, the idea that the market is rational and efficient falls out of fashion pretty swiftly.
Mr Market is big enough to take care of himself, but I feel obliged to offer a few words in his defence. There is a danger in writing him off too casually, a temptation (to which I know Authers and Kay would not succumb) to think that if Mr Market is so demented, it would be easy to do better. But Mr Market is not as silly as you think.
We journalists are partly to blame for the market’s crazy reputation in times like these. It seems rather limp to write that the market rose 1.9 per cent, then dropped back 0.7 per cent, and nobody really knows why. It’s far easier all round to write a story explaining that the pattern was due to bullishness about growth, followed by profit-taking. It may even be useful, because it helps us remember what happened.
But such impromptu explanations are likely to sound feeble indeed when the market has a month like July – or worse, a day like “Black Monday” in October 1987. We are left to conclude that Mr Market must have lost his mind.
That is why it is irresponsible of me to be talking about “Mr Market” at all. It is an irresistible but misleading metaphor. Market moves that would surely be irrational if made by a single decision-maker can make perfect sense when made by a large group of investors. The economists Jeremy Bulow and Paul Klemperer have shown that even a market full of hyper-rational investors would suffer frenzies and crashes. The intuition behind their model is simple enough to grasp: smart investors pay attention to what other investors may know. When the market moves on no news, that move is the news: it is information about what everybody else is thinking.
This is not to say that all investors – or even most investors – are rational. It would be very surprising if they were. The field of behavioural finance, populated by a potent alliance of financial economists and psychologists, is revealing all sorts of evidence of irrational behaviour. An important example is a reluctance to sell loss-making stocks, because that would crystallise a loss.
This sort of psychological research deserves the serious attention it is getting. But it would be a mistake to believe that behavioural finance offers us an opportunity to put Mr Market on the psychiatrist’s couch. Just because some investors make these mistakes does not mean that the market as a whole will do so: there is too much incentive for the smart money to learn about the biases and try to do exactly the opposite.
Another difficulty for behavioural finance is that some of the behavioural economists’ discoveries have a tendency to evaporate when real money and real experience is on the line. John List, an economist at the University of Chicago, has shown that a well-known psychological bias against trading is not shared by experienced traders in real-life trading situations. (I’ll admit that the traders were dealing in Mickey Mouse badges and baseball memorabilia, but the discovery is instructive.) The experienced, rational traders tend to have more cash than the eager naïf, and so while many traders are irrational, Mr Market may well be sane enough.
It is, in any case, frustratingly hard to turn either psychological research or good solid common sense into a market-beating strategy. Psychologists point to “the endowment effect”, a natural and irrational urge to hold on to what we have rather than trade to something better. Yet wise heads caution against the foolishness of day trading. We can’t both be irrationally eager to trade and irrationally reluctant to do so – unless a split personality is to be added to the list of market traders’ psychological flaws.
Another example has been made famous by Nassim Nicholas Taleb, with his talk of the “black swan”.
Mr Taleb believes we should resign ourselves to the occurrence of dramatic, unexpected events. He claims to profit by betting that these black swans will arrive from time to time. That sounds wise indeed.
And yet the psychologist Philip Tetlock, who has made a life’s work out of studying the forecasting record of political experts, concludes that they have a natural tendency to imagine unlikely events and convince themselves that those unlikely events are, in fact, all too plausible. Mind-broadening techniques such as scenario planning or reading the Financial Times turn out to be embraced too readily by those who are already spotting black swans behind every clump of reeds. Are we too eager to imagine black swans, or too eager to dismiss them?
So I am convinced that human rationality is imperfect; I am far less convinced that those imperfections yet tell us anything profitable about the financial markets. If I am wrong, I urge any behavioural economists who have parlayed their ground-breaking research into stock-market millions and early retirement to get in touch.
Until then, I’ll invest in good old tracker funds and pay little attention to what happens to them in the short term. I’ll admit that Mr Market isn’t perfectly rational. But if I thought I could do better, I’d be crazy.

4th of August, 2007Other WritingComments off

Users’ Guide

I feel that it is time to share a secret. When I left on my holiday just over a week ago, I was fighting a battle with a deep-rooted addiction. I feel able to admit this, since over the course of my holiday I was able to go through cold turkey, conquer the addiction, and face the world clean.

It’s decaffeinated coffee for me from now on. Addiction – even to something as benign as filter coffee – is an unlikely topic for an economist to tackle, because most economic theory is predicated on rational behaviour, and addiction seems to be quintessentially irrational.

The logical response appeared in 1988. A Theory of Rational Addiction was published by Kevin M. Murphy and Nobel laureate Gary Becker, and has defined economists’ approaches to addiction ever since. The theory is easy to state: it is that addicts choose their poison despite knowing that it is habit-forming and dangerous, and they do so because they expect the highs to outweigh the lows.

Even other economists are sceptical. “They don’t know what they’re talking about,” opined Thomas Schelling when I met him shortly after he, too, was awarded the Nobel prize in economics…

Continued at ft.com, subscription free.

Revolutionary napkins

Dear Economist,

I suffer ridicule from economist friends when visiting a local restaurant. The restaurant supplies complimentary tissues and toothpicks to customers. My friends freely use them and even take some for later use. I feel this is wasteful and not “playing the game” but their arguments seem more logical – there’s no extra cost to taking more, it is included in the costing for the meal, and I’m the mug subsidising everyone else. How can I overcome my hang-up and become a maximising consumer?

Stuart

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4th of August, 2007Dear EconomistComments off

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