Tim Harford The Undercover Economist

Articles published in March, 2012

Capital ways to survive the worst

The results of an experiment in Sri Lanka show the impact of financing on small businesses in communities shattered by natural disasters

In 2004, two economists, Chris Woodruff and David McKenzie, applied for funding from the National Science Foundation to do some research in Mexico. The idea was to draw inspiration from medical research and conduct a randomised controlled trial to find out whether small businesses could benefit from more access to capital. The NSF liked the idea, Woodruff recalls, but in the end turned down the funding request.

Then something truly awful happened – the Boxing Day tsunami, which devastated the coast of the Indian Ocean and killed well over 200,000 people. In Sri Lanka, more than 30,000 people were killed and many more left homeless. Small business owners found their stock, their equipment and their premises destroyed.

Against this backdrop, Julia Lane, an officer at the National Science Foundation, contacted McKenzie and Woodruff. She had liked the original research proposal and she had money to spend researching the aftermath of natural disasters. She even knew a local economics lecturer, Suresh De Mel, who might be able to get the research going in what was surely a challenging environment. A few weeks later the three researchers were in Sri Lanka testing out the first surveys.

The experiment itself looked at different kinds of businesses in different situations. All the businesses selected were tiny. Some had suffered huge losses. Others had avoided direct damage but were located in shattered coastal communities. Others were a few miles inland, unaffected by the tragedy on the shoreline. The typical (median) business had about $270 worth of capital, and the researchers were handing out grants of 10,000 rupees (about $100) or 20,000 rupees. These grants were sometimes paid in cash and sometimes made by accompanying business owners to market to make purchases on their behalf.

The results, recently published in articles in Science and the Economic Journal, tell a subtle story of recovery and of the difference access to capital can make. The broad story is this: businesses that suffered direct damage took a couple of years to catch up with those that had merely suffered indirect disruption; and businesses that received grants derived huge benefits from them – about 10 per cent return every month.

Beyond these averages, though, lurk stark differences. Damaged retail businesses enjoyed huge monthly returns when given grants. Unaffected businesses of any sort enjoyed healthy returns to capital – more than 7 per cent a month, suggesting that Sri Lankan small businesses are typically starved of capital.

But manufacturing businesses in affected areas, whether or not they had themselves been damaged, seemed to be able to do nothing useful with the money. One explanation is that they needed more capital to get manufacturing off the ground, but those receiving $200 seemed to do no better than those receiving $100. So a more plausible hypothesis is that each manufacturer was suffering from the disruption of supply chains.

In the coir industry, for example, there’s a long supply chain from the coconut harvest to processors to manufacturers of mats, brushes and other products. Each entrepreneur must deal with the damage to his suppliers and customers, and each entrepreneur may fear that others will simply give up and spend their grant money elsewhere. In such circumstances, says Woodruff, co-ordination and business advice may be critical.

The lesson I draw for other disaster hit areas, from Port-au-Prince in Haiti to Sendai in Japan, is that any industry based on a complex network of local firms is vulnerable. And something we already knew: recovery is dependent on the availability of loans or grants. When disaster has destroyed every physical asset of your business, capital counts.

Also published at ft.com.

VAT reform would keep our pasties hot

“David Cameron has attempted to dispel Labour claims that he leads an elitist ‘out of touch’ government, when he declared his love of Cornish pasties, one of the hot foods that will be taxed more under Budget VAT rises.”

Financial Times, March 29

The FT? Surely The Daily Mash or The Onion.

No, it’s true. This really is the topic of the day. You clearly feel it’s not serious.

I can think of bigger issues. At the risk of being po-faced about the whole thing, do you realise how much is at stake here?

I do. The tabloids are full of the story. And the Guardian quoted the finance director of the West Cornwall Pasty Company as saying that introduction of VAT at 20 per cent would raise the price of a pasty from £3.40 to £4.50.

You, the Guardian and the finance director of the West Cornwall Pasty Company might want to do the maths on that. I’ll wait.

Hm. You have a point. It’s more like 33 per cent than 20 per cent, isn’t it?

That’s not the only way in which this tax rise has been blown out of all proportion. Government tax revenue is £575bn. Her Majesty’s Revenue & Customs reckons the pasty tax will raise £50m this year. You did such a good job on the last maths problem, can you tell me what percentage of the total tax base £50m is?

Not a very big one.

Quite so – about 0.01 per cent, although HMRC reckons it will rise to closer to 0.02 per cent over time. To put it another way, every British citizen pays an average of almost £10,000 in tax and the pasty tax will raise one pound a head.

But people who subsist solely on hot pasties and sausage rolls will be sorely affected.

Well, that’s true. And it was great to see Ed Miliband and Ed Balls calling attention to their plight by travelling to a Greggs bakery to eat sausage rolls in front of the cameras. Whoever said that great ideological clashes were a thing of the past?

I don’t think you appreciate the seriousness of the issue.

Probably not. My father made himself a sandwich lunch almost every day of his working life, so I never got to experience first-hand the lifestyle of someone who eats so many hot sausage rolls that this makes a big dent in the standard of living.

Such people do exist.

I am sure they do, but the budget already cut income tax for low- to middle-income families by over a hundred pounds a year, which will buy a lot of pasties. And if you care about poor families, note the cut in the welfare budget by £10bn a year, or 200 times the sum at stake with the pasty tax.

There’s a broader principle at stake here.

Which is?

Um . . . Well, maybe there isn’t a broader principle at stake here. It just feels like rotten politics.

I don’t disagree.

And it creates absurd anomalies – for instance, a warmish sausage roll will be subject to VAT, or not, depending on whether it’s a cold day or a hot day.

I agree, but VAT is already subject to absurd anomalies, such as whether Jaffa Cakes are cakes or biscuits, and thereby exempt from or subject to VAT.

Biscuits, obviously.

Obviously. But the courts disagreed, so Jaffa Cakes enjoy a tax break relative to chocolate digestives. But serious tax-watchers reckon that the UK’s VAT system makes very little sense, and the pasty tax is a perfect example of it.

How so?

When you wait for a pasty to cool down in order to consume it free from tax, everybody loses: the taxman doesn’t get his tax and you don’t get your hot fresh pasty. That distortion leads to what we economists call “deadweight loss”. The UK system is full of such distortions because so many items are VAT exempt.

So what should be done?

The Mirrlees Review is an attempt to figure out what the UK tax system would look like in an ideal world, and I looked it up. The authors reckon that you could levy a uniform rate of VAT on almost everything, raise benefits, pensions and tax credits, increase the income tax threshold by £1,000, cut the basic rate of tax to 18 per cent and the higher rate to 38.5 per cent, and leave pretty much everyone better off – the government would have more revenue and citizens would be more likely to buy what they really wanted rather than what the tax system nudged them to buy.

So you’re arguing that VAT shouldn’t just be introduced for sausage rolls, but for everything?

Yes. Fancy a sandwich?

Also published at ft.com.

Following in the footsteps of Larry Brilliant

I sat down for a chat with Larry Brilliant on Wednesday at the Skoll World Forum and interviewed him about the threat of global pandemics, something I’m hoping to write a column about. But, Larry being such a remarkable character, I also wanted to ask his advice on behalf of anyone who wants to make the world a better place. Some thoughts:

It starts with ordinary people. Ordinary people do extraordinary things, and then we lionise them. We make heroes out of them. And that’s a problem, because it makes other ordinary people look at these heroes and think that they can’t achieve the same things. But that path is open to everybody. Anybody at any time.

There’s more, and you can read the full interview at How To Make a Difference.

30th of March, 2012MarginaliaOther WritingComments off

Inside the mind of Hans Rosling

We all love Hans Rosling, the world’s most famous data guru. Yesterday, at the Skoll World Forum, I interviewed him for More or Less on the BBC World Service, and loyal listeners and podcast subscribers will get to hear what we talked about in a week or two.

But before the tape started rolling I had a more intimate conversation with Hans about how he began his remarkable career, and what his influences and inspirations were. Here’s a taste; Hans was a 24 year old medical student, with top grades in Sweden, taking a study year in Bangalore:

“I saw the lecturer put up a slide for discussion, I thought, ‘that’s kidney cancer, I’ll keep quiet and let the Indian students talk before I explain’. In six minutes, they had exhausted all my knowledge. In those moments I realised the Indian students were better than me. I had always been in the top quarter. In Bangalore, I was bottom quarter. And that was when I realised how racist we all were, how we thought we were better because we had been born in a richer country, with better institutions.”

You can read the full interview over at How To Make A Difference.

At last: a nice surprise from the taxman

‘Income tax payers will receive a personal statement next year in an effort to increase the transparency of government financing and stir public resentment at the level of taxes and borrowing.’

Financial Times, March 19

Stir public resentment?

That one’s a bit weird, isn’t it? The assumption seems to be that if only people knew how much tax they were paying and the outrageous things the money was being spent on, they would immediately come round to the small-government Conservative way of thinking.

Would they?

I’m not sure. My back-of-the-envelope calculations show that about a quarter of income taxpayers pay more than the average income tax bill, and about three quarters pay less than the average.

What kind of witchcraft mathematics is that?

The rich pay a lot of income tax because they face higher tax rates and have a lot of income. The average income tax bill, per taxpayer, is roughly £5,000 – about £150bn spread over about 30m people. But you’d need to earn more than three-quarters of your fellow income taxpayers do before you paid that much tax. The top 1 per cent of income taxpayers pay more than a quarter of all income tax.

Sounds like the rich are getting a rough deal.

Not necessarily, but it does sound as if they’re useful to have around if you want to pay for public services. My point is that when these tax statements arrive, three quarters of people will be paying less income tax than the average. They might be pleasantly surprised.

So will these statements change the way people behave?

I doubt it. The economists Ritva Reinikka and Jakob Svensson published a study showing that transparency about grants to local schools in Uganda dramatically reduced corruption. The UK government is releasing a lot more data about spending on big contracts, which is welcome – but unlikely to reveal Ugandan-scale graft. Another economist, Raj Chetty, has demonstrated that making sales taxes more obvious to shoppers can discourage them from spending . But it’s hard to make the leap from such research to a major change in attitudes in the UK.

I read in the Guardian that the statements lump together unemployment benefit with more popular spending on pensions, family and disability benefits, to discredit the idea of “welfare”.

Yes, I read that piece, and was baffled about what the problem was supposed to be. I admit that in choosing what to lump together and what to itemise, the government can influence us in subtle ways. But the mock-up tax statement – so much clearer than any document I’ve yet received from the taxman – breaks out unemployment, pensions, family support, housing benefit and disability benefits. Until I saw the breakdown I had no idea that spending on unemployment benefit was so tiny, at 3 per cent of the welfare budget.

Any other surprises in this tax statement?

I hadn’t realised defence cost more than the police, the courts, the fire service and prisons put together. And I hadn’t realised that we spend more on “recreation, culture and religion” than on universities. The statements are a real eye-opener, but will they stir resentment? I’m not sure. Take the Treasury’s hypothetical taxpayer, on £15,000 a year, who pays nearly £2,500 in income tax and national insurance. He will be told that he is paying £12.13 for the fire service and another £12.13 for a contribution to the European Union. Not obviously an outrage. Nor will he necessarily faint when he discovers that the three biggest items on his tax statement are pensions, schools and the NHS.

But these tax statements are still tricksy. They deliberately omit regressive taxes such as council tax, VAT, fuel duty and taxes on alcohol and cigarettes.

Hold on a second. What you’re saying makes no sense on so many levels. First, council tax already comes with a similar kind of statement. Second, the government can’t tell you how much you’ve spent on indirect taxes unless they collect data on every penny you spend. Third, fuel duty isn’t regressive because the poorest people rarely own cars. VAT isn’t regressive either – because poorer households spend disproportionately on low- or zero-VAT items such as food and heating.

And cigarettes?

I would gladly have a pie-chart from the Treasury slapped on every packet of ciggies, both as a gesture of transparency and as an incentive to quit.

Also published at ft.com.

Forensic finance under the microscope

The trend of economists functioning as detectives may ultimately be good for the profession

The first edition of The Undercover Economist sported a pulp-fiction private investigator on the cover. I’d suggested the image because, well, why not? Little did I realise I was anticipating a trend: the economist as detective.

It seems an unlikely development, given the fondness of economists for convenient simplifying assumptions. (Had Sherlock Holmes been an economist, he would surely have assumed that the Hound of the Baskervilles was a perfectly spherical dog moving in a frictionless environment.)

But whether the development seems unlikely or not, “forensic economics” has arrived. A splendidly simple example was published in 1994. William Christie and Paul Schultz noticed that prices on the Nasdaq market, quoted in eighths of a dollar, actually varied by quarter-dollars. Quotes ending one-eighth, three-eighths, five-eighths and seven-eighths were rare. Christie and Schultz checked carefully before concluding that this was probably symptomatic of collusion between market-making investment banks, designed to keep bid-ask spreads plump. An investigation by the Securities and Exchange Commission, class-action lawsuits and out-of-court settlements all followed.

Other examples of forensic economics are more complex. A recent survey on forensic finance by Jay Ritter and a forthcoming one on forensic economics by Eric Zitzewitz jointly outline how forensic economics is evolving.

One approach is to use purely statistical analysis, the most famous example of which comes courtesy of Brian Jacob and Steve Levitt, who identified some improbable patterns in multiple-choice test results in some Chicago schools. These suspicious “answer strings” (with all students giving the same response to clusters of questions) were correlated with sharp, temporary improvements in average scores.

Another approach is to use deviations from what an economic www.stayfitgethealthy.com/med/ theory would predict. Zitzewitz found evidence of “late trading” in mutual funds, which is illegal. He showed that trades were correlated with information the traders couldn’t legally have possessed and could not – according to the efficient markets hypothesis – have deduced. The suspicious patterns disappeared after an investigation was announced.

Field experiments are also increasingly popular as a way of revealing suspicious behaviour. Benjamin Olken studied corruption in road building in rural Indonesia, devising his own measures of how much construction material had been stolen and cross-checking them with an independent audit.

What emerges from forensic economics? Zitzewitz argues that a major theme is government failure: not just the failure of dysfunctional governments in poor countries, but the failure of police and regulatory authorities in the United States and other wealthy countries. Perhaps in these gloomy times that will not come as a huge shock.

It’s fair to ask why economists feel they are qualified to undertake this kind of analysis. They are a self-confident bunch and may not be inclined to ask such questions of themselves. But answers do exist.

Economics is unusual in requiring statistical sophistication plus the ability to think about man-made institutions and human motivations. And economists are naturally suspicious: rational economic man, after all, is smart and amoral, the kind of person you’d want to keep an eye on.

The forensic economics trend may be good for the economics profession, too. It requires economists not to spend too much time thinking about theory, but to pay close attention to data, and to the messy way in which markets actually work. These cannot be bad habits for economists to acquire.

Also published at ft.com.

Mr Speaker, let an economist speak sense!

“Order! Order! That concludes questions to the prime minister. Now, I have a quick procedural change to announce before the Budget speech. Technocratic leadership is all the rage these days so I have tied the Right Honourable George Osborne up in a cupboard and appointed an unsuspecting economist chancellor of the exchequer for the afternoon.”

Gosh, Mr Speaker, this is all a bit of a surprise. I’ve hardly had time to have a couple of stiff drinks before coming to speak to you all today, and I certainly haven’t had any time to look at the forecasts from the Office for Budget Responsibility. They’ll probably be wrong, anyway, so I hope you won’t mind if I move straight to the measures I plan to introduce. My fellow economists have lots of ideas and I suppose this is a good time to implement them.

My Budget is simple: short-term stimulus; long-term fiscal consolidation; and reform aiming at a sane system of taxation. This seems to be the precise opposite of what most of my predecessors had in mind, but they will get over it.

First, stimulus. Mr Osborne has been boasting of his plans to reduce taxes and spending simultaneously. This is precisely the opposite of what is required at a time of weak aggregate demand, and every bit as foolish as when Gordon Brown increased both taxes and spending in a boom. I will unveil a package of spending on roads, railways, primary schools in oversubscribed areas and social housing. In many cases this will simply mean implementing pre-existing plans, so the building work can start without delay. By utilising spare resources in the economy, this plan will stimulate demand and provide urgently needed infrastructure at a low cost to the wider economy. On the “stitch in time” principle it will also reduce the total need for public spending over the next decade and beyond.

Naturally, none of these schemes will seek private finance or other costly accounting gimmicks. Bond investors have shown a huge appetite for lending to governments outside the eurozone and it would be quite absurd to ignore this willingness to lend, especially when the long-term fiscal position of the UK would be enhanced as a result.

As an additional short-term stimulus, I will follow the advice of the National Institute of Economic and Social Research and temporarily scrap national insurance for the young and for low earners. This will encourage employers to take on, or keep, people who might otherwise be shut out of the labour market, with disastrous long-term consequences.

All of these measures will increase the deficit. None of them, however, will increase the structural deficit or make a material difference to the long-term debt profile of the country. Nevertheless, long-term fiscal consolidation is a challenge that must be met. I will start by breaking the stranglehold the elderly have on the public purse. The triple-lock commitment to steadily ratchet up the value of pensions was a promise that should not have been made. It will be abolished, as will expensive, arbitrary and poorly targeted perks, such as free television licences.

We care about the genuinely infirm and will implement in full the Dilnot Commission’s proposals to cap the costs of long-term care for the elderly, a policy that costs little, is fair and will do much good. But my government has no interest in transferring ever more resources from the young to an ever larger and healthier group of people who just happen to be older.

Further long-term fiscal consolidation will come from simplifying the tax system. I have been encouraged by Mr Osborne’s rhetoric on this subject, but less so by his specific plans, which at the time of his sudden disappearance involved: as many tax bands as ever; fresh complexities with child benefit; and differential treatment for the oil, pharmaceutical, aerospace, and video-game industries, for broadband infrastructure, renewable energy, low-emission cars, road hauliers and anyone or anything that is not a bank. In short, Mr Osborne thought tax simplification was all about the rate of value added tax on biscuits.

I disagree. I would seek to implement the advice of the Mirrlees Review – broadening the tax base, unifying national insurance with income tax, abolishing the majority of special treatments, aligning tax on income with that on capital gains and dividends, taxing property and land rather than taxing transactions, and in general treating the tax system as a whole rather than a messy patchwork. This is a major effort that promises major benefits.

Finally, I am sure this House will agree it has had quite enough of the Budget circus. It may be an enjoyable political platform but there is no economic justification for the annual kaleidoscope of trivia. Therefore, I propose that the next Budget speech not be made until 2015. I do not expect to be the person delivering it.

First published on FT.com

Is it okay to lie in the service of a greater truth?

I’m just catching up with this quite remarkable episode of one of my favourite shows, This American Life.

Quick background. The “monologist” Mike Daisey has been achieving plaudits for a remarkable, tense, elegantly-written and powerfully-delivered theatre show in which he visits a Foxconn iPhone factory in Shenzhen, meets the illegal unions, the crippled workers, the under-age girls, etc. etc. “Do you really think Apple doesn’t know?”, he asks at one point.
This American Life recorded Daisey’s monologue and broadcast it. It became the most popular ever episode of a deservedly popular show. This American Life fact-checked the background, but they didn’t fact-check Mike Daisey’s traveller’s tale itself – partly, they say, because Mike Daisey deliberately put them off the scent.
And alas, This American Life are now reporting that important parts of Daisey’s story are entirely fictional.

And so TAL have now retracted the entire episode and have a fascinating discussion of what went wrong. I thoroughly recommend listening to the program (I’ve not even finished listening myself but I want to get the word out).
Daisey’s defence, as discussed in the New York Times, is to my mind unacceptable – basically that he was true in his own fashion; he’s a theatre guy, not a journalist, so he can invent and exaggerate.
I am reminded about what a friend at The Economist told me after Johann Hari’s exploits: it’s absolutely fine to make stuff up – and when you do so as a foreign correspondent, it’s also really easy to do – but when you do it needs to be filed under “fiction”, not “nonfiction”.

One thing that always bothered me about the Daisey episode was the way Daisey glossed over what a terrible life people had in China in the 1950s and 1970s. He mentions Shenzhen used to be a lovely sleepy fishing village, and implies – although never comes right out and says it – that things were great before Deng Xiaoping let the bad old corporations into China. (In fact China suffered the worst man-made famine in human history, and the cultural revolution.)
I felt that these were the actions of a man wanted to put his own very strong slant on the truth. Naively it did not occur to me that Mr Daisey might depart from the truth entirely. In his own words, he says that “Stories should be subordinate to truth.”

This has left me feeling a still greater respect for This American Life for confessing their mistakes so straightforwardly, and viewing Daisey as something of a tragic figure – a man who has misused great talents. Maybe I’m wrong. What do you think?

Update: Tim Worstall disagrees with Mike Daisey on most things but he’s backing him on this issue.

Who’s impressed with Osborne’s big bond?

“Mr Osborne will announce plans for the Debt Management Office to test market appetite for “super-long gilts” of 100 years or more, designed to cash in on investor confidence.”

– Financial Times, March 14

What’s this? George Osborne wants to show that his bond is bigger than the next man’s?

Something like that. The UK Treasury, unlike, say, Spain’s or Italy’s, is able to borrow from investors very cheaply. On the surface the chancellor appears to be thinking “instead of borrowing cheaply for two years, I could borrow cheaply for a 100 years, or perhaps for ever”. However, I think his real thoughts are closer to: “I wonder what might provoke every newspaper to mention that the UK Treasury, unlike, say, Spain’s or Italy’s, is able to borrow from investors very cheaply.”

Good politics, bad economics, in other words.

This is George Osborne we’re talking about.

Why is it bad economics?

Well, let’s be clear. Issuing long-dated bonds isn’t necessarily bad economics. But arguing that you can lock in today’s low rates for long periods of time is terrible economics. Today’s low rates are unusual. Why would investors want to extend them for a century?

There’s the Homer Simpson theory of bond investors, of course.

You’re thinking of Homer buying a car on credit and accepting the “CPB clause”?

Yes, the “crippling balloon payment”.

It turns a great deal into a terrible one, but postpones the day of reckoning.

As Homer said, “but that’s not for a while, right?”

I’ll admit that not every bond investor has shown signs of genius, but you can disprove the idea that investors will lend cheaply for ever by looking at bond yields today. Two-year bonds are yielding about 0.5 per cent. The 20- and 30-year bonds are yielding over three per cent, and the “War Loan” bonds, which never stop paying out, are yielding nearly 4 per cent. Just because investors will give you a cheap short-term loan doesn’t mean they will agree to the same rate at any maturity you care to name.

So Mr Osborne can borrow right now at 0.5 per cent, or lock in an interest rate of four per cent for a 100 years?

Pretty much, yes.

That sounds like a terrible idea. Why did you say issuing long-dated bonds wasn’t necessarily bad economics?

At a first approximation, it makes no difference whether bonds are short- or long-dated. Investors who want to lend money briefly can just sell long-dated bonds on the open market and get their money back at any time. Investors who want to lend money for long periods of time can keep reinvesting in a series of short-dated bonds. If either long- or short-dated bonds looked bad value, investors would vote with their feet.

So why are short-dated bonds so cheap right now?

Mostly because investors expect future short-term yields to be much higher, and are figuring they can lend for 10 years at, say, 2.3 per cent, or they can lend at 0.5 per cent now with the likelihood of being able to lend at 3 per cent later. It will all come out in the wash.

Why does anybody care about bond maturities, then?

I only spoke about a first approximation. The UK has benefited from having had a lot of long-term debt when the crisis began, which protected it from short-term panics. And there’s another consideration: in an uncertain world, bond investors will choose the maturity that fits their needs to reduce the risk of something unexpected happening. Some financial institutions like short-term bonds because they have flexibility even in a crisis; whereas pension funds will go for 20- or 30-year index-linked bonds because that matches the payments they have to make to pensioners.

Who likes 100-year bonds?

Nobody that I can think of. The National Association of Pension Funds has already said they are too long. But giant tortoises of the Galápagos can live for well over a century. Perhaps there is a market for Tortoise Bonds.

There’s a tree in California nicknamed Methuselah. It’s over 4,800 years old.

Methuselah Bonds! Now you’re showing some real ambition, although I am not sure that bristlecone pines have the same presence in the bond market as, say, Pimco. Still, who’s to say Mr Osborne’s prudence won’t earn the nation 5,000 years’ worth of credibility? Just show me where to sign up.

Also published at ft.com.

Charity begins… in the back office

One handy way to size up a charity is to pay attention to how much it spends on overheads, rather than frontline do-gooding

You’re a generous person, I can tell. But how much do you think about the effectiveness of your charitable donations? One handy way to size up a charity is to pay attention to how much money it spends on overheads such as administration and fundraising, rather than frontline do-gooding. There’s only one small problem: this ready reckoner is enormously misleading.

For people who think about the effectiveness of charities, this insight is not news. Givewell, a charity that evaluates the effectiveness of other charities, complained five years ago about the “pervasive attitude that nonprofits need to get all their money right to the needy, and do all their administration on the cheap”. Dean Karlan, an economics professor and co-author of More Than Good Intentions, analysed Givewell’s recommendations and found that outstanding charities tended to spend more money, not less, on administration and fundraising.

Caroline Fiennes, author of a new book, It Ain’t What You Give, It’s The Way That You Give It, explains that fundraising costs tend to be determined by donors – who can generous or stingy, ignorant of the cause or conscious of it. Meanwhile, administration costs could include efficient logistics, accounting or purchasing systems – plus paying for rigorous evaluation.

It isn’t just in the world of charitable giving that we pay too much attention to administrative costs. Government ministers of all stripes love to claim that they will cut bureaucracy, sacking administrators and managers and investing the savings in “teachers and nurses”. If your child’s school is closed for a day or so because the heating fails, or your operation is cancelled due to lack of surgical supplies, then you can at least console yourself that those pesky administrative costs are being thoroughly squeezed.

The truth is that in the modern world, a surprising amount of money is spent on what one might call transaction costs. One definition of a transaction cost is any cost that Robinson Crusoe could never conceivably have faced. Costs of processing trades, searching for bargains, standing in line and suing for breach of contract are all transaction costs. So, arguably, are the costs of maintaining accounts and filing (or avoiding) taxes.

John J. Wallis and Douglass North, in a book chapter published in 1986, tried to estimate the importance of transaction costs in the US economy between 1870 and 1970. For simplicity, Wallis and North tried to define whole job categories devoted to supporting transactions (these include managers, sales assistants, lawyers, police and accountants) and also sections of the economy, such as retail, which were almost entirely devoted to supporting transactions.

Wallis and North reckoned that the production of the economy devoted to transaction services had more than doubled over the century, from 26 per cent of gross national product in 1870 to 55 per cent of GNP in 1970. Public sector transaction spending had grown especially rapidly, but from a low base, and the lion’s share of transaction costs remained in the private sector: a total of over 40 per cent of GNP – an awful lot of administrators. All waste? Surely, the story is a continuation of what Adam Smith identified back in 1776: increasing productive power thanks to specialisation and the division of labour. A subsistence farmer may have overheads, but he needs few transaction services. A modern city-dweller, who continually does business with strangers, lives and breathes them.

Spare a thought, then, for the humble back office. Not only are administrators, accountants, lawyers and managers necessary to make a charity work efficiently – such people make the modern world possible.

Also published at ft.com.

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