Tim Harford The Undercover Economist

Articles published in June, 2009

Business Life: Macromaths

First published in Business Life, February 2009
I was recently invited onto a prestigious radio program to debate a provocative idea: perhaps we should stop giving money to charity and instead spend it on the high street to stimulate the economy. I declined.
This is one of those economic ideas that sounds plausible as long as you don’t think too hard about it. The numbers simply don’t add up. Economists are concerned that the recession may consist of a fall in economic growth from about three per cent to zero growth or below. But according to the Johns Hopkins Comparative Nonprofit Sector Project, the British give less than one per cent of their income to charity, far less than a three or four per cent drop in economic output. Economic stimulus is one thing, magic is another.
Not only is the idea daft in practice, it doesn’t even work in theory. Charities spend money too. They buy equipment, rent and maintain offices, and employ staff. There is absolutely no reason that the economy should be stimulated more by shopping than by giving money to a charity and letting the charity shop instead. (I’ll admit that some charities spend a lot of their cash overseas, but the same is true of many high street retailers, whose supplies are often produced abroad.)
Perhaps we put too much faith in the idea that all the economy needs in a recession is a bit of “stimulation”. Sadly, things are rarely so simple. Think of the government “fiscal stimulus” so much in vogue across the world as the recession tightened its grip at the end of the last year. The popular understanding of a fiscal stimulus is that the government cuts taxes, and the grateful citizenry spends the windfall.
That can indeed happen, but it is easy to forget that if government spending doesn’t change, then tax cuts today mean a rise in government borrowing and tax rises tomorrow. In other words, the government is borrowing money in our name and giving us the proceeds; but we’ll have to foot the eventual bill.
Should we really spend more under those circumstances? After all, one logical response would be for taxpayers to save the money (or use it to pay off debt) in readiness for the day when taxes rise and the government asks for the money back.
Economists call this idea “Ricardian equivalence” – an idea dating back two centuries to classical economist David Ricardo – which means that government taxes and government borrowing are roughly equivalent. The taxpayer always picks up the tab in the end.
In the credit crunch, a fiscal stimulus may work after all, for one simple reason: some consumers desperately want to borrow money but the banks won’t lend it to them. But that is not what we usually have in mind when we think of the free lunch that our governments are cooking up for us all.

30th of June, 2009Other WritingComments off

Why weather forecasts can affect your prosperity

Spare a thought for the weather forecasters. Taken for granted when they get it right, they are invariably whipping boys when they get things wrong – despite a far better forecasting record than we economists have. They probably have more to contribute to the economy, too.

A recent case in point: Bournemouth’s woes during the bank holiday at the end of May. The Met Office predicted storms, but the beach resort in fact enjoyed the sunniest day of the year. Bournemouth’s tourist office reckons the town missed out on at least 25,000 visitors and more than £1m of revenue as a result. Subtler losses and gains were registered by the would-be tourists, and the lucky ones who enjoyed both a sunny day and a quieter beach.

Tourists have always been vulnerable to the weather, but they may now be more vulnerable to weather forecasters. The internet has made it easy to check the forecast and easy, too, to make late bookings for short breaks – which are self-evidently more responsive to the weather.

Galvanised by Bournemouth’s woes, I did some research into the economics of weather forecasting for a short BBC documentary. What surprised me was the sheer range of industries that could save money if given a reliable forecast.

Electricity generators need temperature forecasts to gauge the demand for power, and electricity generation itself is weather-sensitive. It’s not just a case of windmills and solar panels: gas-fired power stations are more efficient at lower temperatures. Without a good forecast, both energy and money will be wasted.

Local governments are responsible for salting and gritting roads as they freeze. It’s a costly process, best avoided if the roads are not, in fact, going to freeze at all. Supermarkets consult detailed weather forecasts and adjust the local product mix accordingly. An extra day’s reliable warning of the local weather is a godsend.

The vulnerability to bad weather is even higher in developing countries, sometimes with tragic consequences. As I reported in a column last year, the economists Emily Oster and Ted Miguel have investigated the link between bad weather and “witch” killings. Miguel found that modern-day witch-killings in Tanzania are correlated with droughts and floods. Oster, building on research by historian Wolfgang Behringer, found a connection between cold decades and witch-trials in 16th- and 17th-century Europe.

MIT economist Michael Greenstone has studied the impact of local temperature surges on deaths in both India and the US. He calculates that a year with one extra “heatwave” day – temperatures above 32°C instead of 12°C-15°C – would raise the annual death rate by eight per million in the US. In India, the temperature vulnerability is more than five times higher, notably in rural areas where agriculture suffers and wages drop.

Weather forecasting cannot prevent heatwaves, but it can help in other ways. Accurate forecasts can allow farmers to sow seeds without fear that they will be washed or blown away. A study from the mid-1990s – admittedly, conducted by the World Meteorological Organization – concluded that every dollar invested in weather forecasting services would save $10 in economic losses.

The World Bank broadly agrees, and is supporting Russian efforts to reinvigorate forecasting systems that have been deteriorating since the collapse of the Soviet Union.

The World Bank’s researchers reckon that the benefits of such efforts outweigh the costs by five to one. If those numbers stack up, that suggests an unlikely development tactic for poor countries: hire more weather forecasters.

Also published at ft.com.

Does inflation reflect the size of Mars Bars?

Dear Economist,
I wish I frequented the same high street as the statisticians who calculate measures of inflation. Given their calculations include “Various selected popular brands of sweets, chocolates, gum”, will they take note of a Mars Bar shrinking in size from 62.5g to 58g while remaining the same price? I make this an effective price increase of 7.76%. If not, when are those lying bastards going to stop lying to me?
Ralph Corderoy

Dear Mr Corderoy,

Your arithmetic is correct but your objection is confused. The statisticians – or “lying bastards”, au choix – do indeed adjust for such changes. It is far easier for them to do that than to make the many other adjustments they attempt every year to cope with the fact that nobody knows how many gramophones there are in an iPod.

Certainly, you are right to suspect that when the bean-counters go out to calculate inflation, they are not buying exactly the same products that you buy. How could they? Some people spend a lot on petrol, heating and mortgage payments; others are more interested in clothes, fast-food and laptops. The statisticians’ best can never be quite good enough.

I will concede, though, that the Mars Bar has been worthy of scrutiny ever since the late Nico Colchester noted in the Financial Times back in 1981 that it was a very stable unit of account. It is a veritable ingot of basic commodities (sugar, milk, cocoa) that has kept its value relative to the price of other goods such as small cars, which have cost about 20,000 Mars Bars for the past 70 years.

Fortunately, there is no strong trend towards debasing the Mars Bar – its weight has always fluctuated. It weighed 57g in the late 1970s and as much as 67g in the mid-1980s: 58g is simply a return to historical norms after something of a Mars Bar bubble.

Also published at ft.com.

27th of June, 2009Dear EconomistComments off

How can we tell incompetent from unlucky government?

“The economy, stupid.” An internal reminder for Bill Clinton’s presidential election team eventually became one of the most famous slogans in politics. The first President Bush was duly kicked out by the voters in the teeth of a recession, and Clinton became the 42nd president of the United States.

That is a common story. While there are exceptions, voters tend not to re-elect governments that have trashed the economy. Barack Obama’s electoral fortunes were clearly boosted by the collapse of the US economy – it is easy to forget that, before Lehman Brothers folded, John McCain had been ahead in the polls. After Northern Rock failed, Gordon Brown hesitated and then decided against calling an early election with the economy looking ropey. Unfortunately for him, it has been looking ropier ever since, along with his approval ratings.

But is this really fair? Gordon Brown’s first line of defence is that we are facing a world economic recession, so it’s not his fault. The opposition likes to point out the corollary: in that case, the good times weren’t his doing either.

There’s truth in both claims. Most domestic recessions have an international component. Japan and Germany are certainly in that situation now, having contracted faster than a cowboy’s lasso. Robert Mugabe must take responsibility for Zimbabwe’s economic disintegration, but it is hard to blame Taro Aso for the fact that Japan’s economy shrank 4 per cent in the first quarter of this year.

The question is, can the voters tell the difference between an incompetent government and an unlucky one? Andrew Leigh, an economist at Australian National University, thinks not. In a recent article in the Oxford Bulletin of Economics and Statistics, he looks at 268 elections held across the world between 1978 and 1999. He estimates how much of a country’s economic performance is due to booms in the world economy and how much is due to competent government – and whether the voters can tell the difference.

Both matter, but as far as the voters are concerned, it is better to be a lucky government than a skilful one. For instance, a one-percentage point increase in world economic growth above the norm is associated with a hefty rise in the chance that incumbents will be re-elected – from the typical chance of 57 per cent to a more than decent 64 per cent. A stellar domestic performance, outpacing world growth by one percentage point, contributes less than half as much to the chances of being re-elected, raising them from 57 to 60 per cent.

Why are voters so wretchedly ungrateful? The common-sense answer is that it is not easy to distinguish a lucky government from a skilful one. In addition – and this point is less obvious – an individual voter has little incentive to do so. We all know that elections are almost never decided by a single vote, and so each voter would be right to conclude that her vote is highly unlikely to make a difference.

We vote for many reasons – a sense of duty, a desire to participate, and so on – but nobody votes under the illusion that it’s all down to him. And if the result does not depend on any particular one of us, trying to disentangle luck from skill by ploughing through the latest reports from the International Monetary Fund is likely to remain a minority hobby.

One other thing: Andrew Leigh finds some slight evidence that countries with high newspaper circulation have voters better able to distinguish luck from skill. Radio does not help, and television makes things worse. One more reason to switch off your set and pick up the Financial Times.

Also published at ft.com.

Which was football’s biggest transfer fee?

Dear Economist,
At the time, Kaká’s transfer fee from AC Milan to Real Madrid was reported to be the largest in the world, clocking in at £57.5m (€67.2m). However, in terms of euros, Zinedine Zidane’s transfer from Juventus to Real Madrid in 2001 was the largest, at €76m (£46m). Given that both transfers happened solely in the eurozone, with no English clubs involved, how can we claim this is a world record transfer?
Ed Lewis, London

Dear Mr Lewis,

The fact that the pound was strong in 2001 and weak today does not justify the suggestion that Kaká’s transfer fee is larger than Zidane’s, so you are right to query the way this has been reported. But the problem goes deeper than you suggest. Even if both transfers had taken place in the UK, a 2001 pound is not the same as a 2009 pound.

I have before me an illustration of the so-called world transfer records, courtesy of the BBC. These start in 1905 with Common (£1,000), move through Jeppson (£52,000, 1952), Maradona (£5m, 1984) and others, to Ronaldo (£80m, 2009). But it is absurd to suggest that Ronaldo’s transfer fee was 16 times greater than Maradona’s or 80,000 times greater than Common’s.

According to www.measuringworth.com, £1,000 in 1905 is worth about £80,000 today if adjusted for retail price inflation, and about £425,000 today relative to average earnings. Maradona’s £5m transfer fee in 1984 is worth £12m or £17.5m today, by the same metrics. Cristiano Ronaldo’s transfer fee of £80m is titanic enough to need no flattering.

I am sure the press fail to make these adjustments because they want to be able to announce new records. In future, perhaps they should first convert all monetary sums into Zimbabwean dollars. Records would tumble daily.

Also published at ft.com.

20th of June, 2009Dear EconomistComments off

How to be a smarter saver

First published: Parade Magazine, 10 May 2009

Not very long ago, Americans were terrible savers. In 2007, the average person put aside 60 cents of every $100, or .6% per paycheck. However, the current economic downturn has shocked us into depositing more at the bank. As of February, the personal savings rate was more than 4%. That’s a big improvement, but it’s still half of 1980s levels, when Americans routinely socked away 10% of their paychecks. Why is saving so hard? And how can we be smarter savers?

Behavioral economists—researchers who mix psychology and economics—have uncovered three reasons why people find it so difficult to save. The first is temptation: Although we often later regret it, we just can’t resist spending. The second is lack of understanding: Our brains can’t quite grasp the profitability of saving. The third is optimism: We believe that everything will work out, even if we don’t save. Learn More

18th of June, 2009HighlightsOther WritingComments off

Is barter the best way to move home?

Dear Economist,
One of the first lessons I learnt in Econ101 was that barter trade is inefficient compared with a money economy. Yet, in an interesting article in the FT’s House & Home section (“Fair Trade”, May 16 2009) I read about the rising popularity of websites through which people can swap houses, instead of buying and selling them. Is this another example of how useful my economics degree is?
Confused Economist

Dear Confused,

Up to a point. Your degree probably did not contain much behavioural economics, and that would have been helpful to understand half of the story. People tend to form strong views about what a fair price is for a house, and behavioural economists call this “anchoring”.

Anchoring can take extreme forms. Experimental subjects have been known to be influenced by contemplating the last two digits of their national insurance number or other obviously random numbers. More commonly, people fixate on what some estate agent told them was their home’s value at the peak of the market. When the market weakens, prices do not so much fall as evaporate, as sellers cling on to the hope of a price that buyers are not willing to pay.

Under the circumstances it should not be surprising that barter has become more common. Neither seller needs to acknowledge that his precious house has become less valuable; they simply recognise the fact that their homes are of similar value and get on with the trade.

Still, the practice is not entirely the product of a psychological quirk. In a market as thin as this one, selling a house and buying another one is a big financial risk. Prices can move a long way before the two trades are finalised, and so swapping hedges both parties against that risk. Your degree has a little life left in it yet.

Also published at ft.com.

13th of June, 2009Dear EconomistComments off

How social science ends up as urban myth

Turn up the lights, and the workers work harder. Turn them down again, and they work harder still. The “Hawthorne Effect” is named after Western Electric’s titanic Hawthorne Works in Cicero near Chicago, where a series of productivity trials was carried out between 1924 and 1932. Led by Elton Mayo, a professor at Harvard Business School, they are among the most famous experiments in social science. Not every social scientist is impressed.

Richard Nisbett, a social psychologist at the University of Michigan, complained to The New York Times a decade ago about the study’s fame, calling it a “glorified anecdote”. He had a point. Among managers, the study is generally held to demonstrate that people respond to change: whatever you do, output rises for a while, as long as you do something. Inside academia, “the Hawthorne Effect” refers to the idea that people work hard once you start experimenting on them. Both beliefs are surprising enough to be interesting, while nicely confirming the prejudices of those who hold them.

Interested psychologists have known for a while that all was not well with the study. The experimental room was smaller and quieter than the factory floor. Two workers were sacked and replaced during the study for talking and idling. Experimental conditions were changed on Sundays, so each surge in productivity coincided with a Monday. These were not controlled conditions in the modern sense.

Yet the story survives. As Nisbett complained, “Once you’ve got the anecdote, you can throw away the data.” And for decades that is exactly what seemed to have happened: the data from the most famous Hawthorne experiment – the illumination study – were thought to have been lost, and perhaps deliberately destroyed.

Now two Chicago-based economists, Steven Levitt (best known as the co-author of Freakonomics) and John List, have unearthed the original data in libraries in Boston and Milwaukee, following clues buried in an appendix to an old article in the American Sociological Review.

Levitt and List are fond of experimental studies, but think the effect of being scrutinised sometimes contaminates such experiments. “We believe that there is a Hawthorne Effect,” says List, referring to the idea that people behave differently when studied, “but there is little evidence of it in the actual Hawthorne data.” As for the idea that turning the lights up and down makes a big difference, Levitt and List conclude that “existing descriptions of supposedly remarkable data patterns prove to be entirely fictional.”

It is not the only time that an experiment’s reputation has far outrun what was actually discovered. In 1967, the psychologist Stanley Milgram asked 160 people in Nebraska to get a letter to a stockbroker in Boston, passing it only to someone with whom they were on first-name terms. The popular account says that the letters arrived after six steps – and that we are all just six handshakes away from anyone on the planet. The reality, as the psychologist Judith Kleinfeld found, was that more than 80 per cent never arrived. Follow-up experiments concur. A recent BBC documentary “recreated” Milgram’s experiment, with a Boston-based scientist receiving parcels from all over the world via only six connections. But 37 of the 40 parcels never arrived.

In some ways, the Hawthorne and “six degrees” experiments are the least troubling examples. They are famous enough to have been challenged. Less celebrated “findings” circulate in academia, exerting plenty of influence. They are never put to the test. Trying to replicate old results is rarely regarded as social science worth publishing in the top journals. That must change.

Also published at ft.com.

It’s a bubble’s effects that are hard to predict

One of the benign side effects of the credit crunch has been the boom in popular awareness of behavioural economics – a discipline that brings psychological insights to bear on economic theory. Behavioural economics books, such as Nudge and Predictably Irrational, have sold well and become influential. That is partly because they are good books, but it is also because a superficial reading of both behavioural economics and the credit crunch can lead to the same conclusion: people are crazy.

Yet, while popular awareness of behavioural economics was overdue, the links between irrational behaviour and the credit crunch are more subtle than they first appear. To see this, one need only re-read the behavioural economics books published before the crisis became severe. Nudge has a section on subprime mortgages, but it focuses on consumer protection. Predictably Irrational is being revised in the light of the credit crunch, but the first edition took a similar line, focusing on the vulnerability of naïve consumers. It does not seem to have occurred to the behavioural economists – even after they had seen the first glimmerings of the credit crunch in 2007 – that the banks would need protecting from themselves. The thought did not occur to many other economists, either.

A critical piece of craziness in the credit crunch was the housing bubble in the US, emulated in the UK and around the world. This bubble was spotted and widely advertised by the behavioural economist Robert Shiller, himself the co-author of a new book, Animal Spirits. Several years ago, Shiller had convinced me and many others that the housing boom was a bubble; five years before that, he convinced much the same crowd of people that the dotcom boom was a bubble, too. David Laibson, another behavioural economist, recently gave a keynote lecture at the Royal Economic Society on the subject of “bubble economics”, in which he sketched out some of the psychological underpinnings of bubbles.

The dotcom collapse was a vindication of the theory that we are inherently bubble-prone. Shiller predicted it – and gave plenty of supporting evidence. After that experience, I am surprised that anyone should wonder why the real-estate boom turned sour.

Just as important is how it brought down the world’s financial system. On that point, hindsight is the most powerful tool of all. Traditional schools of thought in economics also have plenty to contribute.

Around the time the behavioural economics boom arrived, I was writing about perverse incentives in big corporations. I explained that when each company’s shares were dispersed among tens of thousands of small shareholders, nobody had a strong incentive to keep an eye on the management. But the managers had an incentive to conceal their compensation in the form of obscure performance contracts that encouraged risk taking, and in the form of pensions and other deferred compensation. The result: large bonuses, excessive risk, outrageous pensions and pay-offs, all while everyone was acting rationally.

I would love to point to this insight and claim that I predicted the credit crunch, but I did not, any more than did the behavioural economists who (rightly) pointed out that consumers were vulnerable to predatory lenders. There is a difference between spotting a problem and predicting that it will corrode the foundations of the world economy. As we try to diagnose the causes of the crisis, cure the condition and vaccinate against a recurrence, behavioural economics has a rightful place in the doctor’s bag. It will not be a panacea; but then nothing ever is.

Also published at ft.com.

Should I eat cheap food to save money?

Dear Economist,
You have advised readers that, in blind tests, most people like the taste of inexpensive wine, and that their impressions of wine are more closely correlated with the price tag than with expert opinion. In other words, it is possible to save money by drinking plonk. In these straitened times, can we draw similar conclusions about food?
Harry Nicholas, Los Angeles

Dear Harry,

My gurus in these matters are the members of the American Association of Wine Economists, and a new AAWE working paper, “Can people distinguish pâté from dog food?”, suggests an answer to your question. The authors were the “Gonzo Scientist” John Bohannon and two food critics who had worked on the earlier findings on cheap wine.

The appearance of food is key, so it was an important breakthrough to realise that dog food and pâté look much the same – once the former has been blended to a mousse-like consistency and garnished with parsley. In order to win over some subjects without deceit, the experimenters began with a wine-tasting session. Subjects were then offered two quality pâtés, two cheap imitations (puréed liverwurst and puréed spam) and the dog food – all accompanied by Carr’s water biscuits.

The results were surprising. Subjects overwhelmingly rated Dish C (the dog food) as the least tasty. However, few actually thought Dish C contained dog food. Broadly, people thought that Dish E (the liverwurst) was the dog food; they also thought it tasted good. Disappointingly, most people correctly identified the expensive pâtés, and the blind-taste rankings correlated exactly with the (unseen) price tags. In other words, there are no bargains to be had by serving dog food to dinner party guests. No wonder economics is known as the dismal science.

Also published at ft.com.

6th of June, 2009Dear EconomistComments off
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