Articles published in October, 2008

From BBC Online.

Is a stock market bubble a medical condition?
You might well have thought so, had you taken a walk around a trading floor and looked at the behaviour of traders at the height of the dotcom bubble in 2000.
“They were displaying classic symptoms of mania,” says John Coates, recalling his time as the manager of a New York trading floor.
“They were overconfident, they had racing thoughts, they had diminished need for sleep and heightened sexual appetite.”
But Dr Coates no longer works on Wall Street.
He is now one of a small but growing number of “neuroeconomists” – researchers who study the brain, hormones and nervous system in search of an explanation of our behaviour as investors and shoppers.
Neuroeconomics is a new discipline that fuses economics and neuroscience, and its practitioners are people who think that everyday phrases such as “impulse buy”, “business brain” and “bull market” are more than just figures of speech. Read the rest of this entry »

This morning, I had a remarkable experience: I strolled into a delicatessen and bought some delicious Stilton. What made the shopping trip unusual was that I was wearing a brain scanner while I did it.

My costume consisted of an electroencephalograph (EEG) cap, which looks like a polka-dot shower cap with wires plugged into it; a pair of wrap-around glasses with a tiny video camera attached; a clothes peg on one finger to measure my heart rate; two other finger monitors that functioned like a lie-detector; a thermometer patch on a fourth finger; and a satchel to hold a computer gathering the data.

Most of these devices, or their equivalent, can be hidden under clothes or baseball caps so that the wearer looks as if they are sporting only shades and an iPod, but in my case the boffins hadn’t bothered, and so I entered the deli looking like an extra from a 1970s episode of Doctor Who.

This was all part of my efforts to understand ”neuroeconomics”, a new, controversial and eclectic marriage between economics, marketing and various branches of physiology and brain science. With very different aims, economists and marketers are attempting to tap into the dramatic advances in our understanding of the brain that have taken place over the past 15 years. Their tools encompass mood-altering drugs, tests for hormone levels, animal studies and fMRI scans (which use immobile scanners to measure blood flows deep inside the brain).

“Neuromarketing” is the simplest application, and the one in which I was participating. David Lewis, a neurophysiologist at The Mind Lab, a spin-off from the University of Sussex, showed me how the physiological readings could be viewed alongside output from my camera to provide a simple but – presumably – useful demonstration of what really grabbed my attention in the deli. Among Lewis’s findings are that eating chocolate is more exciting than snogging (at least, snogging in an electrical shower cap while surrounded by men with clipboards) and that, subconsciously, young men are more interested in trainers than in the wares on display in an Ann Summers sex shop.

While the possible applications for marketers are obvious enough, such trials are hardly unlocking the deepest secrets of thought. It remains to be seen whether neuroscience has much to contribute to economics itself, a subject that has long focused on the decisions people make, without relying on any particular theory of how they make them. It is also hard to point to anything terribly interesting that the neuroeconomists have discovered, although neuroeconomics may contribute more as time goes by.

Neuroeconomics may provide more shape to the older and more famous field of behavioural economics. A mixture of economics and psychology, behavioural economics has used laboratory experiments to expose a bewildering number of exceptions to the traditional economic theory of rational choice. At present, though, there is little pattern to what the behavioural economists are observing, and it’s possible that a greater understanding of how the brain works might help to provide one.

Yet neuroscience might also help reinforce the traditionalists. Wolfram Schultz, a neuroscientist at Cambridge who studies how the brain processes risk and reward, says that just as the brain registers sensations such as sight, he can now see it registering rewards. There was no reason to expect that the mathematically convenient economists’ fantasy of “utility” had any real analogue in the brain – but it seems that it might after all. There’s a thought.

Also published at ft.com.

At the apartment block where I used to I live, I once parked in another tenant’s car bay for a brief period. The tenant called the wheel clampers and landed me with a $120 (£69) fine, despite the fact he doesn’t have a car and there were 30 spare car bays, and despite knowing that the car belonged to me. Up to that point I had had no run-ins with this person.

The tenant gained nothing from this except my bad opinion, and I was $120 worse off. Why did he not either ignore my car, or come up and knock on my door and say: “Look, I’ve got these people on the phone who will clamp your wheels unless you persuade me otherwise.” He could have had a few bottles of beer out of it. But he didn’t. So what was the rational reason behind his action?
Jeremy Cook

Dear Jeremy,

You are right to be puzzled. Clearly, this neighbour did not maximise the value of his bargaining position in the narrow situation you describe. Still, I think there is a certain logic to what happened.

Game theory is the economist’s tool of choice to analyse what happens when two or more people have to negotiate, co-operate, compete or otherwise engage with each other. The essence of game theory is that each side would expect the other side to anticipate and respond to his likely actions.

Game theory shows that there are times when irrationality (real or feigned) is a highly effective strategy. Someone who seems impervious to logic is someone who also gets his own way a lot. Consider, for example, toddlers, terrorists, bosses, dogs and the late Charles de Gaulle.

Your neighbour may have calculated that by demonstrating a willingness to punish you for no immediate personal gain, he will gain in the long term anyway. Irrational perhaps, but rationally irrational.

Also published at ft.com.

The idea that ordinary people have a tendency to be caught up in investment manias is a powerful one, thanks in part to Charles Mackay, author in 1841 of the evergreen book Extraordinary Popular Delusions and the Madness of Crowds. Mackay’s most memorable example was the notorious Dutch tulip bubble of 1637, in which–absurdity!–tulip bulbs changed hands for the price of a house. Read the rest of this entry »

First published: Business Life Magazine, August 2008

You’ll all have heard the old proverb, “Give a man a fish and you feed him for a day. Teach him how to fish and you feed him for a lifetime.” But what happens if you give him a mobile phone?
The economist Robert Jensen has been trying to find out. For over a decade, development types have been debating the idea that new technologies such as mobile phones and email might prove to be important tools for helping poor countries grow richer. It all sounds plausible enough, but the challenge has been to prove it. After all, the sceptical case – that the priority for economic development has to be basics such as vaccines, schools, roads and electricity – is fairly persuasive.
Jensen studied Kerala, in India, whose 400 miles of coastal waters provides the livelihood for a million fishermen, and whose beaches host over 100 local fish markets. In the mid-1990s, this was an industry characterised by waste and shocking uncertainty for buyers and sellers alike.
A detailed data-set collected by Jensen tells the story. One Tuesday in January 1997, for example, fishermen were arriving at the Bagdara market to find that buyers had already purchased all the fish they could possibly want. The excess fish had to be dumped or given away for free, since they were perishable. But within 10 miles, at the markets both north and south of Bagdara, fish were scarce and prices were high; buyers were giving up and going home in disgust.
Buyers and sellers were not able to meet up because they had no way of finding each other. And the next week, exactly the same thing happened – except that the gluts and shortages were located at different markets, the result of the whimsy of the mackerel shoals.
Jensen – who collected his data each week for years – was able to see clearly what happened when the mobile phone masts came to Kerala, erected one at a time along the coast. Although they were not aimed at fishermen, the signals ranged many miles out to sea, allowing fishing boats to call the markets and find the best prices.
If I were to show you the graph of fish prices, you would instantly be able to point to the moment at which the masts were switched on in each region. The graph, which has been jumping around like the ECG of a patient with a heart-attack, sudden flatlines as the prices across different markets equalise. At that point, prices fall but fishing boat profits rise, and spoilage of fish becomes a thing of the past.
When Jensen’s research was published late last year, it was a minor triumph for economic analysis: the moment at which the stories about the magic of technology became something more than fishermen’s tall tales.

Comparisons between today’s financial crisis and the 1930s are looking less strained by the day. So what better to lighten the tension than to revive everybody’s favourite Depression-era board game, Monopoly? Read the rest of this entry »

I struggle to wake up in the morning although I sleep, on average, seven and a half hours. As I do have a flexible timetable, I arrive at work at 10am. I would like to start at 9am, but my laziness makes it impossible.

Do you have any advice?
Ruth

Dear Ruth,

Your guide here must be the Nobel laureate Thomas Schelling. Schelling’s expertise as a game theorist was honed by his experiences as a cold war strategist – he advised John F. Kennedy during the Berlin crisis.

Schelling realised that the same bargaining and bluffing techniques that worked against Nikita Khrushchev might also work in an individual’s struggle with herself, to quit smoking, diet or get out of bed in the morning. He called the idea “egonomics”.

Your predicament is a contest between two competitors, Evening Ruth and Morning Ruth. Evening Ruth has fine ideas about an early start, but her late nights impose costs on Morning Ruth, who then stays in bed.

One option is to tie Morning Ruth’s hands, just as Odysseus ordered his sailors to tie him to the mast. Evening Ruth might buy one of those motorised alarm clocks that falls off the dresser and scuttles under the bed, beeping loudly.

An alternative is to recruit a third player. The British government handed over control of interest rates to the Bank of England. Similarly, ask an early-bird friend to call every morning.

Odder still, Evening Ruth could enlist Bad Cop Ruth to punish Morning Ruth for lie-ins by, say, denying her(self) television privileges. Bizarre as it may seem to turn one person’s decision into a three-way inner struggle, Schelling avers that this technique works.

One final point. Your letter was evidently composed by Evening Ruth. Are you sure that Morning Ruth’s preferences are so mistaken?

Also published at ft.com.

In March 1959, a promising young Harvard economist delivered a lecture in Boston on “The Theory and Practice of Blackmail”, drawing on the then-young branch of economics and mathematics called “game theory”. Strictly speaking, his subject wasn’t just blackmail – the threat to reveal damaging information in order to get what you want – but the broader practice of extortion or coercion.

The lecturer emphasised a central problem in coercion, which is to make the victim believe that if he or she refuses to be coerced, the threat will be carried out anyway. That is not straightforward, but it is possible. For instance, in December 1958, a “little old lady” walked into a bank, placed a glass of colourless liquid on the counter and passed a note to the teller.

“I have acid in a glass, and if you don’t give me what I want I’ll splash it on you,” said the note. It continued, “I have two men in here. I’ll throw the acid in your face and somebody will get shot. Hurry. Put all the fives, tens and twenties in this bag.”

What would you have done in the teller’s shoes? A quick-thinking teller might well have thought that it was safe to refuse, because the lady’s best option would then be to pick up the glass and walk out in search of another bank. She would have nothing to gain from hurling the acid except a longer prison sentence. Yet the teller handed over a bag full of money. It was, after all, not his.

Other bank robbers of the day enjoyed similar success. One convinced a teller that a comb in his waistband was a gun. Another walked away with $5,000, quite a sum in 1958, after brandishing what looked like a grenade; surely he cannot have intended to blow himself up. A third robber managed two hold-ups armed only with a polite note. The little old lady herself was arrested on a second heist and found to be equipped with a glass of tap water.

One lesson is that bank tellers have little to lose by complying, which is why banks started introducing locks, alarms, cameras and other systems that could not be overridden by staff. Another lesson is that small doubts over the rationality of the coercer can go a long way in enforcing a threat. After all, if grandma walks into the bank and starts trying to extort money, she’s already demonstrated herself to be a little out of the ordinary.

Blackmail proper is a more difficult threat to make credible. Richard Posner, a pioneer on the frontier between law and economics, has pointed out the basic difficulty: unless the blackmail victim is himself a criminal, he has the powerful counter-threat of a complaint to the police. If the victim’s secret is revealed, he has nothing to lose by then reporting the crime. If the victim goes to the police immediately, the blackmailer cannot reveal the secret without risking a longer sentence. Small wonder that blackmail seems to be a rare crime.

An epilogue: the economist who gave his 1959 lecture on blackmail later ended up with more practical experience of it than anybody would want. His name is Daniel Ellsberg. After his early contributions to economics, he became far more famous as the military analyst who risked a life sentence for espionage after leaking the Pentagon Papers to the press in 1971 in the hope of obstructing the Vietnam war. It was a memorable instance of blackmail’s heroic twin, whistleblowing.

The Watergate burglars then broke into the office of Ellsberg’s psychiatrist, perhaps with the hope of obtaining blackmail material. That burglary was one reason why the Ellsberg trial collapsed. Blackmail is a difficult business – but even back in 1959, Ellsberg had known that very well.

Also published at ft.com.

FT Magazine, 18 October 2008

In the car on the way to the Lake District, my friend Mark calls. He’s a doctor.

I tell him that I’m planning on going for a leisurely swim in one of the lakes.

“Be careful not to die,” he says helpfully. Read the rest of this entry »

The Financial Times, 14 October 2008

The Nobel economics prize was awarded yesterday to Paul Krugman, one of the great popularisers of economic ideas and a trenchant critic of the Bush administration. However, the prize was awarded for work done almost three decades ago in developing what is known as “new trade theory” and “new economic geography”.

Earlier trade theories suggested that a country would trade with partners that were different – rich would trade with poor, and capital-intensive would trade with labour-intensive. In practice, rich countries tend to trade with other rich countries. Read the rest of this entry »

I read this light-hearted essay on the Today program on the morning of 13th October.

Someone recently grumbled to me that, given the appalling state of the world’s financial system, nobody should be awarded today’s Nobel memorial prize for economics. That’s a little harsh: some economists did warn us of trouble on the horizon.
Still, Nobel-watchers think that this will not be the year that the prize is given to a man called Eugene Fama. Fama, a Professor at the University of Chicago and a long-time contender for the prize, is best known as the man who believes that financial markets are efficient. The timing would seem awkward.
I think that’s a shame. The belief that financial markets are efficient sounds like some Thatcherite creed, but it means something quite different: that the price of shares today reflects everything we currently know about their value. There are no obvious bargains, no easy forecasts, no get-rich-quick schemes. Read the rest of this entry »

On Monday, the winner of the 2008 Nobel prize in economics will be announced. That statement is not quite true: there is no Nobel prize in economics, merely a more recent prize established in memory of Alfred Nobel.

The existence of a quasi-Nobel in economics infuriates some. One objection is that Nobel himself would not have approved. I do not much care. A more serious objection is that economics is not incontrovertibly a science, but then neither is peace or literature.

Nor am I convinced that the economics Nobel is, as some claim, an instrument for the enforcement of orthodoxy. The prize committee has been broad-minded, occasionally even daring. The prize has gone to Keynesians such as James Tobin and to Friedmanites such as, um, Milton Friedman, to a psychologist (Daniel Kahneman), a mathematician (John Nash) and to the unclassifiable Herbert Simon.

Gunnar Myrdal, a socialist politician, shared the prize in 1974 with Margaret Thatcher’s inspiration, Friedrich Hayek. This provoked the joke that economics is the only subject in which two people can share a Nobel prize for saying opposite things. (Myrdal complained that a prize that could be won by the likes of Hayek and Friedman should be abolished.) When Kahneman shared the 2002 prize with Vernon Smith, another joke did the rounds: Smith won the prize for showing that economic theory works, while Kahneman won the prize for showing that it doesn’t. If this isn’t a broad church, I’m not sure what is.

The odd thing is, whether the Nobel memorial prize is a Nobel prize or not surely shouldn’t matter very much: either way, the prize winners are economists considered worthy of distinction. And yet, the Nobel-ity of it does matter, somehow.

The economics Nobel attracts more attention, for example, than the John Bates Clark medal, awarded every two years to the best American economist under the age of 40. This disparity is curious. The Bates Clark medal has gone to many of the same economists, and more promptly. It has a longer pedigree – it was first awarded in 1947, 22 years before the Nobel memorial prize – and it is much rarer. Most early Bates Clark medallists went on to win the Nobel, but many eligible Nobel laureates failed to win the Bates Clark medal – after all, there have been 20 John Bates Clark medallists since 1969, compared with 61 Nobel laureates.

Nobel prizes also attract more attention than, say, the Crafoord Prize, another Swedish prize for sciences. Despite a $500,000 purse, I am still trying to convince myself that the Crafoord Prize actually exists.

All this made me muse about the vagaries of prizes. What is it that makes a prize – the Nobel, the Booker, the Oscars, Olympic gold – truly prestigious? A long history and a sharp public relations team no doubt help.

Yet there is an economic rationality, too. A prize is worth winning if it proves that the winner beat an impressive field on credible criteria. To an extent this is self-fulfilling: lots of people want to win prestigious awards, and that makes them more prestigious. Because everyone wants to win Olympic gold, the victor will be seen to have defeated every important opponent; that is why everyone wants to win Olympic gold.

It’s not easy to begin that process from scratch, but a big purse helps. The prize money attracts a strong field, which legitimises the winner and helps attract another strong field next time.

In the economic jargon, then, successful prizes become “focal points”. We owe that insight to Thomas Schelling, who shared the Nobel prize in 2005. Or was it the 2005 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel? Whatever.

Also published at ft.com.

I have a question which, I hope, you will be able to answer with particular insight. Should I subscribe to the Financial Times?

I buy the FT Weekend every Saturday, for $2.17 including California sales tax. I recently received an e-mail offer to receive the FT for $8.25 for four weeks, which would be a saving of 43 cents, and yet provide me with the newspaper every day.

However, I am conflicted because I primarily enjoy the FT Weekend for the cultural and political coverage. I am somewhat interested in the financial news, but my concern is that I will spend too much of my time following the soap opera that is Wall Street these days. But if there was a time when it would be advisable to read the FT, this would be it.
John Halbert, Los Angeles

Dear John,

I am not sure what puzzles me more, the fact that the FT subscription department is trying to get you to pay less in order to receive more, or the fact that you hesitate to accept.

The most likely explanation is that both you and the subscription department suspect the Financial Times of being an addictive product. They hope that once you are hooked, you won’t stop. Admittedly, this assigns the subscription department the role of crack-pushers, but we should call a spade a spade here.

The story is further complicated by the fact that not all addictions are harmful. You may find yourself addicted to the Pink’un for the happiest of reasons: an infatuation with Lucy Kellaway – or Gideon Rachman, if you prefer.

I suggest that you put this offer to one side, because the sums involved are trifling. Instead, buy and read the FT every day for a week. If you’re hooked by Friday, it will be because you’ve found the daily newspaper to your taste. You can then take advantage of the next subscription offer to feed your habit cheaply.

Also published at ft.com.

During the bail-out of AIG, Fannie Mae and Freddie Mac – and, at the time of writing, the still unresolved debate over the bail-out of the entire US financial system – the phrase “moral hazard” has become popular, typically in conjunction with the phrase “privatising profits and socialising losses”. It’s easy to sympathise: the erstwhile masters of the universe seem to have forgotten the meaning of both “moral” and “hazard”. Why should they be helped now?

Still, we might usefully remember what the antiquated jargon “moral hazard” means. The term originated in insurance, recognising the idea that people with insurance may be careless – for example, paying for secure off-street parking looks less attractive if your car is insured.

Moral hazard can sometimes take extreme forms. According to the Florida newspaper The St Petersburg Times, in the late 1950s and early 1960s, more than two-thirds of insurance claims for the loss of a limb originated in the Florida Panhandle. At the epicentre, “Nub City” – the tiny town of Vernon, Florida – almost 10 per cent of the adult population had lost a limb. One man was said to be insured by dozens of companies when he lost his foot; fortunately he had been carrying a tourniquet at the time of the accident. He pocketed a million dollars. Another man shot his foot off – “while aiming at a squirrel” – just 12 hours after buying insurance. Now that’s careless – and that’s moral hazard in spades.

Sometimes moral hazard is so severe that it makes insurance impossible. Footballers would like to insure against losing football matches, and students would like to be compensated if their exams go poorly. Tough: moral hazard makes such insurance contracts absurd. But all these examples exaggerate the problem. So does the archaic use of the word “moral”. It used to carry no ethical connotation, referring merely to a risk arising from human action rather than natural forces.

Forget the baggage that comes with the word “moral”. While moral hazard makes insurance more expensive and less efficient, many insurance markets work well enough to be useful. Moral hazard need not destroy them, and it need not destroy financial markets either. If AIG had shot off its own metaphorical foot to claim a government bail-out, the argument against the bail-out would be compelling. But it didn’t, and it isn’t.

This perspective can suggest lessons for today’s bail-outs. The government will not help you replace your possessions if you smoke in bed and your house burns down, but government-funded fire engines will put out the blaze, moral hazard or not. That is partly because fire can spread, and your neighbours should not suffer for your carelessness. The same motive lies behind the current spate of rescues. It is also because a civilised society tries to save people from accidentally burning themselves to death. If the consequence is a little more carelessness, so be it.

A second lesson is that remedies for moral hazard will always be imperfect. Insurance companies could fight moral hazard by checking that your behaviour is consistently safety-conscious. Because that’s impractical, deductibles have to serve as imperfect proxies. The current bail-outs are a strong argument for tighter regulation, but regulators cannot be everywhere, any more than a claims adjuster can ride around in your car all day.

Bail-outs can save the innocent as well as the culpable, but even when they don’t, it is fantasy to expect governments to refrain from them. It is useless to pretend otherwise: bail-outs are inevitable and sometimes they are even desirable. The moral hazard they provoke is also inevitable. The final lesson: insurers get paid for the insurance they provide; it would be nice if the taxpayer were shown the same courtesy.

Also published at ft.com.

I work as an escort in Canary Wharf. I wonder if you might have some sound business advice on how workers in my industry should tackle the sudden drop in demand following the collapse of Lehman Brothers?
Miss C

Dear Miss C,

I wasn’t aware that escort services were pro-cyclical, but I shall take your word for it. You have three options, none of them perfect.

One: relocate. Canary Wharf is a pure banking play, and you could seek a more diversified market. The West End is full of hedge funds, oil barons and old money. However, I recognise that it will take some effort to find new clients. The economist Steve Levitt and sociologist Sudhir Venkatesh discovered, in a recent analysis of Chicago street prostitution, that the industry was very concentrated because prostitutes and clients would otherwise fail to find each other. You, of course, are not in quite the same game and may be able to relocate with ease.

Two: tough it out at Canary Wharf and hope that supply falls to match demand. Levitt and Venkatesh found that the supply of street prostitution was highly elastic in response to a demand surge. (The fourth of July holiday provokes a spike in trade for prostitutes – who knew?) Existing prostitutes would work longer hours, other prostitutes would travel to the area, and women who didn’t normally work as prostitutes at all would dabble in the business. This suggests that many of your rivals will find something else to do in the tough times.

Three: you may find that escort services are a little like estate agency, in that even severe demand shocks don’t tend to reduce fees. You’d find yourself well paid when in work, but frequently idle. That spare time could be used to study or find a part-time sideline.

I would give exactly the same advice to an estate agent.

Also published at ft.com.