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

Economists aren’t all bad

‘Some research on students suggests economics either attracts or creates sociopaths’

Justin Welby, the Archbishop of Canterbury, recently bemoaned the way that “we are all reduced to being Homo financiarius or Homo economicus, mere economic units … for whom any gain is someone else’s loss in a zero-sum world.”

The remarks were reported on the 1st of April, but I checked, and the Archbishop seems serious. He set out two ways to see the world: the way a Christian sees it, full of abundance and grace; and the way he claims Milton Friedman saw it, as a zero-sum game.

Whatever the faults one might find in Friedman’s thinking, seeing the world as a zero-sum game was not one of them. So what do we learn from this, other than that the Archbishop of Canterbury was careless in his choice of straw man? The Archbishop does raise a troubling idea. Perhaps studying economics is morally corrosive and may simply make you a meaner, narrower human being.

That might seem to be taking the economics-bashing a bit far but there is a hefty body of evidence to consult here. (Two recent short survey articles, by psychologist Adam Grant and by economist Timothy Taylor, provide a good starting point.) Several studies have compared the attitudes or behaviour of economics students or teachers with those of people learning or teaching other academic disciplines.

Typically, these studies find that economists are less co-operative in classroom games: they contribute less to collective goods and they act selfishly in the famous prisoner’s dilemma (where two people have a strong incentive to betray each other but would collectively be better off if both stayed loyal). In 1993, Robert Frank (an economist) and Thomas Gilovich and Dennis Regan (both psychologists) surveyed academics and found that although almost everyone claimed to give money to charity, almost 10 per cent of economists said they gave nothing.

Frank and his colleagues also gave hypothetical dilemmas to students. Would they correct a billing error in their favour? Would they return a lost but addressed envelope containing cash? (And what did they think other people would do in these situations?) Those studying traditional microeconomics classes were less likely than other students to give the honest response, and slightly less likely to expect honesty from others. Most students said they would return an addressed envelope with cash in it but economics students were more likely to admit to baser motives.

Reading such research suggests economics either attracts or creates sociopaths – and that should give economics instructors pause for thought.

Yet I am not totally persuaded. Economists did actually give more to charity in Frank’s survey. They were richer, and while they gave less as a percentage of their income they did give more in cash terms.

What about those hypothetical questions about envelopes full of cash? Were economics students selfish or merely truthful? Anthony Yezer and Robert Goldfarb (economists) and Paul Poppen (a psychologist) conducted an experiment to find out, surreptitiously dropping addressed envelopes with cash in classrooms to see if economics students really were less likely to return the money. Yezer and colleagues found quite the opposite: the economics students were substantially more likely to return the cash. Not quite so selfish after all.

Most importantly, classroom experiments with collective goods or the prisoner’s dilemma don’t capture much of economic life. The prisoner’s dilemma is a special case, and a counter-intuitive one. It is not surprising that economics students behave differently, nor does it tell us much about how they behave in reality. If there is a single foundational principle in economics it is that when you give people the chance to trade with each other, both of them tend to become better off. Maybe that’s naive but it’s all about “abundance” and is the precise opposite of a zero-sum mentality.

In fact, some of the more persuasive criticisms of economics are that it is too optimistic about abundance and peaceful gains from trade. From this perspective, economists should give more attention to the risks of crime and violence and to the prospect of inviolable environmental limits to economic growth. Perhaps economists don’t realise that some situations really are zero-sum games.

. . .

Economists may appear ethically impoverished on the question of co-operating in the prisoner’s dilemma but they seem to have a far more favourable attitude to immigration from poorer countries. To an economist, foreigners are people too.

This viewpoint infuriates some critics of economics, to the extent that it earned the famous nickname of “the dismal science”. Too few people know the context in which Thomas Carlyle hurled that epithet: it was in a proslavery article, first published in 1849, a few years after slavery had been abolished in the British empire. Carlyle attacked the idea that “black men” might simply be induced to work for pay, according to what he sneeringly termed the “science of supply and demand”. Scorning the liberal views of economists, he believed Africans should be put to work by force.

Economics puts us at risk of some ethical mistakes, but with its respect for individual human agency it also inoculates us against some true atrocities. I’m not ashamed to be a dismal scientist.

Also published at ft.com.

Undercover Economist

Why long-term unemployment matters

‘Research shows that employers ignore people who have been out of work for more than six months’

“Quantity has a quality of its own.” Whether or not Stalin ever said this about the Red Army, it is true of being out of work. Evidence is mounting that the long-term unemployed aren’t merely the short-term unemployed with the addition of a little waiting time. They are in a very different situation – and an alarming one at that.

Researchers in the US are setting the pace on this topic, because it is in America that a sharp and unique shift has occurred. Broad measures of unemployment reached high but not unprecedented levels during the recent great recession. Yet long-term unemployment (lasting more than six months) surged off the charts. It has been extremely rare for long-term unemployment to make up more than 20 per cent of US unemployment, but it was at 45 per cent during the depths of the recession. In the UK and eurozone, long-term unemployment is pervasive but that, alas, is not news.

As long as there is a recovery, why does this matter? A clue emerges when we look at two statistical relationships that are famous to econo-nerds like me: the Phillips curve and the Beveridge curve. (They are named after two greats of the London School of Economics, Bill Phillips and William Beveridge.)

The Phillips curve shows a relationship between inflation and unemployment. The Beveridge curve shows a relationship between vacancies and unemployment. Both of these relationships have been doing strange things recently: given the number of people out of work, both inflation and vacancies are higher than we’d expect.

What that means is that we can hear the engine of US economic activity revving away and yet the economy is still moving slowly. The gears aren’t meshing properly; economic growth is not being converted into jobs as smoothly as we would hope. So what’s going on?

Here’s a thought experiment: what if the long-term unemployed didn’t exist? What if we replotted the Phillips curve and the Beveridge curve using statistics on short-term unemployment? It turns out that the old statistical relationships would work just fine. We can solve the statistical puzzle – all we need to do is assume that the long-term unemployed are irrelevant to the way the economy works.

A recent Brookings Institution research paper by Alan Krueger (a senior adviser to Barack Obama during the recession), Judd Cramer and David Cho examines this discomfiting thesis in greater depth. The researchers conclude that people who have been out of work for more than six months are indeed marginalised: employers ignore them, bidding up wages if necessary to attract workers from the ranks of the short-term unemployed.

I’ve written before about an experiment conducted by a young economist, Rand Ghayad. He mailed out nearly 5,000 carefully calibrated job applications, using a computer to tweak key parameters. He found that employers were three times more likely to call an applicant with irrelevant but recent employment experience, than someone who had relevant experience but had been out of work for more than six months. Long-term unemployment had become a trap.

In Ghayad’s experiment, the long-term unemployed were identical in every other way to other applicants. In reality, of course, it may be that people also become demotivated after a long spell of looking for work. The “benefits culture” at work? It seems not. Earlier research by Krueger and Andreas Mueller tracked job hunters over time and showed them becoming ever less active in the job market – and ever more depressed. They could not rouse themselves, even when unemployment insurance payments were about to expire. It wasn’t that the people joined the ranks of the long-term unemployed because they were demotivated to start with: the long-term unemployment came first, and the unhappiness and the lack of drive came later.

. . .

There is a silver lining to all this: it suggests that those of us worried about deep, technology-driven weaknesses in the US economy may be wrong. Instead, the US economy has a cyclical problem so serious that it left lasting scars – but they will heal eventually. One can hope, anyway. Experience in Canada and Sweden during the past two decades suggests that it is possible to chip away at long-term unemployment but it takes time.

Is there a policy cure for this challenge? The rightwing intuition is tough love, based on the theory that overgenerous unemployment support merely incentivises people to sit on the sidelines of the labour market until they become unemployable. Leftwingers retort that the long-term unemployed are the victims of circumstance and need our support.

Recent evidence gathered by two economists, Bart Hobijn and Aysegul Sahin, suggests the rightwingers have a point in the case of Sweden, whereas in the UK, Spain and Portugal the labour market has been hit not by overgenerous benefits but by a structural shift in the economy away from construction. The supply of jobs no longer matches the supply of workers.

As for the US, Krueger’s research paints a picture of the long-term unemployed as people who are not very different to the rest of us – merely unluckier.

Also published at ft.com.

Undercover Economist

How investors get it wrong

‘We trade too often because we’re too confident in our ability to spot the latest bargain’

Flip through the pages of this august newspaper and you will often see reference to how particular investments are doing: gold is up, oil is down and the S&P 500 is going sideways.

Yet illuminating as all this might be, such reporting draws a veil across what we might call the Investor’s Tragedy: that the typical investor doesn’t do nearly as well as the typical investment.

This isn’t just because Wall Street and the City of London cream off all the money, although of course there is something in that. (In 1940, the author Fred Schwed invited us to contemplate the yachts of all the brokers and bankers riding at anchor off downtown Manhattan; the title of Schwed’s book was Where Are the Customers’ Yachts?)

No, the Investor’s Tragedy wouldn’t be much of a tragedy if it was all somebody else’s fault. Alas, the fault is not in our stars but in ourselves: we underperform the market because we’re doing it wrong.

Our first tragic flaw is that we buy and sell too often. In 2000, Brad Barber and Terrance Odean studied the trading performance of more than 65,000 retail investors with accounts at a large discount broker. Looking at the early 1990s – happy days for investors – Barber and Odean found that while an index reflecting US stock markets returned 17.9 per cent a year, the investors who traded most actively earned just 11.4 per cent a year – a huge shortfall that becomes even more dramatic after a few years of compounding.

Hyperactive investors paid corrosive trading costs while failing to improve their underlying investment performance. The typical investor traded less and underperformed by 1.5 per cent per year, a substantial margin. The investors who hardly traded at all were rewarded with market-matching investment performance.

Our second tragic flaw is our tendency to buy high and sell low. Apologies if this is all a bit technical but it turns out that buying high and selling low is not the aim of the investment game.

Here’s how the self-deception works. You put $10,000 into the stock market. It promptly doubles, leaving you with $20,000. So pleased are you that things are going well that you double up, putting a further $20,000 into the market. Now the market falls back to its original level. Licking your wounds, you sell half your shares for $10,000. The market promptly doubles again, leaving you holding $10,000 in cash and $20,000 in shares after investing a total of $30,000. The market has, after a rollercoaster ride, risen by 100 per cent – but somehow you haven’t made a penny of profit.

The most influential study of such behaviour was published in the American Economic Review in 2007 by Ilia Dichev, now at Emory University. Dichev found that dollar-weighted returns were several percentage points lower than buy-and-hold returns: the market did better when only a few people were in it. A number of subsequent studies have examined this tendency, and while not all of them reach the same gloomy conclusion, many do.

Dichev’s work makes sense in the light of research on the psychology of investment. Robert Shiller, one of the most recent winners of the Nobel memorial prize in economics, has found that stock markets tend to revert to long-run average valuations. When things are booming a bust is on the way, and vice versa.

Meanwhile Stefan Nagel and Ulrike Malmendier have discovered that stock market returns in our formative years shape a lifetime of investment behaviour. An awful bear market scares a generation of young investors away, just as they are being presented with a buying opportunity.

Two tragic flaws are probably enough but here’s a third: Odean also showed, in 1998, that investors had a tendency to sell shares that had risen in value while holding on to losing investments, despite tax incentives pushing in the opposite direction. In Odean’s sample of investors, this bias pulled down investors’ returns.

Explanations for these shortcomings aren’t hard to find. We trade too often because we’re too confident in our ability to spot the latest bargain. We buy at the top and sell at the bottom because we’re influenced by what others are doing. And we hold on to shares that have fallen in value because to sell them at a loss would be admitting defeat. (Anyway, those shares in Lehman Brothers are sure to bounce back at some point.)

Armed with a diagnosis, a cure is also readily available: make regular, automated investments in boring, low-cost funds and try to sell in a similarly bloodless fashion.

Unfortunately this advice doesn’t really fit the modern world. The default option for financial reporting is to tell us what the market has done in the past few hours and how everyone is feeling about that. It is hard to think of a brand of journalism more calculated to breed a herd mentality.

Meanwhile, it has never been easier to fidget with our investment portfolios. Investment platform providers have every incentive to turn their websites into something like Facebook, constantly poking us for attention.

Our investments would be far healthier in the equity market equivalent of an old-fashioned piggy bank; the sort that needs a hammer to open.

Also published at ft.com.

Undercover Economist

Four steps to fixing inequality

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

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

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

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

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

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

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

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

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

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

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

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

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

. . .

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

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

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

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

Also published at ft.com.

Undercover Economist

The business of borders

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Also published at ft.com.

Undercover Economist

Let’s have some real-time economics

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Also published at ft.com.

Undercover Economist

Golden rules of thumb

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

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

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

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

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

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

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

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

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

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

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

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

Also published at ft.com.

Undercover Economist

Testing times for Sochi drug cheats

‘The most famous game of all is the prisoner’s dilemma, and it’s a natural explanation for why athletes take drugs despite the risks’

Testing for performance-enhancing drugs was first introduced by the International Olympic Committee not at a summer games but at the 1968 Winter Olympics. That might seem odd – the winter games aren’t normally associated with performance-enhancing drugs. Yet a dispassionate economic analysis suggests that this disconnection between testing regime and drug prevalence can hardly be a surprise.

The ideal economic tool for thinking about performance-enhancing drugs is game theory, a mathematical approach to understanding co-operation and competition. The most famous game of all is the prisoner’s dilemma, and it’s a natural explanation for why athletes take drugs despite the risks.

The essence of the prisoner’s dilemma in doping is that, regardless of what other competitors do, each individual competitor stands to benefit from taking the drugs – either by ensuring an advantage over a clean field or avoiding disadvantage compared with cheating rivals. And so everyone takes performance-enhancing drugs, even though everyone would prefer a situation where the entire field was honest.

Naturally, sporting authorities wish to change the incentives and so they test athletes and hand out bans to those who break the rules. One might think that such tests largely resolve the prisoner’s dilemma. But an analysis published last year by three economists, Berno Buechel, Eike Emrich and Stefanie Pohlkamp, suggests otherwise.

Game theory is a clever tool but the risk is that the theorist misses some bigger game. Buechel and colleagues argue that the bigger game in this case isn’t just between the athletes and the sporting authorities, but involves sports fans. The sad truth is that sports fans aren’t necessarily providing the right incentives.

Fans, understandably, do not like drug scandals: news that another sprinter has been caught taking steroids or another cyclist has been found using the blood-enhancer EPO does nothing to enhance the reputation of these sports. That typically means lower box-office takings, smaller broadcast revenues and less money from sponsors.

But what constitutes a drug “scandal”? It’s not the doping itself: that’s the offence, not the scandal. The scandal doesn’t break until the offence becomes public knowledge – that is, when the drug-taking coincides with an effective drug test. What, then, is the incentive for sports administrators to beef up their drug tests? The immediate impact will be more scandals, fewer spectators and fewer sponsors.

Of course, a totally foolproof drug-testing regime would solve this problem because nobody would cheat if detection and punishment were guaranteed. But even if such a regime were possible on some plausible budget, the costs of getting there might be prohibitive. Only after a huge scandal such as the discovery of industrialised cheating in the Tour de France do the authorities have an opportunity to improve their testing programmes.

This is a problem that may never be fully resolved. But the drug-testing regime at the Sochi Olympics has had two clever features. First, samples are being kept for 10 years. The usual reason given for this is that it may allow new and improved detection methods to catch cheats after the event, but there is nice side benefit: sporting authorities have more incentive to catch historical cheats than current cheats, because doing so presents an attractive image of a sport that is making progress.

Second, the IOC took great pains to describe the increased numbers of drug tests that would be conducted during the games – up by more than 14 per cent from the tests during the Vancouver Winter Olympics. We’re invited not to think of the failed drugs tests but all the tests that have passed. The real target for such announcements is not the athlete. It’s the sports fan.

Also published at ft.com.

Undercover Economist

The murkier side of transparency

‘Publishing clear information is often a way to make the world a better place – but not always. Sometimes it pays to be selective’

On a recent visit to Toronto, I was able to admire the city’s rather fashionable pedestrian traffic signals, which clearly show you how long you have before the lights change. Crossing the street to a flashing “3 – 2 – 1 – 0” is like experiencing your own little rocket launch.

Toronto isn’t the only city with such signals: Manhattan has them, Washington DC has had them for many years, and London is beginning to introduce them. But it’s Toronto that provides the stage for a fascinating new study in unintended consequences.

From late 2006 through 2008, countdown signals were gradually installed across the city. It is important to understand that from the point of view of safety, the order in which they were introduced was arbitrary. (Some accident black-spots are temporary, the result of bad luck. Had the signals been installed at junctions with a history of accidents, they would have looked like brilliant safety measures simply because the run of bad luck ended.)

In effect, Toronto accidentally arranged a randomised trial of the new signals. By examining the accident rate at each intersection and how it changed with the new signals, economists Sacha Kapoor and Arvind Magesan got a detailed picture of the effect of the countdown.

You might well anticipate that the countdowns would make junctions less dangerous, by telling pedestrians whether or not they have time to cross in safety. Toronto’s traffic planners certainly seemed to believe that would be the case. They were wrong. The new signals caused more accidents.

How could this be? Kapoor and Magesan suggest three explanations. One is that the signals cause pedestrians to take more risks – but it seemed that fewer pedestrians were involved in accidents after each signal was installed.

The other two explanations rely on the fact that it’s not only the pedestrians who see the countdown: drivers can too. If a signal is about to turn red for pedestrians crossing at a junction, then drivers who are trying to get across the junction in the same direction are also about to get a red light. Since there was more speeding and more rear-end collisions after the countdown signals were installed, Kapoor and Magesan reckon the natural explanation is that some drivers were accelerating into the junction to avoid being delayed, just as other drivers were slowing down.

It’s not the first time that economists have discovered that what looks like sensible transparency can have unintended consequences. Ten years ago, David Dranove, Daniel Kessler, Mark McClellan and Mark Satterthwaite looked at the impact of mandatory “report cards” in New York and Pennsylvania, which published data on the performance of individual doctors, hospitals or both.

One might imagine that this information would, at the very least, be convenient. At best it should spur physicians to improve their skills because patients would seek out the very best. But the researchers looked at the impact on cardiac surgery, and found a tragic side effect: once doctors and hospitals knew that their success rates would be published, they had a strong incentive to operate on the healthiest patients. The best hospitals had their pick of the sick and selected easy cases. Meanwhile patients with more complicated conditions were more likely to have surgery postponed. The net result: more money was spent, yet more people died of heart attacks.

Publishing clear information is often a way to make the world a better place – but not always. Sometimes it pays to be selective. Doctors could benefit from report cards, provided their patients never find out what they said. And Toronto’s countdown signals would work perfectly if only they could be hidden from drivers.

Also published at ft.com.

Undercover Economist

Why opposites shouldn’t attract

‘While it may be natural and familiar, assortative mating also breeds inequality’

Those of you out courting next Friday, do enjoy yourselves – but with a twinge of guilt. Inequality has been rising for a generation in many places, especially the Anglophone countries. Let’s be honest: you and your romantic pursuits are part of the problem.

The issue here is something economists call “positive assortative mating”, a charming phrase that we blame on the evolutionary biologists. It describes the process of similar people pairing off with each other: beautiful people dating beautiful people, smokers dating smokers, nerds dating nerds. All perfectly natural, you might think.

While it may be natural and familiar, assortative mating also breeds inequality. Economists often look at sorting by education level, which is common and easy to measure. If the MBAs and PhDs were sprinkled randomly throughout the population that would spread the wealth around. But, of course, they tend to pair up with other MBAs and PhDs; meanwhile the high-school dropouts tend to end up with other high-school dropouts. Already prosperous people are made more prosperous yet by their marriages.

This is an interesting idea in theory but does it have any practical significance? A recent paper by Jeremy Greenwood and others looks at a large data set from the US Census Bureau through the lens of the Gini coefficient, which is a measure of inequality. It’s 63 in highly unequal South Africa, 40 in the UK and 23 in egalitarian Sweden. It’s 43 in the US Census data set; but if the couples in the data set were randomly paired off, the Gini coefficient would be a mere 34. Assortative mating increases inequality.

But does this pairing-off process matter more than it used to? Does it explain any part of the rise in inequality we’ve seen since the 1970s? The answer, again, is yes – but a guarded yes. Marriage patterns have little or nothing to do with the concentration of earning power in the hands of the richest 1 per cent and 0.1 per cent: women are major breadwinners in the top quarter of the distribution but less so right at the very top – not yet, at any rate.

But assortative mating is having an impact on inequality more broadly. It’s not so much that well-educated people are more likely to pair off – although they are – but that educated women are more likely to earn serious money than a generation ago.

Consider my own mother: she was well on the way to a PhD in biochemistry when I arrived on the scene in the early 1970s. She then dropped out of education and spent most of her time looking after her children. Her academic qualifications had no impact on our household income. Assortative mating has always been with us but it’s only in a world of two-income households that it increases income inequality.

The sociologist Christine Schwartz showed in 2010 that the incomes of husbands and wives in the US are far more closely correlated than they were in the 1960s, and that this explained about one-third of the increase in income inequality between married couples. John Ermisch and colleagues have shown other consequences: in both the UK and Germany, assortative mating substantially explains low social mobility because the children of prosperous parents marry each other.

We should not place too much emphasis on all this. Assortative mating explains only part of the rise of inequality, and perhaps very little at the top of the income scale. The usual remedies for inequality – unionisation, redistributive taxes, minimum wages – still have the same advantages and limitations as ever, even if they need to reflect the reality of the two-income household. It’s a reminder that the most welcome social trends can have unwelcome side-effects.

Happy Valentine’s day.

Also published at ft.com.