Tim Harford The Undercover Economist

Articles published in April, 2009

To profit, plump for an also-ran at the helm

Team titles might be what matter to them most, but football fans are also generally pleased if a player in their team wins an award. Publishers rarely object when their authors win Booker or Nobel prizes for literature. So how should shareholders in a company feel when the company’s chief executive wins an accolade such as “Best Manager” from Business Week or “Best Performing CEO” from Forbes? New research from two California-based economists suggests that the correct response would be to feel sick.

Economists have long been intrigued by the prospect that chief executives might use their position to pursue wealth, status and perks to the detriment of shareholders. Shareholders, widely dispersed and sometimes protected by flimsy governance, often have little sway over what managers get up to.

This view has unsavoury implications, such as the idea that corporate social responsibility and philanthropy might in fact mean shareholders paying for their chief executive’s golden halo. It has also been prescient: it was in studying economics that I first discovered that managers might be willing to overpay for merger targets because mergers brought them wealth and status, or that they would arrange to receive some of their pay in the form of a large pension because deferred compensation often only causes outrage once it is too late to do anything about it. If only Sir Fred Goodwin’s board at Royal Bank of Scotland had encountered the same lessons.

Ulrike Malmendier of UC Berkeley and Geoffrey Tate of UCLA wondered if awards for chief executives might shift the balance of power further towards the chief executive. That seems likely: it turns out that award-winning chief executives are paid more and deliver less following their award.

Top performers will tend to have been lucky in the past, and luck rarely lasts. If an award from Forbes celebrates a man who has made a few lucky calls, small wonder if he goes on to disappoint. Yet Malmendier and Tate try to adjust for this statistical tendency by identifying a selection of “nearly men” (and occasionally women) who might have been expected to win an award, but didn’t. The nearly-winners, like the winners, tend to run big companies with strong recent shareholder returns. Like the winners, too, they have probably been lucky. Yet in the three years following an award, the share prices of the companies run by winners lag behind the prices of those run by nearly-winners by between 15 and 26 per cent. Nor is their performance reflected in pay: winners enjoy an extra $8m a year compared with nearly-winners.

Winners also seem to enjoy various distracting perks. Although the statistical analysis is less sophisticated here, Malmendier and Tate believe that award-winners are more likely to write books – often self-aggrandising books, let us be honest – and more likely to accept seats on the boards of other companies. The icing on the cake: award-winning chief executives have superior golf handicaps.

In short, awards for chief executives should be about as welcome as the “curse of the pharaoh”. Before the shareholders of the world march on the offices of Business Week, pitchforks in hand, they might bear in mind one final discovery. Malmendier and Tate check their results against an index of bad governance that tots up tricks, such as poisoned pills, designed to protect firms from hostile takeovers. Almost all of the perverse effects of awards to chief executives – including their tendency to spend more time on the golf course – shrink or even disappear in companies which have strong governance. Even superstar chief executives can be kept on a leash, it seems.

Also published at ft.com.

Do I show my hand and risk my home?

Dear Economist,
I am a third-year university student and I share a flat with a student on the same course as me from the year below. We are good friends, but I, alas, want us to be more than that. The risks of my confessing my feelings are quite high. If it works out, I have a girlfriend; if it doesn’t, I’ll end up homeless, looking for an (almost prohibitively expensive one-person) apartment, having lost my best friend. If I keep her in the dark I’m guaranteed to have a roof over my head for the two remaining years. Can economics provide an answer to my dilemma?
Unnamed student, London

Dear student,

The cost-benefit analysis here is deceptive, so let me walk you through it. Your mistake has been to frame your dilemma as a static choice problem: either you confess now and take your chances, or you never confess.

That is wrong. There is, dare I say it, a third way. Simply wait and see whether anything is clearer tomorrow, or the next day, or the day after that.

In technical terms, you have an option on making a pass at this lucky lady, and you will continue to have that option until either you actually do so, or until either you or she falls for someone else. The option is valuable and should not be exercised lightly, and thus expended. Option valuation models suggest that you should make your move only if you are absolutely sure (you clearly are not) or if other suitors are circling and your option is about to vanish anyway.

Even in the latter circumstance, you shouldn’t make your move if you feel the odds are against you. I suspect they are. The chances are that this young woman knows exactly how you feel. Since she has done nothing to encourage you, I expect she is praying you’ll keep your feelings to yourself.

Also published at ft.com.

25th of April, 2009Dear EconomistComments off

Forbes: Trial, error and the elite

For years, we were told that Wall Street attracted the very best. That was why American investment banks were the envy of the world; that was why stratospheric salaries and bonuses were essential. Other financial centers, such as London, fought tooth and nail to attract the same elite. They were worth it, we were told: If you pay peanuts, you get monkeys.
That argument seems hollow now, but it was always a misunderstanding of the way financial markets work–indeed, the way the whole growth miracle of capitalism works. It’s not that financial markets themselves are a sham: There are indeed very smart investment bankers in the world, and some of them help to make us all richer by providing a bridge between those who could use money and those who have money. It’s just that this is not the whole story.
The fact of the matter is: The market system does not work because of the incredibly smart people in charge. (The Soviets had some pretty smart people.) The market system works because nobody is in charge.
Even when markets surround us, we prefer to forget this. It is easier to focus on personalities, so the financial press like to talk about the leadership of great CEOs. When things go wrong, we search for fools and frauds: a Dick Fuld or worse, a Bernie Madoff. We think that the elite betrayed us or that the elite wasn’t as smart as everyone thought. Politicians–temperamentally inclined to believe in the “great man” theory of everything–tend to agree…

Continued at Forbes.com

24th of April, 2009Other WritingComments off

Is the lottery the best bet for my pay-off?

Dear Economist,
Thanks to the recession kindly engineered by financial whiz-kids, I find myself jobless with large debts and a house that is worth less than the mortgage. I have some redundancy money. What am I supposed to do with it? It’s not enough to pay off my debts. Financial disaster seems very likely, so why shouldn’t I just spend the windfall on lottery tickets?
J.P., via e-mail

Dear J.P.,

I’m not going to argue with you about the expected returns on lottery tickets; you’ll know that your chances of winning anything worthwhile are near zero. Let me make a more striking claim: even if you won, it would be unlikely to save you from financial trouble.

The economists Scott Hankins, Mark Hoekstra and Paige Marta Skiba are in the process of investigating that claim, looking at 35,000 winners of the Florida lottery, almost 2,000 of whom later filed for bankruptcy. The researchers find that lottery winners are more likely to go bankrupt than others – which is not surprising, since many of them don’t win much, and lottery enthusiasts tend to be poor.

More surprising is the discovery that those who won between $50,000 and $150,000 were as likely to have gone bankrupt five years later as those who won less than $10,000. Since the size of a win is random, there should have been no difference between big winners and small winners at the time they bought their ticket. It is remarkable that the additional money was not used to pay off debts.

Admittedly, winning $100,000 did seem to postpone bankruptcy by a year or two, so presumably these winners had a nice time on their way to ruin. Yet this is not an approach I feel able to recommend. Finding a job would go a long way to solving your problems. I won’t pretend that will be easy, but the odds are better than those of winning the lottery.

Also published at ft.com.

18th of April, 2009Dear EconomistComments off

Even in a recession, charitable giving can go up as well as down

Last month, Red Nose Day, a biennial charity extravaganza, managed to break its fundraising record despite the recession. But to what extent are charities recession-proof? Much depends on what motivates us to give, a subject that has been receiving a lot of attention from economists recently.

There are many possible motivations. One is pure altruism: we give to charity because we care about the well-being of others. A second infamous motivation for giving was advanced by the economist James Andreoni: the “warm glow”. Warm-glow givers donate money to charity because it makes them feel good.

There might not seem to be much difference between altruism and a warm glow, but there is: warm-glow givers don’t think too much about whether the money they give will be effective. For example, research by the behavioural economist George Loewenstein, with Deborah Small, a marketing professor, and Paul Slovic, a psychologist, shows that people are typically more generous when presented with an identifiable victim – six-year-old Aisha in Niger – than with statistical evidence of hunger in Niger. While the altruist would want the evidence, the warm-glow giver just wants to feel the connection. A third motivation is social pressure: we give because we think that’s what others expect of us.

All this matters, particularly if we want to understand what happens in a recession. Altruists might well give more. “It’s not rocket science,” says Dean Karlan, an experimental economist who researches charitable giving and microfinance. “The poor are also poorer now, so altruists can achieve more with their donation.” But as Karlan warns, not everyone is an altruist.

John List, a leading light in the field of experimental economics, recently carried out an experiment designed to tease out some of the motives for giving. His team went door-to-door collecting for charities, but in some cases they had forewarned their targets as to the time of their arrival. Genuine altruists would be more likely to give if forewarned, for much the same reason that you are more likely to be in to receive a delivery if told what time it will arrive. But people who give because they feel pressured might simply hide behind the sofa when the charity collectors knocked on the door. In some cases, they could even tick a “do not disturb” box to avoid awkwardness.

List’s experiment, carried out with two University of California, Berkeley, economists, Ulrike Malmendier and Stefano DellaVigna, highlighted the altruists as those who gave money even when it was easy to avoid doing so. In an unexpected twist, the experiment straddled the collapse of Lehman Brothers and of the stock market. List and his colleagues discovered their “no-forewarning” run, which would normally attract grudging donations out of social pressure, raised almost two-thirds less money during the crisis. Perhaps it was just too easy to say no. Altruistic donations, solicited during the “forewarning” run, tended to be larger and held up better during the crisis.

Separately, List has found that large charitable donations such as bequests are strongly linked to stock market performance, but with a delay. The good news is that it may take time for the crisis to hit such donations. The bad news is that charities may suffer for years after the economy recovers.

All the economists I spoke to were pessimistic about the outlook for charitable giving in a recession. Rachel Croson, an economist at the University of Texas at Dallas, summed it up well by pointing out that in a recession, there is less of most things except spare time: “What I’m foreseeing is a lot of people volunteering to serve at the soup kitchen, but less food.”

Also published at ft.com.

Supply and reprimand; The economics of child-rearing

A review of Parentonomics: An Economist Dad Looks at Parenting, by Joshua Gans

What happens when Mr Spock meets Dr Spock? The answer is Parentonomics , an autobiographical account of how an economist used his professional training in game theory to bring up his three children.

Joshua Gans describes his experiences in the labour wards, changing nappies and dealing with tantrums, spousal absences and sibling rivalry – all the while explaining what he did or did not do, the economic principles involved, and whether any of it worked as a parenting strategy.

The obvious question is whether this is supposed to be good advice or some kind of joke. There is no ambiguity in Parentonomics: Gans is not joking. Thankfully, he can be very funny. Although he is an academic – a professor at Melbourne Business School – his writing has a professional snap. While the advice is intended to be useful, readers will come to their own conclusions about that. It does at least tend to be thought-provoking.

The book may not strike a chord with those without children, but parents will wince with recognition. What distinguishes Gans’s approach is not just his regard for economics, but his disregard for social mores. Why do we frown on the idea of putting toddlers on leashes, he wonders? For parents wandering busy streets, they are brilliant; far safer than letting the child run free and far easier than incessantly holding hands. He points out that most parents end up tying their children into a pushchair instead – more restrictive than the leash, but socially more acceptable.

Another observation that brought me up short: when Gans plays his children at any game from chess to snap, he plays to win. “I see no need to coddle my children in game-playing,” he opines. “If they want that, they can go elsewhere, say, to their mother.” That seems wrong, somehow.

And yet, he observes, his children keep coming back for more, develop their own strategies to win (that is, they cheat) and get to play far more games with their father, because he is less likely to make excuses not to play.

There is much more in the same vein, from the logistical impossibilities of driving multiple children to multiple parties, to a deadpan account of how Gans got himself blacklisted at the local labour ward. He advised his wife, “I think you are broadly delusional. You need drugs and you need them now.”

At the heart of the book is the question of using and misusing incentives. Gans is unabashedly in the school of rational choice. Child No. 1 was toilet trained with the promise of jelly beans. Every member of the household received one jelly bean (or two – don’t ask). Child No. 1 would monitor the administration of rewards, standing outside the bathroom and asking whether Daddy had earned one jelly bean or two.

Sadly, jelly beans proved insufficiently motivating, so the reward was then ratcheted up to chocolate frogs. These were hugely motivating – so much so that the toddler spent literally hours on the lavatory waiting for something to emerge so that she could collect her reward. The entire system took some fine tuning.

Child No. 2 achieved a real coup when he earned a toy by emerging from his room with dry training pants every night for a week. Alas, he achieved this by changing his pants in the morning. When told this was against the rules, he simply removed his training pants and left them by the bed, wetting it but keeping the training pants bone dry, as the bonus scheme required. It’s a witty and instructive episode – and the lesson should be noted not just by parents but by anyone setting an investment banker’s bonus.

The Gans family solved the problem for Child No. 3 by outsourcing potty training to daycare. If only we could do the same for Wall Street and the City.

First published, Financial Times, Life and Arts, 18 April 2009

18th of April, 2009Other WritingComments off

Has my neighbour confused me with God?

Dear Economist,
When my neighbour was desperately searching for staff to run her guesthouse, I, after due deliberation about whether to get involved and much trouble, eventually found her a married couple who complied with all her demands. She now thanks God for bringing them to her.
Do you think she’s confusing me with God? If so, should I gently remind her that I’m a simple earthly being and such high praise is making me feel a little uncomfortable? I would prefer you not to use my real name; I don’t want any more people contacting me in search of miracles. In any case, my husband thinks this business has gone to my head.
Mrs S., South Africa

Dear Mrs S.

I would say that a more likely explanation of your neighbour’s actions is that she is trying to ingratiate herself with God, not you. I can imagine how aggravating this is for you, given the trouble you’ve gone to, but this attitude makes sense if God is subject to flattery. God is, after all, omnipotent, so it must be better to have God on your side than plain Mrs S.

The question is, does God pay attention to supplicants? No less an authority than Nobel laureate James Heckman has investigated the answer using highly fashionable statistical techniques. (Some claim that Heckman’s paper is a parody of sloppy statistical practice. I couldn’t possibly comment.)

Heckman observes that “the empirical conclusion from this analysis is important. A little prayer does no good and may make things worse. Much prayer helps a lot.” This is fascinating, suggesting that sit-on-the-fence agnostics are choosing a very foolish approach. Your neighbour has taken this lesson to heart: given the importance of extremely fervent prayer, small wonder that she is giving God all the credit for your hard work.

Also published at ft.com.

11th of April, 2009Dear EconomistComments off

Are those who sweat the big stuff in meltdown?

A confession: I was never very good at macroeconomics as an undergraduate, and my postgraduate studies were even more of a challenge. My lecturers described the economy as the solution to an inter-temporal optimisation problem in which a single representative household decided how much to consume and how much to save. I struggled with the sums (they were hard ones) and almost as much with the entire concept, which seemed to ignore what was interesting about macroeconomics. I did what I could, passed my exams and concentrated on microeconomics instead. (Those confused should recall P.J. O’Rourke’s explanation of the difference between the two: microeconomics concerns things that economists are specifically wrong about, while macroeconomics concerns things that they are wrong about generally.)

I do not regard my own confusion as an indictment of modern macroeconomics, but I am struck by the soul-searching that has gripped the profession in the face of the economic crisis. The worry is not so much that macroeconomists did not forecast the problem – bad forecasts are more a sign of a complex world than intellectual bankruptcy – but that macroeconomics seems unable to provide answers. Sometimes it cannot even ask the right questions.

Willem Buiter, a former member of the UK’s Monetary Policy Committee who blogs for the FT, complains that macroeconomists have simply discarded the difficult stuff to make their models more elegant: “They took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved.”

He is not alone in his frustration. Paul Krugman, a left-leaning New York Times columnist and the most recent winner of the Nobel memorial prize in economics, thinks macroeconomics is in a dark age, in the sense that rather than discovering new insights, we are actually going backwards and forgetting what we used to know. Mark Thoma of the University of Oregon, another influential economics blogger, opines: “I think that the current crisis has dealt a bigger blow to macroeconomic theory and modelling than many of us realise.”

We shall see. While many commentators have reached for Keynes – or some caricature of Keynes – as a solution to this crisis, this is not because he is the fount of all knowledge, but because he was asking good questions about problems that now seem relevant again.

Economists now understand much more than Keynes ever could about networks and complex interactions (thanks to agent-based modelling), psychology (thanks to behavioural economics) and the real world (thanks to econometrics). In principle, these advances should inform our understanding of the crisis. An early attempt is Animal Spirits, a book by George Akerlof, a Nobel laureate, and Robert Shiller, who identified the housing bubble early. But macroeconomics has a lot of momentum and it will take time to turn the oil tanker around.

Justin Wolfers, a new editor of Brookings Papers on Economic Activity and an unabashed microeconomist, says that, “formally elegant but empirically irrelevant macroeconomists had a much harder time getting hired this year,” while Buiter reckons that the central banks have already jettisoned conventional macroeconomics in favour of a pragmatic combination of hunches and judgment calls. If so, the market for macroeconomic ideas seems to be self-correcting – much like the market for financial weapons of mass destruction. It is just a shame, in both cases, that the correction did not come more smoothly and much, much earlier.

Also published at ft.com.

Who gets which room in a rented house?

Dear Economist,
I am moving into an eight-bedroom flat with seven friends in a few months and need to decide fair rates for each of the rooms. Assuming some people want cheaper rent and some want nicer rooms, what is the fairest way to split the total monthly rent of £3,200 and decide who gets what?
Student, St Andrews

Dear Student,

I have answered a very similar question before, but for three people rather than eight. My solution then – a modification of “one cuts, the other chooses” – would not work for you. Therefore I propose a simultaneous ascending auction of the largest seven rooms; whoever does not win one of the largest seven gets the smallest room at whatever rent is necessary to bring the total to £3,200.

Bidding proceeds in rounds. In the first round, any student may choose to bid on any of the seven largest rooms, in increments of £5. Ties are broken with the toss of a coin. In each subsequent round, students without rooms must submit a bid to exceed the current high bid by £5. Any incumbents thus dislodged can bid on any room in the following round.

The auction ends when seven students are incumbents in the seven rooms, and the eighth student does not wish to outbid any of them, but would rather take the small room and pay the balance of the £3,200. (If the bidding is frenetic enough, she may be paid to take the small room.)

At any time, roomless students have an incentive to bid on whichever room offers the best combination of price and quality – or to drop out if they think the smallest room looks cheap. But beware: such an auction is neither foolproof nor, if some players decide to collude, cheat-proof. Still, perfection is for mathematicians, not economists.

Also published at ft.com.

4th of April, 2009Dear EconomistComments off

A capital idea to get the banks to start lending again

I’ve been weighing up a very elegant treatment for the banking crisis that has been buzzing around the economics blogs – so elegant, in fact, that it took me several days to convince myself that it wasn’t just a logical sleight of hand, the kind of subtle fallacy that mathematicians use to “demonstrate” that 1+1=1.

One way to understand the banking crisis is that the banks cannot raise new money and lend it to people who could use it. This is not because there is no money, or no deserving investment projects. It is because the banks, whose assets are worth less than they hoped, are now weighed down by their existing promises to repay depositors and other creditors. They cannot raise fresh money because nobody wants to lend money to a near-bankrupt bank.

So far, governments have been trying to raise or at least stabilise the value of bank assets, but an alternative is to reduce the burden of their liabilities.

The elegant approach I’ve been examining has been developed by long-time collaborators Jeremy Bulow and Paul Klemperer. They suggest splitting crippled banks such as Citigroup or RBS into a good “bridge” bank and a bad “rump” bank. The bridge bank gets all the assets, even the so-called “toxic” assets. These are not truly toxic, simply worth less than everyone hoped. The bridge bank also inherits sacred liabilities such as deposits. The rump bank gets no assets, only the debts the old bank used to owe to creditors.

With a leap and a bound, the bridge bank is well-capitalised and capable of raising new funds to lend out to good projects. Depositors feel secure and the economy acquires a functioning bank. The rump bank, of course, is a basket case, so one might think that the shareholders and creditors in the rump bank have suffered expropriation. They have not: Bulow and Klemperer propose giving all the equity in the bridge bank to the rump bank – this is full and fair compensation. The rump bank may well go bankrupt and the creditors will have to see what they can salvage – which will include shares in the bridge bank. But the bankruptcy process will not damage the bridge bank, nor prevent it from raising new money and making fresh loans.

The plan may not work, for a number of reasons. The most serious objection is that everything is now systemic, and that allowing creditors to lose a percentage of their claims – despite the fact that they lent money to the banks without any government guarantee – may cause further bankruptcies. Even so, the Bulow-Klemperer plan allows the government to pour further money into the banks in a more transparent way: to the bridge bank if the concern is to ensure well-capitalised banks; to the rump bank’s creditors if the concern is to prevent a chain reaction of bankruptcies. Transparency, of course, may be the last thing governments want, given the possible sums involved.

If you are still blinking at the idea that one can produce a healthy bridge bank like a rabbit from a troubled-bank top hat, without injecting new funds and without resorting to expropriation, you should be. But it is true. The confusing thing about the financial crisis is that the physical economy is in the same shape as ever, but it can be paralysed if investment money cannot flow from those who have it to those who can use it. A tangle of – unpayable? – claims against the banks is, like some modern-day Jarndyce and Jarndyce case, stemming that flow. Bulow and Klemperer try to set the tangle to one side to be resolved while the banks continue their business. Put like that, the idea does not seem like such a conjuring trick.

Also published at ft.com.

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