Tim Harford The Undercover Economist

Articles published in November, 2010

Putting pay in perspective

Like all good economists, I am both frugal and insensible to considerations of style, so my battered old spectacles are now more than a decade old. I’d be lost without them, quite literally. My unaided eyes are unable to read a book at a distance of more than four inches. Occasionally, this serves as a superpower – I can take my glasses off in tedious meetings and drift away, as blissfully blind as if I had pulled my jumper over my head. Usually, however, I prefer to be able to see, and so the glasses have followed me into the shower, the karate dojo, and a number of other situations that need not be detailed here. As a result, I rarely mislay my glasses – which is lucky, because they are slim enough that I find them invisible at a range of 3ft.

On the occasions when I do lose them, one thought often leaps into my mind: thank goodness I was born after eyeglasses were invented. Without them I would be severely disabled; with them perched on my nose, that description seems absurd.

The modern world is, of course, full of helpful stuff, from spectacles to penicillin to e-mail – stuff we tend to take for granted, but shouldn’t. The economist Timothy Taylor, editor of The Journal of Economic Perspectives, begins his introductory economics lectures by asking his students whether they would rather be making $70,000 a year now, or making $70,000 a year in 1900.

“$70,000 a year back in 1900, you probably have to multiply that by 10 or more to get how much income it would be right now,” he explained to NPR’s Planet Money show. “So we’re not just talking about just being average rich, we’re talking about really being darn rich – we’re talking about the mansion and the servants.”

Ten times is an underestimate: according to Samuel Williamson’s “measuring worth” database, $70,000 in 1900 is worth almost $2m today adjusted for consumer prices. (Relative to the average unskilled wage, it would be $8.5m today.)

Yet about two-thirds of Taylor’s students would rather have the decent income today than the millionaire lifestyle in 1900. And who is to say they are wrong? Many of the regular things of life – such as central heating, air conditioning, a car, a shower, and restaurant meal – are likely to be as least as good in 2010 on a middle-class salary as in 1900 on a rich man’s income. Even the spectacles would have been awkward and prone to breaking back then. Many modern conveniences would have been unavailable for any money.

This thought experiment is an arresting counterweight to the oft-made observation that we seem to be no happier than our parents or grandparents were, despite the fact that we are richer. Taylor’s students seem to believe they would have been happier than their great-grandparents even if their great-grandparents had been colossally richer.

It also puts into perspective our incessant efforts to adjust nominal prices to take account of the cost of living. By almost any reasonable measure, there has been plenty of inflation over the past 110 years.

A modest pension of $7 a week in 1900 would be worth $184 a week today if it had been linked to consumer prices. Many people believe such index linking is outright stingy, and propose a link to wages. Fine: $7 a week in 1900 would be $1,340 a week today if linked to wages in manufacturing. The idea of such indexation is that $7 was a lot of money in 1900 and it buys very little today.

But Timothy Taylor’s students believe that in some contexts, $7 now is worth more than $7 in 1900. And if you want a mobile phone subscription – or you have an infected abscess and need antibiotics – they may be right. It’s nice to have a justification for looking at the modern world through rose-tinted glasses.

Also published at ft.com.

Call no man happy until he is a government statistic

The British government is apparently planning to measure our happiness. Stop smirking – this is serious business. Happiness is a big deal, especially among economists. Daniel Kahneman, a psychologist and winner of the Nobel memorial prize in economics, has been studying the subject intensively. Two other Nobel laureate economists, Amartya Sen and Joseph Stiglitz, have been working on measures of economic well-being for Nicolas Sarkozy, the French president. President Barack Obama has appointed happiness experts – Cass Sunstein, Betsey Stevenson and until recently Alan Krueger – as senior officials. David Cameron, if not leading the charge, is joining the in-crowd.
The irony is that in proposing to measure the national mood, Mr Cameron seems to have misread that mood. His core supporters on the centre-right are disinclined to give much weight to government-sponsored studies of well-being. The centre-left are instinctive supporters of the idea, but they are feeling a little grumpy right now and are unlikely to crack a smile at anything Mr Cameron proposes.
But what is Mr Cameron proposing? The Office for National Statistics won’t say much for now, although a statement refers to the need to look at “broader” and “more comprehensive” measures of well-being and progress, rather than focusing solely on gross domestic product, or GDP. Part of that might involve measuring “subjective well-being”.
The cynical response is that the government is about to dose us all up with Soma as we enter the brave new world of austerity Britain. The truth is more prosaic, and fortunately I speak Happyconomist so I can translate. The standard measure of economic activity is GDP, and the ONS is thinking about presenting some variations on the theme – which might include adjustments for environmental damage, time wasted in commuting, the value of “non-market work” – that is, doing the dishes – and the like. These GDP variants use the same framework but add extra elements. Alongside them the ONS might gather other data measuring health, inequality and that curious item, “subjective well-being”.
But what is this? One answer is that it’s what economists prefer to speak about instead of “happiness” – I once interviewed Prof Krueger on this and he firmly told me subjective well-being was his preferred term because “happiness sounds a bit frivolous”. Learn More
20th of November, 2010Other WritingComments off

Time to tidy the tax mess

Given the importance of the subject, there isn’t much debate about the fundamentals of taxation. Fundamentalism, yes: on the right, the idea that all tax is theft and that any cut in tax rates will raise revenue; on the left, the idea that the country’s fiscal – and indeed social – problems could be solved quite simply if only the government had the courage to tax the rich more heavily.

(For context: the top 5 per cent of UK earners take in a quarter of the country’s income and pay almost half of all income tax; the top 1 per cent make 12.5 per cent of income, and pay over a quarter of all income tax. Make of that what you will.)

But fundamental principles, no. Instead, we have the increasingly frequent pageant of Budget day, in which the chancellor of the exchequer juggles statistics and pulls rabbits out of hats, while the media scrabble to explain who wins and loses from the performance.

Earlier this month there was a performance of a very different kind when a procession of heavyweight economists, led bythe Nobel laureate Professor Sir James Mirrlees, presented the results of a fundamental review of British taxes by the Institute for Fiscal Studies, the first such exercise for more than 30 years. The results are a bracing blast of fresh air, which deserves to scour away some of the tax junk that has accreted over the decades.

For example, at the top of the income distribution, marginal tax rates rise to 40 per cent, then 60 per cent, fall back to 40 per cent and rise again to 50 per cent – the effect of gradually withdrawing tax allowances above an income of £100,000 a year. In fact the situation is more baffling than that, because national insurance contributions are payable at various rates on wages, but not on income from other sources.

At the bottom end of the income scale the situation is even more cluttered and implicit tax rates are even higher: one case study, for a lone parent, shows take-home income rising, in cliffs and plateaus, from about £220 to about £300, as the parent earns between zero and £230. The marginal tax rate there is around 80 per cent, and in some cases the interaction of benefits is even more baffling.

The broad conclusions of the Mirrlees review are easily summarised: it would be possible to raise the same amount of tax, with roughly the same redistribution of income, more efficiently. There would be fewer loopholes, fewer losses from people making decisions explicitly designed to reduce tax, and fewer arbitrary distinctions between people who deserve to be treated similarly.

One principle that can’t be emphasised enough is that redistribution is a function of the tax system as a whole, not of any particular tax. At the moment, low or zero-VAT rates on items such as food, books, and domestic fuel distort what we buy and encourage us to waste energy in the name of redistribution. This is silly: better to let the income tax system do the redistribution and keep VAT broad and simple. Income tax should also absorb national insurance, which has long been an arbitrary, distorting and opaque parallel income tax.

Not every recommendation of the Mirrlees review tends towards simplicity. For instance, the review advocates tweaking child tax credits, national insurance contributions and the pension system with the aim of giving parents with school-age children and people over 55 and under 70 much stronger incentives to work.

Utopian ideas of tax design must bow both to the messy reality of law and accounting, and to political convenience. Yet the Mirrlees review makes a compelling case that even if tax will never be fun, it could be somewhat simpler and much more effectively collected. The government should take note.

Also published at ft.com.

How to be financially literate

Here’s a little test. You buy a new £1,000 computer, but you need to take on some debt to finance it. You have two options: pay in 12 instalments, £100 a month for a year; or borrow at an interest rate of 20 per cent and pay back £1,200 at the end of the year. Which is the better offer?* Or are they both the same?
Take your time. Annamaria Lusardi, an Italian economics professor now based at Dartmouth College in the United States, has been asking a lot of people this question. Only seven per cent of Americans get the answer right. Even simpler multiple choice questions about interest rates and minimum payments on credit cards baffle the majority of people.

Read the whole column here. The answer is below… Learn More

A case for consultants?

Management consultants don’t have the most stellar reputation for offering value for money – although, truth be told, the infamy of investment bankers has long since left them in the shade – so I was impressed when, early this year, rumours reached me of a fascinating new study in which a consulting firm was implicitly agreeing to subject its advice to a randomised trial.

Not to put too fine a point on it, that’s a ballsy decision. Almost the only people who ever agree to test their stuff in a randomised trial are the pharmaceutical companies, and I am fairly sure they’re underwhelmed by the experience.

Perhaps Accenture (for it was they) didn’t realise what they were letting themselves in for. After all, the study – conducted by a team of economists at the World Bank, Berkeley and Stanford – was ostensibly about whether modern management techniques would improve the productivity of large textile firms in India. (A draft, “Does Management Matter? Evidence from India”, is available from the website of co-author Nick Bloom at Stanford.) But how do you improve management techniques? You send a management consulting firm in.

The researchers hired Accenture to provide management consulting services to 14 factories in Mumbai, chosen at random from a group of 20. The other six factories served as a control group and received a diagnostic performance audit but little serious advice. The World Bank and Stanford paid Accenture at a heavily discounted rate; the factory owners paid nothing.

The results were undeniably impressive. The effect of a few months of consulting advice was that profits rose by almost a fifth, to the tune of several hundred thousand dollars a year. (The latest draft of the study puts the figure at $230,000; an earlier calculation reckoned it was even higher.) Output was up, inventory was tighter and defect rates were halved.

Accenture’s fees for the five-month consulting gig, at commercial rates, would have been roughly the same amount as the increase in profits – so the arrangement would have paid for itself by the end of the year. If any of the consulting advice stuck, this would have been a fantastic investment. The indications are that the advice more than sticks: the new procedures generate more information, more ideas for running a tight ship, and a spiral of continuous improvement.

But before we all rush out to hire a management consultant, two notes of caution. The first is that as the experiment was designed to evaluate management techniques rather than consultants, Accenture was left in charge of collecting its own performance data. (The data was subject to some independent checking, however, and there is no evidence that anything was amiss.)

The more substantial caveat is that textile companies in India have their own distinct problems: tools and machinery were left lying around, and stock control was frequently non-existent. If a worker needed to find a particular item, the technique of choice was to forage around in the storage bins until something useful emerged. Modern inventory-management techniques made a big difference in this particular sector of Mumbai’s economy, but that does not mean that Vodafone or Barclays or the civil service have as much to gain from bringing the consultants in.

Nick Bloom and his colleagues have also studied management practices across the world, and Brazil, China and India rank poorly. Just imagine what these emerging giants will do once they get the consultants in.

As for whether management consultants can earn their keep in London or New York – I don’t know the answer. But I know a few economists who would happily supervise a randomised trial.

Also published at ft.com.

Outside Edge: Sleepless in Seoul

As I write this paragraph, it’s midnight. Or possibly lunchtime. I’m in a hotel room in a city which, I am reliably informed, is Seoul. I got here too late for breakfast but in plenty of time to go to bed at 3pm. Does that make any sense? I really am extraordinarily jet lagged.
The South Koreans are very proud that the G20 summit was held in Seoul, but perhaps that is mostly relief that they didn’t have to negotiate in the wrong time zone – no such luck for most of their guests.
This is in the nature of summitry: leaders whose powers of decision are so indispensable they fly all over the globe, exercise those powers of decision in what can only be described as a highly impaired state.
I have become very concerned – possibly this is just an insomniac’s paranoia – at the amount of important business that seems to be conducted by people who are equally sleep-deprived. The German finance minister called American monetary policy “clueless” last week. I am not sure it was fair then. But it seems a pretty accurate description of how many of the sleepless summiteers must have been feeling last night.
Powers of decision? Even my eyeballs are indecisive. Every time I stop concentrating on them – I was going to write “looking at them”, but how can you look at your own eyeballs? – they start drifting around, sometimes bumping into each other and sometimes edging apart. Is this a common symptom of sleep deprivation, or is it just me?
You’re also going to have to forgive the odd tpyo, I’m afraid.
Don’t get me wrong. I can handle jet lag. It’s just that I’m not sure it’s a terribly good idea to do anything important in this state. Should the future of the world economy really be decided by men and women so tired they just want to curl up in a corner?
This may account for some of the summit’s disappointments. For example, the Americans and Koreans have failed to agree a bilateral trade deal, the whole point of which was to create an impression of progress which the summit proper was always likely to lack.
Jet lag explains all. I get very ratty myself when I’m short of sleep. At least nobody has repeated the performance of the late Shoichi Nakagawa, the Japanese finance minister who managed almost simultaneously to sign away a colossal sum of money to the International Monetary Fund, and slur his words at a G7 press conference last year.
Mr Nakagawa blamed medication for a cold, and others speculated that he had been at something stronger. The way I feel, I can assure you all that the jet lag would have been enough to cause his incoherence. Now we hear that grumpy late-night discussions about currency wars at the G20 were only resolved by an agreement to pass the buck to the IMF. That makes some sense. Say what you like about IMF staff, they always try to get a good night’s sleep.
The writer is going to bed

First published on ft.com
13th of November, 2010Outside EdgeComments off

The Top 10 Economists on Twitter

Twitter’s top 10 economists (11 November 2010)
@CMEGroup Chicago Mercantile Exchange 764,000 followers
@NYTimesKrugman Paul Krugman, Nobel Laureate & columnist 466,000 followers
@andrewrsorkin Andrew Ross Sorkin, NYT Dealbook 317,000 followers
@freakonomics The Freakonomics blog 184,000 followers
@planetmoney NPR’s Planet Money 113,000 followers
@PKedrosky Paul Kedrosky, Financial commentator 70,500 followers
@Richard_Florida Richard Florida, Urbanist 69,800
@nouriel Nouriel Roubini, Economic forecaster 28,700 followers
@dambisamoyo Dambisa Moyo, Aid Sceptic 26,800 followers
@evanHD Evan Davis, formerly BBC economics editor 20,000 followers

Or you can follow them all in one go at this handy list.

Update: The definition of “economist” is clearly subjective but otherwise this list is simply the 10 most popular econ-related twitter accounts that I could find. More suggestions welcome!

Honourable mentions – a subjective combination of econ tweeters who are popular, interesting or under-appreciated:

@DavidMcW David McWilliams, Irish popular economist 12,900 followers
@FelixSalmon Felix Salmon Finance blogger, Reuters 11,500 followers
@jeffdsachs Jeffrey Sachs, Columbia University 9100 followers
@TimHarford Tim Harford, Undercover Economist at the Financial Times, 8500 followers (that’s me)
@Bill_Easterly Bill Easterly, New York University 8480 followers
@danariely Dan Ariely, Behavioural psychologist 6400 followers
@tylercowen Tyler Cowen, curator of Marginal Revolution 6350 followers
@DavidMWessel David Wessel Wall Street Journal’s Economics Editor 4800 followers
@crampell Catherine Rampell, Economix Blog editor 2800 followers
@cblatts Chris Blattman, Political scientist 2000 followers
@diane1859 Diane Coyle, The Enlightened Economist 970 followers
@tutor2u_econ Resources for economics teachers 470 followers

The idea for composing this list came from a post on the Oxford Economics blog.

Feel free to email [undercovereconomist AT gmail] or tweet [ @timharford ] with further suggestions. I’ll update this post from time to time.  Comments are open.

A sense of fair play does pay

I recently had the dubious pleasure of having to deal with someone who is successful and indeed popular, and yet a stubborn, selfish bully when he thinks nobody is looking. It moved me to speculate on an old question: do nice guys finish first, or last?

No doubt whole libraries are filled with psychological and historical research on the topic. To an economist, the natural way to understand such questions is to turn to game theory, which is a way of turning decisions into a simplified mathematical format. Specifically, game-theoretic decisions are those with more than one player, where each player’s choices alter the other players’ incentives.

In one of the simplest games, “Ultimatum”, one player (Abby) receives an envelope containing 100 one-dollar bills. She has to decide how much to offer to the second player (Zach). Zach either accepts this ultimatum, or both players lose everything. If Zach is motivated only by cash, then a single dollar will be enough to get him to agree. Real people have other concerns, and when the game is played in the laboratory, the first player usually offers a more even split, and tends to regret it if her offer is too miserly.

Ultimatum is a fascinating game: Molly Crockett of the University of Cambridge is part of a team examining whether people play Ultimatum differently when drugs are used to lower their serotonin levels. (They do, rejecting more unfair offers.) John List of the University of Chicago has shown that what people offer and accept is highly sensitive to the experimental context – for instance, whether the initial money was perceived as having been earned.

But Ultimatum also tells us something about what Thomas Schelling, winner of the Nobel Prize for economics in 2005, called “strategic pre-commitment”. Imagine Zach walking into the room and announcing, “I’ve given my wallet to the experimenter and told him to throw it down the garbage chute if I accept an offer of less than $50.”

If that’s a believable statement, two things follow: that Zach will regret it bitterly if Abby actually offers him $45, because he will either lose $45 or lose his wallet; and that Abby would be wise to offer a 50-50 split.

Zach’s pre-commitment has cut off his options but is likely to make him better off. Such tactics have a long history – witness Cortés scuttling his fleet to keep his men from fleeing back to Cuba. (The counter-move is even older: Scipio, the Roman general who defeated Hannibal, advocated building a “golden bridge” for an enemy in retreat.) More recently, there are traffic wardens who cannot cancel a parking ticket once their handheld computers have started the process.

An alternative, and much simpler, pre-commitment is to acquire a reputation for being someone who would rather die than accept less than $80 out of every 100.

Such tactics work very well, for a while. Schelling pointed out that toddlers and terrorists have a tremendous advantage in any negotiation because both are immune to reason. They can demand everything, and often get it. (I can’t advise on the subject of dealing with terrorists, but I can attest that most negotiations with two-year-olds go better if conducted at home, rather than in a restaurant, train or bookshop.)

All this is very frustrating for those of us who advocate a bit of give and take in life, but there is a consolation: there’s good reason to believe that co-operative people tend to find each other and do very well sharing and sharing alike. As for greedy bullies, they can do well toe-to-toe with reasonable people, but not so well when they meet other greedy bullies. Two people who won’t back down is a recipe for a well-deserved disaster.

Also published at ft.com.

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