Tim Harford The Undercover Economist

Articles published in February, 2011

Illiteracy rules

I hope you won’t mind me setting a little test of financial literacy. You buy a new £1,000 computer and borrow money to pay for it. You have a choice: either (a) pay 12 monthly instalments of £100; or (b) borrow money at an APR of 20 per cent, meaning you pay back £1,200 at the end of the year. Which offer is better – or are they (c) identical? (The answer is at the end of this column.)

If you don’t get it right, don’t worry: 93 per cent of Americans don’t either, according to Annamaria Lusardi, an economics professor and director of the Financial Literacy Center. (Financial illiteracy is also widespread internationally, she adds.) Far more obvious financial questions baffle the majority of people. And if you think the question is academic – and would like a hint at the answer – just ask yourself why companies are so keen to let you pay in instalments.

The sophistication of financial products has increased dramatically; the sophistication of consumers has not. “Knowledge hasn’t caught up with the real world,” says Lusardi. “The important word is ‘literacy’. You can’t live in society without being able to read and write, and now you can’t live without being able to read and write financially.”

The obvious answer is financial education. But it has been tried and doesn’t seem to work terribly well. According to a survey published by Lewis Mandell of the University of Washington, financial education seems to have no impact on formal measures of financial literacy, although, puzzlingly, it does seem to improve financial decisions a little later in life.

For this reason, financial education sceptics such as law professor Lauren Wills argue that the whole project to boost financial literacy is misconceived and actively harmful. (My analogy: why not improve medical outcomes by teaching people to practise surgery on family members?) Wills would prefer regulators to simplify the financial landscape – presumably with a combination of bans and regulatory “nudges” – and simply abandon the financial education project entirely.

Professor Lusardi disagrees. While the track record of financial education is not encouraging, she says “the evidence that is available now tells us very little” about whether it would work if done right. Classes are often offered by poorly trained teachers, she says, or courses for employees might be a single lunchtime chat about pensions.

“A one-hour seminar is not going to work, for sure,” she says. In short, perhaps the reason that financial education doesn’t seem to work is that nobody has tried it properly.

The Financial Literacy Center is trying more creative approaches. One promising technique is to use video testimony from workplace peers; another tactic, in partnership with a not-for-profit organisation, D2D, is to develop computer games that incorporate some financial concepts. Lusardi says initial results are promising and full randomised trials are in progress.

I sympathise with both sides of this debate. I simply don’t believe that financial education is impossible, or more trouble than it is worth. But without some intelligent regulation to preserve transparency and protect consumers – at the very least, from the most egregious abuses – I fear that the ability of educators to clarify how finance works will be outpaced by the ability of credit-card marketers and subprime mortgage peddlers to muddy the waters again. The financial educators should do better, but the financial regulators may have to meet them halfway.

…………………………………………..

The answer is (b). The instalment payments hide a deceptively high interest rate. Because capital is being repaid almost immediately but total interest is still £200, the true interest rate is much higher than 20 per cent. Reader Ian Nicol informs me that Excel uses the formula (RATE(1*12,–100,1000)*12) to calculate interest rate, in this case more than 35 per cent.

Also published at ft.com.

Spend now, squeeze later

Are we bankrupt? Are countries like the US and the UK in as much fiscal trouble as Ireland or Greece? The bond markets say no: they’ve been quite content to lend to the UK and the US as though they were low-risk propositions, and perhaps they are right.

But even if bond holders look safe enough, citizens may not be. Diane Coyle, author of a new book, The Economics of Enough, argues that we need to go beyond traditional measures of debt in thinking about future obligations.

Consider contracts under the private finance initiative, in which private contractors spend cash now in exchange for service contracts later. Gordon Brown launched his ill-starred campaign for re-election in a spectacular new hospital in Birmingham – but the hospital, which cost several hundred million pounds, hadn’t been paid for.

I have no problem with the idea that governments often rely on contractors to build and even run prisons, hospitals and schools – but PFI seems beloved of governments because much of it is a kind of shadow debt that does not appear in the national accounts. In its 2009 Green Budget, the Institute for Fiscal Studies estimated that future payments under PFI contracts, appropriately discounted, would be around £130bn. (For context, official British government debt is fast closing in on £1,000bn.) It would be cheaper – but would raise official debt – to borrow from bond markets and pay the private contractors up front.

Then there are public sector pensions, which would add around £750bn to £1,000bn to our tally of unofficial government debt. All these look like legally binding promises to me, even if swindling nurses, teachers and soldiers out of their pensions would not trigger an official bond market default. On the plus side, as an Office for National Statistics paper on “wider measures of public sector debt” points out, the government does own several hundred billion pounds worth of roads, railways and buildings.

There is more. In the UK, we expect the government to take care of us when we are sick and to provide some kind of pension when we are old. These promises are by no means firm: women born in the spring of 1954 are now seeing their retirement date recede with alarming speed. But governments will always feel obliged to do something for the sick and the old, and demographics are not on our side. The state pension alone likely represents a current liability of well over £1,000bn.

In the US, the situation is yet more alarming. Laurence Kotlikoff, a US-based economist, reckons that the US has promised to pay out over $200,000bn more in the long run than it seems inclined to collect in taxes – this is roughly 15 times bigger than both the official US national debt and the US economy. Even a tiny tweak to taxes or spending can raise many billions over the decades, but if Kotlikoff’s estimate looks huge, it should: to close it would require halving spending on everything in the US government budget from this point forward, or doubling every tax.

Kotlikoff, with Roberto Cardarelli and James Sefton, produced “generational accounts” for the UK 11 years ago and concluded that all was well – providing NHS spending did not grow too quickly and the state pension was linked to prices, not wages. Gordon Brown did not stick to those provisos. George Osborne also seems committed to pensions and health spending. This means spending elsewhere must continue to fall relative to the size of the economy, or taxes must rise.

Keynesians would argue that now is not the time for fiscal tightening, and perhaps they would be right. The problem is that for an elected politician, the best time for a squeeze is always after the next election. Tomorrow’s taxpayers should be looking carefully at tomorrow’s spending promises.

Also published at ft.com.

Top 10 Economists on Twitter

Twitter’s top 10 economists (12 February 2011) (previously)
@CMEGroup Chicago Mercantile Exchange 772,973 followers
@NYTimesKrugman Paul Krugman, Nobel Laureate & columnist 518,219 followers
@andrewrsorkin Andrew Ross Sorkin, NYT Dealbook 342,976 followers
@freakonomics The Freakonomics blog 248,927 followers
@WSJ_Econ Real Time economics from the Wall Street Journal 169,736 followers
@planetmoney NPR’s Planet Money 150,370 followers
@Richard_Florida Richard Florida, Urbanist 90,773
@PKedrosky Paul Kedrosky, Financial commentator 90,153 followers
@nouriel Nouriel Roubini, Economic forecaster 37,536 followers
@dambisamoyo Dambisa Moyo, Aid Sceptic 31,791 followers

Or follow the full Top 10 at this list.

Honourable mentions (I am doing a rolling update to reflect comments at the moment):

@evanHD Evan Davis, formerly BBC economics editor 24,847 followers
@DavidMcW David McWilliams, Irish popular economist 22,582 followers
@FelixSalmon Felix Salmon Finance blogger, Reuters 16,224 followers
@jeffdsachs Jeffrey Sachs, Columbia University 15,990 followers
@TimHarford Tim Harford, Undercover Economist at the Financial Times, 12,694 followers (that’s me)
@Bill_Easterly Bill Easterly, New York University 10,740 followers
@Paulmasonnews Paul Mason, economics editor of BBC Newsnight 10,560 followers
@danariely Dan Ariely, Behavioural psychologist 9,483 followers
@tylercowen Tyler Cowen, curator of Marginal Revolution 7,808 followers
@DavidMWessel David Wessel Wall Street Journal’s Economics Editor 6,957 followers
@crampell Catherine Rampell, Economix Blog editor 3,956 followers
@EconEconomics Economics news from The Economist 3530 followers
@EconTalker Russ Roberts, econ professor and host of EconTalk 3211 followers
@cblatts Chris Blattman, Political scientist 2,824 followers
@plegrain Philippe Legrain, author 1917 followers
@B_Eichengreen Barry Eichengreen, economics professor 2,223 followers
@diane1859 Diane Coyle, The Enlightened Economist 1,454 followers
@DLeonhardt David Leonhardt, New York Times columnist 1364 followers
@AndrewSimms_NEF Andrew Simms, New Economics Foundation 864 followers
@Gregoryip Greg Ip, US Economics editor, The Economist 835 followers
@dismalscientist Tweets from Moody’s Analytics, 616 followers
@tutor2u_econ Resources for economics teachers 607 followers
@dsmitheconomics David Smith, Economics editor, Sunday Times 396 followers
@OlafStorbeck Olaf Storbeck, Economics editor, Handelsblatt 327 followers

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.

Bye, bye easy money

Don’t fixate on the financial crisis. Our economic problems have been far longer in the making, and would have caught up with us sooner or later anyway.

That is one of the conclusions I take away from two striking essays: “The Great Divergence”, published in Slate last September by the journalist Timothy Noah; and The Great Stagnation, just published as a short e-book by the economics professor and blogger Tyler Cowen.

The two essays describe two disturbing trends that, while logically separable, seem to be related. Noah discusses a sharp increase in income inequality in the US since the early 1970s. After analysing many explanations, he concludes that the chief culprits are a tolerance for super-high salaries and bonuses on Wall Street and in the boardroom, and a failure of the US education system. Blaming China is considered, but largely dismissed.

Cowen begins with the fact that median family income in the US has barely increased, again since the early 1970s. Its growth rate has been about 0.5 per cent a year after inflation. The median family income is the income of the family in the middle of the income distribution. It is a useful measure precisely because it ignores the action at the top: if a Connecticut hedge fund manager made an extra $11bn in a year, this would raise the mean income of the US’s 110 million-ish households by $100 each. It wouldn’t alter the median income by a cent.

In the UK, the situation is not as grim. Median earnings in the UK have increased by more than 1.25 per cent a year since 1968, over and above RPI inflation. That figure is for men working full-time; for women the gain is more than 2.25 per cent a year. At the bottom of the income distribution (the tenth percentile) the gain is slightly under 1 per cent annually for men and 2 per cent annually for women.

If Timothy Noah is right, part of the solution is to improve schools. (It is not clear whether voluntary pay restraint, or more redistributive taxation, would be effective in shifting more money to the median household. Perhaps.)

But if Cowen is right, it is not at all clear what the cure might be. Cowen blames the disappearance of “low-hanging fruit”. The US can no longer reap easy gains simply by sending more bright people to school. Better schools would help, but it used to be as simple as making sure bright 12-year-olds stayed in school for a few extra years.

Another easy gain in days gone by was to enjoy the gradual roll-out of the staggering array of vital innovations developed in the late 19th and early 20th centuries, including electrification, refrigeration, aeroplanes, indoor plumbing, bulk chemical processing, the internal combustion engine, and the telegraph, telephone and television. Everyday life was transformed by these technologies between 1930 and 1970, Great Depression notwithstanding. Since 1970, we have the rise of computers and mobile phones – truly wonderful inventions – but not much else.

In short, if Cowen is right, there will be less growth in future unless a new wave of technology arrives, and our political institutions will have to cope, if they can. The same argument surely applies to western Europe too, and will come as no news to Japan.

And the solution? I am not sure, and neither is Cowen. He hopes to raise the status of scientists and researchers – a good idea, but how? The UK coalition plans to introduce charter schools; we shall have to see whether that delivers results. The government is also reducing subsidies for universities and, indirectly, for public libraries. Both those policies are probably progressive: universities (certainly) and libraries (probably) tend to be middle-class haunts. But if the great stagnation is the problem, making access to knowledge more expensive is surely not much of a solution.

Also published at ft.com.

Best economics podcasts

I’ve recently – and belatedly – come to the podcasting thing and wanted to put together my favourite economics podcasts as a resource for others.

NPR’s Planet Money is quite simply the best economics podcast out there. Great production values, very creative, serious economics topics treated with a light touch. The team also produced perhaps the greatest economics radio documentary ever made, This American Life’s The Invention of Money.

Another brilliantly-produced podcast is Freakonomics Radio. Stephen Dubner presents a range of topics which can only be described as Freakonomicsy – recent episodes looked at molecular gastronomy and the business of trash disposal. If you want pure economics you won’t find it here, but Dubner brings the same storytelling verve he brought to the Freakonomics books.

Russ Roberts’s EconTalk is, by contrast, pure economics: Russ, a professor at George Mason University, has strong views of his own – he’s a Hayek man through and through – but brings on a wide range of guests and gives them a sympathetic hearing. (As I type I’m listening to Russ discuss whether the stimulus worked with the Keynes expert Steve Fazzari – and a thoroughly civilised conversation it is too.) EconTalk offers no fancy production techniques – guests are usually speaking down a phone line. It’s like eavesdropping on a one-hour conversation between smart economists, including 8 Nobel prize winners. Count ’em.

Owen Barder, a totipotent development guru based in Addis Ababa, is the host and producer of Development Drums. With some exceptions, the format is similar to EconTalk: a one-hour conversation with the experts about a topic of interest. (Somehow Owen seems to get better sound quality than Russ Roberts does.) Guests have included Peter Singer, Rachel Glennerster, Paul Collier, Nancy Birdsall and many other development luminaries. A must for development wonks.

Radio 4’s Analysis often covers economics topics – for instance Jamie Whyte, with the aid of the Keynes v Hayek rap, exploring the revivial of Austrian economics. Mostly talking heads but with high production values.

Two other recommended Radio 4 podcasts about business rather than economics: Peter Day’s World of Business (in depth, on location) and Evan Davis’s The Bottom Line (studio discussion with business leaders).

The London School of Economics has a stellar collection of speakers and releases many events as podcasts.

I have to put in a word for my own team. More or Less on Radio 4 is a half-hour look at the numbers in the news and in the world around us. The producer, Richard Knight, always finds fresh angles, plenty of humour, and high production values. And sometimes – nay, often – it’s about economics.

And an honourable mention for FT Podcasts, which are collected here. I am told that Martin Wolf’s podcast has, alas, been discontinued.

One last thing: more suggestions very welcome. I feel there’s a lot out there I must be missing. Comments are open.

Update: Vox, the excellent blog in which economists write accessible summaries of their work,. has an audio section.

Update 2: I have just discovered that Paul Kedrosky of Infectious Greed has a podcast, Infectious Talk, with some brilliant guests – Dan Ariely, Kathryn Schulz, Paul Romer, Josh Lerner and many others. Looking forward to giving it a listen.

Board gaming with the FT: Michael Lewis

“This game is going to end up like the tortoise and the hare,” Michael Lewis declares, halfway through his inaugural game of Saint Petersburg. Lewis’s green wooden pawn is well ahead on the board, but he’s already picked up enough of the game to realise that – to paraphrase one of the characters he describes in his book The Big Short – he’s about to get his eyeballs ripped out.

It is hard to understand quite why Lewis has agreed that I will teach him an obscure modern German board game while he is interviewed. Poker would have seemed the obvious choice. Liar’s Poker, Lewis’s description of the surreal Wall Street world he inhabited for two years as a bond trader at Salomon Brothers, was definitive of an era and, to some extent, of Lewis’s own career as a narrative writer. But Lewis isn’t interested.

“I haven’t played poker since I was in high school,” he says. “It would be false to portray me as a gambler. It bores me. It’s always bored me.”

Was that why he left Salomon Brothers to become a writer? “No. It was fun gambling with other people’s money. I liked that.”

In a small meeting room in a Mayfair hotel, the logistics are awkward: I can’t take notes and it’s hard even to talk because we’re concentrating on the board. Even a simple game can be baffling to a first-timer, and Saint Petersburg is not a particularly simple game. It describes the building of the city by Peter the Great and his minions (but the theme is very loose: the artwork depicts Czarist Russia).

Players buy cards which provide a flow either of roubles – the currency to buy more cards – or of victory points, which advance the player’s pawn and bring victory closer. There are four types of cards: aristocrats, who supply money and victory points and a bonus at the end; buildings, which supply victory points; peasants, who supply money; and upgrades, which improve the other three types. Returns on investment are very high, but there are never enough roubles to buy all the bargains on offer.

I am about to offer some opening hints when Lewis cuts me off. “Don’t tell me tactics. You don’t have to tell me. I’ll screw up. I’d rather just get beaten, and learn that way.”

We play in fits and starts, for the first half hour talking only about the game and its rules, before switching to Lewis himself while the game is forgotten for a while.

I’ve been reading The Big Short, his account of the men who bet against the subprime bubble, and express my baffled admiration at his ability to get inside the heads of his characters. One, the hedge fund owner-manager Michael Burry, gave him access to every e-mail he had ever sent. “God’s gift to the narrative writer was Michael Burry’s e-mail trove. He lived his life via e-mail.”

But how does he persuade people to give him such access?

“I never really thought about it. I’ve had so many people enter into the spirit of the arrangement. It starts with the relationship before it becomes a literary engagement. It’s a very long-term investment.”

The only time he’s had someone pull out after beginning such a relationship was with George Soros, whom he had accompanied on a private plane all over eastern Europe in 1994. Lewis published a magazine piece which suggested that Soros’s qualities as a philosopher were overrated.

“He was furious with the piece. It just said what I thought. Is it my turn?”

“Your turn.”

Lewis is fascinated at the revelation that Germany is the world’s board-game heartland. “This game is all about trade-offs … it’s made for the Anglo-Saxon Protestant work ethic. The Greeks would never appreciate it.” He tries to persuade me to write a piece about the German response to the euro crisis, using board games as a motif.

Although I am building a winning position, producing a flow of roubles that will in due course allow me to buy what I need to overtake Lewis, he understands what is going on. He knows why he’s going to lose. After I reap a particularly profitable investment, Lewis expresses alarm.

“Sorry,” I offer.

“That’s OK.”

Talk turns to Lewis’s upbringing in New Orleans. His father had a largely hands-off philosophy, but begged Lewis not to turn down Princeton in favour of a life in New Orleans with his high-school sweetheart. “He went white and said, ‘I’ve never told you what to do, but don’t do this.’”

Lewis followed his father’s advice. “It was the right decision. But I really was in love with that girl, and it ended up ending our relationship. And I always felt I violated something in me, making that decision.” When the time came to quit Salomon, he steeled himself against any further paternal entreaties.

. . .

Explaining his decision to leave Salomon, he casually compares the $40,000 book contract to the $250,000 salary and potentially millions more – big sums in the late 1980s. But he insists that money does not motivate him.

“I grew up with a mother who came from a pretty wealthy family – in fact a very wealthy family by New Orleans standards – and my father was kind of a poor boy.” By the age of nine he’d abandoned any sense that money brought fulfilment, because “my father’s family was so happy and my mother’s family so miserable”.

Although there is outrage in Lewis’s descriptions of high finance, it is muted by the fact that he seems to regard much of life on Wall Street as risible. His former tutor at the London School of Economics, a certain Mervyn King, didn’t always see the funny side.

“Four or five months after I got the job at Salomon, the head of the London office comes over to me and says, ‘We’ve got this guy in the lobby. He’s the academic adviser to the new FSA, and he’s been sent in to see how the markets really work and nobody wants to sit with him. Could you sit with him?’ It was Mervyn.”

After three hours “listening to me selling people stuff”, King asked what Lewis was paid.

“It was two-and-a-half times what they were paying him to teach me at LSE. And he was, ‘This is just criminal, this is outrageous.’ He couldn’t believe it.”

I realise that Lewis has been hoping to overtake me, banker-style, by scooping a big bonus score at the last gasp, but he has missed a subtlety of the scoring and gets less than he hoped. He is, in any case, too far behind for any bonus to help him. The final score – 197 to 147 – is a comfortable win for me, but no disgrace to my pupil. We’ve been playing and talking for two hours.

“How do you feel?” he asks me.

“Pretty scummy, actually.”

“No that’s alright, that’s alright. I learned.”

…………………………………………..

Also published at ft.com.

How much should we have to disclose?

Has economics sold its soul to Wall Street, or does it just seem that way? An economist can wear many hats – as media commentator, academic, political advisor – while also collecting significant income from gigs in the financial services industry. Do we have a right to know about such links?

Nearly 300 economists signed a letter last month urging that the American Economic Association adopt a code of ethics that would require economists to disclose possible conflicts of interest when, for instance, publishing newspaper articles or giving speeches.

The resultant debate has been fascinating, not least because economists are acutely alert to two countervailing risks: the possibility of self-serving, financially motivated behaviour, but also the chance of unintended consequences if a rule is adopted too hastily. George DeMartino, an economist at the University of Denver, has just published a book advocating professional economic ethics called The Economist’s Oath – but fearing the consequences of haste, he did not sign the letter.

DeMartino argues that there is far more to the question of professional ethics than a disclosure code. Economists wield their influence in many different fields, and DeMartino wants the whole profession to reflect far more deeply on the ethical issues that might arise in the course of practising economics.

To return to the narrower idea of disclosure, practical objections soon occur. For instance, Professor DeMartino’s book is published by Oxford University Press. My first book was published by Oxford University Press and I still receive royalties from them. Was it essential that I disclose that financial relationship now that I have mentioned DeMartino’s book? Could any written code reliably guide that judgment call?

Dr Ben Goldacre, who is currently researching a book on the pharmaceutical industry, says that when it comes to disclosing conflicts of interest, “medicine is the best of a bad lot”. Medical journals can and do require authors to disclose relevant financial interests, but Goldacre complains that other activities – such as speeches – can be carried out without disclosure. A researcher could also accept a $500 honorarium from half-a-dozen companies and hundreds of thousands from a single backer. Since the sums of money are not disclosed, the true financial interest can be buried in a pile of trivia. Nor is it terribly attractive to suggest that economists must release their tax returns in order to publish in a peer-reviewed journal.

Even if disclosure is necessarily imperfect, isn’t it better than nothing? Professor Lant Pritchett of Harvard strongly disagrees, arguing that the entire idea is not only unworkable but actively corrosive. “Disclosure is going in the wrong direction.” What should matter, he says, is the quality of argument, analysis and evidence. “If we really wanted to improve economic science, we’d insist that every article be anonymous, rather than saying, ‘This guy is friends with so and so, and has a consulting gig.’”

I suspect Pritchett is fighting a losing battle, and believe that economics journals should figure out a way of managing disclosure without reducing all economic debate to ad hominem debates about who is funding whom.

Yet Ben Goldacre makes a telling observation: “Part of the process of changing the culture around conflict of interest lies with the audience for conflict of interest statements.” In other words, you can expect sensible disclosure of potential conflicts only in a world where other people read and digest disclosure statements in a sensible fashion, rather than exploiting any whiff of impropriety for political advantage. With memories of the crisis so fresh, it may be some time before we live in that world.

Also published at ft.com.

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