Tim Harford The Undercover Economist

Articles published in January, 2009

My advice to the US Treasury? Go back to Plan A

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.

Can I become happy by association?

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.

3rd of January, 2009Dear EconomistComments off

What lessons can schools learn from streaming by ability?

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.

Business Life: Resolutions special

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. Learn More

1st of January, 2009Other WritingComments off
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