Undercover Economist

Monday is a big day in the Harford household: my oldest daughter will start school. That is a cue for the full spectrum of middle-class parental emotions: nostalgia for the toddler she once was; pride at seeing her reach a new stage of independence; and, of course, anxiety that the school will not be good enough for our little darling.

We have been given few reasons to fret about the quality of the teaching, but like many parents we’re nervous about the impact our daughter’s peers may have on her, many of whom are from deprived backgrounds or homes where nobody speaks English. Will the teacher be distracted by the need to teach the class skills she already has?

I have written before about “peer effects” in education, which are the influences, positive and negative, that classmates and school friends have on each other. They are hard to identify with much certainty. Bright children might make friends with each other without actually improving each other’s test scores. Or pushy middle-class parents might all flock to the same popular school. Or a class of smart kids might attract a good teacher. All these situations would produce clusters of high and low achievement, yet no true peer effects need be at play.

Still, there are occasions on which classmates are assigned absolutely at random. For example, in North Carolina, 120,000 children were randomly assigned classmates over the period of a decade. Using such situations, economists think they are identifying peer effects.

Caroline Hoxby, a Stanford professor of economics and a leading figure in the field, explained the emerging consensus to me in an interview last year. First, peer effects exist. Second, they are not nearly as important as good teachers: given the choice between the best class in town and the best teacher in town, parents should choose the best teacher any day.

Third, peer effects take the form of what Hoxby describes as “the sports model”. If you were looking to improve at a sport, you would typically seek to play against people who were a little better than you, because they would drag you up to their level. The same appears to be true in a classroom: children benefit from having classmates who are just a little ahead of them.

This is useful to know, since there are many other plausible models of peer effects, including the “rainbow” (children benefit from having a wide range of abilities around them), the “bad apple” (if the troublemakers can be deterred, cured or excluded, their classmates will be fine), the “shining star” (one classroom genius inspires everyone) and the “boutique” (what matters is that the whole class is at much the same level, so the teacher’s lessons can satisfy everyone). Since it is mathematically impossible for every child to have slightly superior classmates, the “boutique” model seems to be the next best thing, and that suggests some form of streaming by ability is wise.

There is new evidence of that from Kenya, whose education system is at the cutting edge of a newly popular type of economic analysis, the randomised controlled trial. In the latest example – studied by the economists Esther Duflo, Pascaline Dupas and Michael Kremer – 121 Kenyan schools were given a grant to hire an extra teacher and so split one large reception class into two smaller classes. In 61 randomly chosen schools the students were streamed by ability; in the other 60, they were randomly assigned to their classes. The result: better grades for everybody in the streamed classes, whether they were originally judged to be high, medium or low ability. It is not a shocking conclusion but it is good to have the gold-standard of the randomised trial to support it. If only there were more such trials outside east Africa.

Also published at ft.com.

The John Templeton Foundation recently sent me a collection of essays addressing the question: “Does the free market corrode moral character?” Lacking an agreed definition of the free market, a conception of good moral character, and above all a sense of how character is shaped, it is not surprising that the answers tended to wander off topic. The writer Kay Hymowitz fears that internet chatrooms facilitate paedophilia. The economist Jagdish Bhagwati argues that globalisation makes the world a better place. However right he may be, that was not the question.

It is easy to point to systems that are far more injurious to moral character – not to mention prosperity, peace, the environment and human life itself – than the free market: German fascism, Stalinist communism. It is harder to reverse the exercise, although free markets do look corrosive when compared to some childlike state of grace.

I am not sure if it is the same question or not, but one might also ask: “Does the free market punish moral character?” On balance, the answer is no. Markets tend (but do not guarantee) to reward hard work, calculated risk-taking, applied creativity, amiability and honesty. Competition is the key here: it allows us to find alternatives to doing business with lazy, timorous, unimaginative, rude or dishonest people.

All this assumes that we can see such people coming. Often we can. Most market interactions are repeated, directly or indirectly. I buy something from the same corner shop every day, and it is in neither the shop owner’s nor my own interests to rock the boat. So we smile, chat, perform (very) small favours for each other and do not cheat. My relationship with a Tesco shop attendant is less straightforward, but, although unlikely I will ever see the attendant again, Tesco has an ongoing relationship both with its own employee and with me and does its best to ensure things run smoothly.

When market interactions are not repeated, there is more temptation to cheat. There is a logical reason why holiday guides, estate agents and pension salesmen tend to be regarded with caution.

All this is closer to pub philosophy than science, but some scientific evidence does exist. One suggestive finding comes from a cross-cultural study carried out by three economists and published earlier this year in the journal Science. Simon Gächter, Benedikt Herrmann and Christian Thöni invited subjects in 16 cities across the world to play a “public goods” game, in which players had to choose, repeatedly, between contributing to a pot for the benefit of all or selfishly hoarding their own resources.

Earlier research had found that if players were given the option of punishing the selfish by removing their resources, they did so and near-full co-operation quickly emerged. Gächter and his colleagues found that, in many societies, the opposite occurred: rather than accepting their punishment and co-operating, those who had been punished tended instead to take revenge.

The results were striking: co-operative behaviour seemed to flourish in countries where market democracies were long established.

The Americans, Australians, Britons and Swiss were the least likely to inflict recriminatory punishment. Russians, Greeks and Saudis were most prone to reprisals. Co-operation was best sustained in the US, Denmark and Switzerland, and fell apart in Turkey, Saudi Arabia and Greece.

Co-operation and aversion to vengeance are hardly the sole definitions of moral character; and this was merely a laboratory game. Still – despite a long history of reasonably free markets in the US, Australia, the UK, Switzerland and Denmark, important aspects of morality in those countries seem to have held up rather well.

Also published at ft.com.

Were an alien to pick up our news channels, it would conclude that human civilization depended on the production and purchase of cheap plastic rubbish. First came the concern that we might talk ourselves into not spending enough, then the fear that the banks wouldn’t lend us the money to spend even if we wanted to. In November, our governments borrowed money and gave it to us in the hope that we’d catch on. Are we really so dependent on consumption?

In the short run, yes. Economists worry about a sharp fall in consumer spending, because when demand for goods falls, so does demand for labor. Our desire to spend less is quickly revealed as a desire to spend less hiring each other (and our friends in China) to make things. Result: economic collapse, unemployment, misery.

In the long run, the picture is completely different. We earn—this is a very rough average—twice what our parents did when they were our age. When today’s teenagers are in their 40s, there is no reason why they shouldn’t decide to enjoy their increased prosperity by working less instead of earning more. Rather than being twice as rich as their parents, they could be no richer but start their weekends on Wednesday afternoon.

If this were a gradual process, mass unemployment would not result. People would simply earn less, spend less, wear a few more secondhand clothes, and spend more time reading or going for walks.

This would be perfectly possible. We are rich enough already. Even the Chinese might cope: They already devote much of their economy to making things for each other.

Here’s the big question of the season, then: Why don’t we do as countless moralists urge every year and focus less on money and more on leisure (or spiritual concerns, if you must)? Why haven’t we all decided to work less, spend less, and consume less?

There is an anti-consumer movement with a ready answer: We’re helpless, enthralled by advertisers and hooked on shopping. I’ve always had a slightly more optimistic view of human autonomy.

A more convincing answer is that we work hard because income is linked to our desire for status, which is collectively insatiable, because status is largely relative. A famous survey by economists Sara Solnick and David Hemenway found that many Harvard students (although few Harvard staff members) would rather have an income of $50,000 in a world where most people were poorer than an income of $100,000 in a world where most people were richer. The survey has arguably been overinterpreted in the 10 years since it was published, but it does seem to point to an important truth: It matters to us how much money other people have.

When it comes to leisure, positional concerns seem to matter less. Perhaps that is because leisure is not closely linked to status—anyone can enjoy leisure by walking out of his job. It is hard to imagine many people preferring four weeks of annual vacation in a world where most people have less to eight weeks of vacation in a world where most people have more.

This may be part of the story. The other part is that we do have more leisure. According to economists Mark Aguiar and Erik Hurst, leisure time for women has increased by at least four hours a week since 1965. Men have done even better. That may well understate the leisure gains. A hundred years ago, many people would start working at the age of 10 or 12 and work until they died. Now it is common to spend fewer than half our years working; the rest of the time we spend studying, traveling, and in retirement.

The “work less, spend less” movement is winning. It’s a shame it hasn’t noticed.

Did Robert Peston cause the credit crunch? Some people seem to think so: the Daily Mail recently asked if he had too much power; Neal Gandhi, the chief executive officer of an outsourcing company, claimed that “because of his influential position, his predictions come true almost exclusively because he has predicted them”. This seems implausible, and I’m not saying that merely because Peston once worked for the Financial Times. After all, there’s a credit crunch on in New York too, where few have ever heard of the BBC’s inimitable business editor.

It is less absurd to claim that media exaggerations have deepened the recession, perhaps even caused it. Mark Fenton-O’Creevy, a professor of organisational behaviour at the Open University, argues that “media stories on the current turmoil are not just reflecting events, they are also creating them”. The journalist Michael Blastland, an evangelist for responsible use of statistics, argued in a debate at the Frontline Club in November that the media’s gloom about consumer spending had far outpaced any signs of a slump in the data and was contributing to the downturn.

Let’s examine this for a moment. Media reports are often excitable and rarely put economic data into context – but are they powerful enough to tip us into recession? That could only be true if economies were largely confidence tricks, with consumer and business spending tied less to income and more to the front pages of the tabloids. Economies very rarely work like that: were the FT to pronounce “everything’s nifty” on Monday, niftiness would remain elusive. We have run up against hard constraints. Banks made large losses long before depositors started twitching. Consumers had borrowed heavily, making it almost inevitable that at some stage spending would fall as they paid off debts. Ignorance or overconfidence allows us to defy gravity for a while, but not forever.

One case where prophecies can be self-fulfilling is a bank run. Banks can become unsafe for no reason other than that everyone believes them to be unsafe. Peston could bankrupt the safest bank in Britain if he announced on the breakfast news that it was going under and everyone should pull their money out at once. But the banks have largely melted down without the help of panicking depositors. They have been stricken because institutional investors, who do not make their financial decisions based on mass-market media reports, would not lend to them; and, indeed, because they would not lend to each other. When Iceland’s banking system collapsed in October, the problem was not that the media had panicked depositors. On the contrary: even as the money markets utterly lost confidence, British newspapers were claiming that Icesave offered one of the best savings products around.

Beyond the bank run, I am even less convinced that the media are to blame. Most of us continue to make our decisions based on our unique personal financial circumstances.

It is true that the media can set the economic mood. Two Federal Reserve economists, Mark Doms and Norman Morin, have found evidence that media reports of economic distress (pre-credit crunch) have always tended to knock consumer confidence, even if the economy is doing well. Thankfully, it is a long way from the survey to the high street. Researchers at the National Institute of Economic and Social Research have concluded that surveys of consumer confidence do not provide much help in predicting what consumers subsequently do. In other words, if Peston tells us it’s bad, we repeat his incantations when someone with a clipboard asks us how we’re feeling. Then we pull out our wallets and hit the shops.

Also published at ft.com.

To most thoughtful people, unemployment benefit embodies a painful trade-off. It’s the mark of a civilised society, clubbing together to provide assistance to those in need. It is also, regrettably, an incentive to remain unemployed. At its worst, unemployment benefit pays people to watch daytime television; it is particularly pernicious if the skills of the jobless decay, and unemployment becomes unemployability. Yet, at its best, it is a life-saver.

In balancing these two effects, it’s hardly surprising that different societies have adopted very different systems. According to the Organisation for Economic Co-operation and Development, member governments spent an average of 0.75 per cent of gross domestic product on unemployment benefits in 2006. France spent nearly twice this sum, and Germany almost three times as much, while the US spent a third of the average, and the UK just over a quarter. Germany spent more than 10 times as much as the UK, relative to GDP.

Paying people to stay out of work is an example of that increasingly familiar phenomenon, “moral hazard”, but moral hazard can be more fearsome in the theorist’s imagination than it is in reality. Does unemployment benefit really encourage people to duck work? Unfortunately, the evidence suggests that it does: increases in benefits have repeatedly been linked with longer periods between jobs.

But new research from Raj Chetty, a young Berkeley economist, suggests that moral hazard may not be why more generous benefits seem to lead to more unemployment. Chetty realised that unemployment benefit does not merely pay people to stay out of work; it also protects them from having to rush into an unsuitable job. It is nothing to celebrate if unemployed engineers cannot afford to spend three months finding a job for which they are qualified, but are forced to work as estate agents to put food on the table. A longer gap between jobs is sometimes preferable.

This is an interesting theory, but distinguishing between moral hazard and the effect of having some cash to hand is tough. Chetty looked at sharp breaks in the unemployment insurance rules in the US, comparing one state’s rules with another’s, or examining moments when the rules changed. One suggestive finding is that when unemployment insurance becomes more generous, not everybody lingers on benefits. The median job-loser in the US has $200 when he loses his job and is unlikely to be able to borrow much, but some people have plenty of money in the bank when they find themselves unemployed. Chetty found that those with savings do not take any longer to find a job when paid more generous benefits, while those with little in the kitty when they lose their jobs do. This suggests that those without their own cash reserves are using unemployment benefits to buy themselves time to find the right job.

Of course, there may be many differences between people with savings and those without, so this merely suggests that Chetty is on to something. But there are other clues – for instance, Chetty and two colleagues looked at the system in Austria, where severance pay is due to anyone employed for more than three years. By looking at – for example – a factory closure in which lots of staff are fired simultaneously, they could treat severance pay almost as a randomised experiment. Those lucky enough to get severance pay spent more time looking for a new job, despite the fact that severance pay provides no direct incentive to stay out of work.

Unemployment benefit does encourage unemployment in the short term; but that may be no bad thing.

Also published at ft.com.

Anyone wondering how consumers behave in a recession need simply trawl the tabloids for inspiration. According to The Sun, sales of aphrodisiacs are up and so are sales of maternity dresses: not everything turns down in tough times, it seems. Elle Macpherson’s underwear is said to be doing well; so too is the budget store Poundland. Some stories seem contradictory: one newspaper claims that Ryanair is set to make a profit, while another reports that weekend breaks to European cities are no longer in demand. Other stories are frankly bizarre: the crunch is alleged to have given a fillip to sales of cake, wooden “gravestones”, West End musicals and tickets to see the film Mamma Mia!

The quality press has not resisted the temptation to join in the guessing game: The Economist imagined the return of the nutritious fish snoek, while this paper found evidence that physiotherapists were in demand to perk up stressed City workers.

All this speculation is an engaging diversion, but tells us little. Even the more solid reports are often based on anecdotes; many are simply spin or wishful thinking. I’ve heard a food retailer muse that Fairtrade-branded goods are recession-proof, because once people have seen the light about the importance of fair trade, they never turn back. A travel industry expert told me that the worse things get, the more people feel in need of a holiday. Perhaps he is right. I wouldn’t bet on it.

I doubt that these early reports will tell us much about what will happen in the trough of this recession. One of the reasons people curtail their spending is because they lose their jobs. But unemployment is not yet especially high: it was higher in late 2006 than in September this year. There is plenty of scope for things to worsen on that score.

Economic theory tells us that consumers should cut back their spending if they believe that their earning power will fall for an extended period of time, but if they believe the hard times are temporary – say, a short period out of work – they should “smooth” by borrowing in hard times and paying back when things pick up. Because of smoothing, consumption should not shrink as much as the economy does. That sounds reassuring, but Ray Barrell of the National Institute of Economic and Social Research has two pieces of bad news.

The first is that this is the wrong sort of recession: because it was precipitated by a banking crisis, consumption may well fall much more dramatically. That’s plausible. Consumers who want to smooth consumption can’t borrow to do so. This is what happened during the 14 banking crises in various high-income countries that Barrell and his colleagues have studied.

The second piece of bad news relates to the first. Because consumers were already borrowing heavily in the good times, both credit constraints and a long overdue realism are likely to bite all the more deeply. That, too, is a tendency Barrell finds in the data.

Of course, as the sellers of herbal Viagra are said to be discovering, when consumer spending falls, some products do well and others do very badly. Nervous retailers looking for clues might wish to pick up research from the 1990s by the economists Martin Browning and Thomas Crossley, called “Shocks, Stocks and Socks”. They found that when people are unemployed they save money in a logical way, by not buying “small durables” such as socks, and indeed clothes in general. In the short term, people get by and save about 15 per cent of their household budget. When they find a new job, they replace the tired old socks. Bad news for Marks & Spencer; good news for sellers of needles and thread.

Also published at ft.com.

Any first-time visitor to Africa is faced with a whirl of new experiences, but the awful roads are guaranteed to make an impression. That is true even in many cities – when I visited Douala, the commercial hub of Cameroon, I was appalled to realise that a four-wheel-drive vehicle was all but a necessity.

Cameroon’s roads also made an impression on Robert Guest, author of The Shackled Continent. Guest once hitched a ride on a Cameroonian beer truck travelling the equivalent of London to Newcastle upon Tyne – about 300 miles. The journey, detouring around a collapsed bridge on unpaved rainforest roads, took four days.

More rigorous studies have also found that the cost of transporting goods around west Africa is astonishingly high. One, albeit 15 years old, went so far as to conclude that road transport in Francophone Africa was six times more expensive even than in Pakistan.

Pity the entrepreneur who wants to do business under such conditions. If goods travel at 75 miles a day, as Guest’s beer truck did, it is almost impossible to import materials or export products profitably from Africa’s backwaters. The economic geographers Nuno Limão and Tony Venables have estimated that high transport costs explain almost all of Africa’s economic isolation. Certainly, exporters have not been able to take full advantage of US and EU trade concessions.

Since the 1970s, the World Bank has been pouring money into improving African roads. That seems to make sense but, puzzlingly, transport costs do not seem to have fallen in the way one would hope.

Guest’s experience suggests why. His beer truck was stopped 47 times at police roadblocks, sometimes for hours, while the police tried to find fault and extract bribes. At one point, he protested; the gendarme patted his holster and pointed out: “I have a gun, so I know the rules.” Clearing away such corruption may not be easy, but at least it requires no great expenditure on roads.

In fact, pure extortion is not the only bureaucratic obstacle to imports and exports. The World Bank’s annual “Doing Business” project collects data on the time and expense involved in meeting official demands for signatures, permits and licences. Cameroon’s regulations require nine documents, 27 days and almost a thousand dollars in official fees to export a shipping container; and Cameroon is by no means the worst offender. “Doing Business” data suggest that about two-thirds of the time taken to import or export products is thanks to paperwork such as customs clearance.

A new World Bank study of Africa’s transport corridors has found yet another obstacle to exporters that could, in principle, be cleared away without much expense: trucking cartels in west and central Africa. The study’s authors, Supee Teravaninthorn and Gael Raballand, believe that reducing transport costs would do little to bring down transport prices: better roads, swifter customs clearance and cheaper fuel would all simply add to the profits of the trucking companies.

If this view is correct, what west and central Africa’s exporters need to reach the world’s markets is a deregulated trucking industry. And, indeed, when landlocked Rwanda did deregulate, transport prices fell quickly.

This is good news: it is easier to scrap daft regulations than to build new roads, and, according to ”Doing Business”, sub-Saharan African countries have been leading reformers of customs regulations. With more such progress, it may even become worth worrying about the roads themselves.

Also published at ft.com.

The Nobel memorial prize in economics is typically awarded to researchers who have jointly advanced some important method or idea. When the 2008 prize was awarded to Paul Krugman alone, for his contributions to trade theory and economic geography, other candidates who might have shared the prize – but didn’t – must have counted themselves one small step further away from receiving the call from Stockholm.

Among them are Jagdish Bhagwati, Krugman’s teacher and champion, and a giant in the field of international trade; and Elhanan Helpman, who wrote an influential book with Krugman on the new trade theory.

But I thought in particular of Avinash Dixit, without whom Krugman might have abandoned economics 30 years ago and so never formulated his new trade theory. Krugman has said he left graduate school “directionless … I was not even sure whether I really liked research.”

That was changed by what is now known as the “Dixit-Stiglitz” model. In 1977, Dixit and Joseph Stiglitz – one of the Nobel laureates in 2001 – published a new way of modelling how companies compete. The Dixit-Stiglitz model described “monopolistic competition” between many products in a particular market.

Monopolistic competition sounds like an oxymoron, and Dixit-Stiglitz certainly addressed a longstanding tension. Adam Smith had emphasised the importance of competition, but also the power of specialisation and the division of labour. His famous account of a pin factory, in which 10 men produced thousands of times as many pins as could one man, illustrated this point and thus the significance of economies of scale.

That poses a conundrum. Economies of scale push towards larger and larger companies. Logically, a monopolist should be the lower-cost provider. The tension between economies of scale and competition is obvious.

Yet while obvious, it is hard to model mathematically in a useful way. Dixit and Stiglitz resolved the problem by observing that consumers have a taste for variety as well as a taste for low prices. In the market for cars, for instance, Volvos compete with Fords and Ferraris. It would be cheaper if there was only one model of car; it would be nicer if there was an infinite variety. Somewhere in the middle is the equilibrium where economies of scale are balanced by customers’ desire for variety.

The elegant mathematics of the Dixit-Stiglitz model was new, even if the tension it described was as old as Smith’s Wealth of Nations. Krugman described it is as “beautiful”. It quickly became a workhorse, pulling economists to new frontiers of trade theory, growth theory and economic geography. Dixit later said he and Stiglitz had not realised the model would have so many uses – “obviously, otherwise we would have written all those subsequent papers ourselves!”

That is typically generous of a man who has often praised others, especially Krugman. He once told young economists that a good place to have ideas was in front of the shaving mirror. Krugman has a beard. Imagine, quipped Dixit, how much he could have achieved if he shaved!

Although the Nobel now seems overdue, Dixit hardly languishes in obscurity. He is president of the American Economic Association. He is a brilliant game theorist whose book with Barry Nalebuff, Thinking Strategically (now revised as The Art of Strategy) is a model of popular economics. And he may yet win the Nobel for his research with Robert Pindyck of MIT on “real options”, which describes how economic uncertainty can delay the most promising of business investments. It is a body of work that looks alarmingly relevant today.

Also published at ft.com.

Here are the chief investment lessons of the financial crisis for today’s young people: they should be buying more shares and running up debts to do so. I’m not saying that the market is undervalued – how would I know? I am merely suggesting a way of reducing risks.

If that seems strange, reflect for a moment. We know that stocks can be very volatile. We also know that some generations have been luckier than others when it comes to the performance of the stock market. The baby boomer who started regular purchases of US stocks in 1970 and sold up in 2000 would have felt pretty sick after the awful bear market of 1974, but in retrospect his timing would have been perfect, filling his boots with bargain late 1970s and early 1980s shares, and selling out right at the top. His daughter, entering the stock market in 1995 and aiming to retire in 2025, would have spent the past 13 years buying shares at prices that now seem to range from high to extortionate. We could call this “generational risk”.

Now, think about the current prevailing wisdom on investing in shares, which reflects the fact that shares tend to produce high but risky returns. It is to start by putting most of one’s savings into the stock market, and as retirement approaches, increasingly shifting one’s portfolio to bonds and other less volatile investments. That seems to make sense. In fact, it is nonsense.

For one thing, there is nothing particularly safe about holding stocks for the long term. Whether you plan to sell a portfolio of stocks next week, or hold them for another 40 years, a 20 per cent fall in the stock market this week reduces the eventual value of that portfolio by 20 per cent, relative to where they would have been had you sold them the day before the crash and reinvested afterwards.

Further, a long-term investor following the consensus advice is exposed to stock-market risk in a very strange way. When young, he has almost no exposure. Although his tiny pot of savings is largely invested in stocks, that tiny pot contains almost none of the shares he eventually plans to own. That’s too conservative. In middle age, he is overexposed in a desperate attempt to enjoy the high returns on stocks. Then as he approaches retirement he becomes too conservative again as he pours his portfolio back into safe assets. It is this bizarre pattern that produces generational risk.

The logical way to fight generational risk is to borrow money to make large, regular investments in shares while young, then use a proportion of later savings to pay back the loan rather than to pile into the stock market in middle age. That sounds risky, but it is in fact exactly what people do in the housing market. Knowing that they will need a place to live all their lives, they tend to buy a small house and gradually trade up to a bigger one, only paying off their mortgages late in life.

Most of us need a retirement fund as well as a place to live; there is nothing intrinsically risky about regular borrowing to get that fund off to an early start.

Not only does the concept make sense, it has paid off in the past. The Yale academics who proposed it, Ian Ayres and Barry Nalebuff, have looked at historical stock market data covering 94 cohorts who retired between 1913 and 2004. For every single cohort, the early leverage strategy beat the conventional wisdom; it also almost always beat the gambler’s strategy of investing every penny in stocks until the moment of retirement. Only the blessed cohorts who retired in 1998 and 1999 did better. Such gambles rarely pay off, so if you’re 20 years old and want to spread your risks, mortgage your retirement today.

Also published at ft.com.

The stock market is efficient.

It might seem a strange time to be making that claim, but despite its apparent absurdity I am now convinced that it is by far the most sensible way for an investor to look at the world. It may even be broadly true.

The efficient market hypothesis states that historical information provides no help in forecasting share prices. That would mean that examining graphs of a share’s performance, even reading this morning’s FT, would not produce a reliable strategy for judging the price of a share tomorrow or next year. That is because all useful information would already have been assimilated in today’s price. Paul Samuelson, perhaps the most influential economist of the 20th century, summed it up in 1965 in the title of his article: “Proof that Properly Anticipated Prices Fluctuate Randomly.” Since all available information is already reflected in the price, future prices will move only as news arrives. News itself arrives unpredictably, otherwise it is not news.

If the efficient markets hypothesis is true, then sensible economists will admit that they simply do not know what the outlook is for the stock market. How dull! It is much more fun to have somebody predict the future.

Yet it would explain the recent edition of FT Money in which the two star columnists offered precisely opposing views on the outlook for the stock market: Anthony Bolton anticipating recovery and Merryn Somerset Webb arguing that the market is still too optimistic about the future. Are they then both charlatans? Not at all. In an efficient market, disagreements between well-informed people are exactly what one would expect. Both are equally likely to be right.

The hypothesis is affectionately lampooned by a famous old joke about two economists who pass a $100 bill on the street. One reaches to pick it up, and his friend tells him not to be absurd. There couldn’t possibly be a $100 bill lying in the street because someone would already have picked it up.

The joke is a good one, but nobody has convincingly proved or disproved that the efficient markets hypothesis is true.

Nevertheless, investors should act as if it is. Belief in efficient financial markets suggests a three-pronged investment strategy. First, ignore advertisements (and newspaper articles) that tout the past performance of particular sectors or funds. In an efficient market, past performance is not only no guarantee of future performance, it offers no clue whatsoever. Second, don’t try to pick stocks and don’t ask others to pick stocks for you: in other words, choose a low-cost index tracker. Third, don’t try to time the market: get in and out gradually.

This third point is not widely appreciated enough. While many investors now realise the attractions of tracker funds, few realise that the typical fund does much better than the typical investor. This is because investors tend to buy high and sell low. Ilia Dichev of the University of Michigan has recently calculated “dollar-weighted” returns for major stock indices – a good adjustment for the tendency of investors to plunge into the markets as they are about to turn bearish. Dichev found that such returns were lower than “buy and hold” returns by 1.3 percentage points annually – 8.6 per cent instead of 9.9 per cent – between 1926 and 2002 on the New York Stock Exchange and American Stock Exchange. For a long-term investor this is a big difference. The same picture holds true since the early 1970s for international markets, and dramatically so for Nasdaq.

Perhaps the market is not efficient after all. All I know is that those of us who act as though it is have a substantial advantage over the typical investor.

Also published at ft.com.