Tim Harford The Undercover Economist

Articles published in March, 2014

Four steps to fixing inequality

‘As the example of Finland makes clear, it is possible to change income distribution dramatically’

By most measures, and in many countries, income inequality has been increasing for a generation. Some people don’t care, so here’s another way to look at the problem: over the past 20 years, the pre-tax incomes of the poorest 99 per cent in the US grew by just 6.6 per cent after adjusting for inflation. That is a pathetic one-third of 1 per cent per year. Those who aren’t worried about increasing inequality should still be concerned at such widespread stagnation of living standards.

So what is the solution? Here is a modest proposal to fix inequality in four easy steps.

The first step is to be precise. Are we using the Gini coefficient or the share of the top 1 per cent to measure inequality? Wealth, consumption or income? Before taxes and benefits or after?

This last question is often ignored but it makes a big difference. Consider Finland, France and Japan. Looking at pre-tax household incomes, Finland is the most unequal of the lot. But after the tax system has done its work, Finland is the least unequal. (My source here is a database compiled by the political scientist Frederick Solt.)

Finland’s market economy delivers outcomes roughly as unequal as those of the UK and the US but the tax system is far more redistributive. In contrast, Japan is more equal than the UK and US despite a tax system that redistributes less than theirs, because the country’s economy delivers more egalitarian outcomes.

The second step is to look at underlying causes rather than symptoms. As the philosopher Robert Nozick forcefully observed, there is something strange in worrying about income distribution without considering what processes, just or unjust, produced that distribution.

This isn’t just a philosophical argument – there are practical implications. Consider JK Rowling who is extremely rich because every time someone buys a Harry Potter book, she gets a cut – and a very large number of people have bought Harry Potter books. Unless Bill Gates is out shopping, every time a Potter book is purchased income inequality increases.

Rowling’s wealth is underpinned not only by Harry Potter’s commercial success but by copyright laws which ensure she reaps the benefits of that success. Rowling is not yet 50, so with luck she will still be with us in 2050, and her books will continue to generate inequality-increasing copyright revenue for the rights holders until 2120. A different set of rules might have produced a result that was more equitable yet perfectly efficient. Rowling did not need several hundred million pounds to persuade her to tell us what happens to Hermione in the end.

My point is not to single out Rowling for any criticism but to point out that fortunes do not accumulate through skill and luck alone – there is always a particular underpinning of laws and regulations that could, if we wish, be changed. Carlos Slim’s América Móvil and Gates’s Microsoft could have been broken up by antitrust authorities.

Chief executives enjoy inexplicably large – and often opaque – remuneration packages. Oversight could be tightened, shareholders given teeth.

When we look directly at the sources of high incomes we will sometimes discover policies that would be a good idea in their own right and might reduce inequality only as a side effect.

The third step is to reform redistribution. As the example of Finland makes clear, it is possible for a rich and successful nation to change its income distribution dramatically through the tax system. (A recent and celebrated research paper from the International Monetary Fund adds some more careful empirical backing to this intuitive idea – although there are too many imponderables in such an analysis for it to clinch any argument.)

. . .

Not only must we ask how much to redistribute – largely a political question – we must also ask how to do it. Tax codes are riddled with loopholes and special cases, and under the pressure of the deep recession, such tangles appear to be proliferating. The British system has two nationally levied income taxes and in recent years has introduced a new (and gyrating) tax band for high earners; a separate band over which allowances are withdrawn arbitrarily; and a third band over which child benefit payments are withdrawn. Further crenellations are promised if the Labour party is elected.

However much redistribution we might feel is just, it’s certainly clear that we could redistribute for less trouble if our politicians paid more attention to sensible tax design and less attention to crowd-pleasers.

Step four is to remember the small stuff. Inequality is a consequence of countless policy choices too trivial to trouble finance ministers: whether there are good teachers in most classrooms; whether poorer areas of town are safe at night and have access to affordable public transport; whether toddlers are receiving stimulating childcare; whether the pension system encourages savers without making millionaires out of slick middlemen. We should gather better evidence on such questions and act on that evidence.

A final, fifth piece of counsel: don’t for a moment think this is a problem that can be solved in four easy steps.

Also published at ft.com.

Economic quackery and political humbug

British readers will be well aware that the UK Chancellor George Osborne unveiled his budget statement on Wednesday. Here was the piece I wrote that afternoon:

Has there ever been a chancellor of the exchequer more entranced by the game of politics? Most of George Osborne’s Budget speech was trivial. Some of it was imponderable. The final flurry of punches was substantial. Every word was political.

Consider the substantial first: in abolishing the obligation for pensioners to buy annuities, Mr Osborne has snuck up behind an unpopular part of the financial services industry and slugged it with a sock full of coins. (No doubt he will tell us they were minted in memory of the threepenny bit and in honour of Her Majesty the Queen.) This is a vigorous but carefully calibrated tummy rub for sexagenarians with substantial private-sector pensions.

Nobody else will even understand what has been done. The benefit to pensioners is immediate and real. The cost comes later – but Mr Osborne will be long gone by the time the media begin to wring their hands about some poor pensioner who blew his retirement savings on a boiler-room scam.

His other significant moves were equally calculated. A meaningless and arbitrary cap on the welfare budget is no way to rationalise the welfare state but it is a splendid way to tie Labour in knots. A new cash Isa allowance of £15,000 will benefit only the prosperous, and has political appeal while delivering no real benefit – and no real cost to the Treasury – until long after the 2015 election.

Next, the imponderable. Mr Osborne devoted substantial time to the forecasts of the Office for Budget Responsibility, and no wonder: at last the news is good. But while the OBR is independent it is not omniscient. Like other economic forecasters, it has been wrong before and will be again. Mr Osborne forgot this and spoke of growth in future years being “revised up”. This is absurd. The OBR does not get to decide what growth in future years will be. We can draw mild encouragement from its improved forecasts, nothing more.

Finally, the trivial. Any chancellor must master the skill of announcing policies that have little or no place in the macroeconomic centrepiece of the political calendar. Mr Osborne showed no shame. The news that, for example, police officers who die in the line of duty will pay no inheritance tax is appealing but irrelevant. Police deaths are blessedly rare and, since police officers are usually young and modestly paid, inheritance tax is usually a non-issue even in these rare tragedies.

So let us applaud Mr Osborne for playing his own game well – a game in which economic logic is an irritation, the national interest is a distraction and party politics is everything.

You can read this comment in context at FT.com

The business of borders

‘The economic dividing line in the UK does not run along the Scottish border, it circles London’

This Sunday, the Ukrainian region of Crimea will vote over whether to become the Russian region of Crimea.

The circumstances are far grimmer, and hastier, than Scotland’s independence vote later this year, yet both votes are a reminder that national boundaries can be arbitrary things. They spring up, evaporate or move around based on popular votes, brute force or – as may happen in Ukraine – both.

Looking back 70 years, the broad trend is for borders to appear rather than disappear. There were 76 independent countries in the world in 1946; today the US recognises 195. The diplomatic definition of an independent country does not always accord with common sense: a beautiful district in Rome is on the list but Taiwan is not. Nevertheless, the story is indisputable: the world is home to more and more independent countries. Colonies have won independence from old empires and countries have been carved into smaller pieces. Mergers, as between East and West Germany, are rare.

The curious thing about nation states is that they aren’t economic units at all but political ones. We forget this because economic statistics are compiled on a national basis but a country is an unnatural unit of economic analysis. (This point was made forcefully by Jane Jacobs in her book Cities and the Wealth of Nations.) Far more sensible is to think about the economies of major cities and the regions that supply them. Barcelona and Madrid are separate economies. The economic dividing line in the UK does not run along the Scottish border between Berwick and Gretna – it circles London, taking in Oxford, Cambridge and Brighton. London is the true economic outlier in the UK. The reason it remains part of the country is because political boundaries are determined by politics, not economics.

Yet economics matters, at least at the margin. No purely economic theory could account for the simultaneous existence of China (population: 1.35 billion) and the Vatican City (population: less than the average British secondary school). But economic theories can explain some of the changes we have seen since the second world war.

The world economy is far more integrated now. Some of this globalisation is independent of national borders – the internet and the shipping container would make long-distance trade easier whether the world had a single nation or a thousand – but much of it is a function of lower tariffs and fewer non-tariff barriers.

In a world of high trade barriers it was expensive to be a small nation, because being a small nation meant having a small market. The historian Eric Hobsbawm tells us that the British prime minister, Lord Salisbury, admonished the French ambassador in the late 19th century, “If you were not such persistent protectionists, you would not find us so keen to annex territories!”

Trade barriers have fallen steadily since the end of the second world war while the number of nation states has risen – a pattern documented in the American Economic Review by three economists, Alberto Alesina, Enrico Spolaore and Romain Wacziarg.

There is some circularity here: smaller states are keen to lower trade barriers while low trade barriers enable smaller states to flourish. Scottish nationalists have, over the years, argued that the United Kingdom is unnecessary because an independent Scotland could prosper within the European Union and that trade would be easy because Scotland could use the euro or the pound. Unionists in the UK – and in Spain, which faces secessionist pressures of its own – have argued the reverse.

It is ironic that the pro-union side is so keen to talk about barriers to integration and the separatist camp is eager to portray a borderless economy. Still, the economic logic on both sides is clear enough.

So is there an ideal size for a nation? That depends on whose ideal we consider. Alberto Alesina distinguishes between the democratic equilibrium and the “Leviathan’s equilibrium”. A democratic equilibrium is what might result if any region could secede by popular vote. The Leviathan’s equilibrium is the outcome of a process in which larger countries may find it convenient to absorb smaller ones.

The Leviathan’s equilibrium has fewer and larger sovereign states because dictators do not much care about regional self-determination but they love the military strength that comes with scale. This is something Russia’s neighbours well understand. Smaller nations can form alliances but these are an imperfect substitute for having your own aircraft carrier. San Marino, the Holy See and doubly landlocked Liechtenstein are reliant on the indulgence of their neighbours for their existence.

Yet here, again, there is more at play than pure politics. As the world economy becomes ever more intangible, there is less to be gained from seizing territory by force. France could occupy Monaco before breakfast, if it so chose. But leaving aside history, law and simple good manners, what would be the point? An occupied Monaco would not be Monaco any more.

So smaller states are a consequence of democracy, of peace, and of free trade. Let us hope they continue to thrive.

Also published at ft.com.

How a prison camp recession explains the economy

For more about these ideas, why not buy my new book?

13th of March, 2014VideoComments off

Let’s have some real-time economics

‘It would have done the Fed no harm to have had more people with a habit of making snap decisions’

What would it take to make economics more useful in a crisis? Not more rigorous or more realistic – although that would be nice – but simply better equipped to deal ad hoc with the financial equivalent of a burning building?

It’s sobering to read the recently published transcripts of the Federal Reserve’s Open Market Committee meeting held on September 16 2008, the day after Lehman Brothers filed for bankruptcy. Fed chairman Ben Bernanke and his colleagues knew AIG was also in trouble but not that the worst recession since the 1930s was under way.

The transcripts induce, at times, the frustration of watching Titanic. The ship is doomed, yet our heroes suspect nothing! The Fed committee raises the possibility of a sharp cut in interest rates but inertia wins out. They are unwilling to act until the dust settles.

The rearranging-the-deckchairs moment comes as the committee discusses the right words to use in its press release. Should it say it is watching developments “closely”, or “carefully” or just watching? Nobody really knows.

In retrospect, the Fed was slow to act – as subsequently evidenced by three later, large rate cuts in an attempt to catch up. But it would be unfair to suggest that the committee was clueless. The meeting begins with a crisp discussion of the impact so far of the Lehman collapse. That’s followed by an agreement to swap currency, without limit, with other major central banks.

The overwhelming sense, however, is of a group of men and women who are rooted to the spot in the face of uncertainty. One of the staff economists, Dave Stockton, presents a detailed economic outlook before admitting, “I don’t really have anything useful to say about the economic consequences of the financial developments of the past few days.” With hindsight, what that meant was that he didn’t really have anything useful to say at all.

Bernanke himself sums up the mood perfectly as he reflects on the rapidly evolving bank bailouts and the risk of moral hazard: “Frankly, I am decidedly confused and very muddled about this.” There is wisdom there – but not of a very reassuring sort.

Hindsight is a wonderful thing and nobody should envy policy makers in such a situation. But is there a better way to conduct emergency policy? I have three suggestions.

First, increase diversity. Despite the reputation of the US for having a revolving door between big business and government, the Fed’s board looked weighted towards government insiders such as Timothy Geithner, then head of the New York Fed, and academics such as current Fed chairwoman buykeppraonlinenow.com Janet Yellen and Bernanke himself. Not many board members had high-level business experience. A variety of perspectives tends to generate a more honest conversation, and it would have done the Fed no harm to have had a few more people with a habit of making snap decisions.

Second, overhaul the economic data available. The Fed was flying blind: it knew surprisingly little about who was exposed to a collapse of Lehman and, immediately after that collapse, a vast tangle of contracts sat in limbo while the picture was slowly sorted out.

In a speech in New York two years ago, Andrew Haldane of the Bank of England argued that financial regulators and risk managers should draw inspiration from the development of supply-chain standards. These standards turned the humble barcode into a way of tracking products as they moved around the world. Because firms could follow products through the production and logistics system, bottlenecks could be bypassed and supply crunches spotted in advance.

What we need now are barcodes for financial products and companies – and they are on the way. The Financial Stability Board, which tries to co-ordinate financial policies across borders, has been developing the building blocks of a system designed to identify specific financial products and legal entities. That last point sounds trivial but it isn’t. Lehman Brothers was a Gordian knot of corporate vehicles. An up-to-date network map of who owned whom would have been invaluable.

Once better data are available, they also need to be displayed in a clear, robust and timely manner. Emery Roe of UC Berkeley, author of Making the Most of Mess, studies high-reliability systems such as electricity networks, whose operators must keep the system up and running despite a constantly evolving set of constraints and setbacks. Roe argues that one key feature of such systems is a clear visual display of trustworthy information. Electricity network operators have this but finance is way behind. The ultimate goal should be for regulators to glance at a computer display and spot stresses and vulnerabilities in the financial system, in real time – not easy.

Perhaps we should also treat such endless firefighting with more respect. In economics, ecology and other disciplines, Roe argues, those making tough decisions in the field are disparaged as practising “agency science”. Yet somewhere there is an ecologist who needs to decide how to respond immediately to the latest toxic spill, and there is an economist who needs to decide how to respond immediately to the latest bankruptcy.

We need people with the art of real-time economics – an art that shouldn’t be dismissed just because it cannot match the rigour of the ivory tower.

Also published at ft.com.

Sorry decline of English social housing

We are getting rid of homes that are compact, cheap, fully used and warm, writes Tim Harford

‘In 2012-13, the private rented sector overtook the social rented sector to become the second largest tenure in England.’ English Housing Survey Headline Report 2012-13, Department for Communities and Local Government, February 26

What on earth does it mean to be the ‘second largest tenure’?

You know you’re reading a government report when the top line of the “key findings” section is incomprehensible without an explanatory note. What they mean is that there are more English households renting private housing than renting social housing. Social housing is provided at a discount by local authorities or housing associations, and the number of households renting social housing has been in slow but steady decline for three decades despite a rising population.

And as traditional social housing has been in decline, privately rented housing has been rising to take up the slack?

Over 15 years, yes – the private rental sector has boomed. But the longer-term story is that home ownership is on the rise, from about 55 per cent to about 65 per cent. The private bit of the rental sector has a much larger slice of a smaller pie.

Well, that’s good. Private markets deliver prosperity.

Sometimes. But there are reasons to mourn the decline of social housing. A quarter of the people now privately renting are receiving a government handout in the form of housing benefit, so this isn’t an argument about needing help from the taxpayer – it’s an argument about which form of help might work best. Social housing is smaller, cheaper and less likely to be “under-occupied” than private housing. Yet social housing is also the best insulated by some measures – and private rentals are the worst insulated no matter how you look at them. There’s also a thing called the “decent homes” standard, meant to eliminate the worst damp, drafts and hazards. Social housing is the most likely to pass that standard, and is improving quickest. Private housing is the most likely to fail, and is improving slowest. Social housing is compact, cheap, fully used, fast-improving, safe and warm – and we’re getting rid of it.

But at least homes in general are more likely to pass safety and energy efficiency standards. That’s surprising: I keep hearing we’re in a housing crisis.

The crisis is that we’re not building enough houses. The quality of the ones we have is indeed improving.

You seem grouchy about social housing, but the big ‘right to buy’ sell-off did have one positive consequence: far more people now own their own homes.

I hadn’t realised that counted as a positive consequence.

Isn’t it? Isn’t owning your own home what prosperous people do?

You’re getting confused. It’s true that many people want to own their own homes, and that these days you need a good sock of cash to do so. But that doesn’t mean that it’s a good idea for a society as a whole to have very few rented properties. Have you heard of Oswald’s Hypothesis?

Didn’t they just put out a second album?

Oswald’s Hypothesis is that home ownership is a cause of unemployment. The idea was put forward by Andrew Oswald of Warwick University in the mid-1990s after he observed some worrying correlations. First, home ownership and unemployment had been on the rise across the OECD for many years. Second, countries such as Spain had high home-ownership rates and high unemployment, while countries such as Switzerland had low home ownership rates and low unemployment. There are similar correlations across US states.

It must be a coincidence. Surely you’re not saying that home ownership is hazardous to your job?

In the social sciences, who really knows anything for sure? But Mr Oswald’s story has some plausibility. If you own your house it’s not easy to move, so home ownership reduces the number of jobs you can consider.

So maybe the rise of owner-occupation isn’t good news at all?

It has its risks, for sure. But consider something that Mr Oswald wrote in 1999: “A key part of the problem is young unemployed people living at home, unable to move out because the rental sector hardly exists.” That’s no longer the reason young people live at home; the private rental sector has boomed. Maybe that helps explain why – despite all the economic woes of the past six years – unemployment in the UK was never as bad as economists feared.

Also published at ft.com.

Golden rules of thumb

‘The human brain is a marvellous thing but it does not seem to have evolved to cope with high finance’

The human brain is a marvellous thing but it does not seem to have evolved to cope with high finance. I’ve written before about the economist and financial literacy expert, Annamaria Lusardi. One of her findings is that one-third of Americans over the age of 50 failed to answer this question correctly: “Suppose you had $100 in a savings account and the interest rate was 2 per cent per year. After five years, how much do you think you would have in the account if you left the money to grow: more than $102, exactly $102, less than $102?”

One answer to this woeful situation is financial education. But can such depths of ignorance be paved over with a few evening classes? Another option is to nudge us into sensible decisions – for example, by automatically setting up pensions for us. Again, this is fine as far as it goes.

A third line of attack, embraced by some financial gurus, is the rule of thumb.

Here’s one: your age in years should be the percentage of your portfolio that is not invested in shares. Here’s another: your debt payments should be no more than 36 per cent of your gross income. A third, widespread in the US, is that in retirement one should draw down 4 per cent of current wealth each year.

Such rules of thumb are clearly limited. For example, the suspiciously precise stricture that debt payments should not top 36 per cent of gross income ignores inflation. If your mortgage interest is 12 per cent, your annual pay rise is 10 per cent and inflation is 10 per cent, then all you need do is survive two or three years and inflation will erode your mortgage. But if interest rates are 2 per cent, your pay is flat and inflation is low, then a difficult repayment schedule now isn’t going to get any easier in the future.

Some economists have been investigating how close these rules of thumb are to the optimal strategies they can compute. In a research paper entitled “Spending Retirement on Planet Vulcan”, Moshe Milevsky and Huaxiong Huang compare the “4 per cent” rule to the optimal drawdown of assets in retirement, as it might have been calculated by Star Trek’s Mr Spock. They conclude that the 4 per cent rule is not a very good one.

Another economist, David Love, looks for more sophisticated rules of thumb – for example, “moving to a (piecewise) linear rule based on the share of financial wealth relative to the sum of financial wealth and a simple approximation of the present value of future income”. Such a rule produces outcomes that closely track the Spock-like optimal strategy – which would be great if I could figure out what the rule actually was.

Love’s research suggests that it is possible to approximate the Spock strategy with decision rules that are simple enough for a website or a trained financial adviser to compute – even if it would be stretching it to call them rules of thumb.

But is the Spock strategy really the one we want to emulate? The psychologist Gerd Gigerenzer has examined a number of genuinely simple heuristics. One example: if you’re buying shares, buy the names you recognise. Another: if you’re distributing a fund between various asset classes, just distribute it equally between them all. Such clumsy-seeming rules suggest themselves naturally to the unschooled investor. Astonishingly, they work splendidly.

Here’s what seems to be happening: economists with powerful computers get hold of a stream of data on asset returns; they compute a complex optimal strategy given this historical data; then the world changes and the old “optimal” strategy turns out not to be quite so optimal.

Meanwhile the naive heuristics work rather well. Perhaps there is some hope after all.

Also published at ft.com.

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