Articles published in January, 2009

Dear Economist,

I was living with my boyfriend when he got accepted to a very good university in London. He convinced me to go with him. I applied and got accepted to another very good university to pursue a masters degree that I long dreamed of. He broke up with me before I knew I had been accepted, arguing he wasn’t prepared to carry the responsibility of me leaving a life behind to go after him. Of course, it was his idea in the first place.
He has been living in London since September. I have just arrived. I still love him, but I think he has been very selfish. Should I forgive him and look him up? Human selfishness and economics have always walked hand in hand. I would love to have your advice.
CP

Dear CP,

The whole episode seems to have been very good for you: at your boyfriend’s urging, you followed your dreams and now you are realising them. Wonderful.

However, this happy fact does not translate into a compelling reason to renew the relationship. Normally I advise people that they should ignore “sunk costs” – to put it another way, there is no use crying over spilt milk. In this particular case you should ignore the “sunk benefits”. Forget the fact that it’s all worked out well, and focus instead on what this story tells you about the prospects for a happy future together.

If your boyfriend is not rational then his behaviour is self-destructive and self-obsessed. Even worse, if your boyfriend is rational – as economists usually assume – then he seems simply to have been opening up an option (to have his old girlfriend in London) and discarding it when it had no value to him.

I’d guess he thought he could do better than his old relationship in London. I’m quite sure that you can.

Also published at ft.com.

Late last year I sat with members of my extended family and we talked about which banks might be safe havens for savings, and which might be about to collapse.

“Remember this conversation,” I instructed my young nephews. “The last time people talked like this was before your granddad was born.”

It made me think how the great crash of 1929, or the Great Depression, must have shaped the attitudes of those who lived through them. I used to think, in the arrogance of youth, that elderly people were just crazy if they stored their savings under the mattress because they didn’t trust the banks. Now I realise that painful memories, rather than senility, might explain the choice.

If experiences of major booms and busts shape the way we behave, it’s something that macroeconomists may need to take into account.

Consider two plausible theories of consumer behaviour, the “smoothie” and the “boomy”. The “boomy” theory is that when times are good, we get overconfident and spend freely, then retreat into a risk-averse shell when times get tough. The “smoothie” theory contends that people save for a rainy day in a boom and then draw down savings to maintain living standards during a recession. “Boomy” consumer behaviour makes recessions worse. The “smoothie” world is one where cool-headed and far-sighted consumers help smooth out booms and busts.

Keynes started with a boomy theory but abandoned it, believing it predicted implausibly wild swings in the economy. He switched to the smoothie theory instead in 1931. Here’s the intriguing thing: John Coates, the neuro-economist whose work on traders and testosterone I described two weeks ago, points out that the smoothie theory wasn’t borne out by US depression-era data at all. Americans became smoothie consumers only during and after the war. What happened? Perhaps consumers began smoothing only after being chastened by the memory of the roaring twenties and the subsequent hangover. And, says Coates, they began to return to unstable, boomy behaviour after 1981. Fifty years was long enough to forget.

A more formal analysis of these issues has been circulating since late 2006, well before the credit crunch, but has attracted new interest since. Ulrike Malmendier and Stefan Nagel, both California-based economists, have been investigating how economic experiences early in life seem to shape our later behaviour.

Using financial surveys that date back to 1964, they look at how returns on the S&P 500 over the course of an individual’s life to date shape his or her financial behaviour at the date in question. They control for age (perhaps 65-year-old retirees are always more cautious than 40-year-olds) and for the year (everyone investing in, say, 1988, faces a particular investing environment), but nevertheless find that an individual’s earlier experiences seem to shape his or her behaviour.

For example, young investors in the late 1990s were keen stock market investors, having experienced a lifetime of excellent returns; old investors were more cautious. Whereas in the early 1980s, it was the older investors who were more bullish: unlike young investors, they could remember the good times of the postwar boom.

If these results predict future risk attitudes, and if the credit crunch does prove to be the definitively unpleasant event that many economists fear, then a fascinating future lies ahead. Consumers will remember what it means to put money aside in the good times, while the stock market will be an old-timer’s game, tempting only for those greybeards who remember the long boom of the 1980s and 1990s. Those were the days.

Also posted at ft.com.

Why the NFL should replace the overtime coin toss with an auction system.

If the Super Bowl goes into overtime for the first time ever, it’s fairly certain who will be victorious: the team that wins the coin toss. In the first round of the playoffs, the Chargers beat the Colts 23-17 in OT, marching down the field for a touchdown after winning the toss. In the 14 overtime games that produced a winner this season, the coin-toss victor won 10 of the games, more than 70 percent. Since 2002, the team that’s gotten the toss has won more than 60 percent of overtime games.

Chess faces a similar problem—it’s generally regarded as an advantage to play white. But the chess world has long had a solution: Take it in turns and play a lot of games. That’s easy for the chess guys—they have all the time in the world, and more forgiving TV schedules. College football has a similar philosophy, giving each team the ball at the opponents’ 25-yard line and alternating possessions until someone breaks the tie. But the NFL’s competition committee, which pondered the overtime problem in depth in 2003, decided to stick with the status quo of “sudden death.”

With a little ingenuity, there is a way for overtime to be both fair and fast….

Continued at Slate.

First published: Business Life Magazine, August 2008

Sir William Petty, an advisor to Oliver Cromwell and a Professor of Anatomy at Oxford, seems an unlikely hero for economists. Yet nowadays his claim to fame is that he produced the first estimate of Britain’s national income, which he put at £40 million a year back in 1664, or about £4.5 billion in today’s money. The modern equivalent, UK gross domestic product (GDP), is a little larger: about £1400 billion.
Sir William was celebrated in his day, but the field he fathered, national income accounting, seems to be the most tedious in modern economics: back-office bean counting, far removed from eye-catching “Freakonomics”-style research.
Yet the bean counters have been having their revenge. New ways of gathering data have gradually been transforming our understanding of how economies grow, and even changing the way we think about what really matters when they do.
One important step was taken Alan Heston and Robert Summers, two professors from the University of Pennsylvania’s economics department. (Summers was the brother of economics demigod Paul Samuelson, and the father of Larry Summers, US Treasury Secretary under Bill Clinton.) After the World Bank neglected to take up the task, Heston and Summers collected international data on prices all over the world, allowing a meaningful comparison, like-with-like, of rich countries with poor ones. The fruits of this labour, the first Penn World Table, were published in 1986, and circulated to the profession via floppy disks. The two decades since have seen a great outpouring of studies based on the Penn data, trying to answer the question of what makes poor countries poor, and how they might get rich. One conclusion: investment in roads, factories and even education doesn’t seem to matter as much as was once thought. What matters is that rich countries manage to used these investments well.
With this in mind, the World Bank is now trying to count things that might matter for the business environment – for example, its Doing Business project, which has been running for five years, collects and broadcasts information about red tape in 178 countries, such as the number of days an entrepreneur needs to wait before legally establishing a new business. The project is intended to diagnose problems, but it is also a terrific spur to shamefaced bureaucrats.
Other statistics aim to show economic performance in a new light. The most respected is the Human Development Index, published since 1990, which emphasises literacy and health as well as economic growth, and has helped to change the focus of development agencies.
And the data gathering goes on: Nobel laureate Daniel Kahneman is trying to develop credible happiness accounts, based on time-weighted data on how people feel throughout the day. Not so much bean-counting as smile-counting – Sir William would have been astonished.

Dear Economist,

Finding myself alone again, I have joined a dating agency. As a result, I am taking delightful, unattached women out to dinner. This is almost always very enjoyable and, according to tradition, I pay for the meal.

I am very happy to do this but I am disappointed when the woman in question does not send me a text or other message the next morning to say thank you. Am I expecting too much in this modern world?
R.S., London

Dear R.S.,

Oh dear. I am inclined to agree that a thank-you is appropriate, and if you are not receiving so much as a text or an e-mail, this is a bad sign. But a sign of what?

Scenario one: the woman is a rational self-interested agent. If she regarded a free dinner as sufficient compensation for the time she had to spend in your company, then a “thank you” would be a simple way of securing a repeat of the experience. The fact such gratitude is not forthcoming suggests your dining companion did not wish for a second date. Nor did she care if you regarded her as ungrateful or said so to others. In short, she would be happy never to see you again.

Scenario two: your date wished to continue the relationship, but was too stupid or self-obsessed to realise that “thank you” would be a good first step. In which case, you are better off without her.

A final possibility is that your offer to pay for dinner struck your companion as sexist. But then, either she protested and you boorishly ignored her, in which case scenario one now applies (you have no chance); or she let you pay anyway and then sulked, in which case scenario two applies (you got away lightly).

The good news? You seem to enjoy these first-date dinners – and I suspect many more are in prospect.

Also published at ft.com.

In 1987, an 18-month old baby named Jessica McClure fell down a narrow disused well in a Texas backyard. It took two and a half days to rescue her, bloodied but alive and alert, after an astonishing media circus. The rescue won a Pulitzer prize for the photographer who captured it, and inspired a TV movie. “Well-wishers” from across the US donated so much money that when Jessica turns 25 she’ll receive a fat trust fund. Media speculation puts it at a nice round $1m.

Jessica’s case was uniquely famous, but $1m is not a remarkable sum of money to save an American life. Government agencies regularly plug larger sums into their cost-benefit calculations, and few voters think they are wrong to do so.

To some extent that’s cheap talk – we’re talking about spending each other’s money, after all. Yet even if we wouldn’t spend $1m of our own money, we would all be willing to make financial sacrifices to save a specific baby. Imagine that you had been passing the back yard at the moment baby Jessica had slipped down the well, had rushed over and peered down to see her just within reach, snagged by a fraying babygro. If you lunged down and grabbed her you could save her life at no risk to your own, but would ruin your new suit – price tag, £300. Would you do it? Unthinkingly and without regret.

Here is the difficulty: faced not with a specific baby right in front of us, but some unnamed baby far away, £300 suddenly seems like a steep price tag. That £300 is a plausible estimate for the cost of enough mosquito nets or health education to save a child’s life in sub-Saharan Africa. Few Britons donate that much to charity each year.

Peter Singer, the utilitarian philosopher, animal rights champion and author of a new book, The Life You Can Save, is disturbed by the equanimity with which we accept the widespread death and suffering of millions of unidentified – but undeniably, real – people in poor countries.

In part this may be because we wrongly believe that our governments have it all covered. Singer reports several surveys suggesting that US citizens think that 15-20 per cent of the US government budget is spent on foreign aid; the true sum is less than one per cent. I suspect that we also worry that £300 will not, in fact, save any lives at all. Much aid money is wasted, and evidence on the effectiveness of aid remains too thin. By coincidence, as Peter Singer’s book crossed my desk, so did a peer-reviewed report on a randomised trial carried out in Ghana by Dr Evelyn Korkor Ansah and others. The trial provided free healthcare to young Ghanaian children, with the result that their families took them to the clinic more often. Yet there was no evidence that the children’s health improved in any way. It’s rare to find such careful evaluation, but not hard to find cases where money has been spent in Africa with no great result, or even with harmful results.

Yet our affluence is so great – just think of the money most of us could save if we drank only tap water – that the hurdle for giving is surely very low. Even if 95 per cent of the money we send to Africa is wasted, £5 to them probably does more good than £100 to us.

The true reason we do not give freely is because of an almost unlimited capacity to put out of our minds the suffering of people we will never meet. One of the effects of Singer’s book is to refocus the reader on that suffering, at least for a while. After I finished the book, I contacted Oxfam to give money. I always knew I didn’t need a new suit; Peter Singer reminded me.

Also published at ft.com.

“They were displaying classic symptoms of mania. They were overconfident, they had racing thoughts, they had diminished need for sleep and heightened sexual appetite.”

John Coates, a former Wall Street trading floor manager, was describing to me not drug addicts or rutting stags, but the male traders he had supervised during the dotcom bubble.

The similarities are not just skin deep. Successful traders and dominant stags are indeed high on something: testosterone. Spikes in testosterone levels are both the cause and the consequence of a profitable day on the trading floor. After a good day, traders find their systems flooded with testosterone, which encourages them to take more risks the following day and, up to a point, to make more money.

The same testosterone surges and streaks of success and failure can be seen in bulls, stags and other sexually competing male mammals. Female traders – who remain rare – don’t act in the same way.

Coates – a research fellow at Cambridge university who quit Wall Street to study the boundaries of economics and neuroscience – made a splash last year by publishing research (with the neuroscientist Joe Herbert) showing all this. Now, in a new paper with the endocrinologist Mark Gurnell and the economist Aldo Rustichini, Coates has been asking whether traders’ behaviour is influenced by high levels of testosterone (and other “androgenic” steroids) they may have been exposed to in the womb.

This is not an outlandish hypothesis, given what endocrinologists already know: high levels of pre-natal testosterone seem to be correlated with confidence, a tolerance for risk and quick reaction times, as well as sporting prowess. So it is not unreasonable that high-frequency traders, who take billion-dollar positions for minutes or even seconds, might benefit from having developed in a conducive womb.

One might ask how Coates, studying the behaviour of traders who were typically in their twenties, could know what had happened to them in the womb. In fact, there is a convenient and widely used proxy: the ratio of the index finger to the fourth finger – or the 2D:4D ratio. Low 2D:4D (a relatively long fourth finger) is evidence of high exposure to testosterone in the womb.

Coates, Gurnell and Rustichini found what they were expecting: that high-testosterone foetuses grew up to be excellent high-frequency traders. What was surprising was the huge size of the effect. Traders with a low 2D:4D ratio made six times as much money as those with high 2D:4D ratios. In an environment when the best traders earned more than £4m a year, this is hardly a trivial discovery.

The high-testosterone advantage seems to come from two sources. First, pre-natal testosterone seems to shape brains with quicker reactions and a greater ability to concentrate. Coates and his colleagues found that low 2D:4D traders did particularly well in volatile markets, when speed of action was paramount. They weren’t just “better”, they were better in a way that gave them an edge in frenzied times. In contrast, experienced traders have a more generalised advantage: they make more money than inexperienced traders in quiet times as well as volatile ones.

Second, pre-natal testosterone amplifies the “rutting stag” behaviour Coates and Herbert had already discovered. It seems to pave the way for a more intense response to later surges in testosterone: once the low 2D:4D traders get on a roll, they really start winning. By the same token, losses are also self-perpetuating for such traders, because they drain away testosterone and with it, the willingness to take risks.

Also published at ft.com.

Although Christmas in the company of various members of the extended family was fun, it was interrupted and spoiled by family rows over who got to watch what television programme, who got the best seat, who did the washing up, and so on. Can economics prevent such rows spoiling next Christmas?
Penny Belton, Gloucester

Dear Penny,

I am all in favour of assigning clear property rights in such cases. Someone can “own” the right to the remote control; the best seat can also go up for grabs, as can exemption from the washing-up rota.

One can get pretty fancy about these auctions, but I wouldn’t advise doing so unless you’re going to buy bespoke software and hire a team of specialist economists. A simple set of auctions for temporary use of selected scarce resources should do the trick.

I have made this sort of recommendation before on the basis of sound economic theory. This year, I am delighted to report that I have empirical support. Bev Stewart, a grandmother from Yorkshire, auctioned the right to spend Boxing day in the comfy armchair in front of the telly. All family members were eligible to bid; she was expecting a “rabble of Stewarts” to descend upon her the day after Christmas.

The winner, after 17 bids from a range of bidders, was her daughter-in-law for the sum of £13.50. The ingenious Grandma Stewart not only raised money for a good cause, but prevented the annual arguments over what she is quoted as saying is the “perfect seat … straight in front of the TV and has got the coffee table at the side for you to rest your drink on and the TV remote, so everybody wants to sit there”.

Twenty-five family members and no arguments. If auctions can work for Bev Stewart, they can work for us all.

Also published at ft.com.

I wrote this for the Today program; scroll down and you can hear an interview with me on the subject from this morning’s show.

“I’m backing Britain…”, crooned Bruce Forsyth in 1968. “Yes I’m backing Britain/We’re all backing Britain.”
Despite Brucie’s support, the “I’m Backing Britain” campaign did not last long. The campaign’s T-shirts were even produced in Portugal. Typical, perhaps, of the difficulty of building up a head of steam in support of the national economy.
Economic patriotism was never really Britain’s thing, but it seems to be enjoying a comeback.
Dr John Sentamu, Archbishop of York, told an audience of farmers last October that he wanted a return to the “Buy British” mindset, with government support.
Last week, the environment secretary Hilary Benn also called for consumers to buy British food, also at a farming conference.
No doubt it was crowd-pleasing stuff, but it is puzzling.
After all, every time we deliberately Buy British we are also deliberately “Not Buying From Foreigners”.
In a world where racism is rightly viewed with disgust and contempt, it is a strange thing that discrimination against foreigners is regarded as acceptable, even laudable.
It is also not very smart, because there are so many more foreigners than us.
The economist Gary Becker has tried to calculate the economic costs of discrimination. What he found was common sense. When a large group and a small group discriminate against each other, it is the small group that suffers. The rest of the world could happily do without British products, but Britain cannot happily do without the rest of the world.
It is true that if a “Buy British” campaign persuaded many of us to seek out British products and turn away from imports, that would be a shot in the arm for the workers and companies who produced those products.
But here is the bad news. If foreigners find they cannot sell us their products, foreigners would also find that they had no sterling to buy exports.
For every local product that beat off foreign competition, there would be a British exporter struggling to find customers. We cannot have a world where we sell lots of products to foreigners, but we never buy anything from them.
Granted… such a world would, at least, cut down on food miles and you might think that would be good for the planet.
But not necessarily. Buying foreign products may add to food miles but it can also cut down on the need for heated greenhouses or intensive farming. In any case, international freight is very efficiently done. (No, those cut flowers from Kenya do not fly first class.)
When Hilary Benn had a different job – development secretary – he agreed with me, calling for people to buy Kenyan flowers for Valentine’s Day in 2007. He must have forgotten.
The biggest environmental cost of food transport comes, not from international shipping, but driving to and from the supermarket, often with just a couple of carrier bags in the back of the car.
Having looked closely at the evidence, I have concluded that what really reduces carbon emissions is making sure you walk or cycle to the shops.
Do not get me wrong. I am backing Britain. I am just not backing the British at the expense of foreigners, or national producers at the expense of British exporters.
But if I have not convinced you, please wait a moment before getting on the phone to Portugal to order your T-shirts.
There is already a hugely effective policy in place that will help support British firms and British workers: the collapse in the value of the pound, which makes it harder for foreigners to find buyers here and easier for British exporters to expand. It will have more impact than 1,000 “Backing Britain” campaigns.
Perhaps Brucie could sing us a song about it.

Dear Economist,
Here in Michigan we have a problem: the automobile industry. Thanks to foreign competition and the doubtful management of the Big Three, the state’s economy is in serious trouble. Should we just sell the state to the Chinese? There is a history of this in Michigan – we once traded the city of Toledo to Ohio in exchange for the upper peninsula. So perhaps it would be a good idea. But what would be a good price?
Mrs J, Michigan

Dear Mrs J.,

Make sure you don’t sell yourselves cheap. According to the US Bureau of Economic Analysis, Michigan’s GDP was $382bn in 2007. This is an attempt to measure the value added to all goods and services in Michigan, which includes anything from haircuts to assembling a car – but not, for instance, any components imported from out of state.

The $382bn figure is impressive. It would sneak Michigan into the top 25 economies in the world. Even China’s GDP is less than nine times greater.

So how much would it cost to buy $382bn of productive power? No corporation adds nearly as much value; the economist Paul de Grauwe reckoned that in 2000, value added was $67bn for Wal-Mart and $53bn for Exxon, the two largest companies. Their market value at the time was about five times their value added.

If the same ratio applies, buying Michigan would cost the Chinese almost $2 trillion –roughly what China’s State Administration of Foreign Exchange has to spend. All this assumes that Michigan’s residents, like Wal-Mart’s employees, would be free to leave if they didn’t like the new management.

Still, don’t hold out too long: even before the credit crunch hit, Michigan’s GDP per head was falling in real terms. This may be the right time to sell.

Also published at ft.com.

Imagine an auction in a looking-glass world, with the auctioneer offering cash to the highest bidder and the participants frantically outbidding each other with a jumble of assorted assets. Should a million dollars be sold to the man in the front row for his bundle of 2006-vintage toxic mortgage securities? Or the lady behind him, for her 2005-vintage offering?

That was the auction the US Treasury was hoping to hold until it abruptly changed its plans in November. It was going to spend up to $700bn – the “Tarp” (toxic asset relief programme) fund – buying a variety of toxic assets from banks. The idea made sense: by establishing a market price for these dubious assets, the auction would have improved transparency and helped solvent banks to prove that they really were solvent.

The Tarp fund was then cannibalised to recapitalise banks (probably a good idea) and then dole out suitcases of cash to all-comers (a less good idea). But the original auction concept should be resurrected, because it solves a problem that has not gone away.

And yet – how could the looking-glass auction work without the US Treasury overpaying for junk? Holding a single auction with a single price would be a disaster: only the most worthless assets would have been offered for sale. To do the job properly and establish realistic prices, the auction needs to distinguish between different assets: some good, some bad and some ugly.

But simply holding many different auctions is not much better. Once finished, a bank might be surprised by the prices, wishing it had sold more of one kind of asset at a generous price, and fewer of its others. Not only would the banks have acted differently with hindsight, but the Treasury would want them to, in the interests of higher revenue and more price transparency.

So two economists from the University of Maryland, Larry Ausubel and Peter Cramton, proposed a dynamic design that would have allowed banks to adjust their bids as the auction proceeded, shifting their emphasis to compete more aggressively wherever prices seemed tempting. The auction was tested to destruction by graduate students and seemed to work well. But there is a flaw: each auction would take a day, with the auction prices affecting financial markets and the markets affecting the auction prices.

However, a solution was already being developed to answer a similar problem for the Bank of England. Paul Klemperer, one of the economists behind the 3G mobile spectrum auctions in the UK, has published a paper explaining how the Bank might auction off loans secured against different qualities of collateral.

He suggests having banks simultaneously submit combinations of bids. Each bank would be considering different scenarios – one in which loan rates were high and it preferred to borrow the absolute minimum; another in which rates were low and it happily offloaded collateral to the Bank of England.

The same approach could work for a Tarp auction, too; Klemperer and three economists from Stanford have been working out the details. A computer would compile bids from both sides, with both the banks and the US Treasury saying in advance what they would be willing to buy or sell at different possible prices. The computer would calculate the result. Because each bidder submitted bids to cover each eventuality, the auction should be efficient and nobody would regret having told the computer the truth.

Whether the US Treasury will relent and return to an auction remains to be seen. The Tarp auction is a fiendishly difficult design problem, but it looks solvable. At the time of writing, it seems that the Treasury prefers to spend the cash ad hoc. Shame.

Also published at ft.com.

Should I associate with happy people because they make me feel good by association, or unhappy people because they make me feel good by comparison? Or do economists claim that I should be indifferent?
D.K., New York

Dear D.K.,

Economic theory makes no such claim: it insists merely that your preferences be consistent and complete because that makes the mathematics easier. Although many economic models concentrate on your demand for physical goods, that is merely to keep things simple. There is no theoretical reason to insist that your happiness cannot depend on the happiness of others.

Your question, then, should be addressed empirically, and a fascinating new paper in the British Medical Journal tries to do just that. The authors, James Fowler and Nicholas Christakis, find that happiness is contagious.

If just a single nearby friend becomes happy, your chances of being happy rise by a quarter. Physical proximity seems to be important, and happiness is far more contagious among people of the same sex.

This has a ring of plausibility, yet there are some curious results – for instance, that a happy next-door neighbour seems to affect your mood more than a happy spouse. Meanwhile, in another BMJ study, Jason Fletcher and the economist Ethan Cohen-Cole use a similar data set and methodology to demonstrate that height also seems to be contagious, which seems rather unlikely.

The trouble is that it is hard to separate genuine contagion from other effects – such as a shared physical environment, or people befriending others who seem similar to them. My recommendation: by all means seek out happy people, but do not expect miracles.

Also published at ft.com.

Monday is a big day in the Harford household: my oldest daughter will start school. That is a cue for the full spectrum of middle-class parental emotions: nostalgia for the toddler she once was; pride at seeing her reach a new stage of independence; and, of course, anxiety that the school will not be good enough for our little darling.

We have been given few reasons to fret about the quality of the teaching, but like many parents we’re nervous about the impact our daughter’s peers may have on her, many of whom are from deprived backgrounds or homes where nobody speaks English. Will the teacher be distracted by the need to teach the class skills she already has?

I have written before about “peer effects” in education, which are the influences, positive and negative, that classmates and school friends have on each other. They are hard to identify with much certainty. Bright children might make friends with each other without actually improving each other’s test scores. Or pushy middle-class parents might all flock to the same popular school. Or a class of smart kids might attract a good teacher. All these situations would produce clusters of high and low achievement, yet no true peer effects need be at play.

Still, there are occasions on which classmates are assigned absolutely at random. For example, in North Carolina, 120,000 children were randomly assigned classmates over the period of a decade. Using such situations, economists think they are identifying peer effects.

Caroline Hoxby, a Stanford professor of economics and a leading figure in the field, explained the emerging consensus to me in an interview last year. First, peer effects exist. Second, they are not nearly as important as good teachers: given the choice between the best class in town and the best teacher in town, parents should choose the best teacher any day.

Third, peer effects take the form of what Hoxby describes as “the sports model”. If you were looking to improve at a sport, you would typically seek to play against people who were a little better than you, because they would drag you up to their level. The same appears to be true in a classroom: children benefit from having classmates who are just a little ahead of them.

This is useful to know, since there are many other plausible models of peer effects, including the “rainbow” (children benefit from having a wide range of abilities around them), the “bad apple” (if the troublemakers can be deterred, cured or excluded, their classmates will be fine), the “shining star” (one classroom genius inspires everyone) and the “boutique” (what matters is that the whole class is at much the same level, so the teacher’s lessons can satisfy everyone). Since it is mathematically impossible for every child to have slightly superior classmates, the “boutique” model seems to be the next best thing, and that suggests some form of streaming by ability is wise.

There is new evidence of that from Kenya, whose education system is at the cutting edge of a newly popular type of economic analysis, the randomised controlled trial. In the latest example – studied by the economists Esther Duflo, Pascaline Dupas and Michael Kremer – 121 Kenyan schools were given a grant to hire an extra teacher and so split one large reception class into two smaller classes. In 61 randomly chosen schools the students were streamed by ability; in the other 60, they were randomly assigned to their classes. The result: better grades for everybody in the streamed classes, whether they were originally judged to be high, medium or low ability. It is not a shocking conclusion but it is good to have the gold-standard of the randomised trial to support it. If only there were more such trials outside east Africa.

Also published at ft.com.

First published Business Life magazine, January 2008

Are you keeping your new year’s resolutions? If not, perhaps you should turn to economics for help.

That might seem like a strange piece of advice, because the staple of economic models, “rational economic man”, does not suffer from a nicotine habit, nor impulsively grab chocolate bars at the supermarket checkout. If the vice is worth the health cost, he indulges it; if it is not, he does not. Rational economic man needs no resolutions. Read the rest of this entry »