Tim Harford The Undercover Economist

Articles published in December, 2008

Santa Claus’s impact on the business cycle

Dear Economist,

When you think about it, Christmas is a strange ritual. Is there any economic logic to it?
FR, London

Dear FR,

The late Cambridge economist, Nicholas Kaldor, is said to have observed that the money supply surges in December and then falls back in January, before dryly remarking, “At last I have discovered the cause of Christmas!”

Professor Kaldor – a staunch critic of monetarism – asked whether central banks might be able to halt the Christmas spending spree by keeping a tight rein on the money supply in December. No, he concluded: people would turn to credit cards. How ironic that this year, the central banks desperately pumped money into the economy in an attempt to ensure that Christmas wasn’t cancelled.

But you are right: the spend-and-give, spend-and-eat side of Christmas makes little economic sense. Mainstream theories suggest that consumers should prefer to smooth their consumption rather than binge at Christmas and then, broke and fat, cut back in the new year. So economists are turning to psychological research to understand what is going on. Demarcation seems to be an important part of the story: we look forward to Christmas, enjoy it while it is happening (if done right), and recall past Christmasses fondly. All of which only happens if the day itself stands out.

Gift-giving works best when co-ordinated – on birthdays, anniversaries and at Christmas. A.A. Milne, in Winnie the Pooh, wished people “happy Thursday” instead of happy birthday; Lewis Carroll’s Humpty Dumpty received unbirthday presents. Alas, neither concept has caught on. Perhaps that is no bad thing. I am always forgetting my wife’s unbirthdays, and live in fear of forgetting our anniversary. But even I remembered Christmas.

Also published at ft.com.

27th of December, 2008Dear EconomistComments off

Can the free market give you moral backbone?

The John Templeton Foundation recently sent me a collection of essays addressing the question: “Does the free market corrode moral character?” Lacking an agreed definition of the free market, a conception of good moral character, and above all a sense of how character is shaped, it is not surprising that the answers tended to wander off topic. The writer Kay Hymowitz fears that internet chatrooms facilitate paedophilia. The economist Jagdish Bhagwati argues that globalisation makes the world a better place. However right he may be, that was not the question.

It is easy to point to systems that are far more injurious to moral character – not to mention prosperity, peace, the environment and human life itself – than the free market: German fascism, Stalinist communism. It is harder to reverse the exercise, although free markets do look corrosive when compared to some childlike state of grace.

I am not sure if it is the same question or not, but one might also ask: “Does the free market punish moral character?” On balance, the answer is no. Markets tend (but do not guarantee) to reward hard work, calculated risk-taking, applied creativity, amiability and honesty. Competition is the key here: it allows us to find alternatives to doing business with lazy, timorous, unimaginative, rude or dishonest people.

All this assumes that we can see such people coming. Often we can. Most market interactions are repeated, directly or indirectly. I buy something from the same corner shop every day, and it is in neither the shop owner’s nor my own interests to rock the boat. So we smile, chat, perform (very) small favours for each other and do not cheat. My relationship with a Tesco shop attendant is less straightforward, but, although unlikely I will ever see the attendant again, Tesco has an ongoing relationship both with its own employee and with me and does its best to ensure things run smoothly.

When market interactions are not repeated, there is more temptation to cheat. There is a logical reason why holiday guides, estate agents and pension salesmen tend to be regarded with caution.

All this is closer to pub philosophy than science, but some scientific evidence does exist. One suggestive finding comes from a cross-cultural study carried out by three economists and published earlier this year in the journal Science. Simon Gächter, Benedikt Herrmann and Christian Thöni invited subjects in 16 cities across the world to play a “public goods” game, in which players had to choose, repeatedly, between contributing to a pot for the benefit of all or selfishly hoarding their own resources.

Earlier research had found that if players were given the option of punishing the selfish by removing their resources, they did so and near-full co-operation quickly emerged. Gächter and his colleagues found that, in many societies, the opposite occurred: rather than accepting their punishment and co-operating, those who had been punished tended instead to take revenge.

The results were striking: co-operative behaviour seemed to flourish in countries where market democracies were long established.

The Americans, Australians, Britons and Swiss were the least likely to inflict recriminatory punishment. Russians, Greeks and Saudis were most prone to reprisals. Co-operation was best sustained in the US, Denmark and Switzerland, and fell apart in Turkey, Saudi Arabia and Greece.

Co-operation and aversion to vengeance are hardly the sole definitions of moral character; and this was merely a laboratory game. Still – despite a long history of reasonably free markets in the US, Australia, the UK, Switzerland and Denmark, important aspects of morality in those countries seem to have held up rather well.

Also published at ft.com.

Why Not Start Your Weekend on Wednesday?

Were an alien to pick up our news channels, it would conclude that human civilization depended on the production and purchase of cheap plastic rubbish. First came the concern that we might talk ourselves into not spending enough, then the fear that the banks wouldn’t lend us the money to spend even if we wanted to. In November, our governments borrowed money and gave it to us in the hope that we’d catch on. Are we really so dependent on consumption?

In the short run, yes. Economists worry about a sharp fall in consumer spending, because when demand for goods falls, so does demand for labor. Our desire to spend less is quickly revealed as a desire to spend less hiring each other (and our friends in China) to make things. Result: economic collapse, unemployment, misery.

In the long run, the picture is completely different. We earn—this is a very rough average—twice what our parents did when they were our age. When today’s teenagers are in their 40s, there is no reason why they shouldn’t decide to enjoy their increased prosperity by working less instead of earning more. Rather than being twice as rich as their parents, they could be no richer but start their weekends on Wednesday afternoon.

If this were a gradual process, mass unemployment would not result. People would simply earn less, spend less, wear a few more secondhand clothes, and spend more time reading or going for walks.

This would be perfectly possible. We are rich enough already. Even the Chinese might cope: They already devote much of their economy to making things for each other.

Here’s the big question of the season, then: Why don’t we do as countless moralists urge every year and focus less on money and more on leisure (or spiritual concerns, if you must)? Why haven’t we all decided to work less, spend less, and consume less?

There is an anti-consumer movement with a ready answer: We’re helpless, enthralled by advertisers and hooked on shopping. I’ve always had a slightly more optimistic view of human autonomy.

A more convincing answer is that we work hard because income is linked to our desire for status, which is collectively insatiable, because status is largely relative. A famous survey by economists Sara Solnick and David Hemenway found that many Harvard students (although few Harvard staff members) would rather have an income of $50,000 in a world where most people were poorer than an income of $100,000 in a world where most people were richer. The survey has arguably been overinterpreted in the 10 years since it was published, but it does seem to point to an important truth: It matters to us how much money other people have.

When it comes to leisure, positional concerns seem to matter less. Perhaps that is because leisure is not closely linked to status—anyone can enjoy leisure by walking out of his job. It is hard to imagine many people preferring four weeks of annual vacation in a world where most people have less to eight weeks of vacation in a world where most people have more.

This may be part of the story. The other part is that we do have more leisure. According to economists Mark Aguiar and Erik Hurst, leisure time for women has increased by at least four hours a week since 1965. Men have done even better. That may well understate the leisure gains. A hundred years ago, many people would start working at the age of 10 or 12 and work until they died. Now it is common to spend fewer than half our years working; the rest of the time we spend studying, traveling, and in retirement.

The “work less, spend less” movement is winning. It’s a shame it hasn’t noticed.

What’s the best Christmas present?

Dear Economist,
Can economics help me pick out the perfect Christmas gift for my brother?
Tim Maly, Ottawa, Ontario, Canada

Dear Tim,

Your letter obliges me to disinter the influential research of the economist Joel Waldfogel on the “deadweight loss of Christmas”. Fifteen years ago, Waldfogel published an academic article demonstrating that the recipients of gifts would not generally have been willing to pay what it cost to provide the gift. A £30 sweater was valued at £20, for example, creating a “deadweight loss” of £10. Siblings were not the most incompetent givers – that honour goes to aunts and uncles – but they were not especially competent either.

Waldfogel’s work is often misinterpreted as suggesting that gift-giving is pointless. That is not true. He explicitly excluded the sentimental value of gifts from his calculations, and, of course, the sentimental value is part of the purpose of giving presents. That may explain why the economists Sara Solnick and David Hemenway have discovered that we prefer unsolicited presents to those we have specifically requested. It may also explain why gift vouchers are a bad idea: they have no sentimental value but still create deadweight loss, since many expire without being used, or are sold at a loss on eBay – as the economist Jennifer Pate Offenberg has documented.

All this points to the optimal gift-giving strategy: you need to minimise the deadweight loss while maximising the sentimental value. This suggests buying small gifts and striving for emotional resonance. Look for something inexpensive, and consider supplementing it with a letter, a photo, or time spent together.

If you feel a financial transfer is necessary, slip a cheque into the envelope too. I wish you, your brother, and all the readers of this column an optimal Christmas.

Also published at ft.com.

20th of December, 2008Dear EconomistComments off

Shock news? The media didn’t get us into this mess

Did Robert Peston cause the credit crunch? Some people seem to think so: the Daily Mail recently asked if he had too much power; Neal Gandhi, the chief executive officer of an outsourcing company, claimed that “because of his influential position, his predictions come true almost exclusively because he has predicted them”. This seems implausible, and I’m not saying that merely because Peston once worked for the Financial Times. After all, there’s a credit crunch on in New York too, where few have ever heard of the BBC’s inimitable business editor.

It is less absurd to claim that media exaggerations have deepened the recession, perhaps even caused it. Mark Fenton-O’Creevy, a professor of organisational behaviour at the Open University, argues that “media stories on the current turmoil are not just reflecting events, they are also creating them”. The journalist Michael Blastland, an evangelist for responsible use of statistics, argued in a debate at the Frontline Club in November that the media’s gloom about consumer spending had far outpaced any signs of a slump in the data and was contributing to the downturn.

Let’s examine this for a moment. Media reports are often excitable and rarely put economic data into context – but are they powerful enough to tip us into recession? That could only be true if economies were largely confidence tricks, with consumer and business spending tied less to income and more to the front pages of the tabloids. Economies very rarely work like that: were the FT to pronounce “everything’s nifty” on Monday, niftiness would remain elusive. We have run up against hard constraints. Banks made large losses long before depositors started twitching. Consumers had borrowed heavily, making it almost inevitable that at some stage spending would fall as they paid off debts. Ignorance or overconfidence allows us to defy gravity for a while, but not forever.

One case where prophecies can be self-fulfilling is a bank run. Banks can become unsafe for no reason other than that everyone believes them to be unsafe. Peston could bankrupt the safest bank in Britain if he announced on the breakfast news that it was going under and everyone should pull their money out at once. But the banks have largely melted down without the help of panicking depositors. They have been stricken because institutional investors, who do not make their financial decisions based on mass-market media reports, would not lend to them; and, indeed, because they would not lend to each other. When Iceland’s banking system collapsed in October, the problem was not that the media had panicked depositors. On the contrary: even as the money markets utterly lost confidence, British newspapers were claiming that Icesave offered one of the best savings products around.

Beyond the bank run, I am even less convinced that the media are to blame. Most of us continue to make our decisions based on our unique personal financial circumstances.

It is true that the media can set the economic mood. Two Federal Reserve economists, Mark Doms and Norman Morin, have found evidence that media reports of economic distress (pre-credit crunch) have always tended to knock consumer confidence, even if the economy is doing well. Thankfully, it is a long way from the survey to the high street. Researchers at the National Institute of Economic and Social Research have concluded that surveys of consumer confidence do not provide much help in predicting what consumers subsequently do. In other words, if Peston tells us it’s bad, we repeat his incantations when someone with a clipboard asks us how we’re feeling. Then we pull out our wallets and hit the shops.

Also published at ft.com.

Is the credit crunch suitable for children?

Dear Economist,
My young son came home from school and asked me: “Mummy, what’s a credit crunch?” How can I explain this to a five-year-old?
Ms LG, London

Dear Ms LG,

Once upon a time, there was a blameless girl called Consumerella, who didn’t have enough money to buy all the lovely things she wanted. She went to her Fairy Godmother, who called a man called Rumpelstiltskin who lived on Wall Street and claimed to be able to spin straw into gold. Rumpelstiltskin sent the Fairy Godmother the recipe for this magic spell. It was written in tiny, tiny writing, so she did not read it but hoped the Sorcerers’ Exchange Commission had checked it.

The Fairy Godmother carried away armfuls of glistening straw-derivative at a bargain price. Emboldened by the deal, she lent Consumerella – who had a big party to go to – 125 per cent of the money she needed. Consumerella bought a bling-bedizened gown, a palace and a Mercedes – and spent the rest on champagne. The first payment was due at midnight.

At midnight, Consumerella missed the first payment on her loan. (The result of overindulgence, although some blamed the pronouncements of the Toastmaster, a man called Peston.) Consumerella’s credit rating turned into a pumpkin and Rumpelstiltskin’s spell was broken. He and the Fairy Godmother discovered that their vaults were not full of gold, but ordinary straw.

All seemed lost until Santa Claus and his helpers, men with implausible fairy-tale names such as Darling and Bernanke, began handing out presents. It was only in January that Consumerella’s credit card statement arrived and she discovered that Santa Claus had paid for the gifts by taking out a loan in her name. They all lived miserably ever after. The End.

Also published at ft.com.

13th of December, 2008Dear EconomistComments off

Are loans at 100 per cent APR good for the poor?

FT Magazine, 6 December 2008

Bob Annibale’s corner office, high up in one of London’s few real skyscrapers, overlooks the Thames and the Millennium Dome from one window, Greenwich Park and the Royal Observatory from another. It is the kind of enviable perch you’d expect Citigroup’s senior treasury risk manager to enjoy. But that is the job Annibale left three years ago; now he is Citi’s “global director of microfinance”… Learn More

More or Less

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7th of December, 2008RadioComments off

Should I take down last year’s Xmas tree?

Dear Economist,
Due to multiple disruptions to my schedule since the first of the year I have not had the opportunity to take down my Christmas tree. At this point, should I leave the tree up for the remainder of the year or take it down now?
D. Seattle

Dear D. Seattle,

We all procrastinate from time to time. I, for example, received your e-mail in the spring of 2007. Forgive me if in the interim you have solved your dilemma, but it is possible that my answer will still be useful.

I think we can postulate a utility function along the following lines: having a Christmas tree up during the Christmas season brings positive utility, but diminishing marginal utility over time. After a while, the marginal utility is negative: the tree becomes an irritation, offering neither use nor ornament.

Given that parsimony is a virtue in economic modelling, let us assume that if the tree (presumably plastic) survives the year, its presence at the following Christmas will not seem like old news, but will be as welcome as ever. Assume also that putting up the tree and taking it down bring disutility, although in my experience this is not necessarily the case.

All these simplifying assumptions create a bias towards leaving the tree up; despite that, working through a few numerical examples suggests to me that in almost all cases you are better off taking the tree down. Even now, in early December, I would advise you to dismantle your festive foliage and enjoy the thrill of renewing it on Christmas Eve.

If the tree is still up, I would suggest that your problem is deeper than poor cost-benefit analysis: it is a profound tendency to put off action that is troublesome in the short term. We have developed an institution to deal with this. It is called the New Year’s resolution.

Also published at ft.com

6th of December, 2008Dear EconomistComments off

Is unemployment benefit a good thing after all?

To most thoughtful people, unemployment benefit embodies a painful trade-off. It’s the mark of a civilised society, clubbing together to provide assistance to those in need. It is also, regrettably, an incentive to remain unemployed. At its worst, unemployment benefit pays people to watch daytime television; it is particularly pernicious if the skills of the jobless decay, and unemployment becomes unemployability. Yet, at its best, it is a life-saver.

In balancing these two effects, it’s hardly surprising that different societies have adopted very different systems. According to the Organisation for Economic Co-operation and Development, member governments spent an average of 0.75 per cent of gross domestic product on unemployment benefits in 2006. France spent nearly twice this sum, and Germany almost three times as much, while the US spent a third of the average, and the UK just over a quarter. Germany spent more than 10 times as much as the UK, relative to GDP.

Paying people to stay out of work is an example of that increasingly familiar phenomenon, “moral hazard”, but moral hazard can be more fearsome in the theorist’s imagination than it is in reality. Does unemployment benefit really encourage people to duck work? Unfortunately, the evidence suggests that it does: increases in benefits have repeatedly been linked with longer periods between jobs.

But new research from Raj Chetty, a young Berkeley economist, suggests that moral hazard may not be why more generous benefits seem to lead to more unemployment. Chetty realised that unemployment benefit does not merely pay people to stay out of work; it also protects them from having to rush into an unsuitable job. It is nothing to celebrate if unemployed engineers cannot afford to spend three months finding a job for which they are qualified, but are forced to work as estate agents to put food on the table. A longer gap between jobs is sometimes preferable.

This is an interesting theory, but distinguishing between moral hazard and the effect of having some cash to hand is tough. Chetty looked at sharp breaks in the unemployment insurance rules in the US, comparing one state’s rules with another’s, or examining moments when the rules changed. One suggestive finding is that when unemployment insurance becomes more generous, not everybody lingers on benefits. The median job-loser in the US has $200 when he loses his job and is unlikely to be able to borrow much, but some people have plenty of money in the bank when they find themselves unemployed. Chetty found that those with savings do not take any longer to find a job when paid more generous benefits, while those with little in the kitty when they lose their jobs do. This suggests that those without their own cash reserves are using unemployment benefits to buy themselves time to find the right job.

Of course, there may be many differences between people with savings and those without, so this merely suggests that Chetty is on to something. But there are other clues – for instance, Chetty and two colleagues looked at the system in Austria, where severance pay is due to anyone employed for more than three years. By looking at – for example – a factory closure in which lots of staff are fired simultaneously, they could treat severance pay almost as a randomised experiment. Those lucky enough to get severance pay spent more time looking for a new job, despite the fact that severance pay provides no direct incentive to stay out of work.

Unemployment benefit does encourage unemployment in the short term; but that may be no bad thing.

Also published at ft.com.

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