Tim Harford The Undercover Economist

Articles published in May, 2008

Mentoring madness

My employer has just instituted a new mentoring scheme and as a relatively new recruit I’m eligible. I can’t make up my mind whether this is an important opportunity to learn or a colossal waste of everybody’s time.
Any thoughts?
Ben Harmison

Dear Ben,

Some new research by Jonah Rockoff, an economist at Columbia University, is possibly of interest to you. Rockoff studied an acclaimed mentoring programme for New York City teachers. He adjusted for confounding factors – such as the fact that duff teachers may get more mentoring help, making it seem that mentors reduce teaching standards.

Rockoff found some evidence that the programme encouraged teachers to stay in their jobs and improved the achievements of their students. If his results apply more widely, they suggest that the thing you are most likely to learn from a mentor is how to operate in your particular company, rather than picking up transferable skills.

But the effects seem rather modest. Why, then, is mentoring so popular? Rockoff finds that teachers are convinced that their mentors have helped their teaching skills, even if the effect is not obvious from their students’ results. Overall, I’d suggest that you go for this mentoring scheme. It will make you look co-operative and you might even learn something – but even if it is useless, you’ll still convince yourself it was time well spent.

Also available at ft.com, subscription free.

31st of May, 2008Dear EconomistComments off

Why a tax cut just isn’t fair on teenagers

Alistair Darling did something rather strange recently, to baffling applause from his own backbenchers, and cries of “bribery” from the opposition: he announced a tax on teenagers.

Darling’s plan – for those who missed it – is to cut income taxes temporarily for all but the most prosperous taxpayers. The apparent windfall is £120 a head. A similar plan is already in place in the US, where a temporary “tax rebate” began to arrive in the bank accounts of a grateful nation about a month ago.

But there is no such thing as a free lunch: since neither the UK nor US governments plans to alter its spending plans, these tax holidays will be funded by government borrowing – borrowing that must eventually be repaid. That will require taxes to go up in the future, or not to fall when they otherwise might.

Who should celebrate? Not the typical taxpayer, that is for sure. The tax cut makes no difference to her. If she – assume she is British – had wanted an extra £120 right now, she could already have it in her pocket, either by withdrawing it from savings or by borrowing the money. If she did that, of course, she would later have to repay £120 plus interest. But that is exactly what Darling’s successor as chancellor will require of her. To look at it another way, the rational taxpayer should save the £120 windfall now, keeping it to pay the higher taxes that are surely on the horizon.

But whichever way you look at it, the US and UK governments are handing their citizens borrowed cash – and the citizens themselves are liable for the debt. If my bank manager arranged a surprise loan in my name and handed me the cash, I might feel pampered or put-upon depending on whether I was planning to take out the loan myself anyway. Either way, I doubt I would feel any richer.

Of course, some people should count themselves wealthier after the tax cut. Anyone expecting to die without making a bequest should be pleased: if the Grim Reaper knocks on the door before the taxman does, he can spend the tax rebate now and leave the bill for some other sucker.

Who will be the fall guy? We don’t know for sure, because we can’t say who a future government will tax. But an obvious candidate would be today’s teenagers, very few of whom are paying income tax right now, but most of whom will pay it in the next few years. Their best hope is that their grandparents add the tax windfall to their bequests rather than blowing the money on a weekend in the sun.

The idea that a debt-funded tax cut makes little difference to anybody is called “Ricardian equivalence”, after David Ricardo, one of the founders of modern economics. The equivalence is between government taxes and government borrowing. However government spending is funded, it generates a bill that will fall due sooner or later. Far-sighted taxpayers will immediately take note.

Clearly, there are reasons for some taxpayers to care whether taxes arrive today or later on with interest. Even so, these tax gimmicks matter much less than we might think. It is current government spending, not current government taxation, that is the real measure of a government’s size.

Empirical economists are still arguing over whether Ricardian equivalence holds good, but one study by Matthew Shapiro and Joel Slemrod concluded that most US citizens used a 2001 tax windfall to pay off their debts, leaving more money available to pay future taxes – Ricardian equivalence in action.

That suggests that as consumers and taxpayers, we aren’t fooled by fiscal sleight of hand. Are we fooled as voters? Alistair Darling obviously hopes so.

Also available at ft.com, subscription free.

Business Life: Betting your future

First published in Business Life Magazine, March 2008

One of my favourite Dilbert cartoons begins with the pointy-haired boss asking for a revenue forecast on a project; it finishes with his subordinate screaming “Just tell me which lie to use!”
That might give a hint as to why internal corporate forecasts are often no good. It’s always hard to foretell the future, but harder still when managers are promoted on the basis of self-serving projections, or because they have successfully sat on bad news.
There is an alternative: something called a “prediction market”. Such markets enable a company’s employees to bet on, for example, whether the new flagship product will beat sales projections in the third quarter. The odds in the market should be a reality check for the official forecasts.
Consider a prediction market “ticket” that pays ten dollars if the flagship does indeed beat expectations in the third quarter, and nothing otherwise. The sales team, knowing that retailers are enthusiastic, might want to buy the ticket. The engineers, knowing the product is full of bugs, might want to sell. If the ticket trades at, say, three dollars, that means that the market’s opinion is that the sales target is only 30 per cent likely to be achieved.
A corporate prediction market allows employees to trade on the basis of their own unique information. They can do so anonymously, without fear of jeopardising their careers. And if they get it right, there is money to be made.
You might think that no company would dare to use a betting market to make forecasts, but the economists Justin Wolfers and Eric Zitzewitz have pointed to Arcelor Mittal, Chrysler, Eli Lilly, General Electric, Microsoft and others as having been publicly identified as experimenting with the idea. The first company to do so seems to have been Hewlett-Packard, during the first technology boom, and their tentative experiment did indeed outperform internal forecasts. The largest and most liquid prediction markets seem to be at Google, which has embraced the idea with gusto. Analysis by Wolfers and Zitzewitz, along with Google researcher Bo Cowgill, suggest that the markets have worked well – albeit with a bias towards overly sunny forecasts.
Google being Google, one trader wrote a software robot to do his trading for him and made money. But the traders who did best were those who had the longest tenure at the company. That might be a crumb of comfort for top managers. They may be usurped by prediction markets, but at least they can make a profit.

28th of May, 2008Other WritingComments off

Day release?

Dear Economist,
In some countries, mothers and their newborn babies are kept in hospital for many days, while in others they are discharged quickly. Which is right? I’m pregnant, and I want to know whether I should be lobbying for a long stay or for early release after my baby is born.
Michelle, north London

Dear Michelle,

A simple analysis won’t answer you, because we would expect more complicated or worrying cases to stay longer in hospital. But that does not imply that long hospital stays cause complications and worry.

Instead, we need to observe what happens to mothers and babies sent home early or late for no good reason.

Fortunately, there is no shortage of such cases. Californian insurers will pay for a certain number of nights in hospital, but the clock starts at midnight. A baby born at one minute past midnight has nearly 24 hours before clocking up one night in hospital; a baby born two minutes earlier will clock up her first night in hospital within seconds. The economists Douglas Almond and Joseph Doyle used such comparisons to examine whether the extra night was helpful.

They looked at whether mother and baby survived, and whether they had to be readmitted later. There was no evidence that longer hospital stays were helpful.

My experience is that an extended stay for mother and baby is a welcome respite – for the father.

Also published at ft.com, subscription free.

24th of May, 2008Dear EconomistComments off

The tax that might just save the world

The Financial Times has been calling for a credible price to be put on carbon emissions, either through a carbon tax or a serious cap-and-trade scheme. Most economists – including this one – would agree.

The textbook argument is that putting a price on carbon would raise the cost of everything we consume that contributes to carbon dioxide emissions. The result would be that consumers and businesses would waste less energy and would switch to lower-carbon alternatives, while businesses would develop new low-carbon technology.

That is all fine in theory.

In practice, would it happen? It’s important to find out. For one thing, politicians remain unconvinced, often insisting – probably because of political cowardice – that consumers do not respond to such taxes.

And there are other reasons beside politicians’ feebleness to indicate that a carbon tax might not be as effective as economists would hope.

Behavioural economists have shown that we sometimes procrastinate. This could be a real problem: a carbon tax could make it rational to install double-glazing, insulate the loft and buy an energy-efficient fridge. Yet as frail human beings, we might put off all of those rational investments, perhaps indefinitely. Or we might waste energy because we are ignorant of our energy-saving options. (How much money, for instance, could you save, each year, by buying a more efficient fridge? I haven’t a clue.)

Perhaps businesses are more rational, but even there, a carbon tax is not guaranteed to inspire the kind of carbon-saving innovation we need. The problem is the vagaries of innovation: not all spending on new ideas produces a patent, and not all patents produce profits – even if society as a whole stands to gain.

That’s why textbook assumptions can’t be waved through without question. We need some evidence as to what consumers and businesses would actually do if faced with a carbon tax. The main evidence comes from analogies with previous energy price spikes or regulatory efforts.

David Popp, an economist at Syracuse University, used patent data to evaluate the response to the energy crisis of the 1970s. He found some cause for optimism: as oil prices rose and rose, more and more energy-saving patents were applied for (and eventually approved) in every field from heat exchangers to solar panels. The process wasn’t automatic, and patent applications seemed to peter out before oil prices reached a maximum – perhaps all the obvious ideas had been applied for. But Popp’s analysis suggests that high prices do inspire an innovative reaction.

So too does research by Suzi Kerr of Motu, a New Zealand think-tank, and Richard Newell, of Duke University. They looked at the response to gradually more rigorous standards on the lead content of petrol in the US. Refineries brought in the latest technology as the standards tightened, and appeared to be rational about the timing of their investments.

Even Joe Public, the regular consumer, is not as stupid as he seems. One study, by Alexander Brill, Kevin Hassett and Gilbert Metcalf, asked whether ignorance might explain our unwillingness to invest in energy-saving home improvements. It seems not: more educated consumers make the same decisions as less educated ones. But the return on such improvements is closely correlated with consumers’ willingness to make them.

Metcalf is convinced that any sustained rise in the price of carbon emissions would be rewarded with lower pollution. In the long run, simple energy saving should trim energy demand by 3 to 5 per cent for each 10 per cent rise in the price of energy. That is a worst-case scenario, ignoring the possibility of technological improvements and switching to low- or no-carbon fuels.

The textbooks seem to be at least partially right. To find out for sure, all we need is some backbone in our politicians.

Also published at ft.com, subscription free.

Service charge is optional

Dear Economist,
I have been trying to discourage the practice of “service” being added to restaurant bills. Where it’s added I ask for its removal and don’t leave a tip, and where it isn’t I tip a fair amount plus the saved service charges from other restaurants. What else can I do?
Patrick Gillett

Dear Patrick,

Discard any question of whether the service charge is aimed at the staff or at the restaurant managers. It makes no difference. Because staff are not stupid, lower tips must mean higher wages, otherwise the waiters will find somewhere else to work.

Similarly, higher service charges will have to mean lower up-front prices, or commercial disaster will surely follow.

That noted, it seems to me that optional tips are an attractive way of doing business. By leaving the customers some discretion, the restaurant manager creates a way of charging less to stingy customers and more to fat-walleted ones. Huge marketing databases are interrogated to achieve the same effect; the tip system is easy by contrast. The American reputation for excellent service may also owe something to a culture of high and variable tipping.

In short, I have no idea why restaurants are abandoning this most excellent, business-friendly custom. If you wish to stamp out the practice, perhaps management consultancy would be an influential place to start?

Also published at ft.com, subscription free.

17th of May, 2008Dear EconomistComments off

Why economic forecasts are so hard to get right

Economic forecasting is a long-standing joke, but the laughter has turned harsh and bitter in the wake of the credit crisis. The conventional wisdom seems to be that economic forecasting is impossible, and that economic forecasters are charlatans.

“In that case,” asked Professor David Hendry in a spring lecture at the Royal Economic Society, “why am I wasting my time on this?”

For one of Britain’s most respected economists, Hendry gives the strong impression of a man ploughing a lonely furrow.

His choice of field – the theory of economic forecasting – is to blame. It is viewed with scepticism not only by laymen but by most academic economists, too. But his research – a heady mix of bewildering computer-assisted mathematics and straightforward common sense – has convinced me that economic forecasting shouldn’t be consigned to the realm of quackery quite yet.

There is a simple reason why most economic forecasts are useless, which is that forecasting is hard. We don’t fully understand the underlying economic processes that produce the results we wish to forecast (growth, inflation, house prices), nor can we measure all the variables accurately, nor anticipate the sudden shifts caused by politics or technological change. Some forecasts – notably of the price of shares and other assets – are intrinsically self-defeating, because if it was obvious that share prices would rise, then they would have risen already.

But one of Hendry’s insights – developed with his co-author Michael Clements – is that not all of these difficulties produce bad forecasts. What really screws up a forecast is a “structural break”, which means that some underlying parameter has changed in a way that wasn’t anticipated in the forecaster’s model.

These breaks happen with alarming frequency, but the real problem is that conventional forecasting approaches do not recognise them even after they have happened. Oil-price forecasters have been predicting since 2000 that the oil price will fall; all the while it has been climbing. The reverse problem applied during the 1980s: oil prices collapsed, but the expert consensus was that the price would recover soon. That consensus persisted for years. The pound appreciated sharply in 1997; for the next eight years, forecasters predicted this appreciation would soon be reversed.

In all these cases, the forecasts were wrong because they had an inbuilt view of the “equilibrium” oil price or sterling exchange rate. In each case, the equilibrium changed to something new, and in each case, the forecasters wrongly predicted a return to business as usual, again and again. The lesson is that a forecasting technique that cannot deal with structural breaks is a forecasting technique that can misfire almost indefinitely.

Hendry’s ultimate goal is to forecast structural breaks. That is almost impossible: it requires a parallel model (or models) of external forces – anything from a technological breakthrough to a legislative change to a war.

Some of these structural breaks will never be predictable, although Hendry believes forecasters can and should do more to try to anticipate them.

But even if structural breaks cannot be predicted, that is no excuse for nihilism. Hendry’s methodology has already produced something worth having: the ability to spot structural breaks as they are happening. Even if Hendry cannot predict when the world will change, his computer-automated techniques can quickly spot the change after the fact.

That might sound pointless.

In fact, given that traditional economic forecasts miss structural breaks all the time, it is both difficult to achieve and useful.

Talking to Hendry, I was reminded of one of the most famous laments to be heard when the credit crisis broke in the summer. “We were seeing things that were 25-standard deviation moves, several days in a row,” said Goldman Sachs’ chief financial officer. One day should have been enough to realise that the world had changed.

Also published at ft.com, subscription free.

Presentation matters

Dear Economist,
I have been invited to give a presentation at a conference. Naturally, I’d like to look as good as possible. I have been given some flexibility over length, topic, timing and so on. What advice can you give me, and is it best for me to open or close the proceedings?
Jeremy L, London

Dear Jeremy,

Anyone can tell you the obvious stuff: don’t use boring bullet-point slides and keep it simple. Obvious, but most people, at the expense of their audience, ignore this advice.

Let me instead focus on a less-obvious insight, discovered by the economist Lionel Page and his wife, the psychologist Katie Page. The Pages looked at years of results from talent contests such as X-Factor and American Idol, in which contestants perform and viewers vote as to who they’d like to see again.

The Pages were able to measure whether it was an advantage to appear first or last, or immediately after a flop or a show-stopper. Because most singers appeared several times, the Pages could take account of the fact that the show’s producers might deliberately open and close with strong performers. In effect, they looked at what happened to the same contestant when they appeared earlier or later.

The bottom line is that it’s OK to go first but better to go last. A partial explanation is that these acts are easier to remember. Obscurity doesn’t seem to attract you, so make sure you’re closing the show.

Also published at ft.com, subscription free.

10th of May, 2008Dear EconomistComments off

Happiness is a more expensive nicotine hit

Would smokers prefer that cigarettes be expensive? The Office of Fair Trading seems to think so, to judge by its recent announcement alleging that some supermarkets and tobacco companies had been fixing the price of tobacco.

Certainly, higher cigarette prices would make smokers healthier. There is plenty of evidence that smoking is very bad for you, and almost as much evidence that people smoke fewer cigarettes if they are expensive. But “healthy smokers” are not the same thing as happy smokers.

So, do high cigarette prices make smokers happier? If smokers are rational, they don’t. But if smokers are wracked by temptation and are trying unsuccessfully to quit, then higher prices might make them happier by encouraging them to smoke less, or even to stop entirely.

This turns out to be a controversial point for economists, surely members of the only profession that could argue about whether smoking is rational. The “rational addiction” theory was put forward by the celebrated pair Kevin Murphy and Gary Becker, a Nobel laureate. They argue that people weigh up the health risks of smoking, the possible social and psychological benefits and the fact that it is habit-forming, before deciding whether to light up.

That is not as absurd as it sounds. Even smokers know that their habit is dangerous; in fact, the economist Kip Viscusi established that smokers overestimate the risks. And there is nothing necessarily irrational about deciding to embark on a course of action that many find enjoyable but that is painful to reverse. Otherwise marriage would be irrational, too. Addictive or not, the question is whether, for some people, the benefits might reasonably outweigh the costs.

A second possibility is that, rather than acting rationally, smokers are helpless puppets who will pay any price for a smoke. If so, expensive cigarettes are bad news for them; making them poorer without encouraging them to quit. But that possibility doesn’t fit the facts: we know that smokers respond to price signals by smoking less. They also smoke less if prices are expected to rise at some later stage. This implies that smokers both think about the future and recognise their own addiction, because a self-diagnosed addict who expects prices to rise may try to begin the difficult process of quitting before the habit becomes expensive.

A third possibility is that smokers are neither puppets nor ultra-rational robots, but simply creatures of flesh and blood. They recognise the risks and would like to quit, but keep valuing the short-term bliss of the nicotine hit over the longer-term benefits of kicking the habit. For smokers who fit this description, expensive cigarettes can indeed be a blessing by encouraging them to cut down or quit. Rational and temptation-wracked smokers behave in similar ways, smoking less if prices rise; they just feel differently about price-fixing in the cigarette market.

One way to resolve the debate is to ask smokers how they feel. Six years ago, the economists Jonathan Gruber and Sendhil Mullainathan did the next best thing, looking at two large sets of data on overall happiness, one covering Canada and one the US. By comparing what happened to happiness in US states and Canadian provinces where cigarette taxes rose, they were able to take an educated guess at whether high prices made smokers more or less cheerful. They had to make some heroic assumptions, but the results did point in the direction of the temptation model: where cigarette taxes rise, “potential smokers” – the people whose age, class, income and domestic circumstances suggest that they are likely to smoke – are happier. If the tobacco industry did collude to fix prices, at least it may have spread a little cheer while it did so.

Also published at ft.com, subscription free.

Can the Brixton currency ever pay its way?

I was recently invited to appear on radio to give an economist’s perspective on the costs and benefits of local exchange trading schemes (LETS), which are alternative currencies that circulate around a small community. This made me scratch my head a bit. I could not think of any real benefits, but then I couldn’t really think of any serious costs, either.

Advocates of community currencies argue that they have social, economic and environmental advantages. BerkShares, which organises a local currency in Massachusetts, claims that the currency helps businesses to connect with their customers, and strengthens the regional economy by favouring locals. In the UK, “transition towns”, which are seeking to use less oil, are exploring the environmental benefits of local currencies.

The common-sense economic case for these currencies was summed up for me by John Walker, acting treasurer of Brixton LETS in London: “They’re more appropriate for local communities, because the money doesn’t drain out of the local community.”

That seems plausible: the money (“Brixton Bricks”) goes round and round Brixton and isn’t sucked away by the insidious multinationals of neighbouring Clapham.

But this is one of those cases where common sense lets us down. Money (whether pounds or Brixton Bricks) isn’t wealth. It’s just a way of keeping accounts, and swapping one system of accounts for another isn’t going to alter the basic productive potential of Brixton.

True, community currencies may very gently encourage trade with locals rather than strangers. But the gains from more trade with locals are more than offset by the losses from less trade with strangers – otherwise, economic sanctions would be a blessing. This also explains why no community currency movement tries seriously to restrict broader trade. Everyone knows that is a recipe for a return to the dark ages.

There have been times and places when national currencies have so malfunctioned that community currencies would have been preferable: Weimar Germany, modern Zimbabwe, perhaps also the Depression-era US, where community currencies briefly flourished. There is also a healthy debate in economics over the appropriate size of a currency union, but few serious economists think that the optimal currency area is the size of Brixton or the Southern Berkshires.

Nor are the environmental benefits of community currencies terribly persuasive. Local trade sounds environmentally friendly, but it is a distraction: the environmental costs of driving to the shops or growing food on inappropriate local land far exceed the costs of carbon emissions from long-range shipping.

The real benefits, if they exist, are not economic but social, and best explained not by an economist like me, but by a sociologist such as Ed Collom, a professor at the University of Southern Maine.Collom’s work looks at first glance like bad news for the community currency movement.

He has found, for example, that most currency schemes in the US last only a few years before collapsing. The ones that thrive are in places that already have strong, liberal, middle-class communities, such as Portland, Oregon, or Ithaca, New York.

In rust-belt regions that would seem to need them more, they have not taken root. Also, the schemes take a lot of effort to set up: Brixton LETS, for instance, is only in its early stages.

But despite the obstacles, Collom is convinced that local currencies can strengthen neighbourhood ties and allow people to make friends: they are a focal point for the community-minded, even when they do not last.

That is possible. I live near a determined, community-minded entrepreneur who owns the local cafe, the sort of person who helps to get community currencies started. But rather than minting a Hackney dollar, she has founded a traders’ association and is trying to set up a street market. I think she has her priorities straight.

Also published at ft.com, subscription free.

3rd of May, 2008Undercover EconomistComments off


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