Tim Harford The Undercover Economist

Articles published in January, 2010

Does the altruism theory help anyone at all?

People respond to incentives, so if you want something done, reach for your wallet.That’s what you’d expect an economist to say, but it is a belief that infuriates many commentators.

I will concede that offering cash is not always productive. In the days when I was young, free and single, I was never tempted to try to seduce cute girls at parties by slipping them a couple of crisp twenties. (Perhaps I should have done it. It is not as if my hit rate on an unpaid basis was particularly good either.)

Yet many policy wonks believe not just that there are some things that money can’t buy, but that cash incentives are counterproductive and even morally corrosive. The touchstone of this school of thought is Richard Titmuss’s book The Gift Relationship, published in 1970.Titmuss’s most memorable and influential claim was that the British system of voluntary blood donation led to better outcomes – healthier blood, supplied in a more timely fashion – than the American system of paying blood donors.

Titmuss’s argument was influential. In an example made famous by Freakonomics, when parents at an Israeli kindergarten were fined a small amount for showing up late to collect their children, their punctuality actually declined. The behavioural scientists Dan Ariely and James Heyman asked experimental subjects to perform a boring task; those paid a few cents did less work than those paid nothing at all.

Another experiment showed that when kindergarten students were given little awards when they drew with crayons, they tended to refuse thereafter to draw for nothing. Who colours in for free, anyway?

And there is even the evergreen idea that by underpaying nurses, we might attract the right kind of people – those with a vocation.

I can’t help feeling that we believe in the altruism thesis so strongly because it feels like the way the world should work. But the empirical support for the belief is thinner than we like to think. In the Ariely-Heyman experiment, a payment as low as five dollars was enough to remotivate their subjects. It was only the laughably small payments that caused problems. Bear in mind, too, that Ariely and Heyman were not trying to test a hypothesis about payment for performance, which is why they did not make the reward conditional on results.

Attachment to the Titmuss hypothesis has the power to cause harm. The psychologist Barry Schwartz used the kindergarten experiment to excoriate an experimental New York schools programme which paid older children to show up and work hard. It was depressing to see a write-up of a small experiment being used to argue that New York should not run a large and realistic one.

The “cheap nurses are good nurses” thesis is demonstrably false; in the British health service, the economists Emma Hall, Carol Propper and John van Reenen have shown that lower real wages for nursing staff mean more temporary staff, more overpromoted staff – and more patient deaths. As for blood donation, Titmuss’s thesis is far less pressing now that better blood-screening techniques have been developed. It is not clear how solid the idea was, since he himself complained about the lack of good data. But perhaps he was right that paying for blood was counterproductive.

Still, it is interesting to see a new study by the economists Nicola Lacetera, Mario Macis and Robert Slonim concluding that paying for blood increases the quantity donated without lowering the quality. Distasteful it may be, but sometimes the way to get results is to pay for them.

Also published at ft.com.

Can a cheap wine be a winner at dinner?

Dear Economist,
As an economics student, I look to impress my girlfriend on a budget, and I know I am not alone. When it comes to choosing the wine to have with dinner, on the rare occasion that I get to take my girlfriend out, I avoid going for the cheapest bottle, as this makes me look, er, cheap. So instead I go for the second-cheapest bottle. But now I hear that restaurants, having cottoned on to people like me, ensure the second-cheapest bottle is highly profitable, overpriced plonk. My best response now is to go for the third-cheapest bottle, at least until everyone else does the same. Or is it? Based on price alone, what is the best bottle to buy?
William Nicolson

Dear William,

You assume that the price of the wine and its quality can be neatly separated out. This seems reasonable, but is wrong. Price changes the very experience of quality. Neuro-economists have found, for instance, that while placebo painkillers work, they work best if the subject thinks they are expensive. Energy drinks give you less energy if you buy them at a discount. (Yes, really.) And of course, wine tastes better if you believe that it is expensive.

One possibility is to conceal the price of wine from your girlfriend and tell her you’re buying the expensive stuff when in fact you are buying the house red. This is a white lie: many people prefer the taste of cheap wine in blind tastings, and by claiming it is expensive you will quite genuinely improve the way she thinks it tastes.

If your girlfriend knows nothing about wine, this will work. If she knows more than you about wine – which seems likely – then why not invite her to choose? You’ll get a better bottle. And if she blithely splashes your money around, console yourself: you will have learnt a lesson about her that would have been even more costly to learn later.

Also published at ft.com.

30th of January, 2010Dear EconomistComments off

Should we rethink the reasons for divorce?

Dear Economist,
The betting markets reckon Elin Nordgren will shortly divorce Tiger Woods. Considering the experiences of the wives of Shane Warne and Bill Clinton, that seems hasty. Shane Warne’s wife tolerated his scandals for years before divorcing him. Australian cricketers do not make as much money as global golf stars, hence, the probability of her receiving a large alimony was low. It would have been rational for someone in her position to try to salvage the marriage and lay aside their emotions. Hillary Clinton had a much lower probability of political success as a divorcee.
I think we should look at economic rather than emotional reasons for divorce. Have I discovered a new canon in marital economics?
Chetan S.

Dear Chetan,

Your theory goes well beyond Ray Fair’s “Theory of Extramarital Affairs”, published in the Journal of Political Economy. Still, you need to clarify your reasoning a little. You contrast Shane Warne’s earnings with those of Tiger Woods, which suggests you have in mind some kind of income effect, where the richer the husband, the more likely the wife is to divorce him. This has the merit of being a falsifiable theory, but I am not sure it is true.

Such cases belong instead to the theory of the firm. When two units of production – Hillary and Bill, say – are worth more together than they are separately, we call them “complementary assets”, and there is a strong reason to keep them together. If one of the units of production is sleeping with a pancake waitress, then that is a reason to separate them. It’s all a question of how annoying the affairs are versus how strong the complementarities are. Hillary and Bill are highly complementary assets; this is less obvious for Nordgren and Woods. As for a general theory, there is plenty of data out there – a research project for a diligent student of economics such as yourself?

Also published at ft.com.

23rd of January, 2010Dear EconomistComments off

Why US banks and taxpayers owe big thanks to Hank

On October 13 2008 – a public holiday in the US – the Treasury Secretary of the day, Henry “Hank” Paulson, summoned bank bosses to a meeting and made them an offer they couldn’t refuse: $125bn of taxpayers’ money in exchange for equity in nine US banks. Some banks, such as Citigroup and JP Morgan, received as much as $25bn each. The Treasury also guaranteed new issues of bank debt. It was a bail-out of enormous value to bank shareholders and bondholders, so it can hardly be a surprise that the Obama administration is planning to try to get the money back with some kind of levy.

But how much did the banks benefit from Hank Paulson’s “gift”? Did the policy have the desired effect? If so, why? All these questions are answered in research carried out by Pietro Veronesi and Luigi Zingales, economists at the University of Chicago, updated last month. One fascinating conclusion is that Paulson, a former chief executive of Goldman Sachs, may have missed a huge money-making opportunity.

The plan apparently stabilised the financial system in the short run; in the long run, it may have the opposite effect by encouraging some future generation of bankers to take more risks. Both these effects are impossible to quantify.

Veronesi and Zingales restrict themselves to the narrower question of whether the gain to bank shareholders and bondholders outweighed the loss to the US taxpayer. (Perhaps that sounds like a low threshold. It isn’t: most government protection costs the taxpayer or consumer far more than they ever benefit the beneficiaries – witness almost every trade tariff in history.) They conclude that shareholders and bondholders in the banks were about $130bn better off as a result of Paulson’s gift. Taxpayers stumped up less than that, taking a loss of perhaps $20bn-$45bn. As much as $5 may have been gained for every tax dollar spent. Infuriating as it may be to those taxpayers who had no desire to write a cheque to bank bondholders, it may be some consolation that the policy was terrific value for money.

It is no surprise that injecting cash into banks would increase the wealth of their shareholders and bondholders. What is less obvious is why the effect was so large. Veronesi and Zingales believe the gift prevented runs on the banks, the risk of which was depressing bond and share prices. A bank run is a situation where a bank can be bankrupted simply on the strength of the fear that it might happen. If a government guarantee can relieve such panic, it can create great value at little cost. And, indeed, the banks that gained most from Paulson’s gift are also the banks that were in imminent danger of a run.

The mix of guarantees and equity injection also appears to have been superior to most of the other ideas floating around at the time. The original idea behind the Troubled Asset Relief Program (Tarp) was to buy assets from the banks, apparently at market value. This would have required a cool $4,000bn of purchases and subjected the taxpayer to enormous risks – and profit opportunities. A straight equity injection also looks expensive and would have required near-nationalisation of many banks.

Pats on the back all round then. But one lingering question: if the plan created such gains, why didn’t Paulson ask for more from the banks, as Warren Buffett had done three weeks earlier when he invested in Goldman Sachs? Veronesi and Zingales reckon that if Paulson had secured the same terms as Buffett, the taxpayer would have made more than $40bn, a roughly even split with the banks’ creditors. Easy to say now – but it would have made a big difference to the politics of the bail-out. No wonder the Treasury is drawing up a bill for services rendered.

Also published at ft.com.

Lessons in complexity, from a field in Afghanistan

Just over two years ago, British soldiers in a remote region of Afghanistan came across a solitary man sowing seed – wheat rather than poppies. This was risky and unusual: a planting at the turn of the year was very late, and the area had been made dangerous by incessant fighting. But the farmer had his reasons. Benazir Bhutto, the former prime minister of Pakistan, had been assassinated a couple of days earlier. The man reckoned that wheat prices would soar as a result and wanted to cash in.

The story – told by Major General Andrew Mackay CBE and Commander Steve Tatham in a new paper on “Behavioural Conflict” for the UK’s Defence Academy – illuminates the situation facing coalition forces in Afghanistan. There has been a tendency among commentators and politicians to treat the “hearts and minds” aspect of counter-insurgency as a popularity contest. But the “voters” are not casual spectators, trying to choose between the Taliban or the coalition forces; they are individuals weighing up complex choices in difficult circumstances.

I met Andrew Mackay, who commanded 52 Brigade in Helmand Province (and who announced his resignation from the army in September), because of his interest in the problem of influence in conflict situations. He was reading books about behavioural economics, including my own, in the hope of adding some insight to experience gained in the field.

Some of the more successful tactics in Iraq and Afghanistan have indeed been built on the simple economists’ prescription: if you want to change behaviour, change incentives. For example, killing insurgents without holding territory did not encourage co-operation from bystanders, as anyone who had collaborated would be killed when the insurgents returned. When coalition forces switched to the tactic of holding territory and preventing the return of insurgents, people became happier to share information.

The more psychologically detailed insights of behavioural economics may also be promising. Mackay and Tatham cite Afghanistan’s National Solidarity Programme as an example of the “choice architecture” described by policy guru Cass Sunstein and the behavioural economist Richard Thaler. The NSP handed out grants to villages, provided the village leaders were elected by secret ballot, held communal meetings, and posted accounts in a public place: a nudge towards better governance.

Yet it is unrealistic to hope for too much oven-ready insight from behavioural economics. The armed forces need to develop their own approaches, and this cannot be done from Whitehall. A patrol leader will have to make his own decisions about how to influence the local population. Without the right training, they will often be bad decisions. Mackay and Tatham offer a worrying analysis: the British armed forces have little expertise in psychology or public relations, and what expertise they do have is centralised. British research capability in this area is weak, and is being dismantled.

Whether or not generals can learn from economists, economists can certainly learn from generals. I have been as guilty as anyone of being fascinated by behavioural economics. But the financial system did not fail because of some psychological trait, but because it was riddled with damaging incentives that were hard to spot because the system was complex and changing quickly. So, too, with counter-insurgency: Mackay started by thinking about economic psychology but ended up focusing on complexity, and what it takes to create an organisation capable of adapting to complexity. It has taken me too long to come to the same conclusion myself.

Also published at ft.com.

How can I bring my son to book?

Dear Economist,
This Christmas, I asked my three children, aged 19, 18 and 16, for the following present: that they read the book Notte, Nebbia, a true story set in Gusen concentration camp, to help them remember the importance of tolerance, justice and freedom. This was also a condition of them receiving their Christmas presents, three presents for each child.
The girls read the book and received their presents. The boy (18) didn’t finish it. He said he couldn’t read a sad story during his holidays. So he received only two presents. What am I supposed to do? To hide the last present until next Christmas? To ask my son to finish the book and to read another one as a penance, or to think in a different way? Am I insane?
Francoise Gilli

Dear Francoise,

It is hardly insane to give your children incentives to do your bidding, but you have clearly bodged this scheme.

First, behavioural economists have found that offering miserly incentives can discourage people, relative to no incentives at all. Your incentive was a gift that most children tend to expect with no strings attached, which seems a miserly payment. No wonder your son disobeyed you, and I doubt if your daughters were quite as compliant as you imagine.

Second, you made a fundamental error by making a non-credible threat. You tacitly admit that it would be silly to hide the present until next Christmas, while demanding a second book compounds your folly. Game theory says that non-credible threats will be ignored, and your son is evidently a game theorist.

This is a lost cause. If you wish to control your children’s reading, I advise a significant incentive payment on top of the customary present. Alternatively you could simply recommend a book wholeheartedly. They may not read it, but at least you will look less foolish.

Also published at ft.com.

16th of January, 2010Dear EconomistComments off

Why are traffic jams so bad on Mondays?

Dear Economist,
I have always been curious about two things. First, why are traffic jams always heavier on Mondays than on other weekdays? Second, I wonder why traffic is heavier when it rains. I know drivers get more cautious on rainy days, but even when it rains so little that I can hardly feel the raindrops, the traffic gets a lot heavier than on sunny days. Why?
Confused commuter, South Korea

Dear commuter,

I began by checking the data, and they surprised me. Inrix, who supply data to in-car satellite navigation systems, reports that the worst mornings of the week – in the US, at least – are actually Tuesday, Wednesday and Thursday. Monday and Friday are low-congestion mornings. Friday evenings are bad, but Monday evenings are particularly quiet. My guess is that Monday is a popular day to take a holiday or call in sick.

As for data on rain, two Australian academics have found that the heavier the rain, the lighter the traffic in Melbourne. You are asking me to explain two illusory phenomena.

So what is going on? One possibility is that things are different in Korea, but I am not so sure: I think that Australians, Americans and we Brits all share your perceptions that rainy days and Mondays are bad for traffic. And we seem to be wrong.

I think we need to turn to psychology for our answers. Norbert Schwarz – a psychologist who is well known to economists thanks to his work with Nobel laureate Daniel Kahneman – has famously showed that if you want people to tell you that their lives are a wreck, just ask them on a rainy day. There is also some psychological evidence that Monday mornings depress us, too.

In short, rainy days and Mondays always get you down. You’re living in a Carpenters song, but please don’t blame the traffic.

Also published at ft.com.

9th of January, 2010Dear EconomistComments off

Stimulus spending might not be as stimulating as we think

Few things annoy me more than rhetoric that implies government spending is funded by the generosity of ministers rather than by taxpayers. (Alistair Darling’s pre-Budget report speech included lines such as, “Mr Speaker, we chose not to let people sink when they lost their jobs but to intervene to help them stay afloat.” No, Mr Darling, you didn’t – the taxpayer did.)

Such quibbles aside, it seems only sensible that when unemployment rises and companies stumble, the taxpayer should take up the slack. And yet the economic case for government stimulus is far from clear cut. Stimulus spending can erode private spending. My wife, for example, is a portrait photographer. Recently she secured a contract from a local council that kept her busy for weeks. While she was working on it she kept her head down, actively avoiding work in the private sector. A company looking for a photographer would have had to go elsewhere, perhaps paying more for an inferior snapper, perhaps giving up on the whole business.

The pro-stimulus view is that the government hires otherwise-unemployed workers, who spend money, which is used to hire other otherwise-unemployed workers, who go on to spend more money, and so on. No wonder such government spending is said to have a “multiplier”. But the example of my wife suggests that the multiplier could also be zero. Rather than reducing unemployment, the government may be shifting workers from the private to the public sector.

There is nothing absurd about assuming a multiplier of zero. It is implicit in the traditional cost-benefit analysis of government projects, photographic or otherwise, which simply asks whether the projects should go ahead on their own merits, rather than speculating on all the jobs that might be multiplied into existence. If the multiplier is zero and you want to spend a billion dollars on bridges, then make sure you think the bridges are worth a billion dollars.

If government spending snarls up the economy, the long-run multiplier might well be negative (look up “Soviet Union” in any encyclopedia). But the assumption has tended to be that it is positive, at least in times of recession. In his General Theory, Keynes outlines an example with a multiplier of 10. President Obama’s Council of Economic Advisers puts forward a multiplier of 1.6, which seems modest in comparison. But even a multiplier of 1.6 would be impressive. It means that if the government spends a billion dollars building a few bridges, the knock-on effects will be to increase the size of the private sector by $600m. We get the bridges, and we get more of everything else, too. With a multiplier of 1.6, paying people to bury money and dig it up again is sound policy. Even a multiplier of 0.5 would mean we could get a billion dollars of bridges while losing only $500m of private sector activity – a pretty good deal.

This analysis helps to clarify what we’re talking about. But it does not tell us what the multiplier is. I have seen estimates based on careful work by respected economists that range from zero to 1.5 – perhaps higher still if we think the world economy was on the brink of depression in 2009.

It should be no surprise that there is disagreement, sometimes ill-tempered disagreement. Government spending varies because the economy is in flux; it is almost impossible to say what causes what, and the tantrums tend to be about whose methodology is the least absurd.

My own conclusion: government projects probably do enjoy a multiplier-related discount in straitened times. But it is still worth asking whether the projects themselves are worth doing.

Also published at ft.com.

My girlfriend’s the rich one, yet I pay…

Dear Economist,
I’ve been dating a great, loving and caring woman for a year and a half. She’s in her early thirties – eight years older than me – and works as a senior manager in a big company; she earns around £60,000pa, and her company provides a car and a city-centre flat. I am about to finish my PhD and my stipend is £14,000pa.

We’re in love and think it’s about time to move our relationship to the next level – which is moving in together. However, I feel that my girlfriend is stingy towards me. I’m the one who treats at posh restaurants and buys expensive gifts, and when we spoke about me moving into her flat she said that I’d have to pay the bills in return.

I’m finding it silly to mention such things, but they do annoy me. Am I shallow, greedy and opportunist? I understand her pay isn’t supposed to be a perk of our relationship but I must admit that, deep inside, I feel that a better lifestyle out of it wouldn’t go amiss.
Confused student

Dear Confused,

Your girlfriend is testing you, and you are at risk of failing. Naturally she is pleased to have a young, intelligent boyfriend, but she is worried that you only love her for her cash and will dump her for a younger model once you have a decent income of your own.

So she is using a “screen”, as described by Nobel laureate Michael Spence. By ensuring that she remains a cost centre rather than a cash cow, she is creating a situation that would be intolerable to a genuine gold-digger. She wants to see how you react, but by assuming that the “next level” is a free apartment for you, rather than a proposal of marriage, you are simply confirming her fears. Forget the flat, buy her a diamond ring, and she will mellow.

All this assumes, of course, that she is not just a miserly sociopath. Either way, good luck.

Also published at ft.com.

2nd of January, 2010Dear EconomistComments off

Lights on – or off? Low-carbon living is anything but easy…

Those of us resolving to lead a lower-carbon life in 2010 could do worse than acquire a copy of Prashant Vaze’s new book, The Economical Environmentalist, in which the author picks over the fine details of his life. He works out how much CO2 he could save by driving more slowly, installing loft insulation or becoming a vegetarian. The result will be a little dense for some, but it is delightfully geeky and has the virtue of being right more often than not.

This virtue is underrated. Environmentalists have been slow to realise that the fashionable eco-lifestyle is riddled with contradictions. The one that particularly exasperates me is the “food miles” obsession, whereby we eschew tomatoes from Spain and roses flown in from Kenya, in favour of local products grown in a heated greenhouse with a far greater carbon footprint.

Other less-than-obvious truths are: that pork and chicken have substantially lower carbon footprints than beef and lamb (yes, even organic beef and lamb); that milk and cheese also have a substantial footprint; that dishwashers are typically more efficient than washing dishes by hand; and that eco-friendly washing powders may be distinctly eco-unfriendly because they tend to tempt people to use hotter washes.

My conclusion is that a well-meaning environmentalist will make counterproductive decisions several times a day. I don’t blame the environmentalists: the problem is intrinsically complicated. Over a vegetarian curry in London recently, Vaze ruefully described to me the “six bloody months” he spent trying to research an eco-renovation of his home.

Even the experts can tie themselves in knots. Duncan Clark, author of The Rough Guide to Green Living, unveiled “10 eco-myths” in a Guardian podcast in November. Many of them were well chosen, but unfortunately his number one “myth” was not a myth at all: that switching off lights will reduce CO2 emissions. Clark’s logic is seductive: some European carbon emissions, including those generated by electricity, are subject to a cap. Clark is right to say that conserving electricity will allow other sectors to take up the resulting slack, because they will be able to buy permits to emit more cheaply than if we left our lights blazing.

Where Clark goes wrong is in assuming the cap will remain fixed forever. If we all turn out our lights, the price of permits will fall and politicians will find it politically easier to tighten the cap. So, keep installing those energy-efficient light bulbs. (Another less-than-obvious truth is that it’s not worth waiting for your old bulbs to burn out before you fit the new ones.)

After picking through the ideas of Vaze, Clark, David MacKay (a Cambridge physicist) and others, my view is that it is hopeless to expect that volunteers will navigate this maze of decisions.

That is why a broad-based, credible carbon price will be the foundation of any successful policy on climate change. The price would affect the cost of every decision we make; it would take away the guesswork. Current carbon pricing schemes, such as the European emissions trading scheme, are a good start, but they leave out too many sectors, and permits are too cheap.

And a final admission: not every feature of the low-carbon lifestyle is impossibly obscure. I felt rather smug when I realised I could stop drinking cappuccino in favour of espresso, saving 90kg of CO2 a year. Then I totted up my carbon footprint from air travel in 2009. It is the equivalent of almost 50 tonnes of CO2 – or more than the entire footprint of a typical British family of three. It doesn’t take a genius to figure out how to shrink that particular footprint. This year I shall do better.

Also published at ft.com.


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