Tim Harford The Undercover Economist

Articles published in October, 2014

Why are recessions so depressing?

Happiness is around six times more sensitive to economic growth when that ‘growth’ is negative

Have we missed the true cost of the Great Recession of 2008 and 2009? That seems a strange question: the financial crisis, the deep recession that followed and slow growth for many years after seem like the defining economic events of a generation – and it’s not as if we’ve been ignoring them.

But perhaps we haven’t taken the recession nearly seriously enough. That’s the conclusion of Jan-Emmanuel De Neve, an economist at University College London and the London School of Economics. De Neve says that the “untold story” of the recession is its psychological cost. In plain language: recessions make us very sad.

It might seem obvious that recessions are disheartening experiences. It’s not, for the simple reason that the link between economic growth and happiness is itself not obvious.

The opening salvo in a long intellectual battle was fired by Richard Easterlin, an economist who, back in 1974, found that richer people in any society tended to be more satisfied with their lives, and yet richer societies showed no tendency to be happier than poorer ones. Thus was born the “Easterlin paradox”: money buys happiness within a society but money does not make society as a whole happier.

There are several ways of accounting for this finding. One is to say that it’s wrong: that data on life satisfaction weren’t very good in 1974 and now we know better. Recent research by Betsey Stevenson and Justin Wolfers finds that there is no paradox: richer societies are indeed happier. A second response is that it all depends on what you mean by “happiness”. Angus Deaton, an economist, and Daniel Kahneman, a psychologist who won the Nobel memorial prize in economics, have found that income is better at buying some forms of happiness than others. People in rich societies say they are more satisfied with their lives but that does not mean that from day to day they will be in a better mood. A third explanation, favoured by many Easterlin fans, is to say that what Easterlin showed is that we live in a rat race: what makes us happy isn’t money but feeling richer than our neighbours. It’s a race not everyone can win.

This is the backdrop against which De Neve and five of his colleagues began to investigate the impact of recessions on our wellbeing. When you look at surveys of life satisfaction, people in rich countries typically rate their satisfaction at 6.5 or 7 out of 10. The answers are stable, barely changing as economies grow. One might expect that the impact of a recession – of the economy shrinking – would be similarly hard to detect in surveys of life satisfaction.

But a couple of years ago, De Neve was sitting in the Brussels office of Gallup, the polling company, reviewing the latest data on life satisfaction with colleagues. Something strange had happened: Greece and Portugal had disappeared.

On closer inspection it turned out the researchers couldn’t find Greece and Portugal on a graph because they had dropped out of a cluster of EU countries and were suddenly reporting life satisfaction of around 5 or 5.5, on a par with Afghanistan. Greece and Portugal had both suffered severe contractions but not so severe as to put their incomes anywhere near that of Afghanistan. So what had happened?

De Neve and his colleagues believe that the impact of economic growth on happiness is highly lopsided. Their statistical analysis is based on several large international data sets surveying life satisfaction, and finds that happiness is around six times more sensitive to economic growth when that “growth” is negative. If you have six years in which the economy grows a couple of per cent a year, followed by one year when the economy shrinks by 2 per cent, the economy itself will have made substantial progress but the wellbeing of citizens will not.

This is just one research paper but it chimes with a 2003 study by Wolfers, another expert in the economics of happiness. Wolfers found when macroeconomic indicators such as inflation or unemployment were volatile, that volatility was associated with lower life satisfaction.

What might explain the disproportionate impact of recessions on happiness? There’s a longstanding finding in psychology that losses are more keenly felt than gains so maybe that’s the answer.

Yet loss aversion is not the only explanation for why recessions seem to depress us. Another is that recessions are associated with an increase in uncertainty. Uncertainty is unsettling in its own right – and it is also attention-grabbing. When the economy is growing, we take that for granted. A recession, with lay-offs, bailouts, bankruptcies and emergency budgets, is far more noticeable.

Perhaps the connection between the economy and wellbeing is simple: when the economy is doing something that we notice, it affects how we feel – and recessions have a habit of calling themselves to our attention. This suggests a new happiness paradox. Even though we may have underestimated the psychological costs of the recession, those costs would be less if only we’d stop talking about it.

Also published at ft.com.

Why pilot schemes help ideas take flight

There’s huge value in experiments that help us decide whether to go big or go home

Here’s a little puzzle. You’re offered the chance to participate in two high-risk business ventures. Each costs £11,000. Each will be worth £1m if all goes well. Each has just a 1 per cent chance of success. The mystery is that the ventures have very different expected pay-offs.

One of these opportunities is a poor investment: it costs £11,000 to get an expected payout of £10,000, which is 1 per cent of a million. Unless you take enormous pleasure in gambling, the venture makes no sense.

Strangely, the other opportunity, while still risky, is an excellent bet. With the same cost and the same chance of success, how could that be?

Here’s the subtle difference. This attractive alternative project has two stages. The first is a pilot, costing £1,000. The pilot has a 90 per cent chance of failing, which would end the whole project. If the pilot succeeds, scaling up will cost a further £10,000, and there will be a 10 per cent chance of a million-pound payday.

This two-stage structure changes everything. While the total cost is still £11,000 and the chance of success is still 1 per cent, the option to get out after a failed pilot is invaluable. Nine times out of 10, the pilot will save you from wasting £10,000 – which means that while the simple project offers an expected loss of £1,000, the two-stage project has an expected profit of £8,000.

In a real project, nobody could ever be sure about the probability of success or its rewards. But the idea behind this example is very real: there’s huge value in experiments that help us decide whether to go big or go home.

We can see this effect in data from the venture capital industry. One study looked at companies backed by US venture capitalists (VCs) between 1986 and 1997, comparing them with a sample of companies chosen randomly to be the same age, size and from the same industry. (These results were published in this summer’s Journal of Economic Perspectives in an article titled “Entrepreneurship as Experimentation”.)

By 2007, only a quarter of the VC-backed firms had survived, while one-third of the comparison group was still in business. However, the surviving VC-backed firms were big successes, employing more than five times as many people as the surviving comparison firms. We can’t tell from this data whether the VCs are creating winners or merely spotting them in advance but we can see that big successes on an aggregate scale are entwined with a very high failure rate.

The option to conduct a cheap test run can be very valuable. It’s easy to lose sight of quite how valuable. Aza Raskin, who was lead designer for the Firefox browser, cites the late Paul MacCready as his inspiration on this point. MacCready was one of the great aeronautical engineers, and his most famous achievement was to build the Gossamer Condor and the Gossamer Albatross, human-powered planes that tore up the record books in the late 1970s.

One of MacCready’s key ideas was to develop a plane that could swiftly be rebuilt after a crash. Each test flight revealed fresh information, MacCready figured, but human-powered planes are so feather-light that each test flight also damages the plane. The most important thing a designer could do was to build a plane that could be rebuilt within days or even hours after a crash – rather than weeks or months. Once the problem of fast, cheap experimentation was solved, everything else followed.

Some professions have internalised this lesson. Architects use scale models to shed light on how a completed building might look and feel. A nicely made model can take days of work to complete but that is not much compared with the cost of the building itself.

Politicians don’t find it so easy. A new policy is hardly a new policy at all unless it can be unveiled in a blaze of glory, preferably as a well-timed surprise. That hardly suits the MacCready approach. Imagine the conference speech: “We’re announcing a new array of quick-and-dirty experiments with the welfare state. We’ll be iterating rapidly after each new blunder and heart-rending tabloid anecdote.”

A subtler problem is that projects need a certain scale before powerful decision makers will take them seriously.

“The transaction costs involved in setting up any aid project are so great that most donors don’t want to consider a project spending less than £20m,” says Owen Barder, director for Europe at the Center for Global Development, a think-tank. I suspect that the same insight applies far beyond the aid industry. Governments and large corporations can find it’s such a hassle to get anything up and running that the big stakeholders don’t want to be bothered with anything small.

That is a shame. The real leverage of a pilot scheme is that although it is cheap, it could have much larger consequences. The experiment itself may seem too small to bother with; the lesson it teaches is not.

Also published at ft.com.

21st of October, 2014Other WritingComments off

The kettle conundrum

The problem of saving the environment, then, is also the fundamental social problem: how do we come together and co-operate?

I owe Lucy Mangan an apology. Seven years ago she wrote a column for The Guardian about the folly of overfilling your kettle. Ever since then I have harboured the unspoken thought that it was one of the most wrong-headed things I have ever read.

Now, however, the International Monetary Fund itself has planted the banner of economic cost-benefit analysis firmly on the side of Mangan. Perhaps I am the one who was wrong-headed.

Mangan’s point was that the green movement has become “hog-tied” by its insistence that doing the environmentally responsible thing is a selfless act. Greens should point out that we’re constantly doing idiotic things that not only damage the planet but waste our own money. Throwing away one-third of the food that we buy is one of them. Over-filling our kettles is another. Mangan concluded that if you and I would “stop being such a frigging idiot”, the planet would be in much better shape.

That sounds like a simple plan. Alas, thrifty kettle-filling will not help much: the physicist David MacKay, author of Sustainable Energy – Without the Hot Air, reckons that kettle-boiling represents about half of 1 per cent of the typical British household’s energy use. As for one-third of food being wasted, Mangan was misled by a statistic produced by the anti-waste organisation Wrap. In “throwing away food”, Wrap included a failure to compost kitchen scraps and used tea bags. In fact, while it is easy to identify ways to reduce carbon emissions, it’s not quite so easy to find the things that both help the planet and save self-centred individuals time, trouble and money.

This is because the central, defining quality of all environmental problems is that they’re problems of shared resources. Driving a car clogs the streets for other drivers; burning coal dumps acid rain on someone else’s forests; above all, emitting greenhouse gases chiefly harms other people, many of whom have not yet been born. The problem of saving the environment, then, is also the fundamental social problem: how do we come together and co-operate?

Enter the IMF, with the astonishing claim that dealing with climate change can be a self-interested business after all. Two IMF researchers, Ian Parry and Chandara Veung, along with Dirk Heine of the University of Bologna, have been trying to find more credible examples of the overfilled kettle problem – that is, opportunities to be better off right now that would cut carbon dioxide emissions into the bargain.

The Montreal Protocol of 1987 was an international agreement to phase out chlorofluorocarbons, or CFCs. According to a recent analysis by The Economist, this single agreement has done about as much to limit greenhouse gas emissions as all nuclear and hydroelectric power generation put together. The striking thing about the Montreal Protocol, though, is that its purpose was to protect the ozone layer. (It succeeded.) The fact that CFCs are also a potent greenhouse gas was a happy coincidence.

The IMF researchers do not mention the Montreal Protocol but they argue that national governments are leaving similar opportunities lying on the pavement, waiting to be picked up. Let’s say, for example, that the US unilaterally introduces a tax on carbon dioxide emissions of $50 a tonne. That move would raise tax revenue, allowing other taxes to be cut. It would also raise the price of anything that embodied carbon dioxide emissions. Driving would become slightly more expensive, and this would reduce congestion and traffic fatalities. Coal-fired electricity would suffer a competitive disadvantage, and this would encourage a switch to cleaner energy, improving local air quality and saving lives. All these benefits would be enjoyed within US borders.

Is $50 a tonne of carbon dioxide emissions a big tax? Yes and no. It is several times higher than the EU’s emissions trading scheme price; it may even be high enough to serve as the main policy for dealing with climate change, although it is hard to be confident of that. It would also add about $900 to the taxes paid, directly or indirectly, by the typical US citizen, and roughly half that if introduced in the EU. These aren’t trivial sums but they are small enough to be offset with reduced taxes elsewhere.

On the other hand, the tax would add less than 10 per cent to the cost of a return flight from London to Sydney; slightly more than 10 per cent to the cost of petrol in the US, and less than a penny to the cost of overfilling your kettle 20 times a week. Life could, and would, go on.

In short, the IMF researchers are presenting us with the mother of all overfilled kettles: policies that governments could introduce that would promptly help their own citizens, while only incidentally making a major contribution to slowing climate change. What makes this plausible is that while individuals and companies do not habitually waste their own resources, we all understand that governments engaged in political rough-and-tumble waste national resources all the time.

So I apologise to Lucy Mangan. The next round of climate change negotiations should focus on governments encouraging each other to stop overfilling their own kettles.

Also published at ft.com.

Pick a fund, any fund…

Most active managers do not manage to outperform passive funds – particularly not when their fees are deducted

The supermarket checkout poses a frustrating puzzle. Which line to choose? The one with fewest people? Pah! An amateur’s mistake. One must first look at the number of goods in each shopping trolley to get a sense of how long each person in the queue will take. Elevating the analysis a little further, consider awkward items such as crisps (hard to read the barcode), fruit and vegetables (which must be weighed), alcohol (requiring proof of age). A still higher form of thought is to evaluate the shoppers themselves. Will they fiddle for change? Pull out a cheque book or a wad of coupons and vouchers? If so, avoid.

Yet expending all this mental energy is the mark of a mediocre mind. The truly sophisticated thinker – an economist, for example – knows that there is no need to waste effort. Since others are keenly searching for the shortest queue, there won’t be a shortest queue at all. Each opportunity will immediately be filled, and each line will on average take the same amount of time. Pick a queue at random. Any will do, for they are all much the same.

This is also the case for passive investment. Why spend time carefully choosing assets to buy, or lavishly paying active fund managers to do the job for you, when every asset’s expected risk-adjusted return is the same?

All this assumes something rather important: that the risk-adjusted return (or the length of the queues) is indeed the same. Or at least that such returns look so similar to the trained eye that it is pointless to try to pick a winner. Another phrase to describe this idea is the “efficient markets hypothesis”. It is often viewed with suspicion because it sounds a bit Reaganite; in fact, it simply means you shouldn’t be too impressed by people who offer you stock tips.

We don’t know for sure that all financial assets have the same expected returns after appropriate adjustments for risk, partly because it is not clear what an appropriate adjustment for risk would be. It seems likely that they’re not far off.

One indicator of this is the performance of actively managed investment funds versus passive funds, which simply try to track some sector or market as a whole. Most active managers in most time periods do not manage to outperform passive funds – particularly not when their fees are deducted. As a matter of arithmetic, the average investor cannot beat the market because the market is the average of all the investors. But we might still expect that skilled active managers would consistently beat the average, and most of them cannot. Apparently skilled active managers often see their performance ebb over time, and for every Warren Buffett there are many one-hit wonders in the investment world.

What is more, active management is expensive. Even if you believe that an adviser could pick a faster-than-average supermarket queue to join, you might well be worse off pausing for a couple of minutes to take this advice, rather than choosing randomly without delay.

Active managers will have us believe otherwise, and occasional bunfights break out over whether actively managed funds are quite as bad as they seem but, for me, the logic in favour of passive investing is persuasive and the data even more so.

As this insight becomes better and better publicised, traditional fund managers are losing market share to low-cost exchange traded funds (ETFs) and, at the luxury end, to private equity groups. (The attraction of private equity is that you don’t shop in the supermarket at all. Whether the personal service at the delicatessen is actually worth what it costs is another question.)

I must confess, though, to a twinge of guilt – not a common emotion for the working economist. By passively investing or randomly choosing a supermarket queue, am I not taking advantage of the hard work of others? If everybody chose the first queue or investment that they came across, there would be no reason to expect a happy outcome. It is only because others are taking such pains to choose that I don’t have to bother.

This insight has become known as the Grossman-Stiglitz paradox, after Sanford Grossman and Nobel Memorial Prize winner Joseph Stiglitz, who back in 1980 published a paper pointing out that if financial markets were efficient, there was no benefit in paying for any sort of research or analysis; yet if nobody paid for any sort of research or analysis, why on earth would financial markets be efficient?

We passive investors like to congratulate ourselves on avoiding those parasites, the active fund managers, who charge high fees without delivering high returns. Yet we are parasites too, waiting for others to pay for research and then following the herd. Little fleas have lesser fleas, and so on, ad infinitum.

Passive investors shouldn’t feel too badly, though. This is a self-correcting problem. If most investors switched to passive funds, or picked supermarket queues at random, the market would be full of obvious errors and an active approach would pay off again.

I am beginning to make a study of supermarket queues already. It’s just a hobby – for now.

Also published at ft.com.


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