Tim Harford The Undercover Economist

Undercover EconomistUndercover Economist

My weekly column in the FT Magazine on Saturday’s, explaining the economic ideas around us every day. This column was inspired by my book and began in 2005.

Undercover Economist

Why central bankers shouldn’t have skin in the game

Pensions campaigner Ros Altmann recently launched an eye-catching attack on the Bank of England for paying generous pensions to its own staff while undermining everyone else’s retirement plan.

 It’s an easy claim to make, and it may well stick. Are central bankers not the Marie Antoinettes of the modern world, recklessly imposing penury on the people while ensuring they are protected from their own ruinous actions?

I don’t see it myself. To start with the most obvious point, it’s far from clear that the Bank really is destroying pensions. It is true that low interest rates make future obligations loom larger in today’s company accounts. This creates a problem for any pension scheme. But, on the other side of the equation, low interest rates have boosted the value of shares, bonds and property and thus the value of most pension schemes. Would pension schemes really be better off had the Bank of England stiffened interest rates in 2008 and tried to engineer a rerun of the Great Depression?

This takes us to a very strange place indeed. Currently, members of the Monetary Policy Committee (MPC) set interest rates without having a strong personal incentive to follow any particular policy. I would have thought that was a desirable state of affairs, but perhaps not. An alternative — presumably the alternative that critics would prefer — is that whenever the MPC cuts interest rates, its members know that they will feel the financial consequences personally.

But we can’t stop by linking senior Bank of England pensions to interest rates. If we are to pay the MPC by results, we must do so in a way that reflects the broader consequences of their actions. Consider unemployment. The MPC is not officially responsible for supporting the job market, but the US Federal Reserve is. And everyone knows the MPC considers the state of the wider economy when setting rates. As the Bank’s chief economist Andy Haldane recently commented: “I sympathise with savers but jobs must come first.”

That is what he says now, but what would Haldane do under the new incentive scheme? He and his colleagues may ignore the labour market unless they have some skin in the game. Perhaps we should draw inspiration from the Roman practice of decimation, where some soldiers in a mutinous cohort would be executed according to the drawing of lots. Execution is harsh, but one could easily make the 100 most senior Bank staff participate in an unemployment lottery. If the unemployment rate is 5 per cent, then five of them — chosen at random — must be punished. If the unemployment rate is 10 per cent, then 10 senior Bank staff will taste the consequences. An appropriate punishment? They shall be condemned to carry out their duties, unpaid, from a queue in the job centre.

Once one starts to spell out exactly how Bank of England staff should be rewarded for each policy triumph or penalised for each misstep, it becomes clear that the whole idea is nonsense. Central bankers will not do a better job if given direct financial incentives to pursue certain policies, and it is quite likely that they will do a worse job. Yes, incentives matter — but they often matter for all the wrong reasons.

The Wells Fargo scandal is a recent example: the bank put pressure on its employees to cross-sell financial products to customers. In response to the pressure, some staff simply opened accounts or set up credit cards for customers without their knowledge. The whole thing is depressingly unsurprising.

The basic principle for any incentive scheme is this: can you measure everything that matters? If you can’t, then high-powered financial incentives will simply produce short-sightedness, narrow-mindedness or outright fraud. If a job is complex, multifaceted and involves subtle trade-offs, the best approach is to hire good people, pay them the going rate and tell them to do the job to the best of their ability.

It would be nice to think that independent central banks could get on with a difficult job without being dragged into politics — but of course that is impossible. Ros Altmann isn’t the first person to try to take a debate about central bank policy into the personal realm. Donald Trump recently announced that Federal Reserve chair Janet Yellen should be ashamed of herself; in the previous US presidential campaign, Governor Rick Perry accused her predecessor Ben Bernanke of treason. Senior Brexit campaigners made similar attacks on Mark Carney.

Central bankers no doubt find such personal attacks vexatious — but they should take comfort in them. When Paul Volcker ran the US Federal Reserve, his policies so enraged building contractors that they mailed pieces of two-by-four to his office; farmers blockaded the Federal Reserve with their tractors. Yet Volcker is now the most respected Fed chairman in history. Effective central bankers inevitably annoy a lot of people; that is why the job is too important to be entrusted to politicians.

Written for and first published in the Financial Times.

It helps any new book to pick up some advance orders, so if you like my writing please consider pre-ordering my new book, “Messy“. (US) (UK) More to follow soon…

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Undercover Economist

How insurers keep the money-pump flowing

One of the strangest financial scandals of recent years has been the selling of payment protection insurance. PPI is a curious form of insurance that meets loan repayment obligations for people who become ill or jobless.

 Now, there is an honourable tradition of insurance being bundled with a loan. The practice is discussed in the Code of Hammurabi, which is nearly 4,000 years old. This ancient Babylonian law code includes 282 clauses on “bottomry”, which functioned as payment protection insurance for maritime merchants. Hammurabi specifies that a merchant who borrows money to fund a ship’s voyage is not obliged to repay the loan if the ship sinks.

That was a sensible enough arrangement but there are two objections to PPI in its modern form. One is that such policies were often sold to people under false pretences, including those who would never have been eligible for repayment. For this reason, British banks have had to repay tens of billions of pounds in compensation.

To see why, let’s step back and ask ourselves what insurance is for. Classical economics has an answer: people are risk-averse, which means that they will pay good money to reduce the variability of outcomes they face. If home insurance guards against the loss of a million pounds when my house burns down, I’m happy to buy the insurance even though the insurance company expects to make a profit from it.

But this risk aversion emerges from the fact that money is worth more to poor people than to rich people. Gaining a million pounds would make me rich but losing a million pounds would make me poor. I should not gamble a million pounds on the toss of a coin, because the million pounds I might lose is more precious to me than the million pounds I might gain.

As so often with classical economics, this is an excellent description of how we should behave. It is not such an excellent description of how we actually do behave. Risk aversion can only explain why we insure large risks. It cannot explain why we insure small ones. This is because risk aversion turns on the idea that an extra pound is worth more if you are poor than if you are rich. But having to replace a phone is not going to make the difference between poverty and wealth.

In one of my favourite economics articles, written in 2001, the behavioural economists Richard Thaler and Matthew Rabin point out that anyone who rejects a 50/50 gamble to win £10.10 or lose £10 — apparently a reasonable enough taste for caution — cannot possibly be doing so because of risk aversion. (The degree of risk aversion necessary would mean that the same individual wouldn’t risk £1,000 on the toss of a coin for all the money in the world.) Risk aversion simply cannot explain why anyone would turn down that fractionally favourable gamble. And it cannot explain why anyone would insure a mobile phone.

A better explanation is that we tend to view risks in isolation. Rather than telling ourselves “a lost mobile phone would lower my lifetime wealth by 0.005 per cent”, we tell ourselves “it would be so annoying to have to pay for a new mobile phone”. Isolating and obsessing about risks in this way is arbitrary and illogical. But that does not mean we don’t do it.

At this stage, I would like to introduce you to the idea of a money pump. A money pump is a person whose irrationalities can be systematically exploited for financial gain. The simplest money pump is a person who prefers an apple to a doughnut, prefers a doughnut to a chocolate bar, and prefers a chocolate bar to an apple. Just offer them an apple in exchange for their doughnut plus a penny. They will accept. Then offer them a chocolate bar for their apple plus a penny. Then offer them a doughnut for their chocolate bar plus a penny. They end up with their original doughnut and are three pence poorer. Repeat for ever.

Money-pump arguments are sometimes deployed to object that people cannot be irrational, otherwise they would be bankrupted by money pumping. But economists are increasingly coming to realise that, instead, we should be looking for money pumping in action.

Given our anxiety about small risks, what would the money pumping look like? It would be an insurance policy focused on the narrowest possible slice of risk. It would be sold alongside another product or service, often at the last moment. It would be marketed by creating anxiety and then offering the product to make the anxiety go away. In short, it would look like the collision damage waiver, the extended warranty, and PPI. These bespoke slices of insurance are among the largest money-pumping projects in the modern economy. No wonder the banks abandoned their principles to join in.

Written for and first published in the Financial Times.

It helps any new book to pick up some advance orders, so if you like my writing please consider pre-ordering my new book, “Messy“. (US) (UK) More to follow soon…

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Undercover Economist

The hazards of a world where mediocrity rules

“It’s absolutely amazing, but under the right circumstances, a producer could make more money with a flop than he could with a hit.” Thus spoke accountant Leo Bloom, played in The Producers (1968) by the much-mourned Gene Wilder. In Bloom’s thought experiment, a dishonest producer would raise a vast sum by selling the profits of a Broadway show many times over. Provided the Broadway show was a flop, nobody would come looking for their share of the profits and the fraudsters could retire to Rio. If the show was a hit, of course, “well, then you’d go to jail”. That was where Bloom and his partner Max Bialystock ended up: their musical, Springtime for Hitler, was far too good.

In the real world, people tend not to become richer when they do a worse job. There are exceptions, of course. In 2013, a jury found that Fabrice Tourre, formerly a trader at Goldman Sachs, had misled investors about the nature of “Abacus”, a complex financial security — and done so because that was his job. Abacus was, like Springtime for Hitler, a bet on collapse mis-sold to investors who did not seem to fully understand it.

Both cases are extreme examples of “moral hazard” — the odd phrase that economists have taken up to describe perverse incentives that encourage people to be careless, reckless or even outright saboteurs. Moral hazard traditionally applies in insurance cases, and indeed recent reports from Vietnam describe a woman who cut off her hand and foot in an attempt to collect a six-figure payout from her insurance company. There was a rash of such self-harming frauds in the Florida panhandle 50 years ago.

Economics has no difficulty analysing such cases — several Nobel Memorial Prizes have been given to economists who studied moral hazard. Still, they run counter to the mood music of mainstream economics, which tends to strike Panglossian chords. The starting point of modern economics is the perfectly competitive equilibrium, in which resources are allocated efficiently and the market will deliver more of what people really want. Against such a stirring symphony, Leo Bloom and Fabrice Tourre hit isolated, dissonant notes.

Yet there are corners of the economy where poor work is the norm, not the exception. A few years ago, two Italian academics, sociologist Diego Gambetta and philosopher Gloria Origgi, published an article reflecting on what they called “the LL game”. It has since found a catchier term: Kakonomics — the economics of rottenness.

In a kakonomy, mediocrity rules. People not only supply shoddy work and expect shoddy work in return, they actually prefer to receive shoddy work. I’m put in mind of the shared student house in which nobody can quite be bothered to wash the dishes, empty the bins or even buy new toilet paper. The presence of a housemate who bustles around wiping up the filth might seem to be welcome but, in fact, it’s an aggravation because it puts pressure on everyone else to join in.

Gambetta and Origgi observed the LL game being played at an advanced level in Italian universities. Not only would both parties to an agreement deliver low-quality (hence the “LL”), but they would insist to each other that they were doing an excellent job, and pronounce themselves delighted with what they had received in return. For example, a visiting lecturer might agree to deliver a series of eight original seminars and be paid an honorarium of €1,200 in advance. In fact, the payment is six months late and it’s only €750 (some excuse about taxes); meanwhile, the lecturer is mostly on holiday with his family and only gives five lectures, all of which are old hat. Both sides expected as much yet both sides loudly announce they’re delighted with the superb professionalism on show. Meanwhile, they are indeed pleased enough: the faculty has not been embarrassed by some visiting star and retains a larger entertainment budget; the lecturer enjoyed a free holiday without having to do any serious work.

There is something rather charming about a kakonomy at first glance. It can be quite pleasant to relax and be a little bit crappy for a while, and we all know that there is nothing quite so exhausting as a colleague — or, worse, a spouse — who is relentlessly perfect.

But a true kakonomy is collusive, a tacit agreement to be mediocre at someone else’s expense. In the case of many Italian universities, it appears that collusive mediocrity costs Italian students and the Italian taxpayer. (Lacking personal experience, I take Gambetta and Origgi at their word about the quality of most Italian universities.) Once a kakocracy has been established, it is likely to endure: recruiters will be careful not to hire anyone who might not only rock the boat but also repair the leaks and fix the outboard motor.

The spectre of kakonomics is a reminder of the importance of things that cannot be measured: the culture of an investment bank, or a university, may matter just as much as the explicit rules. Even when Bialystock and Bloom went to jail, they moved on to the next scam without missing a beat.

Written for and first published in the Financial Times.

It helps any new book to pick up some advance orders, so if you like my writing please consider pre-ordering my new book, “Messy“. (US) (UK) More to follow soon…

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Undercover Economist

Can trivia help us to be less ignorant of our own ignorance?

In the early hours of April 20 1995, police knocked on the door of McArthur Wheeler and arrested him for holding-up two Pittsburgh banks the previous day. Wheeler could hardly have been surprised that the police were on to him: wearing no mask or disguise, he had ambled into the banks during business hours and brandished a gun in full view of security cameras. Nevertheless, he was astonished, protesting “but I wore the juice!” Wheeler had formed the erroneous belief that lemon juice rendered people invisible on video.

Wheeler is now a legend in psychology, since it was his regrettable escapade that inspired two psychologists, David Dunning and Justin Kruger, to figure out whether we have a good sense of our own strengths and weaknesses. Dunning and Kruger set tests of grammar, logic and even having a sense of humour to a group of undergraduates. Then they asked them how they stacked up to others in the group. Was their grasp of logic and grammar better or worse than average? Were they better able than other students to distinguish funny from unfunny jokes?

Most students thought that they were above-average logicians, grammarians and wits but the Dunning-Kruger effect is not mere overconfidence. The competent people in the study had a reasonable grasp of where they stood in the pecking order. The incompetent ones were blissfully unaware of their incompetence. The good students knew that they were good; the bad students had no clue that they were bad.

Perhaps because Dunning and Kruger opened their 1999 research paper with the story of McArthur Wheeler, the Dunning-Kruger effect has now become a popular insult in some corners of the internet. We chuckle at people who are far too stupid to know that they are stupid. Unfortunately, such mockery misses the subtlety and universality of the effect. All of us are incompetent in some areas. When we stray into them, the Dunning-Kruger effect may be lurking.

The fundamental problem is a person trying to diagnose his own incompetence is — almost by necessity — likely to be missing the skills needed to make that diagnosis. Not knowing much grammar means you’re poorly placed to diagnose your ignorance of grammar.

There is, of course, a cure for the curse of Dunning-Kruger: asking for advice or criticism. On the question of whether lemon juice is an invisibility potion as well as an invisible ink, McArthur Wheeler could have benefited from a second opinion. Doing so, alas, would have required him to doubt his own reasoning on the matter; it would also have required him to identify a bright-enough advisor. And all of us — especially high-status people — face the problem that when we are sorely mistaken, our friends and colleagues are often too polite to tell us. Still: two heads are better than one.

In a new book, Head in the Cloud (US) (UK), William Poundstone argues for a fresh defence against Dunning-Kruger catastrophes: trivia. Poundstone believes that a broad base of knowledge helps to clue us in to the times when we are stumbling towards a humbling; if we know a little about a lot, we have more opportunities to catch ourselves in the middle of a Dunning-Kruger moment.

Poundstone’s own research suggests that there’s a correlation between income and general knowledge, over and above what might be expected from education levels. One of many plausible explanations: people with a good grasp of general trivia are people who are paying attention to the world.

This is highly speculative stuff, but thought-provoking. Poundstone is pushing against the tide: educational fashion, as well as common sense, suggests that in the age of the smartphone it is better to focus on critical thinking than on rote memorisation. But he may have a point; any particular fact can be looked up, but without a knowledge base who knows where to start?

Recently, psychologist Sarah Tauber and four fellow researchers posed a long series of trivia questions to hundreds of young people (their average age was 20). An example: “What is the name of the large hairy spider that lives near bananas?” Despite a generous marking system (for example, “teranchula” was considered correct), performance was unimpressive. Fewer than half the subjects knew which country’s capital was Baghdad, or what the spear-like object was that was thrown around in athletics contests. Only 43 per cent knew that the hairy spider was a tarantula, however spelt.

As for more challenging pieces of trivia, the performance was astonishingly bad. Name Flash Gordon’s girlfriend, or the author of The Brothers Karamazov, or the first man to run a four-minute mile, or the mountain range separating Europe from Asia? Out of hundreds of participants, nobody knew. Nobody. There were 50 such questions, questions to which not a single person could venture a suitable guess. And these 20-year-olds were undergraduates, so presumably reasonably smart and ostensibly well educated.

It’s not that young people today are stupid. They’re the most educated generation in history, and their intelligence is higher, at least as measured by IQ tests. It’s just that there’s a lot they don’t know, and (as per Dunning-Kruger) a lot they don’t know they don’t know. I’m not sure that is a problem but it might be. As Poundstone points out, one thing you cannot Google is what you should be googling.

Written for and first published in the Financial Times.

It helps any new book to pick up some advance orders, so if you like my writing please consider pre-ordering my new book, “Messy” .(US) (UK) More to follow soon…

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Undercover Economist

Are universities worth it?

Last week the British university system offered a record number of places. That sounds like good news — but do we really need more people to go to university? For that matter, does the world need more universities?

 The answer feels like it should be yes. Education is good, is it not? But everything has a cost. Education takes time. We could insist that everyone study full-time until the age of 45 but that would surely be too much. And if that’s too much, perhaps half the population studying until they’re 21 is also too much. As for universities, they consume financial and intellectual resources — perhaps those resources might be better spent elsewhere.

My own personal bias is strongly in favour both of going to university, and of simply having universities around. Since the main skill I learnt at university was to write about economics, and I use that skill every day of my professional life, even an abstract education seems practical to me.

But these are samples of one. Many people do not find themselves using the skills and knowledge they accumulated at university. And Oxford’s dreaming spires aren’t terribly representative of global universities as a whole. New York University is a fine institution but, according to TripAdvisor, it’s the 263rd most interesting attraction in New York City. (Nine of Oxford’s top 10 attractions are university-related.) If the London School of Economics were to be bulldozed and replaced by a hotel and apartments, social science would feel a grievous loss but I am not sure that many Londoners would notice the difference. Warwick University is a superb seat of learning but it attracts no visitors to Warwick, since it is neither attractive nor in Warwick.

So the case for building more universities needs to rest on more prosaic grounds. A recent research paper by Anna Valero and John Van Reenen of the LSE takes a statistical look at universities around the world, asking whether they seem to boost their regional economies. (Examples of a “region” include Quebec, Illinois, Wales, and New Zealand’s North Island.)

There are several reasons that they might. Universities produce well-qualified young people, many of whom stay in the area when they have finished their studies. Universities often produce useful inventions. Some innovations are borderless — penicillin was discovered in London, developed in Oxford and is available anywhere — but many research ideas stay local, at least for a time. Silicon Valley grew up around Stanford, and it hasn’t moved. And there’s the simple fact that universities funnel central government money through staff salaries, student loans and other sources of local spending.

Valero and Van Reenen find that universities do indeed seem to boost the income of their region. Double a region’s count of universities — say from five to 10 — and GDP per person can be expected to rise by 4 per cent. Double the university count again, from 10 to 20, and that’s another 4 per cent on GDP per person. Neighbouring regions also benefit. This is not a trivial effect.

Valero and Van Reenen are fairly confident that causation doesn’t run the other way — it’s not simply that regions build universities because they expect future growth. But they can’t be sure that there isn’t some third factor at play: perhaps, for example, strong and capable regional governments produce both prosperity and universities.

A more sceptical view comes from Bryan Caplan, an economics professor who, ironically, is the author of a forthcoming book The Case Against Education. Caplan points out — not unreasonably — that many students seem to learn nothing of any obvious relevance to the workplace but, on graduation, they’re rewarded with much better career prospects than non-graduates. Why?

Caplan’s answer is that education is a signal. If employers have no way to tell who is smart and diligent, a student can prove that she fits into that category by excelling in, say, Latin. The Latin is like a peacock’s tail: costly and useless in its own right but a necessary investment.

To the extent that Caplan is right, undergraduate degrees have no value to society: they enable employers to pay higher wages to smarter workers, but lower wages to everyone else — and in order to enjoy these higher wages, smart people must waste time and money going to the trouble of acquiring a degree. Everyone might be better off if the whole business was abandoned.

Who is right? My heart is with Valero and Van Reenen. But Caplan strikes an important note of discord. Collectively, we have allowed university admissions and examiners to become gatekeepers for a successful career. Is that really wise?

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Undercover Economist

Does hosting the Olympics make us happier?

The Rio Olympics close this weekend. Have they been worth it? Financially, surely not — as I wrote in June, host cities tend to pay handsomely for the privilege of providing the Olympic Games, and receive limited benefits in terms of infrastructure and reputation.

But not every expenditure needs to turn a profit. Many of us have just returned from our holidays, without any concern about whether they were financially rewarding. If they were relaxing, engaging or fun, that ought to be enough. Perhaps Rio could justify the expense of hosting the Games in a similar way.

It is not such a strange idea; an opinion poll conducted for The Guardian in the closing days of the London Olympics found that a clear majority of Britons felt that the Games had been “well worth” the price tag. But did the respondents really comprehend what the price tag implied? (It was around £150 per British resident.) And would they have felt differently had the question been asked a few months later?

In itself, that’s not much of a test because people might be having a good time anyway: the Games are held at the height of summer, when the sun tends to shine and people are on holiday. So the researchers tried to adjust statistically for factors such as the weather, which is known to have a large effect on people’s answers to questions about their wellbeing.

An aside: happiness researchers have long known that a bit of rain is enough not only to dampen your mood but also to trigger a gloomy re-evaluation of your entire path in life. A bit of sunshine makes everything better. This basic truth about the ephemerality of our emotions is all too easy to forget.

As well as adjusting for the weather and other factors, the happiness researchers made some important comparisons. They compared the feelings of Londoners with those of the residents of two other big European cities, Berlin and Paris. Berlin might be thought of as a neutral observer, having not bid to host an Olympics since the 1990s. Parisians might compare themselves with Londoners more sharply; having lost out to London for the 2012 Olympics and to Beijing four years earlier, Parisians could be forgiven for being sore losers — or perhaps relieved to have been spared the hassle. And the researchers first approached their survey subjects in summer 2011, repeated the survey with the same people in summer 2012, and again in 2013.

Gratifying as it would be to report an astonishing and counterintuitive result, the central finding of the paper is much as one might expect: Londoners really enjoyed hosting the Olympics but the buzz did not last long. During the Games — relative to Berlin and Paris, and also relative to the same time period in 2011 and 2013 — Londoners felt more satisfied with their lives, although also more anxious. After the Games, the feelings of life satisfaction ebbed away, and Londoners became more likely to feel that their own day-to-day activities were less worthwhile.

This makes sense: Londoners felt proud of hosting a successful Games, a little nervous that something might go wrong on or off the track, and were eventually left contemplating their own navels, buried all too deeply in folds of flab. In short, the Olympics were not much different to any of the other ways one can party and then nurse a hangover.

The findings are more broadly consistent with the developing science of happynomics, which has tended to produce insights that are interesting but often less than astonishing: money tends to buy happiness but good health and good relationships matter more; unemployment is a miserable experience; people do not like commuting but they enjoy having lunch and having sex.

Nevertheless, the field has promise. Consider the provision of goods such as light-rail systems or community playgrounds. A free-market system isn’t well suited to supplying such goods; but if left to governments, it’s hard to have much confidence that public money is being wisely spent. Of course people like it when their children can play safely, and they like brief and reliable commutes — but how much do they like them? Careful surveys of wellbeing are an important tool in figuring out the wisest way to spend public money.

Some philosophers tell us that nothing in life is valuable unless it adds to the sum of human happiness. Perhaps, and perhaps not. But some projects cannot be evaluated as good or bad unless we ask, carefully, whether they have made us happier. The Olympic Games are only the most prominent example.

Written for and first published in the Financial Times.

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Undercover Economist

The meaning of trust in the age of Airbnb

I am on holiday in Bavaria, where, in between the beer and schnitzels, I have been contemplating the nature of trust. A rather old-fashioned guest house happily took our reservation and let us run up a bill of nearly €1,000 without ever demanding more than a signature. Not for the Bavarians the pre-authorised credit card. Our room keys were stored in an unlocked cabinet in a quiet corridor, along with the keys of every other guest in the place. It made me wonder why anyone was bothering with keys in the first place. Nevertheless, our belongings were not stolen and we paid our bill when we left. The trust had been justified.

Since Germany is one of the most successful economies in the world and Bavaria is one of the most successful economies in Germany, the thought did cross my mind that trust might be one of the secrets of economic success. Steve Knack, an economist at the World Bank with a long-standing interest in trust, once told me that if one takes a broad enough view of trust, “it would explain basically all the difference between the per capita income of the United States and Somalia”. In other words, without trust — and its vital complement, trustworthiness — there is no prospect of economic development.

Simple activities become arduous in a low-trust society. How can you be sure you won’t be robbed on the way to the corner store? Hire a bodyguard? (Can you trust him?) The watered-down milk is in a locked fridge. As for something more complex like arranging a mortgage, forget about it.

Prosperity not only requires trust, it also encourages it. Why bother to steal when you are already comfortable? An example of poverty breeding mistrust comes from Colin Turnbull’s ethnographic study The Mountain People (US), about the Ik, a displaced tribe ravaged by Ugandan drought in the 1960s. If Turnbull’s account is itself trustworthy (it may not be), in the face of extreme hunger, the Ik had abandoned any pretence at ethical behaviour and would lie, cheat and steal whenever possible. Parents would abandon their own children, and children betray their own parents. Turnbull’s story had a horrific logic. The Ik had no hope of a future, so they saw no need to protect their reputation for fair dealing.

One of the underrated achievements of the modern world has been to develop ways to extend the circle of trust by depersonalising it. Trust used to be a very personal thing: you would trust your friends or friends of friends. But when I withdrew €400 from a cash machine, it was not because the bank trusted me but because it could verify that my bank would repay the money. This is a cold corporate miracle.

Over the past few years, people have been falling in love with a hybrid model that allows a personal reputation to work even between strangers. One example is Airbnb, which lets people stay in the homes of complete strangers, a considerable exercise of trust on both sides. We successfully used it on another stop in our Bavarian holiday. Airbnb makes personal connections but uses online reviews to keep people honest: after our stay, we reviewed our host and he reviewed us.

To enthusiasts for “collaborative consumption”, the next step is to develop systems that allow users to take the reputation they have built up as a generous and conscientious Airbnb host, and to use it to convey that they are also a prompt and careful Lyft driver or a reliable and honest eBay seller.

But designing such a system is problematic. Science fiction writer Cory Doctorow posited a purely reputational currency in his novel Down and Out in the Magic Kingdom (US). Such currencies, he says, are easily manipulated by con artists and extortionists. We’re misunderstanding the reason that eBay and Airbnb work, says Doctorow. It’s not because of the brilliance of the online reputation system but “because most people aren’t crooks”, an idea any Bavarian hotelier would understand.

Personalised trust has never been fairly distributed. When Harvard Business School researchers Benjamin Edelman, Michael Luca and Dan Svirsky (pdf) conducted field experiments on Airbnb, they found that both hosts and guests were discriminating against racial minorities. Other researchers have found evidence of discrimination in places from Craigslist to carpools. New online tools are giving us the ability to treat faraway strangers as though they were neighbours — and we do, in good ways and in bad.

Trust is as unfairly granted in Bavaria as anywhere else. While browsing for shades in Garmisch-Partenkirchen, I warned my young son not to play with the merchandise: a sign forbade children to touch the sunglasses.

The shopkeeper bustled over and reassured me that the rule did not apply to my son. “It’s for the Arab kids,” she told me, beaming. “They just drop the sunglasses on the floor.”

Ah. My son is adorably blond but he is as capable of snapping a pair of designer sunglasses as any other four-year-old. Trust is sometimes given to people who do not deserve it. And it is often withheld from people who do.

Written for and first published at FT.com

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Undercover Economist

An algorithm for getting through the To Do list

Can computer scientists — the people who think about the foundations of computing and programming — help us to solve human problems such as having too many things to do, and not enough time in which to do them?

That’s the premise of Algorithms to Live By (US link) a book by Brian Christian and Tom Griffiths. It’s an appealing idea to any economist. We tend to think of everyday decisions as a branch of applied mathematics, which is what computer science is.

To be clear, using computer science is not the same as using computers. Computer scientists have devoted decades to problems such as sorting information, setting priorities and networking. Many of the algorithms they have developed for computers can also work for human beings. An algorithm, after all, is not a computer program. It’s a structured procedure, a kind of recipe. (Algorithms are named after a 9th-century Persian mathematician, Al-Khwārizmī, but they predate his work by thousands of years.)

So, what is the optimal recipe for working through the to-do list? Perhaps it is simpler than you think: do all the jobs on the list in any order, as it will take the same amount of time in the end. There is a touch of brilliance in this advice but it also seems to show that computer science will never shed light on the stress and wheel-spinning that we feel when we have too much to do.

Or so I thought. Then I read a 1970 paper by the computer scientist Peter Denning, which describes a problem that computers can have when multitasking. Most computers do not literally multitask; instead, like humans, they switch rapidly between one thing and another. A computer will flit between updating your screen with a Pokémon, downloading more videos from the internet, and checking to see if you have clicked the keyboard or moved the mouse, among many other processes. But even a computer cannot do an unlimited number of tasks and, at a certain point, disaster can strike.

The problem stems from the use of readily accessible “caches” to store data. To understand caches, imagine a pianist playing from two or three sheets of music in front of her. Those sheets are in the fastest cache. There are other sheets behind them, accessible in a few moments. Then there are larger but slower caches: music in the piano stool; more up in the attic, and yet more in a music shop. There is a trade-off between the volume of information and the speed with which it can be accessed.

This set-up is no problem if the pianist only plays one complete piece at a time. But if she is asked to switch every minute or so, then some of her time will be taken retrieving a piece of music from the piano stool. If she must change every few seconds, then she will be unable to play a note; all her time will be taken switching sheet music between the stand and the piano stool.

It is the same with a computer cache: there will be a hierarchy — from super-fast memory in the microprocessor itself all the way down to a hard drive (slow) and offsite back-up (very slow). To speed things up, the computer will copy the data it needs for the current task into a fast cache. If the tasks need to be switched too often, the machine will spend all its time copying data for one task into the cache, only to switch tasks, wipe the cache and fill it with something new. At the limit, nothing will ever be achieved. Denning described this regrettable state of affairs as “thrashing”.

We’ve all had days filled with nothing but thrashing, constantly switching focus from one task to another but never actually doing anything. Can we borrow a solution from the computers? The most straightforward solution is to get a bigger cache; that is easier for a computer than for a human, alas.

The obvious alternative is to switch tasks less often. Computers practice “interrupt coalescing”, or lumping little tasks together. A shopping list helps prevent unnecessary return trips to the shop. You can put your bills in a pile and deal with them once a month.

But we often find it difficult not to flit from one task to another. Computer science says there’s a reason for the pain: there is a trade-off between being swiftly responsive and marking out chunks of time to be productive. If you want to respond to your boss’s emails within five minutes, you must check email at least once every five minutes. If you want to go off-grid for a week to work on your novel, your response time must slow to a week.

Any solution should acknowledge that trade-off. Decide on an acceptable response time and interrupt yourself accordingly. If you think it’s perfectly fine to answer emails within four hours — fine by most standards — then you only need to check your email once every four hours, not once every four minutes. As Christian and Griffiths advise, decide how responsive you want to be. If you want to get things done, be no more responsive than that.

Written for and first published at FT.com

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Fossil fuels have had an aeon’s head start

Will we ever stop using fossil fuels? The question matters because fossil fuels are the largest contributor to climate change. Although finding better ways to produce cement, combat deforestation or even reduce the flatulence of cows and sheep would all be welcome, our only hope of dramatically cutting greenhouse gas emissions is by finding cleaner methods of generating power.

This won’t be easy. Coal, gas and oil are wonderfully concentrated sources of energy, neatly synthesising aeons of solar radiation. The late Professor David MacKay, author of the remarkable Sustainable Energy — Without the Hot Air (2008), underlined that truth with the book’s pointed dedication “to those who will not have the benefit of two billion years’ accumulated energy reserves”. The concentrated nature of fossil fuels means that alternative energy sources are competing against a formidable head start; the head start is lengthened by the fact that our entire existing energy system revolves around fossil fuel.

Despite all this, there are two obvious scenarios in which we might replace fossil fuels with alternative energy sources for purely commercial reasons. The first is grim: we begin to run out of fossil fuels and they become too expensive to use as a source of bulk energy. The second, more benign possibility, is that alternative energy sources become so cheap as to outcompete coal, gas and oil at almost any price; as the former Saudi oil minister Sheikh Yamani once commented, the Stone Age did not end because we ran out of stones.

The grim scenario is unlikely, because we are unlikely to run out of fossil fuels any time soon. According to the BP Statistical Review of World Energy, we have used up all the proven oil reserves that existed in 1980, yet have more than we started with. Gas reserves aren’t falling either. (Coal reserves are but from immense levels.) This shouldn’t be too surprising: “proven reserves” are resources that have been identified, measured, and look profitable. As old reserves are exhausted, new reserves are sought to replace them, and so far we have had little trouble in finding more fossil fuels whenever we wish to.

Another way to observe this is to look at economic behaviour. If the supply of oil was limited and known, owning an oilfield would be like owning any other investment. Producers would have to decide when exactly to sell their finite barrels of oil, and the only logical path for the oil price would be a gentle upward trend, matching the rate of return on other assets such as shares or bonds. (Any other price-path would be self-defeating: a lower price tomorrow would provoke a rush to sell immediately; a sharply higher price tomorrow would mean no oil was sold today.) This well-known theory, demonstrated by the economist Harold Hotelling in 1931, is, of course, in contradiction to the actual behaviour of oil and gas prices: fossil-fuel producers are clearly not treating oil and gas as though they were non-renewable resources.

But the cheerier scenario, in which low-carbon energy sources become very cheap, may be unlikely too. At first glance the signs seem promising — Denmark, Germany and Portugal have all reported occasions this year when their entire electricity grid was fuelled from renewable energy sources. And photovoltaic solar power, in particular, has become dramatically cheaper, largely for the simple reasons that China has over-subsidised production of the panels, which now come in easy-to-install kits.

But it is too soon to declare victory. On a commercial basis, renewable energy sources must do more than outcompete fossil fuels on price. Solar and wind deliver power when the sun shines or the wind blows. Fossil fuels deliver power when people need it. That is a big advantage.

And because fossil fuels pack a lot of energy into a small space, they’re ideally suited for transport. Electric cars are not competitive. A recent survey in the Journal of Economic Perspectives by the economists Thomas Covert, Michael Greenstone and Christopher Knittel estimates that current fuel cells would only be cheaper than gasoline at an oil price of $425 a barrel, eight times current levels. Fuel cells will fall in price, of course, but that figure gives a sense of the scale of the challenge.

And nuclear energy? Economist Lucas W Davis, again in the Journal of Economic Perspectives, concludes that there is little prospect of a nuclear renaissance because nuclear power stations simply cost too much to build. It would require a large upward shift in the price of fossil fuels, not to mention a change in the political winds, to see the technology return at scale.

Overall, there is little prospect of running out of fossil fuels, and it seems unlikely that alternative energy sources will outcompete them. And yet we must make the shift, or risk catastrophic climate change. Our reserves of fossil fuels may be no constraint but the atmosphere’s capacity to safely absorb carbon dioxide is.

There is some space for optimism. Renewable energy sources are no longer impossibly costly. Nor is nuclear power, even though the costs have moved in the wrong direction. We cannot wait for the market to make the switch unaided — but the gap is no longer so wide that sensible policy cannot bridge it. The centrepiece of such a policy would be to raise the price of carbon dioxide emissions, using internationally co-ordinated taxes or their equivalent. Such a tax would make renewable energy sources more attractive — as well as encouraging energy efficient technologies and behaviour. Market forces can do the rest. Low carbon energy is not free — but it is worth paying for.

Written for and first published on FT.com.

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Metropolitan myths that led to Brexit

The Eurosceptic myths that fuelled hostility to the EU are obvious enough. We were told that the NHS was being destroyed by immigration, when more than a third of UK-based doctors qualified overseas. We were told that the EU is a fat bureaucracy, when it employs about as many people as Lancashire County Council. And we were told that the UK was being buried in red tape, when the OECD reckons it is one of the least regulated economies in the developed world.

It is easy (and useless) to sneer. Yet the metropolitan elite that voted so enthusiastically to remain cherishes its own myths, and those myths did plenty to undermine the cause of remaining in the EU.

Here are four tenets of the trendy centre-left of British politics: first, soaring inequality means that ordinary people haven’t shared in the benefits of economic growth; second, rich people and big companies don’t pay taxes; third, gross domestic product (GDP) is a statistic that misses what really counts; and finally, economists are reliably wrong. Flip through The Guardian, browse the popular economics books in your local bookshop, and tell me that these ideas aren’t taken for granted among the chattering classes.

Before the referendum, Anand Menon, director of the “UK in a Changing Europe” project, was speaking at a town hall event in Newcastle. He explained that most economists thought Brexit would depress the UK’s GDP. “That’s your bloody GDP,” yelled a heckler, “not ours”.

Look again at the four articles of centre-left faith. If they are true, then surely the heckler was right. But while there is a little truth in each of these four beliefs, there is less than you might think.

It is true that income inequality in the UK rose very sharply during the 1980s. But by most measures it has been pretty flat since 1990. The top 1 per cent continued to pull away in the 1990s — although not this century — but, counterbalancing that, the gap between people at the 10th percentile and the 90th percentile actually fell between 1990 and 2013-14. Broadly, income inequality is a problem that emerged in the 1980s and has not worsened since. (The Institute for Fiscal Studies report Living Standards, Poverty and Inequality in the UK: 2015 was my source; the 2016 version has been published since this column went to press.)

The pressing issue for the UK has not been rising inequality but weak growth that has affected most people not only during the recession of 2008, but in the five years before and after it. The problem is not that income growth benefits only the rich. The problem is that there’s been little income growth to benefit anyone at all.

The second article of faith is that rich people don’t pay taxes. If true, it would hardly matter to ordinary voters if Brexit hurt the rich or drove them away.

But the richest 1 per cent of taxpayers pay nearly 28 per cent of income tax. And, with about 9 per cent of post-tax income, they presumably also pay about 9 per cent of VAT, which is close to being a flat tax. Of course, some other taxes are grossly regressive — most notoriously the council tax, which the European Commission did urge the UK government to reform — but the rich certainly pay enough tax that the public purse would sag if they disappeared. London, too, generated more than 25 per cent of UK taxes, and that proportion has been rising, according to Centre for Cities, a think-tank. After Brexit, who knows?

What about the idea that GDP itself is flawed? Well, yes. It is flawed. It measures things that do not matter and misses things that do. But a sharp hit to GDP will also be a sharp hit to our everyday wellbeing: people will lose their jobs; schools, hospitals and public services will be squeezed as tax revenue dries up.

Consider an alternative measure: the Social Progress Index, an attempt to measure what matters in global human development with more than 50 different indicators — including access to nutrition, healthcare and schools. The SPI explicitly excludes financial indicators. Yet there is a very high correlation between the SPI and GDP. (For my fellow nerds: Michael Green, director of the SPI, tells me that the correlation is 0.88 when GDP is measured on a log scale. That’s high.) As a measure of human welfare, GDP completely fails in theory. In practice, however, it is not such a bad yardstick.

Finally, there is the low reputation of economists, the result of a global financial crisis that only a few in the profession warned us against. But the institutes that analysed the risks and rewards of Brexit can hardly be blamed for that. The Institute for Fiscal Studies is full of experts on tax and household income; the Centre for Economic Performance studies globalisation, technology and education. Blaming these people for not foreseeing the collapse of Lehman Brothers is like blaming a brain surgeon for the spread of obesity.

Many of the people who rightly scorned the myths put around by Eurosceptics should examine their own fond beliefs. The lesson of the referendum campaign was that emotion trumps rational analysis — and that is not just true of the Leavers.

Written for and first published at FT.com

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