Tim Harford The Undercover Economist

Articles published in May, 2014

Gary Becker – the man who put a price on everything

The Nobel Prize winner believed that no matter what the subject, economics always had something insightful to add

Perhaps it was inevitable that there would be something of the knee-jerk about the reaction to the death of the Nobel Prize-winning economist Gary Becker. Published obituaries acknowledged his originality, productivity and influence, of course. But there are many who lament Becker’s economic imperialism – the study of apparently non-economic aspects of life. It is now commonplace for those in the field to consider anything from smoking to parenting to the impact of the contraceptive pill. That is Gary Becker’s influence at work.

Becker makes a convenient bogeyman. It did not help that he could be awkward in discussing emotional issues – despite his influence inside the economics profession, he was not a slick salesman outside it. So it is easy to caricature a man who writes economic models for discrimination, for suicide and for the demand for children. How blinkered such a man must be, the critics say; how intellectually crude and emotionally stunted.

The criticism is unfair. Gary Becker’s economic imperialism was an exercise in soft power. Becker’s view of the world was not that economics was the last word on all human activity. It was that no matter what the subject under consideration, economics would always have something insightful to add. And for many years it fell to Becker to find that insight.

Consider his first book, still one of his most famous works, on the economics of discrimination (1957). There’s a lot to say about discrimination and Becker doesn’t even begin to claim that economics says it all. Instead, he heads straight to where an economist can make a difference. Assume that some people have a prejudicial distaste for others, says Becker. Assume bigoted workers would rather turn down a pay rise than work in a racially mixed environment. Bigoted employers would prefer to employ a white worker for much the same reason that lecherous employers prefer an attractive young personal assistant: because office life is about satisfying desires other than purely financial ones. Some other employers may prefer to hire a white worker because they know their other workers might be prejudiced against a non-white colleague; or because their customers don’t want to look at a non-white face or talk on the telephone to someone with the wrong accent.

Assume for a moment that we live in this wretched world – which we do, and did so even more in the 1950s. In which case, Becker asks: what happens? How do markets unfold? What happens to the wages for the victims of discrimination? Will competitive forces eliminate the wage gap between whites and non-whites, as non-bigoted employers see a chance to make money? In short, how is a social or psychological prejudice translated into economic outcomes?

These questions are neither reductive nor simplistic, and economics is well placed to provide some answers. Bigots can make life upsetting and dangerous for minority groups even if the bigots themselves are not numerous. But Becker showed that to have an impact on minority wages, bigotry would have to be widespread – otherwise unprejudiced companies would simply hire all the minority workers. Market forces tend to separate the bigots from the victims of their bigotry. Relative wages for minorities are determined not by the average level of prejudice in the population but by the most prejudiced employer who nevertheless ends up hiring someone from a minority.

Four decades after Becker’s original book, two economists Kerwin Kofi Charles and Jonathan Guryan published a research paper examining his theoretical predictions. They concluded: “We find strong support for all of the key predictions from Becker about the relationship between prejudice and racial wage gaps.”

The research paper from Charles and Guryan is one of many to have looked at Becker’s theories over the decades. He had a tendency to inspire or to provoke others to respond. In 2003 Steven Levitt and Pierre-André Chiappori conducted a survey of recent papers in empirical economics, looking for the economic theorists who had inspired the most empirical research. It was Gary Becker who topped their list – and his nearest rivals weren’t close.

Superficially, Becker appears to stand for the opposite of modern behavioural economics, which these days seems to be the acceptable face of the economics profession. After all, while the behavioural economists bring psychological insights into an analysis of markets, Becker did the opposite, imposing a rational-choice model on non-market situations such as marriage and parenting. Behavioural economists love empirical data but Becker was a theorist. Is he not, then, the opposite of all that is cool and forward-looking in economics?

That criticism only survives the most casual acquaintance with Becker’s work. His Nobel speech, for instance, opens with the comment: “I have tried to pry economists away from narrow assumptions about self-interest. Behaviour is driven by a much richer set of values and preferences.”

Or consider a research paper from the prehistory of behavioural economics (1962) with the title “Irrational Behaviour and Economic Theory”. The paper looks at what impact an “extremely wide class of irrational behaviour might have on some of the key theorems of economics”. The paper also declares that the ultimate defence of economic theory “is an empirical one”. Theories are powerful but in the end it is the facts that are definitive. These are key questions in behavioural economics literature today.

The author, of course, was Gary Becker.

Also published at ft.com.

When a man is tired of London house prices

‘Since Londoners cannot seem to stop asking, “Is there a bubble?”, I’ve been trying to figure out the answer’

I predicted the UK house price slump of 2007. I was even planning to devote an episode of my BBC2 series to the subject back in 2006, until my producers demanded a different topic. They argued that house prices would assuredly keep rising, so I would seem silly. The replacement theme was “It’s hard to predict the future”; prices duly fell by 15 per cent in real terms.

This triumph should be set in context: I had been forecasting a slump in 2002, 2003, 2004 and 2005. Nevertheless, since Londoners cannot seem to stop discussing the question, “Is there a house price bubble?”, I’ve been trying to figure out the answer, both for Londoners and others.

This isn’t an easy question for economists to answer – bubbles are a matter of psychology, and psychology is not our strong suit. But we can attempt a diagnosis by looking at economic fundamentals. The price of any investment asset should be related to the future income you can derive from that asset, whether it’s the rent you can earn as a landlord, the dividends from corporate shares, or the interest payments on a bond.

A good working definition of a bubble is that the price of an asset has become detached from fundamentals, which means the only way to make money in a bubble is to find a bigger fool to take the thing off your hands.

What are fundamentals telling us? The most straightforward comparison here is of the price of buying a house versus the price of renting one. In the UK, both prices and rents are at high levels relative to income. This is no surprise: everyone knows that the UK has been building too few houses for many years.

But have prices outpaced rents, suggesting a bubble? It seems so. US house prices are at historical norms relative to rents, and German and Japanese prices are unusually cheap to buy rather than rent. Yet in the UK, house prices are one-third above their long-term value relative to rents. And in London, gross rental yields are lower than in other UK regions at a slim 5-ish per cent. Such returns look low, given the costs of being a landlord. Logically, either rents should soar or prices should fall.

Yet London prices have lost touch with London earnings and with the price of houses in London’s commuter belt, and they continue to rise quickly. All this seems unsustainable, and when interest rates finally rise, surely the distressed sales will begin?

But there are three counter-arguments. The first is that housing is different. The second is that London itself is different. The third is that this time around is different.

Let’s dispense with the argument that housing is somehow bubble-proof. Bricks and mortar seem reassuring but there is no law of economics that says money is safe in housing. Real Japanese house prices have almost halved since 1992. Real house prices in the US have soared and slumped and are now cheaper than they were in the late 1970s.

But what if London itself has a housing market that never falls? We only need to go back 25 years to see that this isn’t true. According to Nationwide, a UK mortgage lender, the average London home was selling for just under £98,000 in the summer of 1989. Prices then fell by one-third and didn’t top £100,000 for nine years. Cumulative inflation over the same period was well over 50 per cent. London housing in the late 1980s was a disastrous investment.

All we have left, then, is the argument that there is something different about London’s housing market this time around, because London has become an investment hotspot for wealthy foreigners seeking a safe haven for their cash.

Surprisingly, there is truth in this story. Research by Cristian Badarinza and Tarun Ramadorai, economists at the University of Oxford, finds that trouble spots across the world are correlated with hotspots in local London property markets. When the Greek economy imploded, for example, areas of London with a higher proportion of Greek residents saw a measurable pick-up in demand. The thinking here is that if a Greek wants to get his money out of Greece and into London, he’ll pick a place where he already knows people who can scout out property and where he might someday want to live himself.

Yet the laws of supply and demand have a habit of reasserting themselves eventually. Londoners might want to glance at New York – another ludicrously expensive city, and another magnet for money and people from across the world. House prices in New York have fallen by about one-third since 2006 and are at about the same level as in the mid-1980s relative to rents, income or inflation. In the long run, why should London be any different?

The final counter-argument is the most depressing. It’s that returns on all assets will be low in future because the world has entered a secular slump. That means that house prices should be expensive because other assets are expensive too. As Oxford economist Simon Wren-Lewis points out, the secular slump theory should apply globally if it is true. And while some housing markets, including those in Australia, Canada, France and Sweden, also look expensive, others do not.

If the secular slump tale is true, London housing is sensibly priced and property in many other parts of the world has yet to catch up. Heaven help us.

Also published at ft.com.

Healthcare: the final reckoning

Somebody, somewhere has to be able to say, ‘‘That’s great – but it just costs too much’’

This piece incorporates a correction made on 9 May 2014.

If the American right is looking for a “death panel” ruling to complain about, one has just appeared: trastuzumab emtansine, a breast-cancer treatment produced by the Swiss pharmaceutical company Roche, looks unlikely to be endorsed by the UK’s National Institute for Health and Care Excellence (Nice). That is not because the drug doesn’t work – Nice thinks it does – but because it costs too much.

The death-panel fantasy has mutated over time. It originally raised the prospect that Barack Obama’s healthcare reforms would require bureaucrats to decide who was worthy of treatment and who would be left to die. Death panels do not exist, so now the allegation has shifted to the idea that the president’s reforms involve the rationing of healthcare.

So far there is little evidence of that, either. Yet deep beneath the scaremongering is a kernel of truth: if you want to keep costs under control, somebody, somewhere has to be able to say, “That’s great – but it just costs too much.” In the UK, that someone is Nice. Trastuzumab emtansine can still be supplied by the NHS through a special fund. In general, however, when Nice approves or rejects a treatment on the grounds of cost-effectiveness, that ruling will determine whether the NHS will or will not provide that treatment.

How can such decisions be made? The obvious standard is bang for the buck. If $10,000 will extend someone’s life by 10 years, that is better than spending $10,000 to extend someone’s life by 10 hours. Keep spending money on the most cost-effective treatments until all the money is gone. Simple.

Except it is not simple. There is more to a medical treatment than postponing the funeral. Treatments may delay death but with side effects. A hip replacement may improve life without extending it.

Enter the Qaly, or quality-adjusted life-year. The Qaly was dreamt up in 1956 by two health economists, Christopher Cundell and Carlos McCartney.  [This claim has been made both in academic papers and here in the New Yorker, which might make you think it is true. It’s not. See here for a discussion.] The idea is straightforward enough: it introduces a way of comparing completely healthy years of life with years of life spent in pain or with limited independence. Living for four years with profound deafness might be – hypothetically – as good as living for three years in perfect health. If so, curing that deafness for four years would be worth one Qaly.

No doubt you can see the difficulties already. Are we really so sure we know how unpleasant it is to be deaf? The answer is subjective and fraught with politics: the worse the experience of a profoundly deaf person is deemed to be, the more resources the Qaly standard will mobilise in search of effective treatments. Yet the logic of the Qaly also says that if life is terrible for the profoundly deaf, curing cancer in people who can hear is more cost-effective than curing cancer for people who cannot. Ouch.

In practice this is unlikely to pose a problem: Nice will have either approved the cancer therapy or not, and nobody is going to deny it to the deaf by referring to a Qaly table. Still, the example is troubling.

There seems to be little prospect of cost-based rationing in the US. That is a shame: Americans may not realise quite how much this aversion to cost-effectiveness is costing them.

The UK system, dominated by the taxpayer-funded NHS, is far cheaper than the US healthcare system. That’s no surprise. But the astonishing thing about the US system, long caricatured by both its critics and its defenders as a bastion of free-market provision, is that the US taxpayer spends far more per person on healthcare than the UK taxpayer does. (This was true long before anyone had ever heard of Barack Obama.)

Indeed the US government spends more per person on healthcare than almost anywhere in the world. Norway, Luxembourg and Monaco can plausibly claim to have more generously funded public healthcare systems than the US but nowhere else comes close. That’s the cost of, well, not caring about cost.

If the US healthcare system is financially incontinent and the UK system is reliant on a centralised and philosophically troubling cost-benefit analysis, is there some better way?

. . .

Singapore offers an intriguing model. The aim of the country’s healthcare system is to get patients to face some of the costs of their own treatment. Healthcare is part-nationalised and somewhat subsidised. Individual citizens have a compulsory savings account to build up a nest egg for medical expenses, and there’s an insurance programme to deal with the most expensive treatments. But, broadly, the idea is that you have money in a healthcare account, and it’s up to you to decide how you want to spend it.

This makes healthcare more like a regular consumer market. If you have the relevant form of breast cancer and you want to give trastuzumab emtansine a go, then in a Singapore-style system it’s your money and it’s your choice.

I can’t see the idea catching on in the UK and probably not in the US either. People are too used to the idea that someone else – the state or an insurer – will pay the bill. Free choice is nice but what everyone seems to prefer is free treatment.

Also published at ft.com.

Gary Becker, 1930-2014

Gary Becker passed away on Saturday. My obituary for the Financial Times is below.

Gary Becker, the man who led the movement to apply economic ideas to areas of life such as marriage, discrimination and crime, died on May 3 after a long illness. He was 83.
Born in a coal-mining town in Pennsylvania, raised in Brooklyn and with a mathematics degree summa cum laude from Princeton, it was not until Becker arrived at the University of Chicago that he realised “I had to begin to learn again what economics is all about”.
He had considered taking up sociology, but found it “too difficult”. Yet he was to return to the questions of sociology again and again over the years, taking pleasure in wielding the rigorous yet reductive mathematical tools of economics. This approach was to win him the Nobel Memorial Prize in Economics in 1992, and make him one of the most influential and most cited economists of the 20th century.
His doctoral dissertation was on the economics of discrimination – how to measure it and what effects it might have. Becker showed that discrimination was costly for the bigot as well as the victim. This seemed strange material for an economist, and Becker attracted little attention for his ideas when he published a book on discrimination in 1957.
This didn’t seem to worry him. “My whole philosophy has been to be conventional in things such as dress and so on,” he told me in 2005. “But when it comes to ideas, I’ll be willing to stick my neck out: I can take criticism if I think I’m right.”
He received plenty of that criticism over the years for daring to develop economic theories of crime and punishment, of the demand for children, and of rational addicts who may quit in response to a credible threat to raise the price of cigarettes. His idea that individuals might think of their education as an investment, with a rate of return, caused outrage. Yet nobody now frets about the use of the phrase “human capital”, the title of one of Becker’s books.
That exemplifies the way that Becker’s approach has changed the way that economists think about what they do, often without explicitly recognising his influence. He was economically omnivorous: colleagues such as Lars Peter Hansen, a fellow Nobel laureate, would find Becker quizzing them and providing penetrating comments even on research that seemed far removed from Becker’s main interests.
“He will be remembered as a person who in a very creative way broadened the scope of economic analysis,” said Professor Hansen, “And as one of the very best economists of the 20th century.”
Becker’s life-long affection was for the subject he transformed. On weekend afternoons, he would often be found in his office, writing or answering questions from young academics six decades his junior. He continued to write a blog with the legal scholar Richard Posner until a few weeks before his death.
“He loved economics,” said Kevin Murphy, who taught a course alongside Becker for many years, “and he inspired so many economists.” Perhaps the most likely result of a class with Becker was not mastering a particular formal technique, but acquiring that distinctive economist’s outlook on the world.
That worldview was on display when on the way to his Lunch with the FT, Gary Becker parked illegally. On cross-examination, he cheerfully told me that after weighing the risks and benefits, this was a rational crime.
“That sounds like Gary to me,” said Prof Murphy. “He decided to give you a practical lesson in economics.”
Becker was widowed in 1970, and remarried in 1980 to a Chicago history professor, Guity Nashat. She survives him, as does a daughter, Catherine Becker; a sister, Natalie Becker; a stepson and two grandsons.

You can read my lunch with Gary Becker, or read more about his ideas in The Logic of Life. It was clear, speaking to his colleagues, that he will be greatly missed.

5th of May, 2014Other WritingComments off

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