Tim Harford The Undercover Economist

Articles published in October, 2010

Stimulating debate

Should the government hire people to bury banknotes down disused mine shafts, thus stimulating the private sector to dig them up again? Keynes argued that there were circumstances in which even government spending as wasteful as this could be economically worthwhile, and ever since he did, people have been tying themselves in knots about how fiscal stimulus actually works.

The subject is laden with snares for the unwary, and yet is clearly one of the critical economic issues of the day. Take the infuriating proposition that private-sector workers create wealth, while public-sector workers are simply a cost centre. I’m sympathetic to the idea that competition works better than government targets, and that large-scale nationalisation is a bad idea. But as a matter of logic, the idea that the private sector pays for the public sector makes no sense.

Refuse collection, for instance, is usually done by private-sector companies, but it’s paid for by the taxpayer. Meanwhile the employees of Royal Bank of Scotland are creating wealth (it makes a nice change) yet they are public-sector workers. In the US, hospitals are private businesses paid for by health insurance. In the UK, they are government-run organisations paid for by taxes. Reasonable people could argue about which system is more sensible, but under either system, citizens have to pay, and in return they receive medical care. It is baffling to suggest that in the US system, doctors are wealth-creators while in the UK they are wealth-destroyers.

As for the stimulus itself, common sense is just as treacherous a guide. The naive pro-stimulus view is that if the government keeps half-a-million extra bureaucrats on the payroll, the bureaucrats will spend their salaries in the high street and create other jobs.

The truth is trickier. By hiring the bureaucrats, the government puts upward pressure on real wages. Private-sector firms might have to go without, unable to offer the same perks. Meanwhile, the bureaucrats’ wages must be paid, and since the government does not wish to raise taxes, it must borrow money. This, in turn, may make it harder for private businesses to borrow by nudging up interest rates. Worse, ordinary citizens may stay away from the high street because they are saving up to pay the inevitable higher taxes that lie ahead. In the jargon, government spending may “crowd out” the private sector instead of stimulating it.

Before deficit hawks start quoting this column, just as many questions remain over the opposing view. With unemployment high, is it really plausible to suggest that the private sector is hobbled because the government has snaffled all the best people? With UK and US government bond rates low, has the borrowing spree really squashed private borrowing? If the private sector always rushes in when there are workers standing idle, what happened to Detroit and Liverpool?

The only certainty is that nobody knows for sure how much the stimulus is needed. Historical statistics can only ever be an imperfect guide to macroeconomic policy.

My own belief, for what it is worth, is that there are circumstances when Keynes was right: the fiscal multiplier is sometimes greater than one, meaning that even the mine shaft stimulus programme is worthwhile. The recent recession was one of those times and large deficit spending was appropriate. I am less convinced that the multiplier is still greater than one, although I could very easily be wrong.

A multiplier of less than one simply means this: that government spending is not a free lunch, even though it may be a cheap one. Even as we argue about the size of the state, we should make sure that it does something more useful than burying banknotes.

Also published at ft.com.

Happiness rethink

For many years the received wisdom in economics has been much the same as that in Buddhism: money doesn’t make you happy (see, for instance, “The Seven Secrets of a Happy Life”, FT Weekend Magazine, August 28/29).

I should probably modify my statement though. Economists who study the subject have tended to believe that beyond some minimum, absolute income has little effect on happiness. In any given society, the rich tend to be happier than the poor, but citizens of rich countries are not notably happier than citizens of middle-income countries, and while we are richer than our parents were at our age, we are no happier.

This finding has been called the Easterlin Paradox, after Richard Easterlin, the economist who first observed it back in the 1970s. The paradox has an explanation: what matters is keeping up with the Joneses. If we care only about our place in society, the pattern Easterlin discovered in the data is readily explained.

But two recent pieces of research suggest a different conclusion. “The concept of happiness has to be reorganised,” says Daniel Kahneman, a psychologist who won the Nobel memorial prize in economics in 2002. Much happiness research focuses on “life satisfaction”, where researchers ask people whether they’re satisfied with life as a whole. But Kahneman studies mood: do people, moment by moment, feel content, relaxed or joyful – or stressed, depressed or frustrated?

Kahneman and Angus Deaton, in research published in August in the Proceedings of the National Academy of Sciences, looked at these two measures of happiness in half a million responses to a daily survey of Americans. They found that money is correlated with life satisfaction, but beyond an income of about $75,000, it doesn’t improve your mood: so whether or not Easterlin is right depends on what you mean by happiness.

A new working paper released by three Wharton School economists, Daniel Sacks, Betsey Stevenson and Justin Wolfers, amplifies the finding on life satisfaction. Not only is money correlated with life satisfaction, but this is true whether they compare the happiness of two people in the same country, one 10 per cent richer than another; or the average happiness in two countries, one with 10 per cent higher income per capita; or the increase in happiness after a period of economic growth has made a single country 10 per cent richer than it used to be. It is absolute income, not relative income, which matters for happiness. The attractions of living in a rich man’s world are back on the table.

Justin Wolfers claims that the relationship between life satisfaction and income is “one of the highest correlations you’ll ever see in a cross-country data set in the social sciences, ever.” If so, why has this not been clear before? Wolfers blames problems with the older data – for instance, it became apparent, after retranslating the questions asked in Japan, that life satisfaction seemed to stagnate as the economy boomed only because the questions kept changing.

But not everyone is so quick to dismiss Easterlin’s work, which has survived careful scrutiny over the years. Andrew Oswald of Warwick University points out that the Wharton research may not have successfully disentangled income from unemployment, which has long been known to be one of the most depressing of experiences.

And everyone seems to agree on one thing: for whatever reason, life satisfaction in America itself has been stagnating for decades. “Score that one for Easterlin,” says Justin Wolfers. Perhaps Barack Obama has been taking note: three leading happiness scholars, Betsey Stevenson, Kahneman’s co-author Alan Krueger and Cass Sunstein all have senior government positions. Maybe they can figure out how to improve the nation’s mood.

Also published at ft.com.

Age comes before austerity

It’s official: George Osborne is Gordon Brown’s mirror-world doppelgänger. Where his forerunner as chancellor offered vast spending sprees, crafted for political effect, Mr Osborne deals out equally vast cuts, with the same close attention to party political advantage. Both use their speeches to play the same old game of three-card monte.

As so often in the Brown era, Mr Osborne left onlookers bewildered as to the details of what just had happened, but quite certain that they had been fleeced. If only the whole performance had been delivered with the speed, panache and dexterity of a market-day conman, we might at least have enjoyed the ride.

Mr Osborne insists that everyone is in this together. Anyone under the age of 65 will beg to differ: every perk and privilege of seniority in British society has been defended. Quite why prosperous pensioners deserve their special treatment is unclear to this economist, but no doubt perfectly obvious to the opinion pollsters.

The effect of changes to taxes and benefits will reduce household income by, on average, 1.5 per cent – but rather splendidly, almost everyone will suffer less than the average. The richest 20 per cent and poorest 10 per cent will pay more. (In cash terms, the rich will pay very much more.) Everyone else will pay less than the average – so much for the squeezed middle.

But the truth is that Mr Osborne’s speech told us little of any importance. Even the long-awaited details of departmental spending budgets tell us less than one might think. As we economists are fond of saying, money is fungible. The Department for International Development’s new focus on “conflict resolution” may take some strain off the Ministry of Defence, while the National Health Service can be handed the bill for social care. The BBC’s budget is being used to cover gaps in the Foreign Office budget – a compromise accepted by BBC management because it was better than propping up the Department for Work and Pensions. That is what fungibility means.

The biggest and boldest of these tricks is the decimation of capital spending . Current spending on schools is to be defended, Mr Osborne boasts. But this means that, while teachers will be paid as before, there will be no money to expand crowded playgrounds or build new classrooms. Slashing capital spending is a way of paying less now and more later – almost exactly like borrowing from the bond markets. Politically, such obfuscation is a smart move. The economic merits are less clear-cut.

The two big questions now are the same as they were before Mr Osborne began speaking: how badly will these cuts damage public services? And how badly will they weaken the economy? Mr Osborne does not know the answer to either question, but gives every indication of having given much more thought to the first than the second.

The economic question is crucial, whether the government knows it or not. It is true the country cannot be kept afloat forever on government borrowing: eventually spending must be cut or taxes raised. The Labour party has never really faced up to this awkward fact, but is right to claim that consolidation will sap the economy’s strength in the short run.

Even if the wildest delusions of the Tory right are realised, and every penny saved comes from the pocket of a benefit cheat or a useless Whitehall pen-pusher, the truth is that benefit cheats and Whitehall pen-pushers spend their income buying goods and services that the rest of us provide.

Mr Osborne is betting that the recovery will not be derailed by his cuts. It is a close call. There is no guarantee that when an established employer leaves town, new businesses will rush in to fill the gap: just ask the citizens of Detroit, Liverpool or Glasgow.

As for public service quality, we can only hope. The last government thought that cash and centralised targets would improve services; the coalition believes in decentralisation and pluralism. That sounds more sensible – as long as nobody utters the words “Big Society” – but, as with New Labour, it is all a matter of faith. And unlike New Labour, the coalition is starting from a wretched financial position. Mr Osborne has flipped his cards deftly, but the long game to come will require more vision – and plenty of luck.

Also published at ft.com.

Attested development

The moral case for doing more to help the very poor is unanswerable. The practical case is more problematic: much foreign aid has been spent poorly in the past and we still have plenty to learn.

No one has done more to draw attention to the moral case than Columbia University’s Jeffrey Sachs. But some other development economists argue that Professor Sachs’s flagship project, Millennium Villages, has passed up a chance to advance our knowledge of what works. A new report, written by Michael Clemens of a pro-aid think-tank, the Center for Global Development, and by Gabriel Demombynes of the World Bank’s Kenya office, criticises the Millennium Village programme for a lack of rigorous impact evaluation.

The Millennium Villages are over a dozen clusters sprinkled across Africa, with an average population of about 40,000 people. The basic idea is that an intensive package of aid – fertiliser, agronomical advice, mosquito nets, school meals, clinics, irrigation and more – can transform the lives of these very poor people. The project aims to become self-sustaining over time, so that villagers can “get on the ladder of development and start climbing on their own”. Another important element is the multifaceted intervention: Sachs says this is necessary because there will be “important synergies”.

Given the complexity of the aid package and the small number of pilot projects, it’s not feasible to evaluate every possible element of the villages with the gold standard of a randomised trial. But several evaluation experts told me that it would have been possible to evaluate the impact of the entire project by randomly assigning control and treatment villages, which would have provided a measure of whether the villages were achieving their goals.

Why might this matter? China’s Southwest Project, supported by the World Bank in the late 1990s, also took a multifaceted approach. At the time, the project looked terrific, but a later evaluation by the World Bank showed that non-project villages largely caught up with project villages within five years. The Millennium Villages hope for a longer-lived impact, but Clemens and Demombynes claim that the current evaluation methods in place will not determine whether they succeed.

They point out that the evaluations published so far on the Millennium Villages website offer simple before-after comparisons showing what’s happening on the ground. These are not the only plausible indicators of success. Demombynes says, “It’s very clear that you can’t use a simple before-after comparison, especially in Kenya.” For example, the evaluation shows that mobile phone use in the first village, Sauri in Kenya, has quadrupled. But, says Demombynes, “Mobile phone uptake has quadrupled in Sauri, in the region, and in Kenya as a whole.”

Adjusting for regional trends, Clemens and Demombynes conclude that the impact of the villages is real, but roughly half what the project’s backers claim. And they are worried about sustainability. They stress that their alternative estimate is itself imprecise compared with a true randomised trial.

Jeffrey Sachs robustly defended the Villages when I asked him to reply: he said it wasn’t appropriate to try to control for regional or national trends. Clemens and Demombynes, he wrote in an e-mail, “don’t seem to realize that the interventions we are pursuing in the MVs are also taking place, albeit more sporadically … in the rest of the country.”

Sachs and his colleagues argue that we will learn a lot from the ongoing process of managing, measuring and observing what works within the villages themselves. I agree. But I think it would have been possible and desirable to learn much more.

Also published at ft.com.

Dissent is a sterling asset

Sir Alec Issigonis, the designer of the Mini and the Morris Minor, once declared the camel to resemble “a horse that was planned by a committee”. He has a point: this column wasn’t written by a committee either.

The risks of committee thinking were highlighted in 1972 by the psychologist Irving Janis in his famous analysis of the role of “groupthink” in the Bay of Pigs fiasco. Groupthink is the tendency of committees to congeal around a particular point of view, reassured by the fact that everybody agrees with everybody else, and nervous about expressing dissent.

A more abstract demonstration, if a powerful one, was delivered in the 1950s by the psychologist Solomon Asch. Asch showed his experimental subjects four lines and asked them to say which two of the four were of equal length. When the hapless subjects were surrounded by actors pretending to be doing the same task, and blatantly delivering the wrong answer, many of the real experimental subjects fell in line with the group, and expressed clear signs of stress as they did so.

But don’t knock the humble committee too much. Get it working in the right way, with the right people, and you have a powerful institution. The risk of committee thinking, as Janis and Asch demonstrated, is that – paradoxically – a group of people may end up considering fewer alternative points of view than a single person. Surely that’s not inevitable.

Groupthink is not usually a topic for economists, but the fact that much monetary policy is now made by committees has attracted their attention. Christopher Spencer of the University of Surrey studied the behaviour of the Bank of England’s monetary policy committee, which has five “internal” members, chosen from the bank’s staff, and four “external” members, appointed for one or two terms from elsewhere. Spencer found that external members were much more likely to dissent from the majority opinion.

Stephen Hansen and Michael McMahon recently published research that attempted to disentangle the reasons for the dissent. It could be simply that external members have a dovish bias towards cutting interest rates, which is why they tend to be out of step with the majority. Or it could be that they are more sensitive to market conditions – more “expert”, perhaps. Hansen and McMahon believe, based on an analysis of when external members dissented, that both of these things are true.

Hansen and McMahon worry that dissent might not be terribly helpful – if it is based on a dovish bias, or if external members are simply dissenting to gain a reputation for intellectual superiority, then that might be something to worry about.

I (ahem) disagree. It’s easy for an economist to undervalue dissent for the sake of dissent. Irving Janis argued that someone should always play the role of devil’s advocate, and different people should play the role at different times. (Alas, the Catholic church, which invented the idea in the late 16th century, abolished the office in 1983.) Asch’s experiments showed that if there was a single dissenter in the room, the experimental subject was far more likely to resist social pressure and pick the correct pair of lines. This was true even if the dissenter himself was also wrong. What mattered was that he said something different.

So let’s hear it for dissent. The Bank of England has had its own dissenter for a few months now: throughout the summer, Andrew Sentance was in a minority of one in consistently voting for interest rate hikes. He’s an external member, nearing the end of his final term on the committee: the perfect conditions for healthy disagreement. I have no idea whether Mr Sentance is right, but I am glad he’s there.

Also published at ft.com.

Models for growth

Is the world like Play-Doh or like Lego? That might seem like an odd question for an economist, but there were some provocative characters present at a recent “Growth Week” at the London School of Economics, organised by a new joint venture between Oxford, LSE and the Department for International Development.

Growth Week assembled policymakers from developing countries alongside development economists, and my attention was grabbed by Paul Romer, Ricardo Hausmann and John Sutton, all three of them, in different ways, economic iconoclasts.

Romer created endogenous growth theory – thus memorably giving Michael Heseltine the chance to remark that the idea “wasn’t Brown’s – it was Balls!” He quit academia, founded a successful online education company, and now travels the world campaigning for the foundation of “charter cities”, modern versions of Hong Kong. More of him in a future column.

It was Hausmann – once a Venezuelan minister, now a professor at Harvard – who was asking about Play-Doh and Lego. Hausmann, in joint work with the physicist Cesar Hidalgo (I’ve written about their work before), has been trying to puzzle out the relationship between the sophistication of a country’s economy and the kinds of products it makes.

Economists have tended to view the economy as a Play-Doh affair: products are produced by a few undifferentiated inputs of “stuff”, which we call capital and labour. More sophisticated accounts might introduce land, education (“human capital”) and institutions (“social capital”). Even then, that’s just five types of stuff, and economic growth just means getting more stuff and using it more efficiently.

Hausmann argues, convincingly, that this isn’t a helpful way to think about the capabilities needed to produce a sophisticated product or service. Amazon, for instance, offers a service that requires widespread access to the internet, credit cards, physical addresses and a trustworthy post office. An orchid business would require the right kind of land, water and electricity, along with appropriate customs regulations to allow shipping. Some countries might have the preconditions to allow internet shopping; others might be fertile territory for orchid production. What’s needed is not “more human capital” but some rather specific, and sometimes subtle, requirements: different Lego bricks, not lumps of Play-Doh.

Hausmann’s Lego analogy is probably too optimistic. In fact, these elusive economic capabilities are probably more like the components of your computer: the keyboard, mouse, screen, internet connection, processor. You can assemble them in various ways, but you don’t have to remove many components before your computer is far less useful, and some components, such as the processor, are indispensable. Hausmann worries about the fact that until a country has a critical mass of capabilities, there’s little point in acquiring more. There is no point in going to the trouble of getting a keyboard for your computer if you have no software.

The LSE’s John Sutton has been trying to figure out how companies acquire the capabilities that they have. His research reveals that in Ethiopia, for instance, many of the key manufacturing companies start not as small manufacturers but as traders. They have the know-how to run an organisation of 50 people and real expertise about the market. One unfortunate matchbox manufacturer was undercut by Chinese imports at one-fifth of the price, including shipping. A wilier company with a background in trading went into steel wire because it understood the Chinese supply chain and knew how to compete.

Sutton and Hausmann have very different research strategies, but a shared question: if “capabilities” are the Lego bricks of economic growth, where do they come from and how can we make more?

Also published at ft.com.

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