Undercover Economist

Spare a thought for the weather forecasters. Taken for granted when they get it right, they are invariably whipping boys when they get things wrong – despite a far better forecasting record than we economists have. They probably have more to contribute to the economy, too.

A recent case in point: Bournemouth’s woes during the bank holiday at the end of May. The Met Office predicted storms, but the beach resort in fact enjoyed the sunniest day of the year. Bournemouth’s tourist office reckons the town missed out on at least 25,000 visitors and more than £1m of revenue as a result. Subtler losses and gains were registered by the would-be tourists, and the lucky ones who enjoyed both a sunny day and a quieter beach.

Tourists have always been vulnerable to the weather, but they may now be more vulnerable to weather forecasters. The internet has made it easy to check the forecast and easy, too, to make late bookings for short breaks – which are self-evidently more responsive to the weather.

Galvanised by Bournemouth’s woes, I did some research into the economics of weather forecasting for a short BBC documentary. What surprised me was the sheer range of industries that could save money if given a reliable forecast.

Electricity generators need temperature forecasts to gauge the demand for power, and electricity generation itself is weather-sensitive. It’s not just a case of windmills and solar panels: gas-fired power stations are more efficient at lower temperatures. Without a good forecast, both energy and money will be wasted.

Local governments are responsible for salting and gritting roads as they freeze. It’s a costly process, best avoided if the roads are not, in fact, going to freeze at all. Supermarkets consult detailed weather forecasts and adjust the local product mix accordingly. An extra day’s reliable warning of the local weather is a godsend.

The vulnerability to bad weather is even higher in developing countries, sometimes with tragic consequences. As I reported in a column last year, the economists Emily Oster and Ted Miguel have investigated the link between bad weather and “witch” killings. Miguel found that modern-day witch-killings in Tanzania are correlated with droughts and floods. Oster, building on research by historian Wolfgang Behringer, found a connection between cold decades and witch-trials in 16th- and 17th-century Europe.

MIT economist Michael Greenstone has studied the impact of local temperature surges on deaths in both India and the US. He calculates that a year with one extra “heatwave” day – temperatures above 32°C instead of 12°C-15°C – would raise the annual death rate by eight per million in the US. In India, the temperature vulnerability is more than five times higher, notably in rural areas where agriculture suffers and wages drop.

Weather forecasting cannot prevent heatwaves, but it can help in other ways. Accurate forecasts can allow farmers to sow seeds without fear that they will be washed or blown away. A study from the mid-1990s – admittedly, conducted by the World Meteorological Organization – concluded that every dollar invested in weather forecasting services would save $10 in economic losses.

The World Bank broadly agrees, and is supporting Russian efforts to reinvigorate forecasting systems that have been deteriorating since the collapse of the Soviet Union.

The World Bank’s researchers reckon that the benefits of such efforts outweigh the costs by five to one. If those numbers stack up, that suggests an unlikely development tactic for poor countries: hire more weather forecasters.

Also published at ft.com.

“The economy, stupid.” An internal reminder for Bill Clinton’s presidential election team eventually became one of the most famous slogans in politics. The first President Bush was duly kicked out by the voters in the teeth of a recession, and Clinton became the 42nd president of the United States.

That is a common story. While there are exceptions, voters tend not to re-elect governments that have trashed the economy. Barack Obama’s electoral fortunes were clearly boosted by the collapse of the US economy – it is easy to forget that, before Lehman Brothers folded, John McCain had been ahead in the polls. After Northern Rock failed, Gordon Brown hesitated and then decided against calling an early election with the economy looking ropey. Unfortunately for him, it has been looking ropier ever since, along with his approval ratings.

But is this really fair? Gordon Brown’s first line of defence is that we are facing a world economic recession, so it’s not his fault. The opposition likes to point out the corollary: in that case, the good times weren’t his doing either.

There’s truth in both claims. Most domestic recessions have an international component. Japan and Germany are certainly in that situation now, having contracted faster than a cowboy’s lasso. Robert Mugabe must take responsibility for Zimbabwe’s economic disintegration, but it is hard to blame Taro Aso for the fact that Japan’s economy shrank 4 per cent in the first quarter of this year.

The question is, can the voters tell the difference between an incompetent government and an unlucky one? Andrew Leigh, an economist at Australian National University, thinks not. In a recent article in the Oxford Bulletin of Economics and Statistics, he looks at 268 elections held across the world between 1978 and 1999. He estimates how much of a country’s economic performance is due to booms in the world economy and how much is due to competent government – and whether the voters can tell the difference.

Both matter, but as far as the voters are concerned, it is better to be a lucky government than a skilful one. For instance, a one-percentage point increase in world economic growth above the norm is associated with a hefty rise in the chance that incumbents will be re-elected – from the typical chance of 57 per cent to a more than decent 64 per cent. A stellar domestic performance, outpacing world growth by one percentage point, contributes less than half as much to the chances of being re-elected, raising them from 57 to 60 per cent.

Why are voters so wretchedly ungrateful? The common-sense answer is that it is not easy to distinguish a lucky government from a skilful one. In addition – and this point is less obvious – an individual voter has little incentive to do so. We all know that elections are almost never decided by a single vote, and so each voter would be right to conclude that her vote is highly unlikely to make a difference.

We vote for many reasons – a sense of duty, a desire to participate, and so on – but nobody votes under the illusion that it’s all down to him. And if the result does not depend on any particular one of us, trying to disentangle luck from skill by ploughing through the latest reports from the International Monetary Fund is likely to remain a minority hobby.

One other thing: Andrew Leigh finds some slight evidence that countries with high newspaper circulation have voters better able to distinguish luck from skill. Radio does not help, and television makes things worse. One more reason to switch off your set and pick up the Financial Times.

Also published at ft.com.

Turn up the lights, and the workers work harder. Turn them down again, and they work harder still. The “Hawthorne Effect” is named after Western Electric’s titanic Hawthorne Works in Cicero near Chicago, where a series of productivity trials was carried out between 1924 and 1932. Led by Elton Mayo, a professor at Harvard Business School, they are among the most famous experiments in social science. Not every social scientist is impressed.

Richard Nisbett, a social psychologist at the University of Michigan, complained to The New York Times a decade ago about the study’s fame, calling it a “glorified anecdote”. He had a point. Among managers, the study is generally held to demonstrate that people respond to change: whatever you do, output rises for a while, as long as you do something. Inside academia, “the Hawthorne Effect” refers to the idea that people work hard once you start experimenting on them. Both beliefs are surprising enough to be interesting, while nicely confirming the prejudices of those who hold them.

Interested psychologists have known for a while that all was not well with the study. The experimental room was smaller and quieter than the factory floor. Two workers were sacked and replaced during the study for talking and idling. Experimental conditions were changed on Sundays, so each surge in productivity coincided with a Monday. These were not controlled conditions in the modern sense.

Yet the story survives. As Nisbett complained, “Once you’ve got the anecdote, you can throw away the data.” And for decades that is exactly what seemed to have happened: the data from the most famous Hawthorne experiment – the illumination study – were thought to have been lost, and perhaps deliberately destroyed.

Now two Chicago-based economists, Steven Levitt (best known as the co-author of Freakonomics) and John List, have unearthed the original data in libraries in Boston and Milwaukee, following clues buried in an appendix to an old article in the American Sociological Review.

Levitt and List are fond of experimental studies, but think the effect of being scrutinised sometimes contaminates such experiments. “We believe that there is a Hawthorne Effect,” says List, referring to the idea that people behave differently when studied, “but there is little evidence of it in the actual Hawthorne data.” As for the idea that turning the lights up and down makes a big difference, Levitt and List conclude that “existing descriptions of supposedly remarkable data patterns prove to be entirely fictional.”

It is not the only time that an experiment’s reputation has far outrun what was actually discovered. In 1967, the psychologist Stanley Milgram asked 160 people in Nebraska to get a letter to a stockbroker in Boston, passing it only to someone with whom they were on first-name terms. The popular account says that the letters arrived after six steps – and that we are all just six handshakes away from anyone on the planet. The reality, as the psychologist Judith Kleinfeld found, was that more than 80 per cent never arrived. Follow-up experiments concur. A recent BBC documentary “recreated” Milgram’s experiment, with a Boston-based scientist receiving parcels from all over the world via only six connections. But 37 of the 40 parcels never arrived.

In some ways, the Hawthorne and “six degrees” experiments are the least troubling examples. They are famous enough to have been challenged. Less celebrated “findings” circulate in academia, exerting plenty of influence. They are never put to the test. Trying to replicate old results is rarely regarded as social science worth publishing in the top journals. That must change.

Also published at ft.com.

One of the benign side effects of the credit crunch has been the boom in popular awareness of behavioural economics – a discipline that brings psychological insights to bear on economic theory. Behavioural economics books, such as Nudge and Predictably Irrational, have sold well and become influential. That is partly because they are good books, but it is also because a superficial reading of both behavioural economics and the credit crunch can lead to the same conclusion: people are crazy.

Yet, while popular awareness of behavioural economics was overdue, the links between irrational behaviour and the credit crunch are more subtle than they first appear. To see this, one need only re-read the behavioural economics books published before the crisis became severe. Nudge has a section on subprime mortgages, but it focuses on consumer protection. Predictably Irrational is being revised in the light of the credit crunch, but the first edition took a similar line, focusing on the vulnerability of naïve consumers. It does not seem to have occurred to the behavioural economists – even after they had seen the first glimmerings of the credit crunch in 2007 – that the banks would need protecting from themselves. The thought did not occur to many other economists, either.

A critical piece of craziness in the credit crunch was the housing bubble in the US, emulated in the UK and around the world. This bubble was spotted and widely advertised by the behavioural economist Robert Shiller, himself the co-author of a new book, Animal Spirits. Several years ago, Shiller had convinced me and many others that the housing boom was a bubble; five years before that, he convinced much the same crowd of people that the dotcom boom was a bubble, too. David Laibson, another behavioural economist, recently gave a keynote lecture at the Royal Economic Society on the subject of “bubble economics”, in which he sketched out some of the psychological underpinnings of bubbles.

The dotcom collapse was a vindication of the theory that we are inherently bubble-prone. Shiller predicted it – and gave plenty of supporting evidence. After that experience, I am surprised that anyone should wonder why the real-estate boom turned sour.

Just as important is how it brought down the world’s financial system. On that point, hindsight is the most powerful tool of all. Traditional schools of thought in economics also have plenty to contribute.

Around the time the behavioural economics boom arrived, I was writing about perverse incentives in big corporations. I explained that when each company’s shares were dispersed among tens of thousands of small shareholders, nobody had a strong incentive to keep an eye on the management. But the managers had an incentive to conceal their compensation in the form of obscure performance contracts that encouraged risk taking, and in the form of pensions and other deferred compensation. The result: large bonuses, excessive risk, outrageous pensions and pay-offs, all while everyone was acting rationally.

I would love to point to this insight and claim that I predicted the credit crunch, but I did not, any more than did the behavioural economists who (rightly) pointed out that consumers were vulnerable to predatory lenders. There is a difference between spotting a problem and predicting that it will corrode the foundations of the world economy. As we try to diagnose the causes of the crisis, cure the condition and vaccinate against a recurrence, behavioural economics has a rightful place in the doctor’s bag. It will not be a panacea; but then nothing ever is.

Also published at ft.com.

If 80 is the new 60, and 50 is the new 30, I’m a teenager again, looking forward to a bright future at university. I certainly had a thought-provoking tutorial recently at the hands of UBS’s professorial George Magnus, one of the prophets of the credit crunch but also the author of a book about demographics, The Age of Aging.

The statistics about an ageing population are starting to become familiar: people are living longer and having fewer children, and this is true not only in rich countries but much of the developing world. But the implications are often misinterpreted. An ageing society is not, primarily, a demographic crisis. The problem is a failure to adapt – a failure that afflicts politics, management and society.

The simplest way to see this is to think again about what the demographic “problem” is supposed to be. It is simply that people are tending to live longer and longer, often in good health. That doesn’t sound like a problem to me – are we supposed to prefer a world in which people die younger and younger?

But our institutions are adapting too slowly. Too many companies rely on a seniority system that, if not “dead man’s shoes”, is certainly “retired person’s shoes”; such systems struggle to deal with employees who no longer deserve or want the top jobs, but who could still be employed at a more “junior” rank. Final salary schemes, still popular in the public sector, amplify the problem, with their presumption that the final salary will also be the highest salary that a worker ever earns. The law offers no help: mandatory retirement on the sole grounds of age remains perfectly legal in the UK. Speaking as someone who once shared an office with an inspirational mentor more than 50 years my senior, I can affirm that on this point, the law is an ass.

Then, of course, there are state pensions, which are still paid out on the basis of age rather than ill-health, and at ages that have not risen to keep pace with our longer lives.

When Bismarck introduced the world’s first state pension, 120 years ago, it was payable from the age of 70; few men would have lived long enough to collect it, although Bismarck himself was 74 at the time. Now, it is not unusual to collect a state pension for 20 years. Several countries are increasing the state pension age – most recently, Australia – but very slowly.

Much ink has been spilt over the question of financial sustainability: have we saved enough into our personal pensions, have our employers properly funded our final salary schemes, and has the government got enough money to pay state pensions in the future? All distractions, because no amount of financial engineering will solve the underlying economic problem of a small number of workers trying to support a large number of retirees. There are really only two solutions: we consume less, or we settle for a longer working life.

If retirement were not hedged about by an institutional thicket, these solutions would arrive without much fuss. Faced with labour shortages, companies would raise wages; meanwhile, as a large cohort tried to retire together, the price of houses and shares would fall, while annuity rates would also be miserly. Working a little bit later and enjoying slightly less of that long, long retirement would become a very tempting offer.

I sympathise with state and corporate paternalism in the world of pensions, because thinking on a 50-year timescale and coping with complex investments are two areas where our enormous brains often seem to let us down. Yet if these helping hands simply push us into premature retirement, we will have little reason to be grateful.

Also published at ft.com.

It is hard to avoid the conclusion that newspapers, at least in their printed form, are dying out. True, almost half of US adults still read a daily newspaper, but that figure is down from more than 80 per cent in 1964. The most obvious impact has been on local competition: a century ago, nearly 700 US cities had more than one daily paper; now, only about a dozen still enjoy the privilege. And this year has already seen the loss of the print editions of the Seattle Post-Intelligencer, Denver’s Rocky Mountain News and the Citizen of Tucson.

All this is despite America’s long-standing Newspaper Preservation Act, which in 1970 gave distressed local newspapers an exemption from competition laws, allowing them to form business alliances, fix prices to advertisers and subscribers, and prop each other up. The act is evidently not enough to keep competition alive.

The internet, of course, is both a cause of this trend and, perhaps, the reason it may not matter much. Publishers are more worried about the loss of advertising revenue than readership. Newspapers flourished by bringing together local advertisers and local readers, but in an internet age, that no longer looks like such a difficult trick.

But while the internet is chipping away at print’s foundations, it also provides an amazing range of alternative sources of information. Journalists and the nostalgic may wring their hands, but should anyone else care? There has never been a wider range of opinion and analysis, available to anyone with an internet connection.

Yet new research by two Princeton-based economists, Sam Schulhofer-Wohl and Miguel Garrido, suggests that we should all be nervous about the trend. They studied what happened when The Cincinnati Post closed at the end of 2007. The answer: local politics suffered. In the suburbs of Cincinnati where the Post had the strongest presence, fewer candidates ran for municipal office in the election after the paper folded, voter turnout fell, and incumbents grew more likely to win re-election.

This may not surprise economists. Matthew Gentzkow of the University of Chicago concluded in 2006 that, in crowding out radio and newspapers, television was a substantial contributor to falls in voter turnout and in the typical person’s political knowledge, as measured by questionnaire. (Gentzkow’s statistical method relies on the fact that television was introduced to different regions at different times.) A study from 2000, co-authored by the Princeton academic Alícia Adserà, found that those US states with higher newspaper circulation also had less corruption. The same was true when the authors compared countries, although in each case it is hard to be sure about the direction of causation.

There is no doubt about causation in the case of The Cincinnati Post. The Post’s date of closure was all but predestined in 1977, when a 30-year joint venture with the Cincinnati Enquirer was established with an expiry date of December 31 2007. (As an evening newspaper, the Post had been losing readers for decades.) Five years ago, the Enquirer announced that it would not be renewing the joint venture and the Post’s fate was sealed. This makes the statistical analysis more persuasive, because it means that the closure date was not determined by some other factor – such as a sudden local recession in Cincinnati – which might also have affected local politics.

It seems that neither blogs nor online news sources serve the same role in Cincinnati’s political life as The Cincinnati Post. That may change, but the trouble is that, with some glorious exceptions, blogs seem to be heavy on opinion and analysis, light on reporting. Analysis is valuable, but is it enough?

Also published at ft.com.

A confession: I have been too complacent about technological fixes for the twin problems of climate change and finite oil and gas reserves. Without looking very closely at the numbers, I figured that if politicians would finally get their act together, and if we avoided some of the more unlucky possibilities (such as the release of methane ice from the oceans), cheap, clean energy would be within our grasp, given suitable research incentives and some technological brilliance.

Looking at progress in computer chips, I dreamt about how cheap photovoltaic solar panels might become over the next 50 years. Solar wallpaper, solar paint – who needs fossil fuels? Most climate-change scenarios look at a 100-year time scale. Surely, in that time, we should have figured out a way to take greenhouse gases out of the atmosphere again.

I still wouldn’t rule out such techno-fantasies, but having read a remarkable book by David J.C. MacKay, a Cambridge physicist (you can download it at www.withouthotair.com) I am far more pessimistic about the potential of technology to help us out. In Sustainable Energy – Without the Hot Air, Professor MacKay makes this point very simply by sidestepping the economics altogether. Technological progress and economic growth loosen the corset of cost-benefit analysis, but not the laws of physics. No matter how cheap and efficient solar collectors become, there is only so much solar power available per square metre of land. Hydroelectric energy is constrained by the quantity of rainfall and the height of reservoirs above sea level. The most perfectly designed windmill is limited by the energy of the wind. It would barely be possible to make the numbers add up even if renewable energy generators were free.

To power a modern country through renewable energy requires country-scale facilities – hundreds of miles of wave turbines, solar panels on every roof, and windmills blanketing highlands and coastal waters. Nuclear fission is more promising, but nuclear fuel is also finite. Technological progress will be essential but, barring a breakthrough in nuclear fusion, it will not set us on a path to an energy system purged of fossil fuels.

MacKay defies glib summaries, but it is fair to say that he sees considerable potential in energy-efficiency measures such as light electric cars and better-insulated homes. This is a different kind of issue because it is a decentralised problem.

The challenge is to encourage the right behaviour. Centrally mandated efforts will not do the trick, in part because “the right behaviour” is not a universal constant. Take, for example, the intermittency of wind power. A nation equipped with battery-powered cars could charge up when the wind is blowing and scale back during lulls. Yet on any given day one individual might desperately need a reliable charge for her car. To a central planner this is simply unknowable. Yet a discount for those relying only on intermittent power would encourage people to fit in with the scheme whenever they could.

Governments also have an inglorious history of getting even the basics right. The British still subsidise fossil fuels by charging a bargain rate of tax on domestic fuel. European subsidies for offshore wind power, a technology of little interest to Mexico or China, are likely to do little to transform the world’s energy system.

Dealing with climate change will need many small decisions to be made differently. The government cannot micromanage these. This is why a carbon price, whether set through taxes or emissions permits, is needed. It is not so much a nudge as a shove in the right direction.

Also published at ft.com.

By raising the top rate of income tax to 50 per cent, Alistair Darling broke a manifesto promise not to do so in the lifetime of this parliament. It was a self-imposed rule whose spirit had already been ignored; now he doesn’t even bother to pretend.

We can leave to one side the merits of the policy itself; both its costs (driving away entrepreneurs) and its benefits (raising revenue) seem to be exaggerated. What interests me more is the value of government promises.

They can be fragile things. Governments can sign contracts, of course, but without strong constitutional oversight, they can violate those contracts. In any case, contracts do not usually apply to the generosity of future state pensions, to tax rates, or to the changing regulatory climate. When citizens, foreigners and businesses make their decisions, then, they have to guess at how the government will behave in future. A government that lacks credibility will invite a hesitant and economically wasteful response.

Politicians from developing countries know that a reputation for whimsicality can send foreign investors running for cover. Some of those politicians do not much care, and their citizens suffer as a result. Yet the governments of rich countries have a credibility problem, too, and it can be costly.

Gordon Brown’s first flourish as chancellor was to give independence to the Bank of England, a decision that economists continue to applaud, precisely because it adds credibility to the fight against inflation. That fight is much easier for a credible general.

Inflation is a constant temptation for governments. It temporarily creates economic activity because, until people figure out what has happened, they mistakenly feel richer. Mervyn King, with less need to court popularity, finds it easier to resist the temptation. It is not credible for Gordon Brown to promise low inflation; it is more credible for him to say that, having given King his authority, he will not revoke that decision.

Other credibility problems are harder to fix. The multiple incarnations of Washington’s efforts to create a market for toxic securities have foundered, and one reason is that the government cannot credibly promise not to offer further bail-outs. A hedge fund might be tempted to buy some trashy assets from a bank, but the bank may quite reasonably expect that if the assets stay where they are, weighing down the balance sheet, further government support will be forthcoming. The two sides will not be able to agree a price.

The problem exists in medicine, too. Governments occasionally override patents, or threaten to do so, in times of emergency. The makers of anti-anthrax drug Cipro and flu-fighter Tamiflu have both had their arms twisted in recent years. Pharmaceutical companies contemplating investing billions of dollars in an HIV vaccine must be given pause for thought by this; does anyone seriously think that the inventor of such a vaccine would be allowed to charge what the market would bear, free of political interference? And so a vaccine becomes less likely.

All this is a shame, but perhaps inevitable. Movies about heists, cons and double-crosses are gripping because the criminals cannot make binding promises to each other, and so resort to tricks and violence. While it is fun to watch, it cannot be much fun to experience.

That is why the credibility of government promises matters. There is little that can restrain a government making a fleetingly popular decision. Constitutional oversight can help, but so can years of reputation-building and precedent. Every little lie has a long-term cost.

Also published at ft.com.

Aldo Rustichini is a genial Italian economist with a head of hair that seems to have been modelled on Albert Einstein’s. A professor at Cambridge and the University of Minnesota, he quickly transformed my interview with him into a full-blown undergraduate-style tutorial, occasionally asking me questions to check my understanding. Yet this likeable economist has been carrying out work with potentially explosive implications – including the possibility that economic success is genetically transmitted.

Rustichini’s latest research – with Stephen Burks, Jeffrey Carpenter and Lorenz Goette – studies the behaviour of about 1,000 trainee truck drivers in the US. The researchers gave the truckers IQ tests and asked them to participate in a number of small experiments.

In one experiment, the truckers were asked to choose between gambles and certain payoffs. In another, the choice was between a sum of money now and more money later. A more complex experiment required the truckers to play an anonymous “trust” game. The first player was given $5 and offered the choice of sending it to the second player; the second player had his own $5 and was asked how much he would send to the first player were he to receive $5 from him, and how much if he didn’t. The researchers promised to double the money sent in either direction – meaning that if the players managed to co-operate then each could get $10.

An intriguing pattern emerged. The truckers who scored highest on the IQ test were also more patient and more willing to take calculated risks, rejecting unfair gambles and accepting favourable ones. Their choices revealed a more consistent attitude to risk and a more consistent level of patience, too.

The high-IQ truckers were also better at predicting what other players would do in the trust game, and secured more money overall. When they played second, they were more discriminating, rewarding co-operation and punishing those who would not trust them.

High IQ goes hand in hand with patience, calculated risk-taking and interpersonal judgment, it seems – and this is true after statistically adjusting for age and race.

Nor is any of this limited to the laboratory. Many trainee truckers drop out before completing their first year of work, even though this means they must repay the trucking company their training costs, which run into thousands of dollars. This indicates a lack of patience, an inability to appreciate how much money is at stake or a serious miscalculation in the initial plan to be a truck driver. Whatever the reason, dropping out is correlated with Rustichini’s experimental tests of low IQ, impatience and bad judgment of risk or of other people.

Rustichini puts this in a far more striking way: that the ingredients for prospering in a capitalist society all seem to be present together, or absent together. This is not entirely surprising but neither is it obvious. And therein lies the dangerous hypothesis: if all these attributes go hand in hand, it is much more plausible to suggest that economic success is passed on from generation to generation.

“Such a process could be cultural, genetic or both,” comment the researchers in a footnote, “but the genetic version is the most controversial.” Quite so. But even the cultural transmission of economic success is a provocative notion, and a painful one to most economists, who are predisposed to hope that good policies alone may promote economic growth.

Rustichini is not perturbed. For all his amiability, he is quite content to contemplate unwelcome possibilities.

Also published at ft.com.

Team titles might be what matter to them most, but football fans are also generally pleased if a player in their team wins an award. Publishers rarely object when their authors win Booker or Nobel prizes for literature. So how should shareholders in a company feel when the company’s chief executive wins an accolade such as “Best Manager” from Business Week or “Best Performing CEO” from Forbes? New research from two California-based economists suggests that the correct response would be to feel sick.

Economists have long been intrigued by the prospect that chief executives might use their position to pursue wealth, status and perks to the detriment of shareholders. Shareholders, widely dispersed and sometimes protected by flimsy governance, often have little sway over what managers get up to.

This view has unsavoury implications, such as the idea that corporate social responsibility and philanthropy might in fact mean shareholders paying for their chief executive’s golden halo. It has also been prescient: it was in studying economics that I first discovered that managers might be willing to overpay for merger targets because mergers brought them wealth and status, or that they would arrange to receive some of their pay in the form of a large pension because deferred compensation often only causes outrage once it is too late to do anything about it. If only Sir Fred Goodwin’s board at Royal Bank of Scotland had encountered the same lessons.

Ulrike Malmendier of UC Berkeley and Geoffrey Tate of UCLA wondered if awards for chief executives might shift the balance of power further towards the chief executive. That seems likely: it turns out that award-winning chief executives are paid more and deliver less following their award.

Top performers will tend to have been lucky in the past, and luck rarely lasts. If an award from Forbes celebrates a man who has made a few lucky calls, small wonder if he goes on to disappoint. Yet Malmendier and Tate try to adjust for this statistical tendency by identifying a selection of “nearly men” (and occasionally women) who might have been expected to win an award, but didn’t. The nearly-winners, like the winners, tend to run big companies with strong recent shareholder returns. Like the winners, too, they have probably been lucky. Yet in the three years following an award, the share prices of the companies run by winners lag behind the prices of those run by nearly-winners by between 15 and 26 per cent. Nor is their performance reflected in pay: winners enjoy an extra $8m a year compared with nearly-winners.

Winners also seem to enjoy various distracting perks. Although the statistical analysis is less sophisticated here, Malmendier and Tate believe that award-winners are more likely to write books – often self-aggrandising books, let us be honest – and more likely to accept seats on the boards of other companies. The icing on the cake: award-winning chief executives have superior golf handicaps.

In short, awards for chief executives should be about as welcome as the “curse of the pharaoh”. Before the shareholders of the world march on the offices of Business Week, pitchforks in hand, they might bear in mind one final discovery. Malmendier and Tate check their results against an index of bad governance that tots up tricks, such as poisoned pills, designed to protect firms from hostile takeovers. Almost all of the perverse effects of awards to chief executives – including their tendency to spend more time on the golf course – shrink or even disappear in companies which have strong governance. Even superstar chief executives can be kept on a leash, it seems.

Also published at ft.com.

Last month, Red Nose Day, a biennial charity extravaganza, managed to break its fundraising record despite the recession. But to what extent are charities recession-proof? Much depends on what motivates us to give, a subject that has been receiving a lot of attention from economists recently.

There are many possible motivations. One is pure altruism: we give to charity because we care about the well-being of others. A second infamous motivation for giving was advanced by the economist James Andreoni: the “warm glow”. Warm-glow givers donate money to charity because it makes them feel good.

There might not seem to be much difference between altruism and a warm glow, but there is: warm-glow givers don’t think too much about whether the money they give will be effective. For example, research by the behavioural economist George Loewenstein, with Deborah Small, a marketing professor, and Paul Slovic, a psychologist, shows that people are typically more generous when presented with an identifiable victim – six-year-old Aisha in Niger – than with statistical evidence of hunger in Niger. While the altruist would want the evidence, the warm-glow giver just wants to feel the connection. A third motivation is social pressure: we give because we think that’s what others expect of us.

All this matters, particularly if we want to understand what happens in a recession. Altruists might well give more. “It’s not rocket science,” says Dean Karlan, an experimental economist who researches charitable giving and microfinance. “The poor are also poorer now, so altruists can achieve more with their donation.” But as Karlan warns, not everyone is an altruist.

John List, a leading light in the field of experimental economics, recently carried out an experiment designed to tease out some of the motives for giving. His team went door-to-door collecting for charities, but in some cases they had forewarned their targets as to the time of their arrival. Genuine altruists would be more likely to give if forewarned, for much the same reason that you are more likely to be in to receive a delivery if told what time it will arrive. But people who give because they feel pressured might simply hide behind the sofa when the charity collectors knocked on the door. In some cases, they could even tick a “do not disturb” box to avoid awkwardness.

List’s experiment, carried out with two University of California, Berkeley, economists, Ulrike Malmendier and Stefano DellaVigna, highlighted the altruists as those who gave money even when it was easy to avoid doing so. In an unexpected twist, the experiment straddled the collapse of Lehman Brothers and of the stock market. List and his colleagues discovered their “no-forewarning” run, which would normally attract grudging donations out of social pressure, raised almost two-thirds less money during the crisis. Perhaps it was just too easy to say no. Altruistic donations, solicited during the “forewarning” run, tended to be larger and held up better during the crisis.

Separately, List has found that large charitable donations such as bequests are strongly linked to stock market performance, but with a delay. The good news is that it may take time for the crisis to hit such donations. The bad news is that charities may suffer for years after the economy recovers.

All the economists I spoke to were pessimistic about the outlook for charitable giving in a recession. Rachel Croson, an economist at the University of Texas at Dallas, summed it up well by pointing out that in a recession, there is less of most things except spare time: “What I’m foreseeing is a lot of people volunteering to serve at the soup kitchen, but less food.”

Also published at ft.com.

A confession: I was never very good at macroeconomics as an undergraduate, and my postgraduate studies were even more of a challenge. My lecturers described the economy as the solution to an inter-temporal optimisation problem in which a single representative household decided how much to consume and how much to save. I struggled with the sums (they were hard ones) and almost as much with the entire concept, which seemed to ignore what was interesting about macroeconomics. I did what I could, passed my exams and concentrated on microeconomics instead. (Those confused should recall P.J. O’Rourke’s explanation of the difference between the two: microeconomics concerns things that economists are specifically wrong about, while macroeconomics concerns things that they are wrong about generally.)

I do not regard my own confusion as an indictment of modern macroeconomics, but I am struck by the soul-searching that has gripped the profession in the face of the economic crisis. The worry is not so much that macroeconomists did not forecast the problem – bad forecasts are more a sign of a complex world than intellectual bankruptcy – but that macroeconomics seems unable to provide answers. Sometimes it cannot even ask the right questions.

Willem Buiter, a former member of the UK’s Monetary Policy Committee who blogs for the FT, complains that macroeconomists have simply discarded the difficult stuff to make their models more elegant: “They took these non-linear stochastic dynamic general equilibrium models into the basement and beat them with a rubber hose until they behaved.”

He is not alone in his frustration. Paul Krugman, a left-leaning New York Times columnist and the most recent winner of the Nobel memorial prize in economics, thinks macroeconomics is in a dark age, in the sense that rather than discovering new insights, we are actually going backwards and forgetting what we used to know. Mark Thoma of the University of Oregon, another influential economics blogger, opines: “I think that the current crisis has dealt a bigger blow to macroeconomic theory and modelling than many of us realise.”

We shall see. While many commentators have reached for Keynes – or some caricature of Keynes – as a solution to this crisis, this is not because he is the fount of all knowledge, but because he was asking good questions about problems that now seem relevant again.

Economists now understand much more than Keynes ever could about networks and complex interactions (thanks to agent-based modelling), psychology (thanks to behavioural economics) and the real world (thanks to econometrics). In principle, these advances should inform our understanding of the crisis. An early attempt is Animal Spirits, a book by George Akerlof, a Nobel laureate, and Robert Shiller, who identified the housing bubble early. But macroeconomics has a lot of momentum and it will take time to turn the oil tanker around.

Justin Wolfers, a new editor of Brookings Papers on Economic Activity and an unabashed microeconomist, says that, “formally elegant but empirically irrelevant macroeconomists had a much harder time getting hired this year,” while Buiter reckons that the central banks have already jettisoned conventional macroeconomics in favour of a pragmatic combination of hunches and judgment calls. If so, the market for macroeconomic ideas seems to be self-correcting – much like the market for financial weapons of mass destruction. It is just a shame, in both cases, that the correction did not come more smoothly and much, much earlier.

Also published at ft.com.

I’ve been weighing up a very elegant treatment for the banking crisis that has been buzzing around the economics blogs – so elegant, in fact, that it took me several days to convince myself that it wasn’t just a logical sleight of hand, the kind of subtle fallacy that mathematicians use to “demonstrate” that 1+1=1.

One way to understand the banking crisis is that the banks cannot raise new money and lend it to people who could use it. This is not because there is no money, or no deserving investment projects. It is because the banks, whose assets are worth less than they hoped, are now weighed down by their existing promises to repay depositors and other creditors. They cannot raise fresh money because nobody wants to lend money to a near-bankrupt bank.

So far, governments have been trying to raise or at least stabilise the value of bank assets, but an alternative is to reduce the burden of their liabilities.

The elegant approach I’ve been examining has been developed by long-time collaborators Jeremy Bulow and Paul Klemperer. They suggest splitting crippled banks such as Citigroup or RBS into a good “bridge” bank and a bad “rump” bank. The bridge bank gets all the assets, even the so-called “toxic” assets. These are not truly toxic, simply worth less than everyone hoped. The bridge bank also inherits sacred liabilities such as deposits. The rump bank gets no assets, only the debts the old bank used to owe to creditors.

With a leap and a bound, the bridge bank is well-capitalised and capable of raising new funds to lend out to good projects. Depositors feel secure and the economy acquires a functioning bank. The rump bank, of course, is a basket case, so one might think that the shareholders and creditors in the rump bank have suffered expropriation. They have not: Bulow and Klemperer propose giving all the equity in the bridge bank to the rump bank – this is full and fair compensation. The rump bank may well go bankrupt and the creditors will have to see what they can salvage – which will include shares in the bridge bank. But the bankruptcy process will not damage the bridge bank, nor prevent it from raising new money and making fresh loans.

The plan may not work, for a number of reasons. The most serious objection is that everything is now systemic, and that allowing creditors to lose a percentage of their claims – despite the fact that they lent money to the banks without any government guarantee – may cause further bankruptcies. Even so, the Bulow-Klemperer plan allows the government to pour further money into the banks in a more transparent way: to the bridge bank if the concern is to ensure well-capitalised banks; to the rump bank’s creditors if the concern is to prevent a chain reaction of bankruptcies. Transparency, of course, may be the last thing governments want, given the possible sums involved.

If you are still blinking at the idea that one can produce a healthy bridge bank like a rabbit from a troubled-bank top hat, without injecting new funds and without resorting to expropriation, you should be. But it is true. The confusing thing about the financial crisis is that the physical economy is in the same shape as ever, but it can be paralysed if investment money cannot flow from those who have it to those who can use it. A tangle of – unpayable? – claims against the banks is, like some modern-day Jarndyce and Jarndyce case, stemming that flow. Bulow and Klemperer try to set the tangle to one side to be resolved while the banks continue their business. Put like that, the idea does not seem like such a conjuring trick.

Also published at ft.com.

Flick through any copy of the Financial Times and you’ll see a lot of chaps in suits. There’s a reason for this: there are many more men than women in the boardrooms of the world’s great companies. Explanations range from the politically correct (women are held back by the oppressive patriarchy) to the sexist (women aren’t up to the job).

Untangling this is difficult, but economists have tackled it with relish, in the process finding evidence to support almost any prejudice. One famous study conducted by Claudia Goldin and Cecilia Rouse looked at what happened when the leading, male-dominated, US orchestras introduced blind auditions for new members. Goldin and Rouse found that blind auditions went a long way towards correcting the gender imbalance. Maybe those pretty little things weren’t such awful musicians after all.

Other studies suggest a different explanation for male-dominated boardrooms: women may avoid intense competition, and cope badly if forced to compete. These studies are intriguing, but usually based on rather artificial experiments, or special cases – such as tennis tournaments. Last April, my colleague Lucy Kellaway wrote: “Men want power enough to hang on to it and women don’t want it enough to make them let go.” I am not sure of that, but I can certainly point to studies that support Lucy.

For my money, the most convincing explanations of the gender pay gap focus on the role of children. An elegant study from Amalia Miller of the University of Virginia finds that if a woman in her twenties waits an extra year before having her first child, her lifetime earnings rise by 10 per cent – a combination of higher wages and more hours worked. The effect is larger still for professional women.

This isn’t a story about high-earning women deciding to have children later: Miller carefully focuses only on non-voluntary changes to the timing of motherhood – miscarriages, problems in conceiving and accidental pregnancies.

Another study by the economists Lawrence Katz and Claudia Goldin charts the dramatic impact of the availability of the Pill: as women were able more easily to delay pregnancy, they enrolled in law, medicine and dentistry in far greater numbers.

Katz and Goldin, with Marianne Bertrand of Chicago’s Booth School of Business, have now produced a new study, examining the experience of Booth’s MBA alumni – a high-flying group from whose ranks one would expect future CEOs to emerge. The outstanding feature of this research is the very detailed data available on this group: their pre-MBA experience, the courses they took and the grades they earned, their career progression afterwards, and the timing of their families. Women did achieve worse grades, and avoided hardcore classes in finance: but the differences were tiny. Far more important was what happened when children came along. If you look only at promotions and earnings, childless women are all but indistinguishable from men. The moment children arrive on the scene, a big gap opens up.

“The penalty for career interruptions is huge,” Bertrand told me in a recent interview. New mothers are derailed from the fast track in investment banking or consulting, and their potential earnings fall by about 40 per cent. The gap is aggravated by the fact that many of these women are married to men so rich that they decide to drop out of the labour force altogether.

The Chicago alumni study throws a spotlight on one big unanswered question: is it really impossible to design a corporate job that can be done in a 40-hour week?

Also published at ft.com.

“Useless tosser” is a popular epithet for cricket captains with a knack for losing the coin toss and thus allowing their opponents to decide whether to bat or to bowl first. Winning the toss is not always an advantage but, depending on the weather conditions, it can give the winner a significant edge.

Language barriers have prevented the phrase “useless tosser” from crossing the Atlantic, but the problem is familiar. When an American football game goes into overtime, it is a distinct advantage to win the coin toss. The coaches know it: when they win, they almost invariably choose to receive possession of the ball. In 2008, lucky callers won 10 overtime games and unlucky ones only four.

The very existence of the coin toss is an admission of defeat – that there is something irreducibly unbalanced about these games, some advantage that cannot be divided but can only be surrendered to the gods of chance. Chess players cannot both play “grey” – one must play white. Cricket teams cannot bowl simultaneously.

The obvious solution is to take turns to enjoy the advantage. This works perfectly well for chess, where a series of games can go on almost indefinitely, but not so well for cricket and even less well for American football, where TV schedules make it difficult to allow overtime to continue too long.

Economics has a natural answer: against the indivisible advantage of winning the toss, trade something that can be more finely divided. In chess, white could be granted less time on the clock. (Tyler Cowen, an economist and chess expert, tells me this has been known to happen, but is regarded as unnecessary because it is so easy to take turns to play white.)

In cricket, the team with the advantage of choosing whether to bat first could give its opponent a head start in the form of extra runs – “bid byes”. In American football, the team with possession is already penalised by having to start far back on the field; the trouble is that they don’t start far back enough.

This exemplifies a second problem. Once we agree that one team must be compensated (in time, runs, or field position), how large should the compensation be? Here, again, economics has the answer. The advantage should be auctioned off to whoever is willing to concede the most compensation to the opposition. The idea is absolutely equitable, intrinsically more exciting than a coin toss, and puts the emphasis on the judgment of the captains. Thankfully, since not all coin tosses are equally important – especially in cricket – the auction price reflects conditions on the day.

Having once written a thesis on sequential auctions with budget constraints (translation: the kind of auctions you get in a game of Monopoly), I am embarrassed to admit that applying auctions to cricket is not my idea – nor that of my fellow professional economists. Creative sports fans are the trailblazers here.

Two brothers, Chris and Andy Quanbeck – both engineers – proposed the auction idea to America’s football authorities in 2003 with, alas, no success. (I have written about their idea in more detail in Slate magazine.) But they were not the first.

To the best of my knowledge, the brilliant idea of replacing a coin toss with an auction had previously been suggested in these very pages. Warren Edwardes, a serial entrepreneur based in London, proposed using an auction in cricket, in a letter to the Financial Times in 1999. As so often, FT readers were the first to know. Alas, the MCC informs me that the proposal was considered by a sub-committee last summer, and “found no enthusiasm”. That is a shame. The idea may not be cricket, but it is excellent economics.

There are two ways to take anti-malarial drugs: the expensive way, which helps the world; and the cheap way, which helps only the patient. Most Africans cannot afford the expensive way and, as a result, the world’s most effective anti-malarial drug may lose its potency.

That drug is artemisinin, available either by itself as a “monotherapy”, or with other drugs as a more costly artemisinin combination therapy, or ACT. For now, the monotherapy is excellent from the patient’s perspective. Yet the ACT is greatly preferred by global health wonks, because monotherapies tend to encourage drug resistance in the malaria parasite.

This is no mere theoretical concern: malaria is now highly resistant to a previous wonder drug, chloroquine, and researchers have detected signs of resistance to artemisinin in areas where monotherapies are widely used.

ACTs make it harder for the malaria parasite to develop resistance. “Finding two keys is far more difficult than finding just one key,” says Ramanan Laxminarayan, an economist and epidemiologist at Resources for the Future, a Washington, DC think-tank that has traditionally specialised in developing economic solutions to environmental problems such as congestion and pollution.

To an economist, the problem of malaria resistance looks very similar to the problem of pollution. In the jargon, there is a “negative externality”. The driver of a gas guzzler enjoys the benefits of his vehicle, while strangers suffer most of the costs of the smog, congestion and climate change to which it contributes. Similarly, a Nigerian woman with a sick child, seeking out treatment in a pharmacy in Lagos, will hardly be inclined to ponder her contribution to artemisinin resistance. And who can blame her?

The classic economists’ solution to a negative externality is a tax on the bad stuff, but it would be fatal to price monotherapy out of the reach of Nigerian children. It should be just as efficient – and far more humane – to subsidise the socially superior product, ACT drugs.

This idea was proposed in 2004 by a committee headed by the economist and Nobel laureate Kenneth Arrow. Five years later, the proposal is becoming a reality under the auspices of the donor-funded “Affordable Medicines Facility – Malaria”, usually called AMFm.

Laxminarayan estimates that to flood the global market with cost-competitive ACT drugs would cost around $300m-$400m a year; for now, a less costly pilot will test the idea.

Unlike many grand aid initiatives, AMFm does not try to reshape reality beyond the narrow subsidy. Developers of effective new malaria treatments – there are three in the pipeline at present – should be encouraged by the prospect of tapping into the subsidy. Meanwhile, the proposal does not put too much reliance on public healthcare systems in Africa: most Africans buy their drugs from pharmacists rather than clinics, and the subsidy would do nothing to change that. Instead, by ensuring that the ACT drugs are cheaper than monotherapies on the way into the wholesale markets, donors hope that they will be cheaper over the counter, too.

That is likely, although not guaranteed. The system could, for example, leak at either end – AMFm must ensure that the subsidy does not also benefit producers of monotherapies, while distributors facing limited competition might be able to keep the subsidy profits for themselves.

Still, Laxminarayan is confident. Arrow, now nearly 90, is more cautious, arguing that there is only one way to find out if it works. Big ideas in development aid have often fared poorly, but the record of the aid industry in public health boasts numerous successes. This plan is worth a try.

Also published at ft.com.

Oscar Wilde once commented that a cynic knows the price of everything and the value of nothing. We economists often find this barb directed at us. That is unfair; economists have always argued for an analysis that incorporates the value of everything. It is also ironic, because if new “neuroeconomic” research is correct, economic models manage to incorporate value as well as price, it is the human brain that can’t keep up.

Economists have no problem with the idea that you might value a lazy Sunday afternoon more than a kiss, and a kiss more than a poke in the eye. If so, we say that the utility of the lazy Sunday afternoon is more than the utility of the kiss, which is more than the utility of the poke in the eye. Utility is not an appeal to some warm fuzzy feeling: it’s just a way of describing, in a mathematically convenient way, the fact that you won’t choose the poke in the eye if the lazy Sunday afternoon is on offer. The theory is quite capable of reflecting the range of things that humans value.

In fact, the theory allows for far more subtle discriminations than we seem to be capable of. The human brain simply may not be wired up to deal with lots of different levels of value. A series of psychological experiments, many dating back to the 1950s, shows that we cannot distinguish between more than about five degrees of … well, almost anything: sweetness in a solution; saltiness; the pitch of a note; brightness; the intensity of an electric shock; the length of a line; or the pungency of a smell. The details vary, but the level of consistency is surprising.

Practice does not help. Neither, surprisingly, does varying the gaps in the scale: it’s no easier to distinguish five sounds between “very loud” and “very quiet” than between “fairly loud” and “fairly quiet”. Some people have perfect pitch and can transcend these limits when it comes to musical tones, but there seem to be few other exceptions. No wonder so many reviews use a scale of one to five stars.

Nick Chater, a psychologist at University College London, argues that the human brain doesn’t have an internal scale for these stimuli, nor for “utility” or “value”. Instead the brain makes comparisons: that light was brighter than the previous light. We can just about wrap our minds around the idea of “much brighter” by comparing a recent gap in brightness with some previous gap in brightness. If the brain works in this binary way, it is easy to see why it struggles to compare more than about five different brightnesses – or sweetnesses, lengths, or “utilities”.

When evaluating a meal, we can place it somewhere between “revolting” and “the best food I’ve ever tasted”, with about three intermediate categories. The scale may shift based on recent or otherwise influential experiences with food. This is a problem for conventional economics – and also for fashionable work on “happiness”, much of which asks people to rate how happy they are on a scale of one to seven.

If Chater is right, this might help to explain the housing boom: people were happy to buy overpriced houses, as long as they were not too expensive relative to relevant comparisons – that is, other houses in the area. Certainly, research by Chater and his colleagues, and by the behavioural economists Dan Ariely, George Loewenstein and Drazen Prelec, suggests that our willingness to pay to avoid unpleasant but unusual experiences such as nasty noises or electric shocks, varies markedly, and can be strongly influenced by price cues provided by the experimenters.

All I need now is a way to persuade people that £100 is a perfectly reasonable price to pay for a paperback book.

Also published at ft.com.

Performance pay is a tricky business. If you hired me as a hedge fund manager and paid me “2 and 20” – a 2 per cent management fee, plus 20 per cent of any gains – then I’d be tempted to take your money to a roulette table and put it all on black. If I won, I’d get to keep 20 per cent of the gains. If I lost – well, I would have been sure to deduct the management fee first.

If I were instead aiming to top a league table of investment managers, worse awaits. This time, instead of betting on black, perhaps I’d put the money on lucky number seven. If the rewards go to the most successful investment managers, then I need to go for broke – especially since “broke” is more likely to describe my investors than me.

All this is an exaggeration, of course, but discussions of bankers’ bonuses are haunted by visions of this kind of perverse “compensation” scheme. (Annoyingly, we use the word “compensation” as though bankers were being awarded damages after the trauma of executive life.) The popular view of bankers’ bonuses is simple enough: they never deserved to be paid millions anyway, and the fact that they seem to have blown up the world’s economy proves it.

A more sophisticated view does not worry about the size of bonuses, as long as they attract sufficiently brilliant people. If they do, they are worth paying; that is true whether they are paid by shareholders or by taxpayers. But it now seems likely that bonuses do not do these wonderful things, and may simply encourage gambling.

I was writing about these risks before the credit crunch, and I was hardly alone – in September 2005, Raghuram Rajan, then chief economist of the International Monetary Fund, was warning that “skewed incentives for investment managers may be adding to global financial risk”.

I fear this is a problem easier to identify than fix, but it may be possible to design sensible bonus schemes. Research from three German economists, Thomas Gehrig, Torben Lütje and Lukas Menkhoff, shows that bonuses for fund managers seem to produce harder work and more attention to fundamentals, but not greater risk-taking. The study did not look at banking, but it does suggest that sensible bonuses are feasible.

Politicians are beginning to take note. Gordon Brown now says that regulators “should be given the right in regulation to penalise a bank which is basing its reward system on short-term deal-making rather than long-term performance”. Fine, but I would expect no miracles.

Shareholders also prefer long-term performance to short-term deals, and if they did not previously realise the risks that bankers were taking with their money, they do now.

But there is a reason that regulators might do a better job than shareholders. The typical shareholder owns a tiny portion of any one company, and is unlikely to find it worth the trouble trying to organise a rebellion against irresponsible pay awards. Like the hapless restaurant diner at a big party, facing a menu in the full knowledge that the bill will be split between 30 or 40 other people, the shareholder realises that there is little point in scrimping when everyone else will order steak and champagne. A regulator could bring more discipline – if a sufficiently capable one exists.

So could a large shareholder: the economists Sendhil Mullainathan and Marianne Bertrand have found that CEO pay is linked much more tightly to credible measures of performance when there is at least one substantial shareholder to take the policing role.

For the banking industry, governments can no longer escape that responsibility.

Also published at ft.com.

No wonder the Financial Times is making a fuss about the downturn: our readers are suffering more than most. That, at least, is my conclusion after reading the research of two economists from America’s Northwestern University, Jonathan Parker and Annette Vissing-Jorgensen. Drawing on US data, they found that the biggest spenders are those whose spending fluctuates a lot. The consumption rates of the top 10 per cent of households fluctuate 10 times more than those of the majority – the bottom 80 per cent of households. So a fall in overall consumption is a blip for most people, but a slump for those near the top. (We’re not just talking about Russian oligarchs here: spending of just over twice the average is enough to place you in the top 10 per cent.)

Other economists – again, in the US – have made similar discoveries. Shane Jensen and Stephen Shore examined the oft-made claim that household income (an indicator of spending) is more volatile in modern times. They found that this is actually only true for the rich: the proportion of US national income earned by the rich surged ahead in the booms of the 1980s, 1990s and 2000s, but stuttered or even fell in the recessions that separated them.

My aim is not to sympathise with the well-off: while no doubt it stings to take the kids out of private school or to sell the sports car at a loss, most people never enjoyed such privileges in the first place. But this research highlights a truth often forgotten in the hand-wringing about the downturn: everyone has their own experience of a recession. Some do badly and others do very well indeed. The gloomy averages we usually see reported fail to convey that range of experience.

Lindsey Macmillan, an economist at Bristol University’s Centre for Market and Public Organisation, kindly investigated this question for me. She looked at data from the British Household Panel Survey, which in 1991 began regularly to monitor the experiences of several thousand families. Macmillan found that more than half of households were earning appreciably more in 1993 than in 1991, and that one in six had seen their income rise by more than half during two years of very low average growth. The figures were much the same between 1994 and 1996, when the economy was expanding briskly: in other words, the variability in individual experience completely drowned out the distinction between growth and stagnation in the underlying economy.

For businesses, too, individual circumstances vary greatly. We are used to being regaled with tales of booms in niche markets: the Financial Times has reported success for manufacturers of frozen food, for physiotherapists, and for a company that sells food past its “best before” date. All doubtless true, but even within a sector there will be winners and losers. Jonathan Haskel of Imperial College, who has access to confidential data on business performance, has found that companies in the most productive tenth of UK manufacturers, in any given industry, get five times more output from each worker’s time than the sector’s least productive 10 per cent.

The lesson for any business is to recognise that each customer, client and supplier is having his or her own private experience of the recession and that, for some of them, that experience is surprisingly benign. A business that can distinguish between its struggling and its prospering clients is likely to have an advantage.

The co-author of Freakonomics, Stephen Dubner, recently called my attention to a $975 calf-leather sewing kit, designed to “keep tailoring bills in line”. Evidently, not everybody is suffering in this recession.

Also published at ft.com.

The credit crisis has provided a series of unpleasant lessons about the importance of financial services. The first lesson was about credit: we began to realise that it would not always be possible to extend our overdrafts or refinance our mortgages cheaply. The second lesson, as queues formed outside Northern Rock, was about savings: there is no iron law of economics that says that the money in your savings account is 100 per cent safe. Last September, those of us still peeping through our fingers at the financial news learnt a third lesson, about the payment system itself: it began to be conceivable that you might write a cheque and the cheque would bounce, not because you lacked the funds to honour it but because your bank did.

The same lessons are being learnt in a different context, that of financial services for the very poor. In the 1970s, pioneers in Latin America and Bangladesh – most famously Muhammad Yunus of Grameen Bank – demonstrated the importance of affordable credit for the poor, and discovered that poor borrowers could reliably repay loans. The early experiments grew into a worldwide microcredit movement.

But just as we were rudely reminded that there is more to our banking system than cheap mortgages, so microcredit experts have been realising that there is more to microfinance than loans for the poor: savings, insurance and payment systems matter too.

The trouble with living on two dollars a day is that you don’t actually get two dollars a day. One day you might get five, then nothing for the next three days. Income is unpredictable. Outgoings, too, are irregular. Emergencies crop up. Under the circumstances, the most basic financial product, such as an easy-access savings account, would be invaluable.

We know about this thanks to a new study by Daryl Collins, Jonathan Morduch, Stuart Rutherford and Orlanda Ruthven, detailed in their forthcoming book, Portfolios of the Poor. These researchers compiled financial diaries for more than 250 families in Bangladesh, India and South Africa, tracking the tangle of transactions over the course of a year. They discovered that poor families are intensive users of financial products.

Take the case of Hamid, an occasional rickshaw driver, and his wife Khadeja. The couple live in the slums of Dhaka with one child. The researchers found that Khadeja and Hamid use a bewildering array of financial instruments. They have a small life insurance savings policy; Hamid deposits money with his boss at zero interest, patiently accumulating a lump sum large enough to send back to his home village for safekeeping; Khadeja takes care of money for two neighbours with spendthrift husbands; the couple have borrowed money from friends, from a microcredit bank, from Hamid’s boss and from a local shopkeeper. Khadeja even took out a pricey loan to fund her saving: she bought gold, an asset she could use if Hamid died or divorced her.

Hamid and Khadeja need this patchwork portfolio in order to manage the daily gap between income and spending. They would benefit a great deal from access to a cheap savings account. Pent-up demand for such accounts is so great that in some areas deposit-collectors are able to charge for the privilege, collecting a hefty negative interest rate of 3 per cent a month.

Still, there is progress. In the Philippines and Kenya, payment systems are emerging on the back of mobile phone networks, with phone companies turning into deposit-taking banks. That is a promising development, but it requires a deft touch from regulators. Another hard lesson from the credit crunch is that deftly regulating banks is easier said than done.

Also published at ft.com.

I know plenty of economists who are fond of Guinness, but not many who realise just how important the beer has been to the profession. The man who laid the foundations for the global success of Guinness also produced one of the most important tools in economics – and a tool that is widely mishandled today.

Faced with an apparent pattern in any data, a key question is always: “Does this pattern represent something real, or is it just chance?” The simplest example: if I measure the heights of five men and five women and discover that the men tend to be taller than the women, I might be on to something, or I might just have some tall men and some short women in my sample. Based on this small sample, how confident should I be that men are in general taller than women?

The statistical apparatus to check this is a test called Student’s t-test. Student was the pseudonym of William Sealy Gosset, an amiable, rucksack-wearing chemist who – beginning in 1899 – worked all his adult life for Guinness and eventually rose to the rank of head brewer. So nervous was the company about commercial confidentiality that Gosset published surreptitiously under his pseudonym.

From the outset, Gosset’s focus was practical – as the economist and historian Steve Ziliak has discovered through his work in the Guinness archives. To produce beer to a high standard on an industrial scale, Gosset needed to sample and experiment with hops, malt and barley. But experiments are expensive and Gosset developed his small-sample methods because he wanted to understand how many experiments were necessary to be confident of his results. That was a clear trade-off: how much confidence is “enough” depends on the costs of further research and the benefits of extra precision.

Ziliak and his co-author Deirdre McCloskey argue in a recent book, The Cult of Statistical Significance, that most academic disciplines have forgotten this trade-off. Instead, they use an artificial standard propagated not by Gosset but by the famous statistician and mathematical geneticist Ronald Fisher, who took Gosset’s calculations and turned them to his own devices. Fisher proposed ignoring any finding that failed to reach the 95 per cent confidence level. In other words, until the odds against a pattern having emerged by chance are 19 to 1 against, disregard the pattern completely.

That might seem a reasonable precaution – and it is certainly standard practice today – but a sharp line for statistical significance makes no sense, and it has a cost. In a recent interview, Ziliak told me about an employment promotion programme in Illinois in the recession of the early 1980s. Researchers estimated that every dollar spent on the programme saved $4.30 and were 87 per cent confident that the result was real. But that was below Fisher’s 95 per cent standard, so the programme was seen as having done nothing. Fisher would have approved.

This is strange: if I offered you the chance to spend a dollar and get back $4.30 87 per cent of the time, you would be right to see this as a good bet. Gosset would have agreed with you.

In any case, what seems like a precaution can be reckless. If a painkiller seems to cause heart attacks, Fisher’s standard says this risk can be ignored unless the statisticians are 95 per cent sure. A more reasonable standard is not to ask, “Are we certain there is an effect?”, but to consider not only the precision of our estimates, but the importance of the pattern that may be emerging. That is what Gosset did: none of his experiments for Guinness was statistically significant at the 95 per cent level. But economically significant? We can say that they were – with confidence.

Also published at ft.com.

Late last year I sat with members of my extended family and we talked about which banks might be safe havens for savings, and which might be about to collapse.

“Remember this conversation,” I instructed my young nephews. “The last time people talked like this was before your granddad was born.”

It made me think how the great crash of 1929, or the Great Depression, must have shaped the attitudes of those who lived through them. I used to think, in the arrogance of youth, that elderly people were just crazy if they stored their savings under the mattress because they didn’t trust the banks. Now I realise that painful memories, rather than senility, might explain the choice.

If experiences of major booms and busts shape the way we behave, it’s something that macroeconomists may need to take into account.

Consider two plausible theories of consumer behaviour, the “smoothie” and the “boomy”. The “boomy” theory is that when times are good, we get overconfident and spend freely, then retreat into a risk-averse shell when times get tough. The “smoothie” theory contends that people save for a rainy day in a boom and then draw down savings to maintain living standards during a recession. “Boomy” consumer behaviour makes recessions worse. The “smoothie” world is one where cool-headed and far-sighted consumers help smooth out booms and busts.

Keynes started with a boomy theory but abandoned it, believing it predicted implausibly wild swings in the economy. He switched to the smoothie theory instead in 1931. Here’s the intriguing thing: John Coates, the neuro-economist whose work on traders and testosterone I described two weeks ago, points out that the smoothie theory wasn’t borne out by US depression-era data at all. Americans became smoothie consumers only during and after the war. What happened? Perhaps consumers began smoothing only after being chastened by the memory of the roaring twenties and the subsequent hangover. And, says Coates, they began to return to unstable, boomy behaviour after 1981. Fifty years was long enough to forget.

A more formal analysis of these issues has been circulating since late 2006, well before the credit crunch, but has attracted new interest since. Ulrike Malmendier and Stefan Nagel, both California-based economists, have been investigating how economic experiences early in life seem to shape our later behaviour.

Using financial surveys that date back to 1964, they look at how returns on the S&P 500 over the course of an individual’s life to date shape his or her financial behaviour at the date in question. They control for age (perhaps 65-year-old retirees are always more cautious than 40-year-olds) and for the year (everyone investing in, say, 1988, faces a particular investing environment), but nevertheless find that an individual’s earlier experiences seem to shape his or her behaviour.

For example, young investors in the late 1990s were keen stock market investors, having experienced a lifetime of excellent returns; old investors were more cautious. Whereas in the early 1980s, it was the older investors who were more bullish: unlike young investors, they could remember the good times of the postwar boom.

If these results predict future risk attitudes, and if the credit crunch does prove to be the definitively unpleasant event that many economists fear, then a fascinating future lies ahead. Consumers will remember what it means to put money aside in the good times, while the stock market will be an old-timer’s game, tempting only for those greybeards who remember the long boom of the 1980s and 1990s. Those were the days.

Also posted at ft.com.

In 1987, an 18-month old baby named Jessica McClure fell down a narrow disused well in a Texas backyard. It took two and a half days to rescue her, bloodied but alive and alert, after an astonishing media circus. The rescue won a Pulitzer prize for the photographer who captured it, and inspired a TV movie. “Well-wishers” from across the US donated so much money that when Jessica turns 25 she’ll receive a fat trust fund. Media speculation puts it at a nice round $1m.

Jessica’s case was uniquely famous, but $1m is not a remarkable sum of money to save an American life. Government agencies regularly plug larger sums into their cost-benefit calculations, and few voters think they are wrong to do so.

To some extent that’s cheap talk – we’re talking about spending each other’s money, after all. Yet even if we wouldn’t spend $1m of our own money, we would all be willing to make financial sacrifices to save a specific baby. Imagine that you had been passing the back yard at the moment baby Jessica had slipped down the well, had rushed over and peered down to see her just within reach, snagged by a fraying babygro. If you lunged down and grabbed her you could save her life at no risk to your own, but would ruin your new suit – price tag, £300. Would you do it? Unthinkingly and without regret.

Here is the difficulty: faced not with a specific baby right in front of us, but some unnamed baby far away, £300 suddenly seems like a steep price tag. That £300 is a plausible estimate for the cost of enough mosquito nets or health education to save a child’s life in sub-Saharan Africa. Few Britons donate that much to charity each year.

Peter Singer, the utilitarian philosopher, animal rights champion and author of a new book, The Life You Can Save, is disturbed by the equanimity with which we accept the widespread death and suffering of millions of unidentified – but undeniably, real – people in poor countries.

In part this may be because we wrongly believe that our governments have it all covered. Singer reports several surveys suggesting that US citizens think that 15-20 per cent of the US government budget is spent on foreign aid; the true sum is less than one per cent. I suspect that we also worry that £300 will not, in fact, save any lives at all. Much aid money is wasted, and evidence on the effectiveness of aid remains too thin. By coincidence, as Peter Singer’s book crossed my desk, so did a peer-reviewed report on a randomised trial carried out in Ghana by Dr Evelyn Korkor Ansah and others. The trial provided free healthcare to young Ghanaian children, with the result that their families took them to the clinic more often. Yet there was no evidence that the children’s health improved in any way. It’s rare to find such careful evaluation, but not hard to find cases where money has been spent in Africa with no great result, or even with harmful results.

Yet our affluence is so great – just think of the money most of us could save if we drank only tap water – that the hurdle for giving is surely very low. Even if 95 per cent of the money we send to Africa is wasted, £5 to them probably does more good than £100 to us.

The true reason we do not give freely is because of an almost unlimited capacity to put out of our minds the suffering of people we will never meet. One of the effects of Singer’s book is to refocus the reader on that suffering, at least for a while. After I finished the book, I contacted Oxfam to give money. I always knew I didn’t need a new suit; Peter Singer reminded me.

Also published at ft.com.

“They were displaying classic symptoms of mania. They were overconfident, they had racing thoughts, they had diminished need for sleep and heightened sexual appetite.”

John Coates, a former Wall Street trading floor manager, was describing to me not drug addicts or rutting stags, but the male traders he had supervised during the dotcom bubble.

The similarities are not just skin deep. Successful traders and dominant stags are indeed high on something: testosterone. Spikes in testosterone levels are both the cause and the consequence of a profitable day on the trading floor. After a good day, traders find their systems flooded with testosterone, which encourages them to take more risks the following day and, up to a point, to make more money.

The same testosterone surges and streaks of success and failure can be seen in bulls, stags and other sexually competing male mammals. Female traders – who remain rare – don’t act in the same way.

Coates – a research fellow at Cambridge university who quit Wall Street to study the boundaries of economics and neuroscience – made a splash last year by publishing research (with the neuroscientist Joe Herbert) showing all this. Now, in a new paper with the endocrinologist Mark Gurnell and the economist Aldo Rustichini, Coates has been asking whether traders’ behaviour is influenced by high levels of testosterone (and other “androgenic” steroids) they may have been exposed to in the womb.

This is not an outlandish hypothesis, given what endocrinologists already know: high levels of pre-natal testosterone seem to be correlated with confidence, a tolerance for risk and quick reaction times, as well as sporting prowess. So it is not unreasonable that high-frequency traders, who take billion-dollar positions for minutes or even seconds, might benefit from having developed in a conducive womb.

One might ask how Coates, studying the behaviour of traders who were typically in their twenties, could know what had happened to them in the womb. In fact, there is a convenient and widely used proxy: the ratio of the index finger to the fourth finger – or the 2D:4D ratio. Low 2D:4D (a relatively long fourth finger) is evidence of high exposure to testosterone in the womb.

Coates, Gurnell and Rustichini found what they were expecting: that high-testosterone foetuses grew up to be excellent high-frequency traders. What was surprising was the huge size of the effect. Traders with a low 2D:4D ratio made six times as much money as those with high 2D:4D ratios. In an environment when the best traders earned more than £4m a year, this is hardly a trivial discovery.

The high-testosterone advantage seems to come from two sources. First, pre-natal testosterone seems to shape brains with quicker reactions and a greater ability to concentrate. Coates and his colleagues found that low 2D:4D traders did particularly well in volatile markets, when speed of action was paramount. They weren’t just “better”, they were better in a way that gave them an edge in frenzied times. In contrast, experienced traders have a more generalised advantage: they make more money than inexperienced traders in quiet times as well as volatile ones.

Second, pre-natal testosterone amplifies the “rutting stag” behaviour Coates and Herbert had already discovered. It seems to pave the way for a more intense response to later surges in testosterone: once the low 2D:4D traders get on a roll, they really start winning. By the same token, losses are also self-perpetuating for such traders, because they drain away testosterone and with it, the willingness to take risks.

Also published at ft.com.

Imagine an auction in a looking-glass world, with the auctioneer offering cash to the highest bidder and the participants frantically outbidding each other with a jumble of assorted assets. Should a million dollars be sold to the man in the front row for his bundle of 2006-vintage toxic mortgage securities? Or the lady behind him, for her 2005-vintage offering?

That was the auction the US Treasury was hoping to hold until it abruptly changed its plans in November. It was going to spend up to $700bn – the “Tarp” (toxic asset relief programme) fund – buying a variety of toxic assets from banks. The idea made sense: by establishing a market price for these dubious assets, the auction would have improved transparency and helped solvent banks to prove that they really were solvent.

The Tarp fund was then cannibalised to recapitalise banks (probably a good idea) and then dole out suitcases of cash to all-comers (a less good idea). But the original auction concept should be resurrected, because it solves a problem that has not gone away.

And yet – how could the looking-glass auction work without the US Treasury overpaying for junk? Holding a single auction with a single price would be a disaster: only the most worthless assets would have been offered for sale. To do the job properly and establish realistic prices, the auction needs to distinguish between different assets: some good, some bad and some ugly.

But simply holding many different auctions is not much better. Once finished, a bank might be surprised by the prices, wishing it had sold more of one kind of asset at a generous price, and fewer of its others. Not only would the banks have acted differently with hindsight, but the Treasury would want them to, in the interests of higher revenue and more price transparency.

So two economists from the University of Maryland, Larry Ausubel and Peter Cramton, proposed a dynamic design that would have allowed banks to adjust their bids as the auction proceeded, shifting their emphasis to compete more aggressively wherever prices seemed tempting. The auction was tested to destruction by graduate students and seemed to work well. But there is a flaw: each auction would take a day, with the auction prices affecting financial markets and the markets affecting the auction prices.

However, a solution was already being developed to answer a similar problem for the Bank of England. Paul Klemperer, one of the economists behind the 3G mobile spectrum auctions in the UK, has published a paper explaining how the Bank might auction off loans secured against different qualities of collateral.

He suggests having banks simultaneously submit combinations of bids. Each bank would be considering different scenarios – one in which loan rates were high and it preferred to borrow the absolute minimum; another in which rates were low and it happily offloaded collateral to the Bank of England.

The same approach could work for a Tarp auction, too; Klemperer and three economists from Stanford have been working out the details. A computer would compile bids from both sides, with both the banks and the US Treasury saying in advance what they would be willing to buy or sell at different possible prices. The computer would calculate the result. Because each bidder submitted bids to cover each eventuality, the auction should be efficient and nobody would regret having told the computer the truth.

Whether the US Treasury will relent and return to an auction remains to be seen. The Tarp auction is a fiendishly difficult design problem, but it looks solvable. At the time of writing, it seems that the Treasury prefers to spend the cash ad hoc. Shame.

Also published at ft.com.

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.

This morning, I had a remarkable experience: I strolled into a delicatessen and bought some delicious Stilton. What made the shopping trip unusual was that I was wearing a brain scanner while I did it.

My costume consisted of an electroencephalograph (EEG) cap, which looks like a polka-dot shower cap with wires plugged into it; a pair of wrap-around glasses with a tiny video camera attached; a clothes peg on one finger to measure my heart rate; two other finger monitors that functioned like a lie-detector; a thermometer patch on a fourth finger; and a satchel to hold a computer gathering the data.

Most of these devices, or their equivalent, can be hidden under clothes or baseball caps so that the wearer looks as if they are sporting only shades and an iPod, but in my case the boffins hadn’t bothered, and so I entered the deli looking like an extra from a 1970s episode of Doctor Who.

This was all part of my efforts to understand ”neuroeconomics”, a new, controversial and eclectic marriage between economics, marketing and various branches of physiology and brain science. With very different aims, economists and marketers are attempting to tap into the dramatic advances in our understanding of the brain that have taken place over the past 15 years. Their tools encompass mood-altering drugs, tests for hormone levels, animal studies and fMRI scans (which use immobile scanners to measure blood flows deep inside the brain).

“Neuromarketing” is the simplest application, and the one in which I was participating. David Lewis, a neurophysiologist at The Mind Lab, a spin-off from the University of Sussex, showed me how the physiological readings could be viewed alongside output from my camera to provide a simple but – presumably – useful demonstration of what really grabbed my attention in the deli. Among Lewis’s findings are that eating chocolate is more exciting than snogging (at least, snogging in an electrical shower cap while surrounded by men with clipboards) and that, subconsciously, young men are more interested in trainers than in the wares on display in an Ann Summers sex shop.

While the possible applications for marketers are obvious enough, such trials are hardly unlocking the deepest secrets of thought. It remains to be seen whether neuroscience has much to contribute to economics itself, a subject that has long focused on the decisions people make, without relying on any particular theory of how they make them. It is also hard to point to anything terribly interesting that the neuroeconomists have discovered, although neuroeconomics may contribute more as time goes by.

Neuroeconomics may provide more shape to the older and more famous field of behavioural economics. A mixture of economics and psychology, behavioural economics has used laboratory experiments to expose a bewildering number of exceptions to the traditional economic theory of rational choice. At present, though, there is little pattern to what the behavioural economists are observing, and it’s possible that a greater understanding of how the brain works might help to provide one.

Yet neuroscience might also help reinforce the traditionalists. Wolfram Schultz, a neuroscientist at Cambridge who studies how the brain processes risk and reward, says that just as the brain registers sensations such as sight, he can now see it registering rewards. There was no reason to expect that the mathematically convenient economists’ fantasy of “utility” had any real analogue in the brain – but it seems that it might after all. There’s a thought.

Also published at ft.com.

In March 1959, a promising young Harvard economist delivered a lecture in Boston on “The Theory and Practice of Blackmail”, drawing on the then-young branch of economics and mathematics called “game theory”. Strictly speaking, his subject wasn’t just blackmail – the threat to reveal damaging information in order to get what you want – but the broader practice of extortion or coercion.

The lecturer emphasised a central problem in coercion, which is to make the victim believe that if he or she refuses to be coerced, the threat will be carried out anyway. That is not straightforward, but it is possible. For instance, in December 1958, a “little old lady” walked into a bank, placed a glass of colourless liquid on the counter and passed a note to the teller.

“I have acid in a glass, and if you don’t give me what I want I’ll splash it on you,” said the note. It continued, “I have two men in here. I’ll throw the acid in your face and somebody will get shot. Hurry. Put all the fives, tens and twenties in this bag.”

What would you have done in the teller’s shoes? A quick-thinking teller might well have thought that it was safe to refuse, because the lady’s best option would then be to pick up the glass and walk out in search of another bank. She would have nothing to gain from hurling the acid except a longer prison sentence. Yet the teller handed over a bag full of money. It was, after all, not his.

Other bank robbers of the day enjoyed similar success. One convinced a teller that a comb in his waistband was a gun. Another walked away with $5,000, quite a sum in 1958, after brandishing what looked like a grenade; surely he cannot have intended to blow himself up. A third robber managed two hold-ups armed only with a polite note. The little old lady herself was arrested on a second heist and found to be equipped with a glass of tap water.

One lesson is that bank tellers have little to lose by complying, which is why banks started introducing locks, alarms, cameras and other systems that could not be overridden by staff. Another lesson is that small doubts over the rationality of the coercer can go a long way in enforcing a threat. After all, if grandma walks into the bank and starts trying to extort money, she’s already demonstrated herself to be a little out of the ordinary.

Blackmail proper is a more difficult threat to make credible. Richard Posner, a pioneer on the frontier between law and economics, has pointed out the basic difficulty: unless the blackmail victim is himself a criminal, he has the powerful counter-threat of a complaint to the police. If the victim’s secret is revealed, he has nothing to lose by then reporting the crime. If the victim goes to the police immediately, the blackmailer cannot reveal the secret without risking a longer sentence. Small wonder that blackmail seems to be a rare crime.

An epilogue: the economist who gave his 1959 lecture on blackmail later ended up with more practical experience of it than anybody would want. His name is Daniel Ellsberg. After his early contributions to economics, he became far more famous as the military analyst who risked a life sentence for espionage after leaking the Pentagon Papers to the press in 1971 in the hope of obstructing the Vietnam war. It was a memorable instance of blackmail’s heroic twin, whistleblowing.

The Watergate burglars then broke into the office of Ellsberg’s psychiatrist, perhaps with the hope of obtaining blackmail material. That burglary was one reason why the Ellsberg trial collapsed. Blackmail is a difficult business – but even back in 1959, Ellsberg had known that very well.

Also published at ft.com.

On Monday, the winner of the 2008 Nobel prize in economics will be announced. That statement is not quite true: there is no Nobel prize in economics, merely a more recent prize established in memory of Alfred Nobel.

The existence of a quasi-Nobel in economics infuriates some. One objection is that Nobel himself would not have approved. I do not much care. A more serious objection is that economics is not incontrovertibly a science, but then neither is peace or literature.

Nor am I convinced that the economics Nobel is, as some claim, an instrument for the enforcement of orthodoxy. The prize committee has been broad-minded, occasionally even daring. The prize has gone to Keynesians such as James Tobin and to Friedmanites such as, um, Milton Friedman, to a psychologist (Daniel Kahneman), a mathematician (John Nash) and to the unclassifiable Herbert Simon.

Gunnar Myrdal, a socialist politician, shared the prize in 1974 with Margaret Thatcher’s inspiration, Friedrich Hayek. This provoked the joke that economics is the only subject in which two people can share a Nobel prize for saying opposite things. (Myrdal complained that a prize that could be won by the likes of Hayek and Friedman should be abolished.) When Kahneman shared the 2002 prize with Vernon Smith, another joke did the rounds: Smith won the prize for showing that economic theory works, while Kahneman won the prize for showing that it doesn’t. If this isn’t a broad church, I’m not sure what is.

The odd thing is, whether the Nobel memorial prize is a Nobel prize or not surely shouldn’t matter very much: either way, the prize winners are economists considered worthy of distinction. And yet, the Nobel-ity of it does matter, somehow.

The economics Nobel attracts more attention, for example, than the John Bates Clark medal, awarded every two years to the best American economist under the age of 40. This disparity is curious. The Bates Clark medal has gone to many of the same economists, and more promptly. It has a longer pedigree – it was first awarded in 1947, 22 years before the Nobel memorial prize – and it is much rarer. Most early Bates Clark medallists went on to win the Nobel, but many eligible Nobel laureates failed to win the Bates Clark medal – after all, there have been 20 John Bates Clark medallists since 1969, compared with 61 Nobel laureates.

Nobel prizes also attract more attention than, say, the Crafoord Prize, another Swedish prize for sciences. Despite a $500,000 purse, I am still trying to convince myself that the Crafoord Prize actually exists.

All this made me muse about the vagaries of prizes. What is it that makes a prize – the Nobel, the Booker, the Oscars, Olympic gold – truly prestigious? A long history and a sharp public relations team no doubt help.

Yet there is an economic rationality, too. A prize is worth winning if it proves that the winner beat an impressive field on credible criteria. To an extent this is self-fulfilling: lots of people want to win prestigious awards, and that makes them more prestigious. Because everyone wants to win Olympic gold, the victor will be seen to have defeated every important opponent; that is why everyone wants to win Olympic gold.

It’s not easy to begin that process from scratch, but a big purse helps. The prize money attracts a strong field, which legitimises the winner and helps attract another strong field next time.

In the economic jargon, then, successful prizes become “focal points”. We owe that insight to Thomas Schelling, who shared the Nobel prize in 2005. Or was it the 2005 Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel? Whatever.

Also published at ft.com.

During the bail-out of AIG, Fannie Mae and Freddie Mac – and, at the time of writing, the still unresolved debate over the bail-out of the entire US financial system – the phrase “moral hazard” has become popular, typically in conjunction with the phrase “privatising profits and socialising losses”. It’s easy to sympathise: the erstwhile masters of the universe seem to have forgotten the meaning of both “moral” and “hazard”. Why should they be helped now?

Still, we might usefully remember what the antiquated jargon “moral hazard” means. The term originated in insurance, recognising the idea that people with insurance may be careless – for example, paying for secure off-street parking looks less attractive if your car is insured.

Moral hazard can sometimes take extreme forms. According to the Florida newspaper The St Petersburg Times, in the late 1950s and early 1960s, more than two-thirds of insurance claims for the loss of a limb originated in the Florida Panhandle. At the epicentre, “Nub City” – the tiny town of Vernon, Florida – almost 10 per cent of the adult population had lost a limb. One man was said to be insured by dozens of companies when he lost his foot; fortunately he had been carrying a tourniquet at the time of the accident. He pocketed a million dollars. Another man shot his foot off – “while aiming at a squirrel” – just 12 hours after buying insurance. Now that’s careless – and that’s moral hazard in spades.

Sometimes moral hazard is so severe that it makes insurance impossible. Footballers would like to insure against losing football matches, and students would like to be compensated if their exams go poorly. Tough: moral hazard makes such insurance contracts absurd. But all these examples exaggerate the problem. So does the archaic use of the word “moral”. It used to carry no ethical connotation, referring merely to a risk arising from human action rather than natural forces.

Forget the baggage that comes with the word “moral”. While moral hazard makes insurance more expensive and less efficient, many insurance markets work well enough to be useful. Moral hazard need not destroy them, and it need not destroy financial markets either. If AIG had shot off its own metaphorical foot to claim a government bail-out, the argument against the bail-out would be compelling. But it didn’t, and it isn’t.

This perspective can suggest lessons for today’s bail-outs. The government will not help you replace your possessions if you smoke in bed and your house burns down, but government-funded fire engines will put out the blaze, moral hazard or not. That is partly because fire can spread, and your neighbours should not suffer for your carelessness. The same motive lies behind the current spate of rescues. It is also because a civilised society tries to save people from accidentally burning themselves to death. If the consequence is a little more carelessness, so be it.

A second lesson is that remedies for moral hazard will always be imperfect. Insurance companies could fight moral hazard by checking that your behaviour is consistently safety-conscious. Because that’s impractical, deductibles have to serve as imperfect proxies. The current bail-outs are a strong argument for tighter regulation, but regulators cannot be everywhere, any more than a claims adjuster can ride around in your car all day.

Bail-outs can save the innocent as well as the culpable, but even when they don’t, it is fantasy to expect governments to refrain from them. It is useless to pretend otherwise: bail-outs are inevitable and sometimes they are even desirable. The moral hazard they provoke is also inevitable. The final lesson: insurers get paid for the insurance they provide; it would be nice if the taxpayer were shown the same courtesy.

Also published at ft.com.

Shortly after the Soviet Union collapsed, a Russian bureaucrat travelled to the west to seek advice on how the market system functioned. He asked the economist Paul Seabright to explain who was in charge of the supply of bread to London. He was astonished by the answer: “Nobody.”

Fifteen years later, I had thought that almost everyone had abandoned the notion that a committee could plan its way through the unimaginable complexities of an advanced economy. I was wrong.

Earlier this month, the Migration Advisory Committee presented a list of professions that would qualify migrants for entry, broadly on the grounds of UK skills shortages. They include geologists of all stripes, veterinary surgeons (but not other veterinarians), chefs (but only those paid £8.10 an hour), sheep shearers with a British Wool Marketing Board bronze medal (or equivalent) and ballet dancers (but not choreographers, nor other dancers).

At least the old Russian bureaucrat would have had an answer to the question, “Who is in charge of the supply of sheep shearers to the UK?” It is the Migration Advisory Committee.

Perhaps the previous patchwork of immigration restrictions was even worse. Yet nobody now thinks that a government-appointed committee, no matter how wise or diligent, could plan how many memory chips the UK should import, or how much beef, or how many copies of Jay-Z’s latest album. The exercise is no simpler when the imports are workers.

If anything, the opposite is true. Many products can be ordered, sight unseen, from a description (“512Mb, 184-pin DIMM, DDR PC3200 memory module”). But people are not commodities. Skilled workers are usually hired with the help of referees, a CV and an interview. A committee cannot predict if a particular hiring decision will make or break an enterprise. Nor would a government committee fancy admitting unqualified immigrants, no matter how remarkable – migrant equivalents of a young Richard Branson, Alan Sugar or John Prescott would not have made it in.

This is not an argument about what the limits on foreign workers should be; it is an argument about how laughable it is to rely on a centrally planned list of what sort of work foreigners should be allowed in to do.

Here’s a crazy alternative: the government could restrict immigration simply by auctioning the right to work in the UK. Permits would have various durations (a month, a year, in perpetuity). Citizens would get a free lifetime permit; non-EU residents would have to pay, or persuade their employers to pay. The price of the permits would depend on their scarcity, a decision that might just be within the competence of the state.

As well as allowing employers and migrants to decide for themselves whether they would get enough out of the match to justify the price of admission, the auction system would raise money to help pay for the public services migrants are so often blamed for clogging up.

It would have other advantages, too. Migration hawks would have a constructive way of expressing their xenophobia: they could buy permits and “retire” them, thus demonstrating that they really did value the absence of foreigners more than others valued what the foreigners had to offer. Citizens who wanted to leave could sell their permits on the way out.

Politically impossible, of course, and perhaps impractical, too. But it cannot possibly make less sense than that list. If nothing else, the high price of permits might remind those of us lucky enough to have been born in a wealthy country how fabulously privileged we are.

Also published at ft.com.

Very few of us remember globalisation in retreat: the last great wave of globalisation swelled in the late 19th century and broke spectacularly with the onset of the first world war. After a rash of protectionism, the great depression and the second world war, the process of expanding trade (and cross-border investment and the flow of ideas and of people) resumed and has continued ever since.

Some economists now wonder if the current wave might also be about to break. The problem is not so much the rolling farce of the Doha round of trade talks, or protectionism in the US – although neither is helpful – but what the price of oil is doing to the cost of shipping goods around the globe. While oil prices have fallen in the past couple of months, they could hardly be described as low. Shipping costs may rise yet further if, as expected, the International Maritime Organisation bans the use of cheaper, dirtier fuel oils by container ships.

There is some anecdotal evidence that this is having an impact on trade: for example, some container ships are reported to be slowing down to save fuel. But there is no sign anything is amiss in the latest World Trade Organization statistics – which, admittedly, date back to 2006. The volume of merchandise trade defied high and rising oil prices to grow at more than 6 per cent a year in 2004, 2005 and 2006.

If that is surprising, perhaps it shouldn’t be. Trade has been bolstered by lower tariffs – China became a WTO member late in 2001 – and by economic growth in general. The economists David Jacks, Christopher Meissner and Dennis Novy argue that much trade has been fuelled by economic growth, rather than by a fall in the costs of trading. They also point out that those trading costs include currency risks, tariffs, customs inspections and informational barriers: transport costs have tended to comprise only a third of trading costs, and of course fuel costs are only a proportion of transport costs themselves – probably just under half, even at current oil prices.

Still, at such dizzy levels, oil prices will surely have some impact on trade. Trade may shift to low-weight, high-value products. The fuel costs of moving steel or timber are large relative to the value of the product; the fuel costs of shipping perfume or memory chips are less significant. We might also expect to see more trade in services. And trading partners closer than China – eastern Europe for the EU, Mexico for the US – may benefit. Some analysts argue that this is already happening.

This is some comfort to protectionists and to those whose jobs are directly threatened by trade, but not much comfort to the majority who benefit from cheaper products and a larger market into which their own employers may export. It is probably particularly bad news for China, which is squeezed twice by transportation costs: once while importing large quantities of raw materials, and again when exporting the finished goods.

There is a more subtle way of measuring the integration of global markets. Rather than looking at the raw volume of trade, we can check the price of similar goods (light bulbs; apples; a T-shirt) in different parts of the world. If prices are very similar across the world, markets are highly integrated. If “price dispersion” is high, then the world is not flat after all.

The economists Paul Bergin and Reuven Glick have done this exercise, and what they find is a shock: for all the globalisation rhetoric of the past decade, international price dispersion has been rising since 1997. Oil prices, of course, have also been rising since the late 1990s. Perhaps fuel costs matter after all.

Also pulished at ft.com.

Why did people murder suspected witches in renaissance Europe? And why do they still do so today in sub-Saharan Africa? As someone whose main source of information about witch trials is Monty Python and the Holy Grail, I was fascinated to learn that witch-burning has its own grim economics.

Clearly, some of the fervour for murdering women – typically elderly widows – had cultural and religious origins. In the early medieval period, the Catholic Church dismissed the idea that witches had supernatural powers, and some Church documents argued that it was heresy to believe in witchcraft. Without Church support, it’s easy to see why witch trials were not popular.

Yet when the trial and execution of suspected witches surged in the mid-16th century and throughout the 17th, it was a cross-cultural phenomenon. Trials took place in many countries and were conducted by both Protestants and Catholics, and in both secular and religious courts. Perhaps a million women were killed across Europe after being accused of witchcraft, and most of them died during this period. Why?

The historian Wolfgang Behringer has one possible explanation: temperatures dropped sharply around the time that the trials gained in popularity. The “little ice age”, in which average temperatures fell by about 1°C, was enough to freeze the Thames on many occasions.

Emily Oster, an economist at the University of Chicago, has tried to gather systematic data on the link between witch trials and the weather. The results look striking: between 1520 and 1770, colder decades go hand-in-hand with more trials. The link may be simply that witches were often blamed for bad weather. Or there may be a less direct link: people tend to lash out in tough times. There is some evidence, for instance, that lynching was more common in the American south when land prices and cotton prices were depressed.

Such deaths are, sadly, not a historical footnote. In Meatu, Tanzania, half of all reported murders are “witch-killings”. Such murders have been documented elsewhere in Africa, in Bolivia and in rural India. The difference between the historical executions and modern attacks are that a Tanzanian “witch” typically dies at the hands of her own family. The machete is the weapon of choice.

Edward Miguel, an economist at the University of California, Berkeley, and co-author of Economic Gangsters, a book about the economics of crime, corruption and war, has studied the Tanzanian situation. He argues that there is a direct economic motive for the attacks. Tough times in a Tanzanian household may well result in starvation, and the elderly – especially women – are at risk of being sacrificed to free resources.

As evidence, Miguel points out that victims of witch attacks in Meatu district – almost all old women – tend to be from the poorest households. The murders are much more common during years of drought or flood.

If the problem truly is an economic one, the solution might be, too. One possibility is to give the elderly generous pensions. Witch-killings all but stopped in South Africa’s North Province after such a pension scheme was introduced in the early 1990s. Unfortunately, such pensions are probably too expensive for Tanzania.

A grass-roots alternative has emerged in another Tanzanian district, Ulanga, where traditional healers “cure” elderly women of witchcraft by shaving their bodies and smearing their pates with “anti-witchcraft paste”. Miguel does not think it’s a coincidence that the healers also provide the women with food and shelter during famines, in expectation of payments from their families in better times. Spiritual ceremony meets social insurance: it is a solution, of sorts.

Also published at ft.com.

It’s a miserable year to be selling a house, on either side of the Atlantic. In the UK, for example, house prices fell by 1.5 per cent in April, according to the Halifax index.

Except: they didn’t. The Halifax’s own figures show that house prices rose in April, albeit by less than 0.2 per cent.

The 1.5 per cent fall, widely reported, is the result of “seasonal adjustment”, an attempt to strip out predictable calendar patterns and report just the underlying trend. House prices usually surge in April, and this April the surge was disappointing enough to be reported as a fall.

House price indices are presented in seasonally adjusted form by researchers, and reported that way by the media. That makes some sense. For anyone trying to understand the big picture, predictable seasonal gyrations just get in the way.

But for anyone trying to buy or sell a house, predictable season gyrations can’t be ignored. Nobody pays a seasonally-adjusted price. If you spend £500,000 on a house in a typical February, you might expect to have paid £530,000 had you waited until August. That £30,000 is money in your pocket, seasons or no seasons.

That raises a fairly big question. If house prices systematically surge in summer and stagnate in winter – and they do, in Belgium, France, the US and especially the UK – then why do so many people buy in summer? Why don’t we make more of an effort to buy earlier, or to wait for a few months until the market cools again?

It’s true that summer is a convenient time to buy a house. It is the season of weddings, and the time when families prepare to send their children to new schools. These are two popular reasons for moving home. House-hunting is nicer in the sunshine, too. But surely these conveniences aren’t worth tens of thousands of pounds?

Another possibility is that summer house-buyers save on expensive summer rents, or that mortgage finance is cheaper. But no: neither rents nor mortgages fluctuate with the seasons.

A new research paper – still at a preliminary stage – by Rachel Ngai and Silvana Tenreyro of the London School of Economics, offers a solution to the puzzle. Start with the observation that, unlike a car or a laptop or a share in Coca-Cola, every house is a little different. Any particular house may match a family’s needs awkwardly or perfectly. Finding out just how well a given house suits you is also a costly and time-consuming business.

That means that buyers like to house-hunt in “thick” markets, when lots of houses are for sale, and a very good fit is likely to come up quickly. It is no fun to house-hunt in a “thin” market, where the meagre crop of houses is unlikely to offer up the dream home.

If Ngai and Tenreyro are right, then the housing market dynamic is something like this: buyers slightly prefer to buy houses in the summer, so house prices are slightly higher in the summer, so sellers prefer to put their houses on the market in the summer, and with more houses on the market, the market is thicker. That means that buyers are more likely to find the exact house they want, and so are willing to pay more; with prices higher, more sellers are attracted into the summer market, and fewer will contemplate selling in the winter. And so on. The self-reinforcing process can produce a large gap between summer and winter prices.

So by all means, wait until winter in the hope of getting a cheaper house. But remember, a cheaper house is not necessarily a better deal – unless you are not very fussy about how well it suits you.

Also published at ft.com.

While marketers and psychologists have long known that you can fool all of the people some of the time and some of the people all of the time, it has taken economic theory a little while to catch up with the idea. Most economic models are populated by decision-makers who have more in common with the cool-headed logician Mr Spock than the impulsive and self-destructive Homer Simpson.

There are good reasons for that. The main argument of my last book was that Spockish behaviour is far more common than most of us appreciate. But unSpockish behaviour certainly exists. Popular discussions of economic psychology tend to start and end with that observation. Yet there is much more to be said, and many economists are now exploring the real-world implications of different brands of unSpockishness.

One useful distinction is between the kind of irrational behaviour so often displayed by Homer Simpson, and that displayed by Odysseus. When Odysseus ordered his sailors to tie him to the mast, it was because he knew that he was weak-willed and would be tempted to his doom by the song of the Sirens. Homer Simpson is also weak-willed, but he lacks the foresight to do anything about it. (Classicists will recall that Odysseus was forewarned by Circe, but Homer is often forewarned by his wife Marge, to no avail.)

Odysseus is sophisticated but “time-inconsistent” – a term that means his preferences change when temptation rears its head. Homer Simpson is both time-inconsistent and naive.

Imagine – I realise this sounds like some bizarre joke – how Mr Spock, Odysseus and Homer Simpson would go about applying for membership of a gym. Spock would choose a suitable contract – a costly payment per visit, or an annual flat-fee for unlimited visits – after correctly forecasting his gym usage. Simpson, wrongly expecting that he would use the gym a lot, would sign up for the expensive annual membership. Odysseus might also choose the annual membership, but for a different reason: he would hope that the “all-the-iron-you-can-pump” contract might provoke him to exercise, despite the foreseeable temptation to stay in bed.

Even if Odysseus and Homer did both choose the same contract, the distinction between them as men still matters. The economists Ulrike Malmendier and Stefano DellaVigna have shown that a government regulator cannot make Odysseus better off. Odysseus will be able to exercise as much as Spock, and for the same price, but will do so by cleverly planning ahead and choosing the contract that will prompt him to do so.

Homer, by contrast, will pay too much and exercise too little, which means that in principle a sufficiently wise and benevolent regulator could save him from himself. Even a clumsy regulator might help Homer by yelling at him not to be an idiot.

The Spocks, Simpsons and Odysseuses of the world face many strange contracts. DellaVigna and Malmendier – whose most famous research paper is titled “Paying Not to Go to the Gym” – have taken inspiration from trying to spot and decipher them. We are all familiar with the odd practice of offering annual gym memberships – and with the naive Homer Simpsons who sign up for them anyway. Subscriptions to worthy magazines and to sophisticated film rental clubs fit much the same mould. In each case, customers are likely to struggle to “consume” as much as they intended, and so prices are front-loaded.

But products priced the other way around are probably more common: credit cards offer “teaser” rates, while customers who sign up for a mobile-phone contract pay nothing for their expensive phone. The companies who offer such contracts expect that customers will binge, consuming more than they expected. That is one reason why they fight with each other to sign up the customers in the first place – and the Homer Simpsons are the juiciest catches of all.

Also published at ft.com.

At tomorrow’s closing ceremony, the Olympic flag will be handed over to London; the next Olympic Games are to be hosted just down the road from the Undercover Economist. Should we east Londoners expect great things?

A wonderful sporting spectacle is assured, but that will be available to anyone with a television or a tourist visa. Not that the world necessarily queues outside the Olympic stadium: fewer people visited Barcelona in 1992, its Olympic year, than in 1991.

If a sporting spectacle was all that was promised, the games would be an unproblematic affair. The Los Angeles games in 1984 focused on the sport, using existing facilities and renting student dorms instead of building an athletes’ village. It turned a huge profit.

Yet few Olympics since then have followed that model. Most aim to leave a legacy, and it is there that the prospects look a bit shakier.

One possibility – emphasised by Lord Coe, the chairman of London 2012’s organising committee – is that the Olympics inspire the nation to spend less time in its collective armchair. No doubt that will happen, but whether the money might have been better spent on grassroots sports (or, indeed, paying off the national debt) is unclear.

Two economists, Stefan Szymanski of City University and Georgios Kavetsos of Imperial College, London, recently surveyed more than 750 managers of sports facilities across the UK, and found that while they were generally bullish about the power of the 2012 Olympics to inspire people to take up sport, almost half of them expected no effect or a negative effect at their own facilities. It seems that while it is easy to be impressed by an abstract feelgood factor, it is harder to pin down specific benefits. Tomorrow’s Olympians may be inspired by today’s, but casual exercise is inspired by easy access to decent local facilities – the sort of local facilities that may be squeezed out by Olympic spending.

Beyond the sporting legacy, there is the much-vaunted economic regeneration of east London. Such regeneration will, of course, do nothing to help Cornwall or Belfast, but that is a red herring. Most government projects are local, and many are paid for by tax revenue from London. Frankly, it’s our turn.

The more important question is whether the area’s regeneration will prove a wise investment or a waste. Time will tell, since government regeneration projects can work well, or badly.

The regeneration plans are uncontroversial enough. London needs more houses. Better transport links in London are long overdue – although Stratford, the Olympic site, is already very well connected to Europe’s richest job market. What divides Stratford from the City will not be bridged by adding a few trains.

But this is nothing to do with the Olympics. Why are the games supposed to have some magical regenerative effect? More likely, the regeneration will be rushed to meet games-related deadlines, while the games will shift bureaucratic priorities in favour of east London. That is hardly helpful.

The only advantage in bundling the games with a regeneration project is that expectations of regeneration can become self-fulfilling. Any serious urban rebirth is going to be built on private housing and private business. In part that is a confidence trick: if everyone expects regeneration to happen, it will. And perhaps, just perhaps, the lustre of the games can create confidence where government proposals merely to spend a few billion pounds will not.

Regenerating east London is thoroughly worthwhile – if only we could work out how to do it. But as far as the games are concerned, why all the fuss? One wise Olympic official complained of the “exaggerated expenses” incurred in staging them, reminding us that “temporary structures would fully suffice”. That was Pierre de Courbertin, founder of the modern Olympics, writing in 1911.

Also published at ft.com, subscription free.

For many business owners, getting the most out of staff is a perennial problem. In the case of fruit farmers, perhaps perennial is the wrong word: workers show up only for the summer harvest. In a couple of weeks they will be heading home, usually to a university course somewhere in eastern Europe.

Tough work for the fruit pickers, the business is also a headache for the owner, who must offer a pay scheme that both satisfies minimum wage laws and motivates workers in an industry in which slacking is an understandable temptation.

The owner of a large fruit farm business, “Farmer Smith”, was pondering the problem one Christmas, when he discovered that the connection between pay and performance was also an area where economists were scratching around for solid evidence.

And so an unlikely alliance was formed between Farmer Smith and the economists Oriana Bandiera, Iwan Barankay and Imran Rasul. The economists would design and administer pay schemes, and in exchange for that (and for confidentiality) Farmer Smith would let them treat his business as a gigantic laboratory for researching the nexus between pay, workplace friendships (which they mapped out) and workers’ productivity.

The owner had been paying a piece rate – a rate per kilogram of fruit – but also needed to ensure that whether pickers spent the day on a bountiful field or a sparse one, their wages didn’t fall below the legal hourly minimum. The owner tried to adjust the piece rate each day so that it was always adequate, but never generous: the more the workforce picked, the lower the piece rate. But his workers were outwitting him by keeping an eye on each other, making sure nobody picked too quickly, and thus collectively slowing down and cranking up the piece rate.

Bandiera and her colleagues proposed a different way of adjusting the piece rate – one that workers could not influence with a collective go-slow – and measured the result. By the time the experiment was over, Farmer Smith’s initial scepticism had long evaporated: the new pay scheme increased productivity (kilograms of fruit per worker per hour) by about 50 per cent.

The next summer, the researchers turned their attention to incentives for low-level managers, who would also be temporary immigrant workers, but who would be responsible for on-the-spot decisions such as which workers were assigned to which row. The researchers found that managers tended to do their friends favours by assigning them the easiest rows. This made life comfortable for insiders, but was unproductive, since the most efficient assignment for fruit picking is for the best workers to get the best rows.

The researchers responded by linking managers’ pay to the daily harvest. The result was that managers started favouring the best workers, rather than their own friends, and productivity rose by another 20 per cent.

Small wonder that the economists were invited back for another summer. They proposed a “tournament” scheme in which workers were allowed to sort themselves into teams. Initially, friends tended to group themselves together, but as the economists began to publish league tables, and then hand out prizes to the most productive teams, that changed. Again, workers prioritised money over social ties, abandoning groups of friends to ally themselves with the most productive co-workers who would accept them. In practice that meant that the fastest workers clustered together, and again, productivity soared – by yet another 20 per cent.

The series of experiments provided a fascinating confirmation that financial incentives can trump social networks, with some precision and much detail about the mechanisms involved. Bandiera and her colleagues have now stopped the experiments, in the belief that there is nothing more to be gained from this particular seam of inquiry. The owner does not seem to agree: he’s hired a consultant to keep on hatching new performance pay schemes.

Also published at ft.com, subscription free.

When people discover that I am an economist, they rarely ask me for my views on subjects that economists know a bit about – such as how to respond to climate change or pay less at a supermarket. Instead they ask me what will happen to the economy.

Why is it that people won’t take “I don’t really know” for an answer? People often chuckle about the forecasting skills of economists, but after the sniggers die down, they keep demanding more forecasts. Is there any reason to believe that economists can deliver?

One answer can be gleaned from previous forecasts. Back in 1995, the economist and FT columnist John Kay examined the record of 34 British forecasters from 1987 to 1994, and he concluded that they were birds of a feather. They tended to make similar forecasts, and then the economy disobligingly did something else, with economic growth usually falling outside the range of all 34 forecasters.

Perhaps forecasting technology has moved on since then, or is the British economy unusually unpredictable? To find out, I repeated Kay’s exercise with forecasts for economic growth for the UK, US and Eurozone over the years 2002-2008, diligently collected at the end of each previous year by Consensus Economics.

The results are an eerie echo of Kay’s: for 2004, for example, 20 out of 21 non-governmental forecasts made in December 2003 were too pessimistic about economic growth in the UK. The Pollyannas of HM Treasury were more optimistic than almost any commercial forecaster, and closer to getting their forecast right. So one might suspect that systematic pessimism is to blame.

But no, in 2005, the economy grew more slowly than 19 out of 21 forecasters had expected at the end of the previous year. At the Treasury, they were again more optimistic than anyone, and thus more wrong than anyone. A year later, all but one of the forecasters were too pessimistic again. Yet at the end of 2001, three quarters of the forecasters were too optimistic about 2002.

An interesting anomaly is 2003: the one year for which the average UK forecast turned out to be close to reality, but also the year where the spread between highest and lowest forecast was widest. The rare occasion when the forecasters couldn’t agree happened to be the occasion on which they were (on average) right.

Recent US forecasters have done a little better: the spread of forecasts is tighter and the outcome sometimes falls within that spread. Still, five out of six were too pessimistic about 2003, almost everyone was too pessimistic about 2002; three-quarters were too optimistic about 2005 and nearly nine-tenths too optimistic about 2006. Perversely, the most accurate forecasts were made about 2007, despite the fact that the credit crunch was a surprise to many.

In the Eurozone, forecasting over the past few years has been so wayward that it is kindest to say no more.

The new data seem to confirm Kay’s original finding that economic forecasters all tend to be wrong in the same way. Their incentives to flock together are obvious enough. What is less clear is why the flight of the flock is so often thought to augur much – but then, some astrologers are also profitably employed.

The curious thing is that forecasters often have something useful to say, but it is rarely conveyed in the numerical forecast itself on which so much attention is lavished. For instance, in December 2006, British forecasters were warning of the risks of an oil price spike, a sharp rise in the cost of credit, and a dollar crash. Their guesses at economic growth were wrong, and would have been little use had they been right. But the forecasters said something worth hearing – if you had been listening carefully enough.

Also published at ft.com, subscription free.

Going overdrawn can be an expensive business. In the UK, unauthorised overdrafts averaged £680m on any given day in 2006 – just over £10 per bank account. According to the Office of Fair Trading, the charges levied by banks on those overdrafts were £1.5bn, a tasty return of more than 220 per cent. Banks also make money by paying risible interest on positive balances – an incentive to keep your current account lean and, Doh!, to overdraw accidentally – and by other obscure charges. The Office of Fair Trading doesn’t like it and nor do many customers – although they rarely express their displeasure by switching bank accounts.

There are two common responses. People either grumble about money-grabbing banks or point out, smugly, that if only others would manage their affairs responsibly, they wouldn’t incur any of these charges.

There’s a certain amount of truth in both responses. Yes, banks are money-grabbing, but healthy competition would keep the greed in check. And, yes, careful customers are being subsidised, heavily, by careless ones. The trouble is that the whimsicality of the pricing makes it hard to find out which bank is offering a good deal. Most people realise that overdraft charges are steep, just as they realise that popcorn in cinemas is expensive and mobile-phone companies will all but pick your pocket if you make calls overseas. Knowing this doesn’t make it easy to find the best product, which means competition won’t work well. When competition works poorly, many customers lose out – even those who bring their own snacks to the cinema and use public phones on holiday.

So what’s the solution? One possibility is for regulators to step in and set price ceilings in such cases, or to ban more complex offerings. But once the tourism office starts fixing the price of a can of Heineken in your hotel fridge, that spells ossification and bad news for consumers in the long run.

Another possibility is better financial education – unobjectionable in itself, but an indirect attack on the problem of complex tariffs. The severity of that problem was clear when two economists, Chris Wilson and Catherine Waddams Price, tracked the attempts of customers to switch to cheaper electricity tariffs. Most picked up less than half of the available gains, and a quarter made themselves worse off.

I have heard one really good – and, I believe, genuinely new – solution, presented in the book Nudge, by Cass Sunstein, a law professor, and Richard Thaler, an economist with a particular focus on flaws in people’s decisions.

They advocate a system of mandatory electronic disclosure. Regulators would specify a standard electronic format in which banks would have to disclose all their fees and charges, and how they intersected with what the customer had actually done. (The idea could also work for credit cards, mobile phone services and others.) Each year, customers would receive an electronic file itemising exactly what they had done and exactly what it had cost them.

Thaler and Sunstein anticipate – correctly, I suspect – that if such electronic files existed in a standard format, other companies (Morningstar? Google? Microsoft? FT.com?) would quickly set up their own services. You would take your electronic bank account statement, upload it to Google Consumer, and be told in plain English how your bank had screwed you, and which bank would do a better job, given your particular banking habits. Even those who couldn’t or wouldn’t use such electronic advice would benefit from the sharpening of competition it would engender.

Implementing the idea may not be easy – but for those of us who think competition can occasionally be given a helping hand, it seems worth trying.

Also published at ft.com, subscription free.

Humans don’t take kindly to outsiders: history is heaped with the corpses of those who were lynched, bayoneted or gassed because of their race, religion or nationality. Even within the relatively civilised sphere of economic relations, there is plenty of room for discrimination. People earn less because of their race or their sex, even in the richest countries in the world.

For example, according to a recent summary by the economists Michael Clemens, Claudio Montenegro and Lant Pritchett, white men earn 27 per cent more in the US than white women. That figure compares the hourly wage of full-time workers with similar qualifications and experience. Again making best efforts to compare like with like, the economists found that white men earn 7 per cent more than black men in the US. Look back to 1939, and the like-with-like wage premium for whites in the US was 60 per cent. In modern Pakistan, meanwhile, men earn three times as much as equally qualified women. None of these numbers is trivial: most are appalling.

It is even possible – although perhaps only an economist would think it pertinent – to calculate the implicit wage loss suffered by US slaves. Several economists have attempted to do this by comparing the “compensation” – food, clothes, shelter and perhaps some medical care – received by slaves with how much one slave-owner would pay another to rent a slave. Of course, low wages were hardly the chief reason that slavery was an atrocity. Yet had slaves earned for their labour what slave-owners paid each other for it, the wage would have been three or four times higher than the basic subsistence owners saw fit to provide.

There is a huge gap between what slaves would have earned in a free labour market and what in fact they were forced to accept. But the gap is dwarfed by the difference between what a Nigerian-born, Nigerian-educated man could earn in the formal sector in Nigeria, and what he could earn if allowed to work in a rich country – more than eight times as much. Nigeria is an extreme example, but there are many other countries in which all that would be needed to quadruple or quintuple a person’s income would be permission to work in a rich country. Restrictions on immigration cause a greater loss of wages than racial and sexual discrimination – and perhaps greater even than slavery. This is what Clemens and his colleagues call “the great discrimination”.

This is unquestionably a research paper with an agenda: Lant Pritchett is a vocal advocate of more liberal immigration rules. Despite the agenda, I see no reason to doubt the numbers. Migrants from very poor countries see huge leaps in wages if allowed to move to wealthy countries – that much is obvious. The question is whether voters in wealthy countries feel morally obliged to take those gains into account. So far, they don’t.

Economists have a habit of poking these sore points. Steven Landsburg, author of The Armchair Economist, secured notoriety four years ago by labelling the vice-presidential candidate John Edwards a “xenophobe”, arguing that his protectionism arbitrarily privileged Americans over foreigners and was no better than arbitrarily privileging whites over blacks. Few non-economists see things that way.

Economists have always tended to be blind to distinctions of race, sex and nationality. In 1849, Thomas Carlyle branded economics “the dismal science” for its insistence that a market wage set by supply and demand was superior to slavery and what Carlyle called the “beneficent whip”. His view is now rightly branded abhorrent.

I have no idea how immigration barriers will be viewed by our descendants. But it is worth reflecting, if only for a moment, on the costs they impose on those trapped on the other side.

Also published at ft.com, subscription free.

Seebohm Rowntree was the son of the wealthy Quaker businessman Joseph Rowntree, but acutely aware of the poverty that surrounded him in late-Victorian York. In 1899 he set himself the task of defining a “poverty line” by working out how much it would cost to supply basic food, housing and clothes. Anyone who couldn’t afford to buy those basics – including a helping of pease pudding with bacon on Sunday – was below the poverty line.

The idea of a poverty line has stayed with us, but the candidates have multiplied. The World Bank has two poverty lines: a dollar a day and two dollars a day (strictly, those are 1985 dollars adjusted for inflation). In the US, the poverty line is $29.58 a day for a single adult under the age of 65. All these are absolute income standards, just as Rowntree’s was.

Eurostat, the European Union’s statistics agency, takes a different approach: it defines the poverty line as 60 per cent of each nation’s median income. (The median income is the income of the person in the middle of the income distribution.)

This has an unfortunate consequence: poverty is permanent. If everyone in Europe woke up tomorrow to find themselves twice as rich, European poverty rates would not budge. That is indefensible. Such “poverty” lines measure inequality, not poverty, and they do so clumsily.

On the other hand, absolute standards of poverty are creepy, reliant as they are on expert definitions of a nutritionally balanced diet. (Rowntree was a Victorian philanthropist, so we’re willing to make allowances.) The US definition dates back to early 1963 and the efforts of a Social Security Administration researcher called Mollie Orshansky. Lacking decent statistics, she based her poverty line on government nutritional advice. It was a decent estimate given the limited resources of the time, yet the threshold has changed only to take account of inflation.

So, the US definition of poverty is stuck in the 1960s. Had Seebohm Rowntree been working for the US government, perhaps it would now have a poverty standard based on the price of pease pudding, and which assumed that electricity and indoor plumbing were luxuries. This cannot be right.

Adam Smith put his finger on the problem back in 1776. In The Wealth of Nations, he wrote: “A linen shirt, for example, is, strictly speaking, not a necessity of life. The Greeks and Romans lived, I suppose, very comfortably though they had no linen. But in the present times, through the greater part of Europe, a creditable day-labourer would be ashamed to appear in public without a linen shirt …”

Smith’s point is not that poverty is relative, but that it is a social construction. A person can lack the money necessary to participate in society. Whatever Eurostat may say, people don’t become poor just because the median citizen receives a pay rise, but they may become poor if something they cannot afford – such as an internet connection – becomes viewed as a social essential.

That is why a new unofficial poverty threshold, published this month by – appropriately – the Joseph Rowntree Foundation, makes more sense than it at first appears. The standard was set by focus groups working out what was and was not necessary “to participate in society”.

The results are frugal – there is a budget of £40 every two years to buy a suit, for instance – but they were always bound to be controversial. The list of essentials includes a self-catering holiday, a mobile phone and enough booze to get drunk twice a month.

But the new threshold’s apparent weakness – its subjectivity – is in fact its strength. Poverty is not relative and it cannot be objectively determined by an expert. Adam Smith understood that very well.

Also published at ft.com, subscription free.

When the economy is in turmoil, no one is demonised more than the speculator. First, we are told, speculators have driven up the price of oil, condemning us to expensive heating and motoring. Then, they have driven down the price of bank shares, dealing vicious blows to the City’s noblest banks. All of this, we are supposed to believe, is immensely profitable and highly destabilising.

With one exception – that I’ll come to – I am not persuaded. I struggle to understand how speculation is supposed to be both profitable and destabilising, all at once. Profitable speculation requires buying low and selling high. Destabilising speculation requires the opposite: short-selling shares in a trough, thus deepening the trough, and betting that frothy shares will become frothier. In other words, destabilising speculation means selling low and buying high. If that is a recipe for profit, I am missing something.

Profitable speculators, in contrast, are veritable philanthropists. When they think oil is going to become more expensive, they buy and hoard oil, or they buy oil futures, encouraging others to buy and hoard. This raises oil prices when they are relatively cheap, and lowers them later when they are relatively expensive. (The corollary, incidentally, is that if central banks lose money when “stabilising” the currency, stabilisation is precisely what they failed to achieve.)

True, when speculators make mistakes, that is destabilising. But in the case of oil prices, it’s hard to see that speculators are playing much of a role. For one thing, inventories don’t seem to be rising; if the inventory data is correct, consumers were burning all that $145 oil.

For another, speculation and prices don’t seem to be closely correlated. BP’s recent Statistical Review of World Energy points out that while few speculators have been betting on a spike in the price of heating oil, its price has soared even more rapidly than the crude-oil price. More striking, speculators have been betting that natural gas prices will slump. Natural gas prices haven’t.

If the intellectual case against speculators is weak, one can always fall back on the emotional one. Short-sellers are a particularly easy target: their hope that prices will fall hardly seems constructive. It is not much of a stretch to move from abhorrence at the idea of short-selling to the implausible conclusion that it is the short-sellers who are dragging down prices. As the great investment writer Fred Schwed Jr commented: “Only the thoughtful ask, ‘What is happening to us?’ The popular cry is, ‘Who is doing this to us?’ and its satisfying sequel – ‘Just let me get my hands on him!’”

In some rare cases, the short-seller really is the one causing the problem. For example, it might be possible to sell a retail bank’s shares short, start unfounded rumours about the bank’s liquidity and cause a run on the bank, making the rumours self-justifying, destroying a valuable asset and making money into the bargain. We should never feel comfortable about short-sellers who also (independently of their short-selling) possess the power to destroy – be they rumour-mongers, board members, or just a sportsman backing himself to lose.

This is the exception mentioned earlier. But I can’t help feeling that the “sell-short, start rumour, make a killing” strategy is more easily planned than executed.

No, the world needs more speculators, especially of the short-selling variety. There is nothing inherently wonderful about inflated prices, but it is not easy to bet that prices will fall. More short-sellers in the dotcom bubble of the late 1990s, and the housing bubbles of the past few years, would have added a welcome dose of stability and sanity. Alas, there were not enough short-sellers – and given the amount of money they were losing at the time, the only people complaining about them were their impoverished families.

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We’ve known for a century that laboratory rats choke under pressure. Back in 1908, two researchers, Robert Yerkes and John Dodson, repeatedly placed rats in a cage and gave them a choice between two pathways. Each time, one of the pathways was lined with black card and delivered an electric shock; the other pathway was lined with white card and was safe.

Yerkes and Dodson varied the intensity of the shock: some rats always got a ferocious zap, other rats always got a mild buzz. The rats which learned quickest were the ones receiving neither mild shocks nor strong shocks, but shocks somewhere in the middle. When the “incentive” to learn was too big, the effect was counterproductive.

So much for rats. Is the same true of humans offered financial incentives? To answer the question, four economists, Dan Ariely, Uri Gneezy, George Loewenstein and Nina Mazar, decamped to rural India to conduct an experiment. They knew that when the experiment’s volunteers were very poor, it would be easier to pay them enough money to make heads spin and hands shake.

The researchers paid bonuses if the volunteers were able to complete assorted mental and physical challenges. The tasks varied from physical ones, such as throwing balls at a target, to concentration-based challenges, such as bashing away on Simon, a toy from the late 1970s that requires the player to memorise sequences of colours.

Just as with Yerkes’ and Dodson’s rats, the participants were offered low, medium and high incentives. Some of the participants stood to win up to a day’s income, others about two weeks’ income, and those with most to gain could, in theory, have scooped about six months’ income. But they didn’t: instead, they choked under the pressure.

Those on low or medium incentives managed to win just over 35 per cent of the available money, while those on the highest incentives cracked, winning less than 20 per cent. (If hell was designed by behavioural economists, sinners would be forced to play Simon for their souls.)

However, one does not need to torment Indian villagers to observe choking under pressure; it is much more fun to torment professional footballers. The torture of choice is the penalty shoot-out, now widely used as a tiebreaker in the most important games, including the most recent Champions League and World Cup finals.

In a penalty shoot-out, each team takes it in turn to try to score a goal from the penalty spot. There might well be additional pressure on the second team, because most penalty attempts are successful, and so the second team tends to be trying to catch up rather than draw ahead.

Between 1970 and 2003, the team which went first was chosen randomly. Since 2003, a coin-toss has given one captain the chance to choose whether to go first or second. That rule change gave two economists, Jose Apesteguia and Ignacio Palacios-Huerta, an opportunity to investigate pressure in a seriously high-stakes environment.

They found that before 2003, the team lucky enough to be forced to go first won more than 60 per cent of the time. This is a huge advantage, and professionals are well aware of it. Since the rule change, most captains have chosen to go first when given the option.

Yet there are exceptions. The Italian team recently lost a penalty shoot-out to the Spanish after their captain, Gianluigi Buffon, won the toss and chose to go second. He might have had a different perspective: as the team’s goalkeeper, when his team-mates shot second, he was able to go first. Whatever the reason, the choice backfired, as history would have suggested.

Professors Apesteguia and Palacios-Huerta are delighted with the result. Presumably this is because it is a powerful vindication of their research, and not because they are Spanish.

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My mother-in-law’s favourite complaint is that the government ignores the interests of rural communities in favour of cities. I was reminded of that view when reading a recent report from the UK’s “Rural Advocate”, a government appointee whose job is to worry about such things. Stuart Burgess argued that rural areas were not living up to their potential, in part because of a lack of government support.

This isn’t a uniquely British trait. Proclaiming support for rural areas is de rigueur for a US presidential candidate. (Barack Obama: “If Washington continues policies that work against America’s family farmers, our rural communities will fall further behind.” John McCain, although lukewarm on government-funded anything, would make an exception for better internet access: “Government has a role to play in assuring every community in America can develop that infrastructure.”)

But who really gets the bad deal: the rural hicks or the city slickers? Urban areas are, on average, richer than rural ones, but it is a real stretch to blame that fact on a lack of government support.

Rural areas get plenty. There are the agricultural subsidies, of course. But there are also bizarre handouts – The New York Times pointed out in 2006 that Wyoming was receiving more than five times the anti-terrorism funding, per person, than New York State. The ordinary workings of the tax system distribute money to rural areas, too: according to a report published by Oxford Economics last year, Londoners pay £1,740 per person more in taxes than they receive in public services; the average resident of largely rural Wales enjoys £2,870 more in public spending than he or she pays in taxes. Per person, rural areas have more roads, miles of phone line, gas pipe and electricity cable than urban ones – funded either directly by the government, or indirectly through regulated companies.

Rural areas are not struggling because of a lack of government support. They are struggling for the obvious reason: a lack of density is a serious disadvantage. Spread over greater distances, more spending on roads, public transport subsidies, or broadband internet provides less in the way of results. Even when infrastructure is good, mere distance may make it hard to get to the closest hospital, library or Michelin-starred restaurant. With thinner labour markets, both rural employers and employees have to make the best of imperfect job matches.

Most importantly, rural areas are terribly vulnerable to economic change and the inevitable creation and destruction of jobs. If a large business shuts its doors in London or New York, sacked employees can be in job interviews for comparable positions within a few days. If the same closure happens in a small town there are no alternatives, and if you want to sell your house and move somewhere with better job prospects, you’ll find few buyers.

The rural advocate admits that rural economies enjoy high “inputs” (new businesses, educated workers, lots of “knowledge businesses”) but low “outputs” (jobs, wages). He hopes that the situation can be corrected, but I strongly suspect that it is as inevitable as the fact that few city dwellers have large gardens.

While the government can – and does – try to help deal with these disadvantages, it can only do so much. The same is true of the advantages and disadvantages of urban life. It’s not impossible that the government could provide some decent inner-city schools – although from where I live in Hackney, the prospect still seems remote. But it is impossible that government assistance could give all Londoners cheap homes and traffic-free streets.

Sometimes my wife and I grow tired of the inconveniences of urban living. I suppose we could always swap places with my mother-in-law.

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In the early hours of November 8 2000, the vice-president of the United States, Al Gore, was travelling to Nashville to make his concession speech. But then the messages began to arrive on Gore’s pager, suggesting that perhaps he wasn’t behind. Having already conceded, informally and in private, Gore called Bush again to tell him that he’d changed his mind.

November 8 was not the only pivotal date. On December 8, the Florida Supreme Court ordered a recount in certain counties, raising the chance that Gore would win. On December 13, after the federal Supreme Court halted the recount, Gore conceded to Bush.

Because these sudden decisions were hard to anticipate, they provide an excellent test of the value of political connections to listed companies. If politics means profit, a “Republican” company should have taken a knock on December 8, but surged on December 13, when Bush’s victory was confirmed.

A recent study by financial economists Eitan Goldman, Jongil So and Jorg Rocholl found exactly that: Republican companies beat the market by 3 per cent over the week after Bush’s victory was assured; Democratic companies took almost a 3 per cent knock. Goldman, So and Rocholl defined “Republican” companies as those with board members who had served as Republican senators or congressmen or members of a Republican administration, and with no Democratically connected board members.

Another example: in May 2001, Senator Jim Jeffords abruptly left the Republican party to become an independent senator. That decision handed control of the Senate and its committees to the Democratic party. Seema Jayachandran, an economist at UCLA, studied the market’s reaction and concluded that it was bad news for the share price of large companies that had donated to the Republicans. The gains to Democratic donors were not as large, so the total effect was to wipe $84bn off the price of US shares.

Broadly the same story seems to hold true internationally, and Thomas Ferguson, a political scientist, and Hans-Joachim Voth, an economist, have shone a light on a ghoulish example. Adolf Hitler was appointed chancellor of Germany in January 1933 as head of a coalition government; after the Reichstag fire, a snap election and a constitutional change, the Nazis had a stranglehold on power by the end of March. There was a surge in the stock market valuation of the (mostly large) companies who tied their fortunes to the Nazis between January and March 1933.

The question, of course, is why these political connections are valuable. Perhaps the intelligence and energy that propelled Tony Blair and Al Gore to high office would have justified their work with, respectively, JPMorgan and Apple, irrespective of any political connections.

A less comforting possibility is that political connections give companies access to the regulations that suit them, or to juicy government procurement contracts. Goldman, Rochol and So have found evidence that such contracts do seem to flow to companies affiliated with the party in power.

If so, that is a disgrace, if not entirely a surprise.

But not every study reaches this conclusion. Economists Ray Fisman, Julia Galef and Rakesh Khurana, and the epidemiologist David Fisman, have tried to estimate the value of personal ties to Dick Cheney. One strategy was studying the share price of Haliburton – where Cheney was CEO from 1995-1999 – when news broke of his heart problems. The estimated value of ties to Cheney? Zero – “precisely estimated”. It would be nice to feel sure of that.

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Last week I mused about whether people in general were saving enough for retirement. (The answer: as far as we can tell, most people are.) This week I have decided to take on a far more important question: am I saving enough for retirement?

Apparently this activity is called “retirement planning”, which strikes me as a silly phrase given the imponderables involved.

Saving for retirement is usually posed as a problem of willpower: foolish, impatient people save too little and doom themselves to an old age devoid of Caribbean cruises. The real problem is not lack of willpower but lack of omniscience.

Hip kid that I am, I started my planning by opening up a spreadsheet. The next steps would have been to project the growth rate of my income, monthly savings, the path of inflation, the return on my growing savings pot, and (eventually) the likely annuity rate on retirement.

That all seemed like hard work, so I shut down the spreadsheet and searched for an online pension calculator instead. These products allow you to type in your basic details and let the computer do the rest. The first British calculator I found, kindly provided by the Department for Work and Pensions, told me that I could collect my state pension when I was 67. This was useful news, but only mildly so, since the DWP did not deign even to guess at what the state pension would be worth in 2040.

Other calculators proved a bit more helpful, but relying on them is a hazardous business, not least because they are often provided by companies trying to sell retirement investments.

Most of them were applying smooth growth rates to judge the growth of my salary and my pension pot. This did at least give me a sense of how much saving is required to produce a certain income, and how much difference early or late retirement might make. I had thought that my hefty regular contribution to my personal pension was likely to be overkill; a retirement calculator informed me that it was nothing of the sort.

But beyond that, those smooth capital-growth curves, so easy for computers to generate, are misleading. Not only do they not incorporate in any realistic way the gyrations of the stock market; more profoundly, they cannot deal with uncertainty over whether I will leap to the top of the corporate ladder in my fifties, be sacked, or be forced to retire because of ill health.

Nor can they tell me when I will die. I have read that the industry rule of thumb is that I should assume I’ll live two years longer than my father did. Happily my father is still alive, and if he wasn’t, I wouldn’t have to plan for any retirement at all. The rule of thumb is utterly useless for most people under the age of 40; which is awkward, since another industry rule of thumb is that you should start planning for retirement in your twenties.

These are not problems of willpower; they are problems of guessing the future in an uncertain world. Insurance, not investment, is what is in short supply. And it matters: research based on surveys of people’s income and consumption suggests that the people who really suffer in retirement do so not because they were spendthrifts but because they were forced to retire sooner than they had expected.

The sensible approach seems to be not to try to foretell the future, but to buy critical illness insurance when it is available on sensible terms, check occasionally with a retirement calculator that you are vaguely on track, and hope for the best.

Most of us manage this, but “retirement planning” just doesn’t come into it.

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Here’s the conventional wisdom on pensions: you’re a weak-willed and short-sighted fool who isn’t saving enough, and as a result you will spend your retirement in poverty. The US press is loaded with hand-wringing on the subject – largely, although not exclusively, based on “research” from companies who sell pensions and investments. In the UK, the definitive statement was made by Adair Turner’s Pension Commission in 2004: “Most people do not make rational decisions about long-term savings without encouragement and advice.” Ouch.

The sense of impending doom has been deepened by the realisation that both corporate pension schemes and implicit pension promises from governments may have too little cash behind them. That may be true, but it is only indirectly relevant to the question of personal pension saving.

One of the results of this nervousness has been a search for ways to encourage people to save more: tax breaks and enrolment by default, for example.

But look more closely, and it is far from obvious that there is a serious and generalised problem with personal pension saving. It’s hard to say for sure, partly because the future is unknown and partly because it’s hard to say exactly how much money should be in a sensibly funded pension. For example, if someone is making £60,000 a year, what pension income would count as sensible? £75,000 would probably be excessive – but what about medical and long-term care costs? £25,000 a year seems low, but many people get by happily on less.

Yet economists have been gamely making the effort; they look for “consumption smoothing” as a sign of sensible saving. In practice that means that aiming to consume about as much after retirement as before. But even that simple comparison can be misleading. The economist Erik Hurst has recently calculated that while most American households do cut back on spending after retiring, that does not literally mean tightening their belts: the cutbacks mean spending less on commuting and work clothes. Spending on food also falls, but the retirees eat just as well: they simply spend more of their plentiful leisure time cooking at home. Spending on entertainment and donations to charity increase. No sign there of a penurious dotage.

An admired analysis of retirement saving was published in 2006 in the Journal of Political Economy by John Karl Scholz and two colleagues. They concluded that more than 80 per cent of Americans seemed to be on track to retire with enough money in the bank; the remainder were mostly not far short of sensible savings. Another economist, Laurence Kotlikoff, is famous for his calculations that the US government has run up a staggering implicit debt in the form of Medicare and social security promises, but seems sanguine about private saving. Kotlikoff believes that the savings plans that tend to be recommended by the “retirement calculators” on investment company websites recommend saving too much and buying too much insurance. (Kotlikoff is now marketing his own retirement calculator.)

So should we be more relaxed about personal pensions? It’s hard to be sure. Some people do suffer impoverished retirements, but they tend to fall into two categories: those who were poor for most of their lives anyway, and those who unexpectedly lost their jobs or their health in their fifties. In neither case is “more saving” the answer to the problem.

The adequacy of personal pensions in the UK is hard to evaluate. James Banks, a pensions expert at the Institute for Fiscal Studies and University College, London, says that the US calculations haven’t been replicated here, because the necessary data have only recently been collected.

In any case, trying to work out how much to save for retirement is hardly a relaxing problem. The mystery is not that some people fail, but that anybody succeeds.

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Alistair Darling did something rather strange recently, to baffling applause from his own backbenchers, and cries of “bribery” from the opposition: he announced a tax on teenagers.

Darling’s plan – for those who missed it – is to cut income taxes temporarily for all but the most prosperous taxpayers. The apparent windfall is £120 a head. A similar plan is already in place in the US, where a temporary “tax rebate” began to arrive in the bank accounts of a grateful nation about a month ago.

But there is no such thing as a free lunch: since neither the UK nor US governments plans to alter its spending plans, these tax holidays will be funded by government borrowing – borrowing that must eventually be repaid. That will require taxes to go up in the future, or not to fall when they otherwise might.

Who should celebrate? Not the typical taxpayer, that is for sure. The tax cut makes no difference to her. If she – assume she is British – had wanted an extra £120 right now, she could already have it in her pocket, either by withdrawing it from savings or by borrowing the money. If she did that, of course, she would later have to repay £120 plus interest. But that is exactly what Darling’s successor as chancellor will require of her. To look at it another way, the rational taxpayer should save the £120 windfall now, keeping it to pay the higher taxes that are surely on the horizon.

But whichever way you look at it, the US and UK governments are handing their citizens borrowed cash – and the citizens themselves are liable for the debt. If my bank manager arranged a surprise loan in my name and handed me the cash, I might feel pampered or put-upon depending on whether I was planning to take out the loan myself anyway. Either way, I doubt I would feel any richer.

Of course, some people should count themselves wealthier after the tax cut. Anyone expecting to die without making a bequest should be pleased: if the Grim Reaper knocks on the door before the taxman does, he can spend the tax rebate now and leave the bill for some other sucker.

Who will be the fall guy? We don’t know for sure, because we can’t say who a future government will tax. But an obvious candidate would be today’s teenagers, very few of whom are paying income tax right now, but most of whom will pay it in the next few years. Their best hope is that their grandparents add the tax windfall to their bequests rather than blowing the money on a weekend in the sun.

The idea that a debt-funded tax cut makes little difference to anybody is called “Ricardian equivalence”, after David Ricardo, one of the founders of modern economics. The equivalence is between government taxes and government borrowing. However government spending is funded, it generates a bill that will fall due sooner or later. Far-sighted taxpayers will immediately take note.

Clearly, there are reasons for some taxpayers to care whether taxes arrive today or later on with interest. Even so, these tax gimmicks matter much less than we might think. It is current government spending, not current government taxation, that is the real measure of a government’s size.

Empirical economists are still arguing over whether Ricardian equivalence holds good, but one study by Matthew Shapiro and Joel Slemrod concluded that most US citizens used a 2001 tax windfall to pay off their debts, leaving more money available to pay future taxes – Ricardian equivalence in action.

That suggests that as consumers and taxpayers, we aren’t fooled by fiscal sleight of hand. Are we fooled as voters? Alistair Darling obviously hopes so.

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The Financial Times has been calling for a credible price to be put on carbon emissions, either through a carbon tax or a serious cap-and-trade scheme. Most economists – including this one – would agree.

The textbook argument is that putting a price on carbon would raise the cost of everything we consume that contributes to carbon dioxide emissions. The result would be that consumers and businesses would waste less energy and would switch to lower-carbon alternatives, while businesses would develop new low-carbon technology.

That is all fine in theory.

In practice, would it happen? It’s important to find out. For one thing, politicians remain unconvinced, often insisting – probably because of political cowardice – that consumers do not respond to such taxes.

And there are other reasons beside politicians’ feebleness to indicate that a carbon tax might not be as effective as economists would hope.

Behavioural economists have shown that we sometimes procrastinate. This could be a real problem: a carbon tax could make it rational to install double-glazing, insulate the loft and buy an energy-efficient fridge. Yet as frail human beings, we might put off all of those rational investments, perhaps indefinitely. Or we might waste energy because we are ignorant of our energy-saving options. (How much money, for instance, could you save, each year, by buying a more efficient fridge? I haven’t a clue.)

Perhaps businesses are more rational, but even there, a carbon tax is not guaranteed to inspire the kind of carbon-saving innovation we need. The problem is the vagaries of innovation: not all spending on new ideas produces a patent, and not all patents produce profits – even if society as a whole stands to gain.

That’s why textbook assumptions can’t be waved through without question. We need some evidence as to what consumers and businesses would actually do if faced with a carbon tax. The main evidence comes from analogies with previous energy price spikes or regulatory efforts.

David Popp, an economist at Syracuse University, used patent data to evaluate the response to the energy crisis of the 1970s. He found some cause for optimism: as oil prices rose and rose, more and more energy-saving patents were applied for (and eventually approved) in every field from heat exchangers to solar panels. The process wasn’t automatic, and patent applications seemed to peter out before oil prices reached a maximum – perhaps all the obvious ideas had been applied for. But Popp’s analysis suggests that high prices do inspire an innovative reaction.

So too does research by Suzi Kerr of Motu, a New Zealand think-tank, and Richard Newell, of Duke University. They looked at the response to gradually more rigorous standards on the lead content of petrol in the US. Refineries brought in the latest technology as the standards tightened, and appeared to be rational about the timing of their investments.

Even Joe Public, the regular consumer, is not as stupid as he seems. One study, by Alexander Brill, Kevin Hassett and Gilbert Metcalf, asked whether ignorance might explain our unwillingness to invest in energy-saving home improvements. It seems not: more educated consumers make the same decisions as less educated ones. But the return on such improvements is closely correlated with consumers’ willingness to make them.

Metcalf is convinced that any sustained rise in the price of carbon emissions would be rewarded with lower pollution. In the long run, simple energy saving should trim energy demand by 3 to 5 per cent for each 10 per cent rise in the price of energy. That is a worst-case scenario, ignoring the possibility of technological improvements and switching to low- or no-carbon fuels.

The textbooks seem to be at least partially right. To find out for sure, all we need is some backbone in our politicians.

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Economic forecasting is a long-standing joke, but the laughter has turned harsh and bitter in the wake of the credit crisis. The conventional wisdom seems to be that economic forecasting is impossible, and that economic forecasters are charlatans.

“In that case,” asked Professor David Hendry in a spring lecture at the Royal Economic Society, “why am I wasting my time on this?”

For one of Britain’s most respected economists, Hendry gives the strong impression of a man ploughing a lonely furrow.

His choice of field – the theory of economic forecasting – is to blame. It is viewed with scepticism not only by laymen but by most academic economists, too. But his research – a heady mix of bewildering computer-assisted mathematics and straightforward common sense – has convinced me that economic forecasting shouldn’t be consigned to the realm of quackery quite yet.

There is a simple reason why most economic forecasts are useless, which is that forecasting is hard. We don’t fully understand the underlying economic processes that produce the results we wish to forecast (growth, inflation, house prices), nor can we measure all the variables accurately, nor anticipate the sudden shifts caused by politics or technological change. Some forecasts – notably of the price of shares and other assets – are intrinsically self-defeating, because if it was obvious that share prices would rise, then they would have risen already.

But one of Hendry’s insights – developed with his co-author Michael Clements – is that not all of these difficulties produce bad forecasts. What really screws up a forecast is a “structural break”, which means that some underlying parameter has changed in a way that wasn’t anticipated in the forecaster’s model.

These breaks happen with alarming frequency, but the real problem is that conventional forecasting approaches do not recognise them even after they have happened. Oil-price forecasters have been predicting since 2000 that the oil price will fall; all the while it has been climbing. The reverse problem applied during the 1980s: oil prices collapsed, but the expert consensus was that the price would recover soon. That consensus persisted for years. The pound appreciated sharply in 1997; for the next eight years, forecasters predicted this appreciation would soon be reversed.

In all these cases, the forecasts were wrong because they had an inbuilt view of the “equilibrium” oil price or sterling exchange rate. In each case, the equilibrium changed to something new, and in each case, the forecasters wrongly predicted a return to business as usual, again and again. The lesson is that a forecasting technique that cannot deal with structural breaks is a forecasting technique that can misfire almost indefinitely.

Hendry’s ultimate goal is to forecast structural breaks. That is almost impossible: it requires a parallel model (or models) of external forces – anything from a technological breakthrough to a legislative change to a war.

Some of these structural breaks will never be predictable, although Hendry believes forecasters can and should do more to try to anticipate them.

But even if structural breaks cannot be predicted, that is no excuse for nihilism. Hendry’s methodology has already produced something worth having: the ability to spot structural breaks as they are happening. Even if Hendry cannot predict when the world will change, his computer-automated techniques can quickly spot the change after the fact.

That might sound pointless.

In fact, given that traditional economic forecasts miss structural breaks all the time, it is both difficult to achieve and useful.

Talking to Hendry, I was reminded of one of the most famous laments to be heard when the credit crisis broke in the summer. “We were seeing things that were 25-standard deviation moves, several days in a row,” said Goldman Sachs’ chief financial officer. One day should have been enough to realise that the world had changed.

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Would smokers prefer that cigarettes be expensive? The Office of Fair Trading seems to think so, to judge by its recent announcement alleging that some supermarkets and tobacco companies had been fixing the price of tobacco.

Certainly, higher cigarette prices would make smokers healthier. There is plenty of evidence that smoking is very bad for you, and almost as much evidence that people smoke fewer cigarettes if they are expensive. But “healthy smokers” are not the same thing as happy smokers.

So, do high cigarette prices make smokers happier? If smokers are rational, they don’t. But if smokers are wracked by temptation and are trying unsuccessfully to quit, then higher prices might make them happier by encouraging them to smoke less, or even to stop entirely.

This turns out to be a controversial point for economists, surely members of the only profession that could argue about whether smoking is rational. The “rational addiction” theory was put forward by the celebrated pair Kevin Murphy and Gary Becker, a Nobel laureate. They argue that people weigh up the health risks of smoking, the possible social and psychological benefits and the fact that it is habit-forming, before deciding whether to light up.

That is not as absurd as it sounds. Even smokers know that their habit is dangerous; in fact, the economist Kip Viscusi established that smokers overestimate the risks. And there is nothing necessarily irrational about deciding to embark on a course of action that many find enjoyable but that is painful to reverse. Otherwise marriage would be irrational, too. Addictive or not, the question is whether, for some people, the benefits might reasonably outweigh the costs.

A second possibility is that, rather than acting rationally, smokers are helpless puppets who will pay any price for a smoke. If so, expensive cigarettes are bad news for them; making them poorer without encouraging them to quit. But that possibility doesn’t fit the facts: we know that smokers respond to price signals by smoking less. They also smoke less if prices are expected to rise at some later stage. This implies that smokers both think about the future and recognise their own addiction, because a self-diagnosed addict who expects prices to rise may try to begin the difficult process of quitting before the habit becomes expensive.

A third possibility is that smokers are neither puppets nor ultra-rational robots, but simply creatures of flesh and blood. They recognise the risks and would like to quit, but keep valuing the short-term bliss of the nicotine hit over the longer-term benefits of kicking the habit. For smokers who fit this description, expensive cigarettes can indeed be a blessing by encouraging them to cut down or quit. Rational and temptation-wracked smokers behave in similar ways, smoking less if prices rise; they just feel differently about price-fixing in the cigarette market.

One way to resolve the debate is to ask smokers how they feel. Six years ago, the economists Jonathan Gruber and Sendhil Mullainathan did the next best thing, looking at two large sets of data on overall happiness, one covering Canada and one the US. By comparing what happened to happiness in US states and Canadian provinces where cigarette taxes rose, they were able to take an educated guess at whether high prices made smokers more or less cheerful. They had to make some heroic assumptions, but the results did point in the direction of the temptation model: where cigarette taxes rise, “potential smokers” – the people whose age, class, income and domestic circumstances suggest that they are likely to smoke – are happier. If the tobacco industry did collude to fix prices, at least it may have spread a little cheer while it did so.

Also published at ft.com, subscription free.

I was recently invited to appear on radio to give an economist’s perspective on the costs and benefits of local exchange trading schemes (LETS), which are alternative currencies that circulate around a small community. This made me scratch my head a bit. I could not think of any real benefits, but then I couldn’t really think of any serious costs, either.

Advocates of community currencies argue that they have social, economic and environmental advantages. BerkShares, which organises a local currency in Massachusetts, claims that the currency helps businesses to connect with their customers, and strengthens the regional economy by favouring locals. In the UK, “transition towns”, which are seeking to use less oil, are exploring the environmental benefits of local currencies.

The common-sense economic case for these currencies was summed up for me by John Walker, acting treasurer of Brixton LETS in London: “They’re more appropriate for local communities, because the money doesn’t drain out of the local community.”

That seems plausible: the money (“Brixton Bricks”) goes round and round Brixton and isn’t sucked away by the insidious multinationals of neighbouring Clapham.

But this is one of those cases where common sense lets us down. Money (whether pounds or Brixton Bricks) isn’t wealth. It’s just a way of keeping accounts, and swapping one system of accounts for another isn’t going to alter the basic productive potential of Brixton.

True, community currencies may very gently encourage trade with locals rather than strangers. But the gains from more trade with locals are more than offset by the losses from less trade with strangers – otherwise, economic sanctions would be a blessing. This also explains why no community currency movement tries seriously to restrict broader trade. Everyone knows that is a recipe for a return to the dark ages.

There have been times and places when national currencies have so malfunctioned that community currencies would have been preferable: Weimar Germany, modern Zimbabwe, perhaps also the Depression-era US, where community currencies briefly flourished. There is also a healthy debate in economics over the appropriate size of a currency union, but few serious economists think that the optimal currency area is the size of Brixton or the Southern Berkshires.

Nor are the environmental benefits of community currencies terribly persuasive. Local trade sounds environmentally friendly, but it is a distraction: the environmental costs of driving to the shops or growing food on inappropriate local land far exceed the costs of carbon emissions from long-range shipping.

The real benefits, if they exist, are not economic but social, and best explained not by an economist like me, but by a sociologist such as Ed Collom, a professor at the University of Southern Maine.Collom’s work looks at first glance like bad news for the community currency movement.

He has found, for example, that most currency schemes in the US last only a few years before collapsing. The ones that thrive are in places that already have strong, liberal, middle-class communities, such as Portland, Oregon, or Ithaca, New York.

In rust-belt regions that would seem to need them more, they have not taken root. Also, the schemes take a lot of effort to set up: Brixton LETS, for instance, is only in its early stages.

But despite the obstacles, Collom is convinced that local currencies can strengthen neighbourhood ties and allow people to make friends: they are a focal point for the community-minded, even when they do not last.

That is possible. I live near a determined, community-minded entrepreneur who owns the local cafe, the sort of person who helps to get community currencies started. But rather than minting a Hackney dollar, she has founded a traders’ association and is trying to set up a street market. I think she has her priorities straight.

Also published at ft.com, subscription free.

If markets are efficient, you will never make profitable trades as a result of reading the Financial Times. Efficient markets move quickly and respond to any new headlines – disappointing earnings, a cut in interest rates, a fraud or a safety incident. Markets will sometimes overreact, drifting backwards after a lurch, or underreact, taking time to digest the true impact of the new information – but overreactions and underreactions should balance out. And when no news is available, the prices of an efficient market won’t change much.

But do markets really react efficiently to news? It would be easy to tell if it were easy to identify all genuine news. Sadly, it is not. Yet two inventive new academic papers claim to have solved the problem of identifying news, in two very different contexts. The studies could not be more unalike. One looks second-by-second at trading data from one of the world’s most active financial exchanges. The other analyses market information that is more than two centuries old.

Karen Croxson and J. James Reade of Oxford University studied the Betfair exchange, a sports betting site that supports many more trades than the London Stock Exchange. Betfair allows punters to bet on football games, and the market stays open throughout the match. Croxson and Reade studied how the price of different bets varied as goals were scored during English league games.

This is an excellent test of the market’s response to news: the bets have a clear value at the end of the game, goals are scarce and important events – and (unless one is a referee) they are easy to spot. And the stakes are not trivial: hundreds of pounds a second are wagered during the match.

The idea of using sports betting to test market efficiency came from Steven Levitt (the co-author of Freakonomics) and Ricard Gil. Levitt and Gil had conducted an earlier study in rather thinner betting markets, and found that prices jumped immediately after a goal, but they then drifted further in the same direction. Was that because the traders were sluggishly digesting news of the goal? Or was it because the clock was ticking down, no news being good news for the team in front? Croxson and Reade offer a clever answer, by looking at those goals scored just before half time. Relevant news hardly ever emerges during half time and the pair find that, although trading is active during the break, prices barely move at all. This shows that the market traders instantly absorb the news of a goal. After the second half begins, prices start to drift again, just as Gil and Levitt found.

That suggests an efficient response both to news and to the absence of news, in sports betting markets at least.

But Peter Koudijs of Barcelona’s Universitat Pompeu Fabra has a different perspective. He looked at prices of three English stocks (the East India Company, the Bank of England and the South Sea Company) on a secondary market in Amsterdam from 1771 to 1777.

Koudijs realised, and proved, that relevant news flowed almost exclusively from London to Amsterdam – and always through the same channel, a boat sailing across the North Sea bringing market data to Amsterdam. Depending on wind speed and direction, the “packet boat” might arrive promptly or after a delay of more than a week, occasionally starving the Amsterdam market of news for days on end.

Koudijs discovered that when the wind was unfavourable and no news was available, Dutch prices for these English companies were highly volatile anyway. That is not an efficient market.

So, have we discovered something uniquely inefficient about Dutch markets, or something uniquely efficient about sports betting? I am not sure. An analysis of Dutch football games is the logical research extension.

Also published at ft.com, subscription free.

Which nation produces the richest people in the world? You might think that an easy question to answer: just grab the latest figures from the International Monetary Fund, and you’ll see that the answer is Luxembourg ($102,000 gross domestic product per head in 2007). The US is in ninth place ($46,000) and the UK in 11th ($45,000).

There are some methodological wrinkles to iron out: what exchange rate to use, for instance. And for the poorest countries such as Liberia ($200 per person in 2007) or Burundi ($130), the numbers involve some guesswork. But overall, these are not controversial statistics – unless you are Lant Pritchett or Michael Clemens.

Pritchett, of Harvard’s Kennedy School, and Clemens, of the Washington, DC, think-tank the Center for Global Development, argue that my opening question should be answered in a radically different way. Rather than measuring the income of people who are now residents of Liberia, Clemens and Pritchett have produced a research paper estimating the income earned by people who were born in, say, Liberia, regardless of where they now live – what Clemens and Pritchett call “income per natural” of Liberians.

For Luxembourg – or any other rich country – there is a trivial difference between income per natural and more conventional measures of national income. But for Liberia, the difference is anything but trivial: the Liberian-born make 50 per cent more than Liberian residents. Nor is Liberia unique: Clemens and Pritchett estimate that the income of the Samoan-born is nearly twice the income of the Samoan resident, and the Guyana-born are more than twice as well-off as residents of Guyana.

These dramatic differences have a simple explanation: many poor people became richer by leaving their country of birth. Clemens and Pritchett estimate that “two of every five living Mexicans who have escaped poverty did so by leaving Mexico; for Haitians it is four out of five”.

There is a point to this exercise: Clemens and Pritchett want to draw attention to the fact that migration has made a lot of migrants richer. Traditional measures of income tend to mask this fact.

In rich countries, we usually ask whether migrants improve the lot of existing residents, not whether migration improves the lot of migrants. Meanwhile, the welfare of migrants rarely figures in debates in developing countries or in development institutions such as the World Bank, because the migrants have gone.

Simply because of the way the discussion is framed, the benefits to migrants tend to be ignored. Imagine a man who moves from earning €10,000 in Poland (an above-average wage) to £15,000 in the UK (a below-average wage). Simple arithmetic says that he has reduced the average income of both countries; that could be true even if he has impoverished nobody and enriched himself a great deal.

The “income per natural” statistic is the latest in a long line of alternatives to gross domestic product, the standard measure of an economy’s size. Others – variously championed by Nobel laureates such as Amartya Sen, Daniel Kahneman, Joseph Stiglitz and the late James Tobin – try to adjust GDP to account for the depletion of natural resources, or to incorporate measures of health and education, or even (in Kahneman’s case) to start from scratch with time-weighted accounts of happiness.

I sometimes wonder if these alternative measures make a difference to the way policy is conducted. After all, no government ever tried to maximise GDP anyway, so why try so hard to measure something else?

But Pritchett is convinced that the way the discussion is framed really does make a difference.

“I’m crazy,” he told me. “I’m a lunatic. But I think we have a chance of changing the way the discourse is carried out.”

Also published at ft.com, subscription free.

My family’s experience of the local hospital has been mixed. Sometimes it is impressive; at others it falls below the standard one would expect in the capital of a developed country. Our rule of thumb is that it’s much safer to get sick in Cumbria, where my wife’s parents live.

Although we have had our fair share of dashes to Accident and Emergency, they have been not been so frequent as to constitute a statistically rigorous study of the local facilities. Still, such studies do exist, and one recently published investigation suggests that patients in London have indeed been suffering unduly.

The reason is that many skilled workers in London have decided they have better things to do than work for the National Health Service: in the private sector they can expect to earn 50 or 60 per cent more in London than further north; in the NHS, wages for London staff are relatively meagre. As a result, hospitals in booming areas such as London have more staff vacancies, seem to over-promote staff as a way of giving them more competitive pay, and use more temporary staff hired through private agencies.

It has always seemed obvious to economists that national pay scales are an oddity. It may appear fair to pay nurses, lecturers or teachers much the same in Chelsea as in Chesterfield. Yet since we cannot eat money, it is silly to compare a Chelsea salary with a Chesterfield one without considering what each might buy, and what alternatives might be on offer.

Still, just because a pay arrangement offends against the principles espoused in economic textbooks does not mean that it is a problem in practice. It is not easy to prove that the theoretical concern is a practical problem, but the researchers have convincingly done so using data from 1996-2001: nationally regulated pay was, at the time, killing National Health Service patients in high-wage areas.

The researchers – they are Emma Hall and Carol Propper of the University of Bristol, along with John Van Reenen of LSE’s Centre for Economic Performance – used as their benchmark the proportion of patients who dropped dead inside a month, having arrived at the hospital suffering from a heart attack. (This is a common measure of hospital performance, since neither the patient nor the hospital have much chance to be selective under the circumstances, and because unlike, say, waiting lists, this number is hard to fiddle with.)

They found that the higher the alternative wages available, the higher the death rate at a region’s hospitals, and the effect does not seem to be due to any intrinsic difference in the type of patient, the journey taken by the ambulance or any of the other likely explanations. Nor is this a trivial effect: if the alternative wage rises 10 per cent, the death rate rises by nearly 5 per cent.

Hall, Propper and Van Reenen also looked at measures of productivity in other service industries, including nursing homes, where pay is not regulated by the government. There is absolutely no sign of trouble in any of them.

The good news is that the NHS has recently moved to more flexible wage agreements, with more pay for staff in high-wage areas and the flexibility to add further inducements when staff shortages are a particular problem. This is a positive step, although just because NHS employers are now allowed to pay staff more in London and the south-east does not mean that they will find the money in their budgets to do so.

Nor is the NHS the only government organisation with nationally agreed pay standards. Readers based in London might enquire about teacher turnover at their local school – and hope the answer does not provoke a heart attack.

Also published at ft.com.

What should top record labels, software giants and other media companies do about digital piracy? There are two obvious options: get tough and defend intellectual property rights with every legal and technological trick in the book, or tolerate some illegal copying in the hope of generating buzz and making money in some other way.

This is a debate that generates strong opinions, and where you stand seems to depend on whether you’re an industry accountant or a new economy guru. (Chris Anderson, editor-in-chief, Wired magazine, coined the phrase “Freeconomics” to describe giving cheap things away for free in order to create buzz.)

But look closer and you realise that the corporate suits aren’t all adopting the same strategy. The music industry doesn’t seem able to make up its mind: first it turned a blind eye to traditional mix-tape piracy, then it cracked down on illegal file-sharing while raising the price of CDs, and finally it slashed the price of CDs in an attempt to compete head-on with downloads, legal and illegal.

Even more perplexing, Microsoft seems to hold two opinions at once: doing its best to prevent piracy on the Xbox console, but (as far as this outsider can tell) accepting that piracy of its Office suite of software is a fact of life.

Karen Croxson is a young economist at Oxford University who claims that there is method in the madness. She argues that there will never be a single correct trade-off between sales lost to piracy and sales generated by the buzz from pirated copies in circulation. That is because there are different kinds of potential consumer in different markets, or even in the same market at different times. A company’s most profitable response to piracy depends on what sort of consumers it is facing.

For example, the consumers who would pay for console games if given no alternative are probably the type of consumers who are happy to use pirated copies: tech-savvy youngsters. That means that an extra pirated copy in the console market is quite likely to mean a lost sale.

But the customers who will pay most for corporate software are, well, corporations. They won’t want to risk being caught and sued for piracy, so an extra pirated copy in the corporate software market probably isn’t a lost sale at all. The guilty party isn’t a customer, but a home-user or a student who would never have stumped up full price. Thanks to piracy, though, that home user is now learning how to use Word and PowerPoint and making the legal copies of Microsoft Office more valuable.

Croxson can even make sense of the record industry’s apparent volte-face with the pricing of CDs. When Napster was starting up and piracy was still a marginal activity, it made sense for record labels to write off a few cheapskate customers as a marketing expense and raise average prices to everyone else – presumably the older, more prosperous customers who were willing to pay for legal music. But as the pirated sector embraced even those customers, the best strategy was to fight back by slashing prices.

In Croxson’s world, then, “promotional piracy” is an alternative to discounted pricing. Both approaches are a way for companies to advertise their products or expand their user base. And as with discounted pricing, promotional piracy only makes sense if there is a decent supply of customers who will eventually pay full price, which is not always true.

Corporations may be able to do more to maximise the gains or minimise the losses from piracy. Why not offer two versions of the product: a cheap-to-pirate, lower-quality product, and a high-end offering incorporating tight security? If Croxson is right, for some industries, piracy is a wonderful distribution channel.

Also published at ft.com.

I recently discovered that I am entitled to an occasional tax-free breakfast, because I cycle to work. (The UK government advises that “Under general principles such meals are a taxable benefit in kind but regulations exempt them from tax, as long as they are provided on designated ‘cycle to work’ days.’’) Good to know – and a reminder that the idea of using the tax system to promote environmental goals has taken a wrong turn somewhere.

The basic idea behind green taxes is sound. Since people usually respond to financial incentives, whenever something is taxed they tend to do less of it. Usually, that is a problem. When the government taxes income, we slack off. When the government taxes moving house, we may stay in the wrong size house on the opposite side of town from our new job. What’s more, whenever the tax dissuades someone from earning income or moving house, the tax office loses out as well.

But when the government levies a “green tax’’ – that is, a tax on some polluting activity – these vices become virtues. If the tax does not dissuade the polluters, they pay through the nose, funding public spending or tax cuts on the rest of us. And if the tax does dissuade the polluters, all the better, because pollution will fall.

All very well in theory, but the practice has been shameful. Green taxes have been fussy and poorly-targeted, by turns too stringent and too lax. For fussiness, one need only point to the tax break on occasional breakfasts for bicycling commuters. It is hard to imagine that the environmental benefits outweigh the red tape, but no doubt some minister was able to burnish his or her green credentials with the hare-brained scheme.

As for the evidence of inept targeting, simply contrast the two most significant features of the UK’s green tax “system’’. On the one hand, fuel for domestic heating is effectively subsidised, attracting VAT of 5 per cent instead of the usual 17.5 per cent. On the other, the tax on petrol, which raises far more money than any other green tax in the UK, is a lot higher than can reasonably be justified on environmental grounds and was raised still further in the recent budget.

That conclusion comes from the environmental economists Ian Parry and Kenneth Small, who tried to estimate the appropriate gasoline tax in the US and the UK, taking into account congestion, pollution, and the fact that gasoline tax revenue would allow other taxes to be cut. They concluded that US gasoline tax should be more than doubled, while UK gasoline tax should be roughly halved. Green taxes are a good thing – but we all know that you can have too much of a good thing.

What are we to make of a government that is so confident of its omniscience that it will subsidise my breakfast on environmental grounds, yet at the same time cannot get the most basic decisions right, setting petrol tax far too high and tax on domestic fuel far too low?

I realise that I am complaining that gas-guzzlers are taxed too much and pensioners in fuel poverty are taxed too little. Fine. I’ll contribute my tax-free breakfasts to the pensioners and recommend that the government use its much-vaunted winter fuel payments to deal with the problem. But holding domestic fuel taxes low, thus encouraging the entire nation not to bother with double glazing, is a clumsy way to help the vulnerable.

But I am not holding my breath waiting for sensible green taxes.

This government – like most governments – likes to use the tax system as a way of expressing its moral views: hooray for pensioners, down with Jeremy Clarkson. Cheap politics for them, less so for the taxpayer.

Also published at ft.com.

Friends of mine, husband and wife, once argued over the price of a branded packet of lemon slices bought at some convenient corner shop or petrol station. She complained that the slices weren’t worth the price she had paid. He pointed out that she had bought them – albeit grudgingly – knowing exactly how they tasted, and that therefore they had to be worth what she had paid. No prizes for guessing which of them is an economist.

We economists know a lot about pricing, but we tend to be baffled by the way the rest of humanity thinks about it. The package holiday offer, “Kids go free to Disneyland”, is, to an economist, a profitable attempt to charge more to couples with two incomes and no children, who are likely to have more cash to burn. To everyone else, it is an idea waved through unquestioningly.

How a pricing policy is presented clearly matters – which is disconcerting to economists, who can translate all the pricing into mathematical equations and make the presentation irrelevant. It seems to be acceptable to charge a higher mark-up for fair trade coffee, organic bread or lower-emission petrol. It is not acceptable for businesses to say, “we are such fans of exploitative coffee, pesticide-laced loaves and dirtier petrol that we’re willing to discount them and accept a lower profit margin.” Underneath the gloss, the pricing policies are, nevertheless, identical.

The most common puzzle of all, to an economist, is why prices so rarely rise in the face of a shortage. There was a shortage of Wii games consoles last Christmas, Xbox 360s in 2005, PlayStation 2 consoles before that, and so on, yet the retail price remained the same. To secure tickets for a hot concert, you will usually need to go to a ticket tout, because the regular concert promoters wouldn’t dare charge a price that might bring demand down to the level of supply. And when US oil companies raised gasoline prices after Hurricane Katrina, there were howls of outrage – despite the fact that the refining infrastructure was badly damaged and it was self-evidently impossible to supply everyone at the customary lower price.

I have pondered before the very clever explanations economists produce to explain why prices do not rise to equalise supply and demand. Perhaps ticket prices are kept low to encourage a memorabilia-buying younger crowd. Perhaps popular restaurants like to have a waiting list for reservations because it adds to the cachet. Even I am starting to feel that these explanations sound strained: are these side-benefits really enough to outweigh the lost revenue from higher prices?

The intuitive explanation, of course, is that we irrationally object to high prices even when the alternative is rationing, long queues, and uncertainty over whether we can buy what we really want.

That is discomfiting for economists, but we might at least take solace in the idea that even though there is no immediate logic to a belief in the right price, there is at least an evolutionary logic. David Friedman – son of the late Milton Friedman, and a superb communicator of economics – has argued that our ancestors evolved in an environment where most transactions were one-on-one bargains. A hard-wired refusal to accept something other than the customary price would, in such a setting, be an advantage. Anyone who reacts to a price rise with irrational rage turns out to be a strong negotiator.

Our stubborn preference for a just price evolved in a setting that is no longer common; but evolution does not respond quickly, which may be why we still shriek with outrage at price hikes. It would also explain why ticket touts still make a living.

Also published at ft.com.

The three most familiar economic statistics are all measures of change: inflation, the growth of gross domestic product, and the daily rise or fall in the price of shares. Even so, they do not begin to capture the mad churn of the economy: the growth and bankruptcy of companies; the millions of sackings and hirings, which unemployment statistics barely summarise; the movement of goods and services around the world and the ebb and flow of consumer fads. Under the circumstances, it is strange that economists do not have a satisfactory way of talking about change; yet we do not.

As any undergraduate student of economics knows, both microeconomists and macroeconomists tend to describe change in the same way that an advertisement for washing powder does: “before” and “after”. When oil cost $20 a barrel the economy looked like this; now oil costs $100 a barrel, the economy looks like that. Quite how the process of change occurred – or how quickly – is a problem glossed over in the textbooks and most journals.

That is worrying. Perhaps it does not even make sense to compare two static “before” and “after” states; perhaps “during” is everything. In fairness, economists are not blind to this problem. Back in 1923 John Maynard Keynes warned that “Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.” He was not the only one with reservations. Yet identifying the problem is easier than solving it, at least using the mathematical tools with which economists are familiar.

Several popular books have argued that economists could learn about dynamics from approaches developed in the sciences. Malcolm Gladwell, a journalist, wrote an entire book – The Tipping Point – devoted to the idea that innovations, fashions and other ideas spread through society in much the same way as a disease does. Philip Ball, a science writer, attacked economics more directly in his book, Critical Mass, arguing that economists should learn from physicists’ understanding of dynamic processes, such as phase transitions. (An example of a phase transition is when cold water suddenly turns to ice. It turns out that, for example, traffic flows can exhibit phase transitions.) Still others advise economists to look to models of evolutionary dynamics.

This is all sage advice, but the details matter. Duncan Watts, who studies dynamic processes on networks, has discovered that neither Ball nor Gladwell has the whole story. Ideas can spread through an economy like a disease or like a phase transition – it all depends on how the social networks along which the ideas flow are connected.

In The Tipping Point, Gladwell focused attention on highly connected individuals – the “connectors” or the “influencers” – who were able to spread anything from a fashion trend to a new software release. He was influenced by epidemiologists who already knew that diseases often spread through such “connectors”. But Watts points out that ideas can flow along many more connections than diseases do. That implies that the epidemiological model does not apply, and a new trend will either ripple through the economy like a near-instantaneous phase transition, or it will ripple nowhere at all because it never gets started. And in either case, the “connectors” will be irrelevant, because we’re all so interconnected anyway.

My guess is that it is just a matter of time before economists embrace methods from other disciplines in an effort to understand dynamic processes better than we do.

But it would be a shame if we looked only to physicists, chemists and biologists for advice; something would be missing if we did. Duncan Watts, after all, is a sociologist.

Also published at ft.com.

So much hot air has been spouted over climate change it is a wonder the ice caps haven’t melted already. At first the debate was whether climate change was happening, and if so whether it was humanity’s fault. Far too late for the tastes of most economists, the debate then started to encompass other important questions, such as whether the costs of responding to the threat outweighed the benefits. Read the rest of this entry »

My father and my mother met at a venerable English university. I went to the same place, as did two of my sisters. Now that my stepbrother has followed in our footsteps, I am starting to think that there may be more than coincidence behind the whole business.

If we accept that fluke is an unlikely explanation for the uniformity of the Harford educational experience, it is an example of what economists call “intergenerational transmission of educational attainment”. Intergenerational transmission of income is a closely related issue: do the children of rich parents grow up to be rich, and do the children of poor parents grow up to be poor?

The simple answer is that it depends in which country they live. In the US and the UK, if your parents were twice as rich as the average for their generation, you could expect to be 40 per cent richer than the average for your generation and so your children could expect to be about 16 per cent richer than the average for theirs.

Sensible readers will be wondering whether that suggests a lot of intergenerational income mobility or not. I do not know the answer: it’s very hard to say what we should expect, or want. What we do know – thanks to the efforts of Gary Solon, a professor at the University of Michigan and a leading light in the field – is that the transmission of income down the generations is higher than we used to think. Estimates from the 1970s and 1980s, which suggested much lower income persistence, were dogged by poor data.

We also know that rich parents are much more likely to have rich children in the US, UK and France than Canada, Sweden or Denmark. In Denmark, if you are twice as rich as the average, your children will tend to be just 15 per cent richer than the average. (These international comparisons come from a survey by Miles Corak of Ottawa University.)

Solon thinks these findings are “just the beginning of a discussion, not the end”. He has a good point. Should policy try to respond to the fact that I went to the same university as my parents? That rather depends on whether I got in because my father called in a favour from the tutor for admissions. What if I simply benefited from a family love of books, or even inherited some bookish genes? It is hard to imagine any but the most totalitarian state doing much about that.

While we think of intergenerational income mobility as a sign of meritocracy, if we did live in a genuine meritocracy, it is hard to know how much mobility we should expect to see. People have a certain kind of “merit” in mind when they speak glowingly of a meritocracy, and that kind of merit tends to run in the family.

That is true for both genetic and cultural reasons. A fascinating new study, co-authored by Solon, looks at a remarkable set of data on adopted Swedish children. The researchers have data on all four “parents” – two biological and two adoptive – and use it to look at the correlation between the parents’ level of education and the child’s. It turns out that all four parents influence the child’s educational level. (If anything, sharing genes has a stronger influence than sharing a home; there is not much in it.)

If, as Solon suggests, this is just the beginning of a discussion, where should the conversation go now? Many economists believe that we should be looking for effective interventions to improve the health, nutrition and education of pre-school children in an attempt to level the playing field. It is not yet clear whether we shall find them.

Also published at ft.com.

Here’s what I like about insurance: you pay the insurers money when you do not desperately need it, and then the insurers pay you money just when you need it most.

Curiously, this is not what other people seem to like about insurance. Most people do not try to arrange for insurance payments to arrive when they will need them most. Instead, they arrange for insurance payments to arrive after bad luck.

If your house has just burnt down, “when you need money most” amounts to the same thing as “after bad luck”. But what if your son has just been accepted by Eton, and his older sister by Harvard? That is when the money would be useful, but we are temperamentally more inclined to insure against the tragic death of a child. It goes against the grain to insure against “good news”.

Meanwhile, we pay through the nose to insure a mobile phone – the loss of which is bad luck, but hardly a life event that suddenly makes money more valuable.

In contrast, we do not buy insurance against living until the age of 95 – a “good luck” event that goes hand in hand with a huge need for extra money. Insurance against longevity is easy to obtain: it’s called a “life annuity” – sometimes just an “annuity” – an investment product that pays you an income as long as you live. If you die young, you lose money on the deal; but who cares?

Yet we seem to dislike annuities. They barely exist in the US. In the UK, they are compulsory for those who want tax relief on their pension savings. Still, we buy them kicking and screaming.

Quite why we have such an aversion to annuities is not clear. True, money spent on an annuity is not available as a lump sum on a rainy day. Annuities are also expensive: after all, insurers must fear that only vegan teetotallers will buy them. But the truth is that our reluctance even to dabble in annuities is almost certainly irrational. So what quirk of human nature is standing in our way, and what might insurers (and governments) do to nudge us in a more sensible direction?

One indication comes from new research by four economists, Jeffrey Brown, Jeffrey Kling, Sendhil Mullainathan and Marian Wrobel. Using an internet-based survey, they presented respondents with a series of comparisons between pairs of fictitious retirees who had made different decisions about funding their retirement.

The survey asked who had made the better choice. Brown and his colleagues found that whether their respondents favoured those with the annuities depended entirely on how the question was presented.

Annuity purchases look attractive when described as sources of spending.

For instance, when told that “Mr Red can spend $650 each month for as long as he lives in addition to social security.

When he dies, there will be no more payments…” respondents preferred Mr Red’s choice (implicitly, an annuity) to Mr Gray’s savings account, which was flexible but would run out of money at age 85 if he spent $650 a month.

But when described as investments, annuities suddenly became unpopular.

Few fancied Mr Red’s decision when told that he had invested “$100,000 in an account which earns $650 each month for as long as he lives. He can only withdraw the earnings he receives, not the invested money. When he dies, the earnings will stop and his investment will be worth nothing.”

The two Mr Reds, of course, chose exactly the same product described in a slightly different way.

The lesson: don’t focus on what rate of return an annuity produces. Just think about what you can spend if you buy one.

Also published at ft.com, subscription free.

Nurses leave Nigeria and come to the UK, hoping for a better career. Farmers leave Mexico to work in construction or catering in the US. Such migrants can have a profound impact on the economy, as well as the society and politics both of the country they leave and the country to which they move. Social scientists, naturally, take an interest.

But one economist, Edward Castronova of Indiana University, studies an unusual kind of migration. Unhappy with your job as a Starbucks barista? Why not become a starship captain instead? Impossible if you stay in the country of your birth, but simplicity itself if, instead, you emigrate to an online fantasy world.

In such worlds, players usually pay a monthly fee for the right to explore richly detailed three-dimensional landscapes inhabited by dragons or aliens or, in some cases, punks and strippers. They are also populated by other players – guess who plays the strippers. If a player spends enough time there, perhaps he has migrated.

You might protest that is not migration at all, and you’d be right in all sorts of ways. But Castronova thinks it is relevant nonetheless, and he may be right too.

Half-joking but curious, his studies began with a survey he conducted in 2001 among regular players of an online game, Everquest. He asked about how much they played, as well as their real and fantasy careers. A third spent more time in the Everquest world than they did working for pay (and the average respondent worked a 40-hour week). One fifth regarded themselves as residents of the Everquest world, and a similar proportion said they would spend all their time in Everquest, if only that were possible.

By itself, that means little. But it should set us thinking. There is no doubt that these games have a modest but real and growing economic significance. People spend time and effort inside the game, creating or obtaining items that other players value. Virtual currency can be traded for dollars, and performing mundane tasks inside a computer game can even provide an income that is attractive to Chinese and eastern European students. Paying real dollars for an in-game item sounds silly, but no more than paying for a new mobile phone ringtone, which is also a digital product of purely aesthetic value. Time is spent, fun is had, money is spent, economic value is added.

As many more people log on and spend time having fun in a synthetic economy, will that really change the mundane world, as Castronova argues in a new book, Exodus to the Virtual World? Is the phenomenon any different from, say, poker – which is also a game in which time is spent, fun is had, and money changes hands?

If there turns out to be a difference it will be because synthetic worlds offer us an alternative vision of how society might work. These are places in which alter-egos live and die, fall in love, and develop careers and alliances. Their politics are very different from those to which we are accustomed.

Most synthetic worlds, for instance, celebrate their huge inequalities. Some characters are helpless and penniless, others are near gods, and every facet of the game’s interface will scream the distinction at you. But nobody minds, because the game is seen as fair. Everyone starts from the bottom and works their way up without state intervention, a libertarian’s dream. Yet other facets of the game are centrally controlled with great care: tremendous effort goes into offering equal opportunity to all players.

Castronova believes that compelling, increasingly popular and radically new experiences in synthetic worlds will start to change the nature of politics “back home”. That remains to be seen. But I find the idea faintly encouraging: a little healthy competition never did anyone any harm.

Also published at ft.com, subscription free.

Family Harford has just put in an offer for the house next door, to hoots of scorn from my colleagues, who know me as a bear among bears. It is true that the London housing market seems (who knows?) to be in the final stages of its biggest-ever bubble. But there are special circumstances involved here, one of which is that no rational economic actor disobeys an order from his wife.

My discomfort at having to make an offer put me to thinking that we often bungle our housing decisions. I am ever the champion of economic rationality, but even I would admit that there are exceptions. Buying a house is a rare event and the stakes are mind-bendingly high. Calamity is, therefore, always possible.

Most people do not seem to see the cost of a house in the same way that they see other prices. House prices are simply viewed through the lens of monthly repayments that either can or cannot be afforded. We spend time and money insuring ourselves against some losses, such as a malfunctioning washing-machine; yet the value of the house we own (or the cost of the house we might someday want to buy) fluctuates by far more, perhaps on a daily basis. Nobody cares, nobody hedges the value of their homes – although it is not hard to do so – and nobody seems to compare the price to any meaningful alternative, such as retiring 15 years early.

We also become irrationally possessive, and not only of our homes. The behavioural economist Dan Ariely – author of an excellent new book, Predictably Irrational – once demonstrated this possessiveness with a clever experiment.

He observed that tickets to see the top basketball games at Duke University are absurdly scarce. Students who want them must queue for weeks (they form teams and take turns). Even then, there is a lottery for tickets. Some win and some lose.

Winners and losers alike queue devotedly and are chosen at random. The only difference is that winners, by chance, hold tickets in their hot little hands. And yet when Ariely phoned the losers offering to sell tickets, they tended to offer around $175. Winners simply wouldn’t sell to him for anything close: their typical asking price was $2,400.

People are even less willing to sell if that means realising a loss. Research by Terrance O’Dean, a professor of finance, suggests that stock-market investors tend to sell shares that have made money and keep poor performers, even though tax efficiency suggests the opposite strategy.

The tendency is called “loss aversion”; people hold on to poor investments grimly, hoping for a turnaround.

“If you can get attached to a stock, imagine how attached you can be to your house,” Professor Ariely told me in a telephone interview.

Other research suggests that high stakes can befuddle the brain. Ariely and his colleagues once offered payments of up to six months’ salary to Indian peasants who could successfully complete certain mental or physical tasks. Modest stakes motivated excellence; super-high stakes simply caused nerves.

Sadly, none of this helps Family Harford very much. We’d like to buy the house next door, but if others offer irrationally exuberant bids, we won’t get it. Nor will we be able to pick it up cheaply after the bubble bursts. In principle that should be easy to do. In practice, that would mean somebody selling at a loss, a rare phenomenon.

And so, if we want the house next door, we must buy it now – even if it means outbidding irrational bidders. It’s a tough job being the sole voice of reason in a crazy world, but somebody has to do it.

Also published at ft.com.

Hillary Clinton and Barack Obama notwithstanding, the world still seems to be ruled by white men. Is this the result of racial and sexual discrimination in the workplace? Or are other factors more important – for instance, that few black kids go to good schools, or that women usually interrupt their careers to have children?

The answer is far from academic, because if we want to change a situation, it’s a good idea to work out what might be behind it.

Economists have been leading this investigation for longer than one might think. Contrary to popular belief, “the dismal science” did not acquire its name because of Thomas Malthus’s gloomy predictions.

The title was bestowed upon us by Thomas Carlyle, who in 1849 attacked John Stuart Mill and his fellow political economists for their “dismal” support for emancipation, and their insistence that former slaves, women, even the Irish, were all equal.

More recently, economists have turned their attention to the subtler question of how to detect discrimination in labour markets. That women or racial minorities are paid less suggests discrimination but does not prove it, even if the statisticians make every effort to adjust for other differences such as part-time work or different choices of job.

One solution to the ambiguity is a random audit. A recent example was carried out by the economists Sendhil Mullainathan and Marianne Bertrand. They generated about 5,000 fake job applications and used a computer to add, at random, distinctively black or white names. The employers who received the applications systematically favoured the Brendans and the Alices over the LaTonyas and the Jamals; perhaps even more perniciously, they paid attention to the qualifications of (apparently) white applicants but did not notice the difference between mediocre black applicants and excellent ones.

But discrimination should also show up in another way. Companies that prefer not to hire workers because of their sex or the colour of their skin are likely to lose money: employing stupid white men when you could be employing smart black women is not a profitable human-resources policy. Employers might nevertheless do this, either because they do not realise that their prejudices are costing them money, or because they do not care.

If so, discrimination is easy to detect in principle: just note that the profitable companies will be the ones employing more women or workers from an ethnic minority.

The economist Stefan Szymanski realised that the English football league was a perfect testing ground for this hypothesis. There was excellent data available as to which clubs employed black players; football has a very clear measure of success, and unlike some sports leagues, the English game does not go in much for redistributing money from successful clubs to minnows.

Szymanski studied the game between 1978 and 1993, a time encapsulated by the image of Liverpool’s Jamaican-born genius, John Barnes, backheeling away a banana that had been hurled at him from the stands. But Szymanski’s numbers suggest that it was the owners, not the fans, who were the worst offenders. Clubs that bucked the norm and fielded several black players did not suffer lower attendance or revenues as a result.

But they did enjoy a higher league position with a lower wage bill than the typical club – clear evidence that black players were underpaid on racial grounds.

As football has become ever more competitive and the financial stakes have become higher, racial discrimination becomes more expensive. I note that are now many more black players in the premiership. That is good news; it’s also no coincidence.

If only competition was as fierce, and talent as undeniable, in the world outside the stadium gates.

First published at ft.com.

Iowa and New Hampshire are tiny states, and they have too few electoral college votes to exert much direct influence over who runs for president. Yet everybody agrees that their indirect influence is vast. The Republican hopeful Mitt Romney was all but written off after failing to win in either state (although Michigan has given him a sudden resurrection); Democratic contender Hillary Clinton went from favourite to also-ran to favourite again after losing the Iowa caucus and then winning the New Hampshire primary. Does it make any sense that such tiny states largely determine the candidates’ fortunes, or does it simply indicate that voters are acting like sheep?

That question poses a false dilemma. Yes, voters are acting like sheep. But, yes, it all makes perfect sense. There are two good reasons why early success matters.

The first is that many donors want to back the winning candidate, whoever that is. Certainly, some donors are true believers, but many others also care about being on the winning side.

“I just got a call from a donor,” one leading Clinton fundraiser told the Financial Times, moments after her unexpected victory in New Hampshire. “If she’d lost, I would not have received the call.”

There’s a parallel here between the emergence of frontrunning candidates and the emergence of new technology standards. (The most recent example is the battle for survival between two high-definition video standards; Sony’s Blu-ray looks like it’s beating Toshiba’s HD DVD.) Most customers don’t care which one triumphs; they just don’t want to be left holding an obsolete format. This is why format wars are miserable for the industry: they encourage customers to stop buying until the fog clears.

Donors who want to back the eventual presidential winner have an easier time. The results from New Hampshire and Iowa often tell them which way to jump. Even if those results are flukes, the donors merely need all to jump in the same direction. That may not be pretty but neither is it irrational.

But voters also matter, which is the second reason early success is important. According to one estimate from economists Brian Knight and Nathan Schiff – who looked at how opinion polls in late-voting states respond to early results – the early voters in US elections each have up to 20 times as much influence as those in later voting states.

That sounds like the later voters are being irrationally passive; it’s passive, yes, but I’m not so sure that it is irrational. The US has such a huge electorate that an individual voter has no influence over the result.

People join in because it’s fun or they feel a sense of duty, but that doesn’t mean they work hard to understand the issues. One would hardly expect the typical voter to scrutinise manifestos as assiduously as a copy of What Hi-Fi? Voting for the wrong candidate will not change the result, but buying the wrong hi-fi would hurt.

So votes cast in Iowa and New Hampshire each carry up to 20 times more weight than elsewhere – and the electoral process seems so much more fun there. Voters go on outings with friends and family, meet the candidates and hear them speak, and in general enjoy personalised politics.

They have a reason to do their homework.

And that’s the implicit deal: America says to Iowa and New Hampshire, “If you do the hard work of deciding for us, we’ll promise to follow where you lead, and the politicians promise to put on a really good show.”

What could make more sense than that? If only the small states could agree to take turns as to who’d be first, the US would have a pretty good electoral system.

Also published at ft.com.

Feng shui is all very well, but the next time you decide to redesign the layout of your office space you might consider calling an economist. That’s because an astonishing new set of data from Google – where else? – has allowed economists to track something that had been utterly ethereal: the flow of information around a physical office space.

The data come from Google’s trials of something called an internal prediction market. Prediction markets are most famously used to forecast presidential elections. If Barack Obama is trading at 35 cents on the Democratic nomination market, that is what punters are willing to pay for a ticket that will pay a dollar if and only if he wins the nomination. In that case the market is giving Obama a 35 per cent chance.

Prediction markets aren’t perfect, but they often beat alternative forecasting mechanisms. That is why some companies have started to experiment with them by asking their own employees to bet on sales and revenue figures – the alternative being to rely on the bureaucracy’s own forecasts, which are often made by people with a vested interest in sitting on bad news.

Google is not the first to try: according to Bo Cowgill, of Google’s economics group, and academic economists Eric Zitzewitz and Justin Wolfers, other pioneers include ArcelorMittal, Chrysler, Eli Lilly, General Electric and Hewlett Packard.

The markets seem to work quite well. But that is not the most interesting thing to emerge from the analysis by Cowgill and his co-authors. By looking at which Google employees trade in which markets (betting on, for instance, how many users Google’s Gmail service will attract by the end of the quarter) and on which side of the trade, they have a good idea about who has what information. And by looking at who else makes similar trades, they can draw conclusions about who has similar information at similar times.

If this was an ordinary company, the researchers might try to correlate information with the organisation chart, and that would be about all there was to say. But this is Google. Cowgill, Zitzewitz and Wolfers had the precise GPS location of each desk (Google offices are open-plan). They had information about which employees were on the same e-mail listings, such as the poker group. From a survey, they had a list of each employee’s friends. They knew which bosses they worked for, which projects they worked on, and where they went to college. All they lacked were the names of the employees, which were stripped out of the database.

The results were striking. Clear correlations existed between the trading behaviour of certain groups of employees. But they were not explained by shared interests or by social connections. Having the same immediate boss only explains a little about information flows.

No, it is the office layout that matters: people who sit near each other tend to know the same things, as evidenced by making similar trades on the prediction markets. Social and professional proximity matters very little for the flow of information: physical proximity is almost everything.

Specialists in organisational behaviour have known for a while that people tend to interact much more with those who sit nearby, but it has never been clear whether that was just social grooming. Now we know that real information is flowing.

We keep being told that because of cheap, ubiquitous communication technology, distance is dead. But if there was ever a company that we should expect to exemplify that idea, surely it was Google. This research suggests that it is as important as ever to be sitting in the right place.

Also published at ft.com.

Roughly five years after internet users caught on, the bookshops are suddenly full of books about the user-generated content that “Web 2.0” makes possible: the blogs, Wikipedia, Facebook and the rest. Well, you can forget them, because easily the world’s most profitable enabler of user-generated content opened the doors of its first superstore 50 years ago, in Almhult, Sweden.

It is now hard to imagine life without Ikea. A folk statistic would have you believe that one in 10 Europeans is conceived in an Ikea bed. But isn’t it pushing it a little to compare Ikea to Facebook?

I’ll admit that the similarities are not apparent at first sight. But a defining idea behind Wikipedia, Facebook and blogging platforms such as Wordpress is that if you give people the right tools, they’ll use them to create wonderful things in collaboration with each other or with the organisation that provides the catalyst.

Ikea’s success is not so very different. Ikea keeps its costs and prices low by enlisting its customers – their time, their cars, their ambitions as interior designers, and their inflated ideas of their carpentry skills.

The management experts Rafael Ramirez and Richard Normann pointed this out in the Harvard Business Review back in 1993. Ikea, they argued, was a success because it enabled “value co-production”. This infelicitous term partly refers to offering consumers a discount to build their own furniture. But it means much more: Ikea recruited its customers to the idea that they could not only put up shelves but they could design their own stylish living spaces, equipping them with tape measures and printing almost 200 million catalogues that also serve as design manuals. It also devoted huge energies to helping its suppliers and designers play their part, rather than passively buying what these people offered and then re-selling it.

We all know that the formula works. But most successful formulas are easy to copy; this one is not, and that is the genius of it. In many ways Ikea seems to be offering yesterday’s business model: surely we have less time than we did 20 years ago, while having more money to spend on our homes. When a typical London home costs £300,000, why are cheap sofas to put in it still such a tempting offering?

Yet Ikea continues to thrive, proving how hard it is for competitors to muscle in on a business that has placed itself at the centre of a web of economic actors, all striving for the same goal: a funky sitting room for Steve and Alice from Croydon.

Not many technology companies have succeeded in mobilising an army of “value co-producers” in the same way. Microsoft is the most important exception, creating a platform that supports – and is supported by – the efforts of countless other software companies. Games console manufacturers live or die with the companies that produce the games. And eBay is an old-school dotcom company that has created a near-unassailable position: the buyers go there because the sellers go there, and vice versa.

Such a market position brings inevitable temptation to exploit it. Microsoft’s tangles with the competition authorities are notorious. Facebook’s new advertising system, “Beacon”, tells your friends about commercial sites you’ve visited; the project triggered a mini-rebellion among Facebook users. Ikea is an old hand at herding customers through a labyrinthine store layout. Customers don’t like it but lacking a good enough alternative, we tolerate it.

Or we tolerate it up to a point. My love affair with Facebook was brief and bland. And Ikea? Let’s just say that my children were not conceived in an Ikea bed, and leave it at that.

Also published at ft.com. 

The aid industry faces a dilemma. On the one hand, countries are more likely to grow rich if their citizens are provided with some important basics, such as a legal system that works, or protection from corrupt officials. Such basics might seem the priority for aid money. On the other hand, it is much easier to measure success in simpler projects, such as building roads and laying pipes.

If development agencies focus on pouring concrete, they may be spending money on infrastructure that will never be used – and perhaps never even be built – because of corruption in the background. But if they focus on the broader stuff – democracy, corruption, human rights – they risk trying to do everything and achieving nothing. William Easterly, the World Bank’s most prominent apostate, argues that development agencies love big agendas because their contribution cannot be measured and found wanting. It is a bitterly cynical view, but that doesn’t mean he’s wrong.

I once gave a talk to a delegation of Danish students in which I advocated careful measurement of results, on the grounds that a lot of development spending is faddy and based on sketchy evidence. The Danes replied that their government concentrated on promoting democracy. “That sounds good,’’ I said. “Does it work?’’ They didn’t know. Nor do I.

But some young economists are changing the terms of this debate.

They argue that it may be possible both to focus on broad issues such as corruption, and at the same time measure results very rigorously with a randomised trial – the sort that would be used to test a new medical drug.

Esther Duflo, a French economics professor at MIT, wondered whether there was anything that could be done about absentee teachers in rural India, which is a large problem for remote schoolhouses with a single teacher. Duflo and her colleague Rema Hanna took a sample of 120 schools in Rajasthan, chose 60 at random, and sent cameras to teachers in the chosen schools. The cameras had tamper-proof date and time stamps, and the teachers were asked to get a pupil to photograph the teacher with the class at the beginning and the end of each school day.

It was a simple idea, and it worked. Teacher absenteeism plummeted, as measured by random audits, and the class test scores improved markedly.

Another young economist, Ben Olken of Harvard, used a similar randomisation technique to work out whether corruption in Indonesian road-building projects was best fought top-down, using audits, or bottom-up, soliciting comments from local villagers about whether money was being embezzled. One challenge was to work out how much embezzlement was taking place. Olken enlisted engineers to take samples of the road’s structure and to estimate how much it should have cost to build; he compared that estimate with how much spending was claimed in the project’s accounts. The missing funds were a rough guide to the amount embezzled.

In contrast to Duflo’s results, Olken found that the bottom-up monitoring was not effective – it shifted the embezzlement from something the villagers cared about (wages) to something they did not (building materials). The threat of a guaranteed audit – a threat that was later carried out – was much more effective, reducing the estimates of missing funds by a third.

It should not be surprising that it took different approaches in different situations to reduce corruption. Economics development is a process full of special cases. All the more important, then, to discover that big goals can be addressed in little steps – and that it is possible to find out whether the little steps are steps in the right direction.

Also published at ft.com. 

Let’s get one thing straight: I only bought Mint Chocolate Baileys as research for this column, and not because I like that sort of thing. I won’t be buying it again. The mint-choc aftertaste is so thoroughly sundered from the initial flavour of the Baileys that it is hard to imagine they once inhabited the same bottle.

But presumably somebody is buying the stuff this Yuletide, along with all the other mutations of everyday consumer goods.

Once there was only Coca-Cola; now we have Diet Coke Plus, which has added vitamins and minerals, and according to a press release from The Coca-Cola Company, joins the “Diet Coke family, which includes the flagship Diet Coke, Caffeine Free Diet Coke, Diet Coke with Lime, Diet Cherry Coke, and Diet Coke Sweetened with Splenda.”

Why are there so many new products, and do they do any good to anyone? Katie Bayne of The Coca-Cola Company has no doubts: “Consumers, including Diet Coke drinkers, are increasingly looking for more beverage options.” That sounds like the kind of thing you start to believe if you work too long for The Coca-Cola Company. But what do you believe if you’re an economist?

Economists try to measure how much consumers are willing to pay for these new twists on existing goods. For example, assume that a customer would be willing to pay £15 for a bottle of Mint Chocolate Baileys, but it retails at just £10. Buying the bottle nets the mint-chocoholic a sort of psychic profit of £5, which economists dub “consumer surplus’’. Supplying a million such mint-choc Baileys lovers would produce a total consumer surplus of £5m.

The trouble is, consumer surplus is invisible: it’s all in the mind of the consumer. Intuitively, Mint Chocolate Baileys would be a more valuable innovation if lots of consumers were willing to pay £20 for it than if most consumers were only willing to pay £11. That is the intuition behind consumer surplus – but of course we do not know how much people really would be willing to pay for Mint Chocolate Baileys – or for any product – if they had to.

The products may seem trivial, but the distortion to economic measurement may not be. If, one year, Baileys sells for £10, and the next year, Baileys sells for £10, and Mint Chocolate Baileys appears on the market for £10.50, is inflation zero? Or negative, since consumers have a new product to choose from? Or positive, since some customers are now paying more for a similar product?

If consumers think new products are very valuable, official inflation measures will be overstated because the buyers are getting a better product for the money. If the new products are nothing more than frills, official inflation measures will be more accurate.

The econometrician Jerry Hausman once attempted to measure the contribution to consumer surplus of one new product: Apple Cinnamon Cheerios. His conclusion was that its existence produced about 27 cents per person per year of consumer surplus – the psychic profit – in the early 1990s, which would be nearly 40 cents per person in today’s money. That is not earth-shaking but it is bigger than most economists expected from a new breakfast cereal.

Hausman’s estimate is disputed by some other economists. But if he is right, inflation in breakfast cereals is lower than it seems: price increases that were measured as inflation are in fact the price consumers willingly pay for a valuable new product.

The broader lesson is that inflation elsewhere may also be lower than official measures suggest.

If so, Diet Coke Plus, Apple Cinnamon Cheerios and even Mint Chocolate Baileys can all take some credit.

Also published at ft.com.

Economists rarely make good forecasts, but let me venture one: most readers of this column will eat and drink heavily over the next two weeks (as will its writer), and many of us will, on January 1, vow to do better in future. Can economics provide a little assistance in coping with this annual ritual?
I think it can, and so do three economists at Yale who’ve been helping me out. Professors Dean Karlan and Ian Ayres (who is also a law professor and the author of Supercrunchers), along with Jordan Goldberg, a business-school student, have a cheque from me for $1,000, about £500.

If I do not do 200 press-ups and 200 sit-ups each week, they’ll start sending my money to a charity, $100 at a time. (I chose the hugely deserving DC Central Kitchen.) They will shortly offer the same dubious privilege to countless others via a new company, Stickk.com – customers name their own pledges, sign pro-forma contracts, and put their cheques in the post.

It’s a clever business idea, and a variant on the old theme of making a bet with a friend that you can lose weight or quit smoking. But it doesn’t fit anywhere in classical economics. The odd robotic creature who populates traditional economic models does not need an incentive to stiffen its resolve. In fact, “resolve” is not a concept that translates into the standard model of economic behaviour.

Yet economists have been thinking about these problems for a long time. More recently, they have used behavioural experiments to raise economics to the level of common sense (no mean feat) and perhaps beyond.

One of my favourite examples: participants in an experiment were offered a choice of films to watch. Depending on whether the film was to be watched immediately or in a few days, the subjects chose something light like Mrs Doubtfire, or something character-building such as Schindler’s List. When offered the chance to change their minds at the last minute, many who had signed up for a highbrow experience buckled and grabbed something less challenging.

Daniel Read, one of the researchers, and an economist at the London School of Economics, told me that he caught himself behaving in exactly the same way.

He subscribed to a film rental service and kept rearranging his favourites so that highbrow films never quite reached the top of the waiting list. These lapses are not rational. But we can still be rational in anticipating them and taking steps to pre-empt them.

Dean Karlan, one of the men behind Stickk.com, discovered this first-hand in his day job, in which he researches the effectiveness of small financial institutions in poor countries. With two colleagues, he designed a new savings product for a small rural bank in the Philippines. The Seed (save, earn, enjoy deposits) savings accounts paid the standard rate of interest but would not allow withdrawals until either a specified date had passed or a specified amount had been saved. (There were exemptions, for example, for a documented medical emergency, but no savers took advantage of them.)

Karlan surveyed some of the customers, asking hypothetical questions designed to reveal indirectly the sort of preferences that might indicate a self-control problem. He found that women (not men) whose responses suggested a lack of self-control were also more likely to open a Seed account. And a randomised trial found that the Seed accounts did substantially boost saving.

In other words: when we need help with self-control, we tend to know it. I certainly did. Two hundred sit-ups a week might not sound a lot, but it is 200 more than I was doing before. And I can say for certain that if my money hadn’t been on the line, there’s no way I’d be sticking to it.

First published at ft.com.

Recently I was invited to a large, televised debate about how we should deal with climate change. The circumstances were spectacularly intimidating, with Tory grandees Nigel Lawson and John Redwood poised to respond to my remarks. (Despite my nerves, I resisted the temptation to follow the old public-speaking advice and imagine my fellow panellists naked.) I was the first to speak, so stood up and I talked about the cappuccino I’d bought that morning.

The curious thing about the cappuccino, I observed, is what a remarkably complicated product it is. The milk came from a methane-producing dairy herd, probably somewhere in the UK but perhaps further afield. Behind the scenes stood the farmers, the cattle breeders, the manufacturers of refrigerated tanker trucks and countless unknown others. The coffee was steamed out of Brazilian beans using a machine of Italian manufacture. The machine was electric, although whether the electricity came from coal or gas or tidal power I have no idea. The complexities are endless. (This whole tale is the kind of story economists like to tell each other, originating – I believe – in “I, Pencil”, a 1958 essay by Leonard Read.)

Then there was my choice of where to buy the cappuccino, how to get to the cafe, and whether to buy it at all. Those decisions were shaped by the location of the FT offices and the location of Borough Market.

I droned on about the cappuccino at some length, explaining that to deal with climate change you had to start with the cappuccino. And my opponents being experienced debaters, ribbed me mercilessly. Cappuccinos are small, they observed, while climate change is big.

And so we have big policies. The UK is apparently to reduce carbon emissions by 60 per cent by 2050, a date at which most of the politicians espousing this target will be dead. That dramatic-sounding commitment chimes nicely with the idea that climate change is an existential threat.

But distant targets change nothing.

So I’d like to defend the humble cappuccino as a unit of analysis. Our human economy may have to change substantially to respond to global warming. Yet what is our economy if not the sum of all the cappuccinos?

This is more than a rhetorical point. Our economy – and its emissions of carbon dioxide and methane – is nothing more and nothing less than the sum of all the everyday decisions we make as consumers, producers, entrepreneurs and the rest. If the economy must change, those decisions must change. And a moment’s thought about the cappuccino suggests what a tangled prospect that is.

We could do nothing and hope that climate change turns out to be manageable – broadly the current policy. Or we could put Gordon Brown and David Cameron in charge of telling us what light bulbs we can use, how many flights we can take, or whether our cappuccinos should be made with UHT milk. That bureaucratic approach is not appealing when you add up all the flights and light bulbs and cappuccinos in the country, reflect on the intricacies of their production and the subtle trade-offs that inform our choices to do this or buy that. Gordon Brown and David Cameron just don’t have the information to make our choices for us.

Or the government could set a price for carbon – using taxes or a workable permit trading scheme – and see what happens. The carbon price would influence every decision we make, nudging us towards consuming less and consuming in less carbon-intensive ways. That seems to be the only sensible way to ask the astonishing sophistication of the market to work around the environmental challenge we appear to be facing today. If society must change, so must the cappuccino.

First published at ft.com.

Christmas is coming, so what do you buy the loved one who has everything? One possibility is the gift card, an electronic version of the traditional gift voucher that has taken the US by storm over the past decade, and is also becoming popular over here. The popularity is odd: this is a gift that combines all the charm of a hideous cardigan, with the can’t-lose flexibility of a rumpled tenner slipped in a Christmas card. Read the rest of this entry »

“Life’s not fair,” my parents always used to say. Bill Gates and the Mexican business magnate Carlos Slim each have fortunes of about $60bn, according to the rich-list boffins at Forbes. A 10 per cent return on that lot would produce a $6bn income, or about $200 a second. That is, very roughly, about what an American makes in a day or an Ethiopian makes in nine months. Small wonder that income inequality is a hot topic.

But reliable numbers on inequality are hard to find. Even in the US, there is no agreement over what is going on. Look across the globe, and the data problems are far more acute. The most commonly reported scare statistic compares the richest country with the poorest. But this method overlooks the fact that about 2.5 billion poor people live in rapidly growing India and China. A better, but more demanding approach summarises inequality both across countries and within countries. Such efforts suggest no strong recent trends in global income inequality, either up or down.

Those efforts have been led by Branko Milanovic of the World Bank. But now – with fellow economists Peter Lindert and Jeffrey Williamson – he has produced a more surprising result. He has found that income distribution within a modern society is much the same as income distribution in imperial Rome, or England and Wales at the time of the glorious revolution. It’s not that there is no variation at all, but that modern societies are as different from each other as from ancient societies.

For example, imperial Rome’s income distribution looks like that of the modern US; China in 1880, like Sweden today, was rather equal; England in 1688 was more unequal than imperial Rome, but modern Brazil is worse still.

This is unexpected, not least because modern societies have the potential to be far more unequal than anything the Romans could have dreamed of. That’s because the richer a society is, the more unequal it could be without its working class starving to death. Prehistoric societies were, by necessity, fairly equal: there wasn’t enough societal wealth to make anybody very rich.

Modern Tanzania seems more equal than modern America, but Milanovic and his colleagues point out that it is as unequal as it could possibly be without mass starvation. The Democratic Republic of Congo is about as unequal as the US, but that is far more than the country can stand – hence the enormous loss of life through war, malnutrition and disease.

The US, as the richest society in history, is therefore potentially the most unequal in history. The US population could be kept alive for the cost of about $100bn a year.

If the elites had total control, that would leave another $13,800bn (the rest of US GDP) a year to distribute among friends of the president – almost enough to give a sum equal to Bill Gates’s lifetime wealth to a new crony each working day.

But the US is not remotely this exploitative, no matter what you may feel the next time you buy a copy of Windows.

In the newly coined jargon, it has a low “inequality extraction ratio”, meaning that the poor have much more than it would take to keep them alive.

That is faint praise for the US, perhaps. But it is interesting to observe that while modern societies are rich enough to be much more unequal than their predecessors, they show similar patterns of income inequality. Perhaps – I am speculating wildly – human societies have some hard-wired tolerance for inequality?

But one conclusion is less speculative. It is no coincidence that richer societies are less exploitative of their own citizens (have a lower “inequality extraction ratio”) than poorer ones.

That is because severe exploitation guarantees poverty.

First published at ft.com.

One thing you can rely on economists to generate is a big bunch of numbers. For that, you can blame a man named William Petty. He developed the first national income accounts, concluding in 1664 that English national income was £40m.

We rely on numbers like those calculated by Petty to help make policy decisions.

First came GDP and inflation, now a plethora of statistics on everything from income distribution to the number of days it takes to start a legal business. We rely on them for policy decisions, and usually we take it for granted that the data actually mean something.

That is an assumption worth questioning. Fraud or simple incompetence might be distorting some economic or accounting data. It would be nice to have a way to check, but it is often impossible to do so directly. So an alternative is to look for patterns in the data that might indicate that something is amiss.

One such pattern is Benford’s Law, first noted by the astronomer Simon Newcomb in 1881, and then independently by the physicist Frank Benford in 1938. The story is that each man had noticed that the early pages of books of logarithm tables were dirtier, suggesting that people tended to look up the log of numbers whose first digit was one – such as 11, 134 or 17,650. Benford then showed that whether he looked at the populations of small towns or all the numbers collected from an issue of the Reader’s Digest, numbers whose first digit was one cropped up 30 per cent of the time.

Benford’s Law does not apply to every set of numbers – for example, it does not apply to post codes or national insurance numbers, which are assigned by bureaucratic processes. But all sorts of “natural” processes should produce Benford data. And since the units in which many quantities are measured are arbitrary (grams or ounces, miles or millimetres, dollars or yen) then converting to a different unit of measurement preserves Benford’s law.

As an example, think about an economy that is growing from an initial value of $10bn. It must grow by 100 per cent before the first digit changes, to $20bn. Then it need only grow by 50 per cent to reach the next digit at $30bn, which is likely to happen more quickly. To grow from $90bn to $100bn requires just over 10 per cent growth; but then to change the first digit back to two, at $200bn, requires that the stock grow by 100 per cent again. That sort of story suggests why Benford data may be common, although quite why Benford’s Law holds so widely is not yet settled.

Regardless, the pattern is a useful test of the plausibility of data. In the early 1970s, Hal Varian, now chief economist at Google, argued that if economic data satisfied Benford’s Law on the way into an economic model but not on the way out, it was worth taking a second look at the model itself.

And Mark Nigrini, an accountancy professor, found fame in the 1990s by using Benford’s Law to discover accounting scams, frauds and tax dodges, such as inventing invoices that were just under some threshold for managerial approval.

John Nye and Charles Moul, two economists at Washington University in St Louis, have now checked some basic macroeconomic statistics using Benford’s Law. They find that OECD statistics fit the law quite well, suggesting that GDP data should follow Benford. But African GDP data do not fit. It is not possible to say whether the anomaly is due to fraud or underfunded statistical offices. But it is a reminder that some data should come with a health warning.

First published at ft.com.

Talk about a baptism of fire: my first experience with a televised panel debate put me up against Tony Benn, a leftist former cabinet minister famous – in part – as perhaps the most formidable debater in the country.

“You’re going to get killed,” said my wife, ever supportive. And rhetorically, perhaps I was – he masterfully trotted out his favourite sound bites, regardless of whether they pertained to the question or not.

This was almost two years ago, and one of Benn’s sound bites has had me thinking ever since. He pointed out that “in a democracy, everybody gets a vote. In the market, the poor and the homeless don’t get a vote.” Ergo, government provision of, well, anything, is preferable to leaving it to the market.

But the concept of a “vote” is meaningless when it comes to the market. If Benn’s claim means anything at all, surely it means this: that a poor person has more influence over the service he or she receives from the government than over the service he or she receives from the market. That claim means something, but it is also hard to sustain.

I am not making an argument about the miracle of the market, but about the limits of politics. Democracy has many virtues, but giving influence to the individual voter is not one of them. Notoriously, an individual’s vote makes no difference to anything. According to the British election watcher David Boothroyd, in 24 general elections since 1918, each spanning hundreds of parliamentary constituencies (most recently, 646), there has only ever been one valid election where your vote could have made a difference: A.J. Flint was elected as Labour MP for Ilkeston in 1931 by just two votes. (The other two-vote victory, in 1997, was declared void.) Even in 1931, the Ilkeston swing voter would not have influenced government policy: the Tories won about three times as many seats as all the other parties put together.

In the US, there is a similar story: the closest presidential race in history, Bush-Gore in 2000, still had a margin of more than 500 votes in Florida.

So my vote gives me no power to influence the government. That might explain the cavalier behaviour of government agencies. I’ve twice received government threats over my presumed late payment of tax. In one case the tax was paid in good time but that didn’t deter them; in the other, I asked for a statement of all tax owed, paid it, and then heard nothing until the court summons a year later. (Their statement had been wrong, so I’d paid the wrong amount of tax – but tell that to the judge.) Never was there an apology – not even the regretful tone that most good corporate bureaucracies are capable of producing if they have to.

These big corporate bureaucracies are equally capable of stuffing things up, of course. The difference is that when they do, you can usually have them grovelling, because they know that you can take your business elsewhere. Most of us do not enjoy the luxury of choosing which tax bureaucracy to do business with. (Those who do, tend to secure favourable results.)

It is true, as Tony Benn would no doubt claim, that a billionaire’s threat to take his business elsewhere carries more weight than a poor person’s does. But businesses still cater to the poor, and do not want to lose customers, even poor ones. And the poorest participants in a market society have more influence over what they receive as consumers than they do as voters. The government could nationalise Tesco, and rich and poor alike would get the same level of individualised service: not much.

Published at ft.com.

I’m a real cappuccino lover myself, but many of my female colleagues don’t seem to go for the stuff. I’d never thought too much about that until recently. I suppose I carelessly assumed that men and women have different tastes, probably as a result of different social influences. Now I know better: my female colleagues don’t go to coffee shops because they’re shabbily treated when they get there. Read the rest of this entry »

I was recently invited to a friend’s wedding in the historic city of Oxford. Wearing our best robes, and with a toddler, a baby, nappies and toys in tow, my wife and I drove from London to Oxford, shunning the alternative of a journey via bus, Tube, train and bus again to the wedding venue. My wife is a keen environmentalist, but not that keen.

On arrival in Oxford, an economic puzzle. It is cheap to park in Oxford’s centre – free, in many areas – but with a maximum stay of two hours, it was impossible to park there for the wedding. I eventually resorted to dropping the family at the city-centre venue and weaving up and down North Oxford’s residential streets for a couple of miles.

I left the car for five hours in a remote two-hour space and hoped I’d get away with it.

(I did.) When the wedding was over, I walked back to the car, drove back into the town centre, picked up the family, and drove them home to east London.

I’ve since asked Oxfordshire County Council what they were playing at…

Continued at ft.com, subscription free.

Until recently, there were two types of newspaper website: those that made you pay to read many of the articles (The New York Times, The Wall Street Journal and the Financial Times) and those that didn’t.

That is changing. The New York Times recently announced that almost all its online material would now be free. FT.com has just moved to a system of free access for occasional visitors. And Rupert Murdoch has strongly hinted that the Journal might do something similar. The theory is that advertising revenue will outstrip subscription revenue.

So is this the death of subscription-model newspapers? And will the availability of so much free online journalism also doom their pricier print editions to a slow death?

These are hard questions, because the internet is changing so quickly that first principles are little help. One smart response is to experiment, but such experiments can be pretty expensive if they don’t work out.

The New York Times’s retreat from a subscription model is widely portrayed by online commentators as a humiliating and belated acceptance of the inevitable. But Matthew Gentzkow, an economist at the University of Chicago, recently published research that suggests that there has been no expensive mistake…

Continued at ft.com, subscription free.

In the late 1870s, a magician named Buatier De Kolta was mesmerising audiences in Paris by producing big bunches of paper flowers from an empty roll of paper. Nobody knew how the trick was achieved, until a gust of wind blew one of the flowers on to the floor in front of the stage. A magician in the audience seized it and ran out – De Kolta’s trick was soon being performed by many of his rivals.

The story is told by Jacob Loshin, a recent graduate from Yale Law School, in a working paper on how magicians protect their tricks. Such outright thefts would be hard to imagine today because magicians have developed a professional code of conduct to defend their most valuable property: their ideas.

The research bears – albeit obliquely – on an issue that is only going to become more important: intellectual property in a world where more and more of the wealth that is created takes the form of ideas rather than objects. Intellectual property law does not protect magicians’ tricks very well, and it does not help much in high fashion or in haute cuisine either – all areas that Loshin describes as a “negative space” for intellectual property.

For the fashion industry, a lack of intellectual property protection may not be a problem: the trickle-down of high-end fashion helps create obsolescence and the demand for more high-end fashion. But chefs and conjurors need a little help protecting their ideas. Lacking legal shelter, they resort to professional norms.

Loshin describes the magicians’ norms, which encourage the selective sharing of techniques, limit copying and credit the re-discoverer of a long-dormant technique with the same rights as the trick’s inventor. The economists Emmanuelle Fauchart and Eric von Hippel report very similar norms for the sharing of recipes among French chefs.

In both cases, the norms are enforced through social pressure that can be very powerful. Loshin describes the case of one company that manufactured tricks that were regarded in the eyes of the profession – although not the law – as proprietary. Magic journals would not accept the company’s ads, professional magicians shunned its offerings, and bankruptcy soon followed.

These techniques work because the fraternity of magicians – and chefs – is close-knit. Aspiring chefs work long apprenticeships and rely on word of mouth for their next job. Magic journals are not available at newsagents, and even Prince Charles had to perform an examination before being accepted as a member of The Magic Circle. A magician who steals from another, or reveals secrets not widely known by non-magicians, will not be entrusted with new ideas or recommended by other magicians.

These informal sanctions work well for both chefs and magicians. But they are not perfect. Magicians, in particular, face another problem that the chefs do not. If a chef’s recipe is revealed to the world, that does not detract from his reputation, and only other professional chefs are likely to be able to use the information. But if a magician’s trick is revealed, his reputation suffers; in fact, a little bit of the mystery is taken away from the entire profession.

In one notorious example, a series of 1990s television shows with the self-explanatory title, Breaking the Magician’s Code, won big audiences by revealing the secrets behind classic illusions. One magician complained that the shows were “peeing in everybody’s cornflakes”. But the magicians’ social sanctions were powerless to prevent television executives from exposing their secrets, and legal challenges to the programme did not succeed.

Loshin’s work is a reminder of how idiosyncratic intellectual property rights can be. Idiosyncrasy is not easy for economists to deal with, but if we want to understand the intangible economy of ideas, it’s a trick we shall have to master.

Published at ft.com, subscription free.

My troubles began while I was tidying up my CD collection, the decaying fruit of a misspent youth. I don’t mean alphabetising it, merely sorting through the piles of scratched silvery discs and putting them back into their cases. The process reminded me just how much music I don’t listen to, simply because of the archaeological dig that would be required. And so I started to think of copying all this music into some wonderful electronic box, and chucking the CDs away.

After a bit of research, I now realise that I have a dizzying range of choices – media PCs, iPod docks, dedicated music servers and wireless “bridges”. Don’t ask me to begin to enumerate the pros and cons, although it seems clear that most of them do things with music that it would have been hard for most of us to imagine 10 years ago. The human response is bewilderment. The economist’s response, of course, is “I wonder how many of these gizmos are in the inflation statistics?”

When I was a boy, there were no CDs. (The CD is 25 years old this year; The Visitors, by Abba, was the first one produced.) The original CD players were ludicrously expensive, so not many people bought them. Only when the price came down did people embrace the CD format.

That makes things difficult for the bean-counters who compile the inflation statistics. The Office for National Statistics (ONS) sends surveyors out to the shops once a month; the surveyors take a note of the prices; someone at the ONS adds up all the prices, and we see how much inflation has taken place in the past month. CD players have been falling in price and improving in quality for years, which should show up as a contribution to lower inflation.

But it is precisely when the price falls and quality improvements are most dramatic that they make little or no impact on the inflation statistics.

Continued at ft.com, subscription free.

Armed with their theories and their statistical models, economists are increasingly marching off to occupy distant intellectual territory: marriage (Gary Becker), racial segregation (Thomas Schelling), obesity (David Cutler) and whether it matters whether your child goes to school with bright kids (Caroline Hoxby).

The practice – which has been around for a while – is often termed “economic imperialism”, perhaps because of the less-than-heartfelt welcome the natives usually extend to the economic explorers.

I am all in favour of economists venturing into new territory – and receiving incursions from outside – but the practice isn’t quite as productive as it should be.

Take the experience of Emily Oster, a young assistant professor of economics at Chicago with a big reputation. One of her celebrated articles is an analysis of the Aids epidemic in Africa: she offers her own epidemiological model and concludes that the virus is best fought by treating other sexually transmitted diseases. The research was published in the prestigious Quarterly Journal of Economics (QJE) in May 2005.

But Oster’s conclusion is probably wrong. Epidemiologists embraced the idea of treating other sexually transmitted diseases a long time ago, but it has been discredited (to their deep disappointment) by a series of rigorous clinical trials. Oster says that the most convincing evidence came out after her paper was written; still, she has repeated her recommendations more recently in Esquire magazine.

Oster also made a mistake in handling her data. The error – which she has acknowledged, and which makes a modest but noticeable difference to her calculations – was quickly spotted when I asked two epidemiologists to review her research. The QJE will be publishing a correction.

Oster quite reasonably says that her article has other merits. But it might have been much better if the epidemiologists had taken a look long before the FT got involved.

The problem is that the economists couldn’t get the epidemiologists to take the research seriously enough to comment. Oster tells me that she tried, but she couldn’t name an epidemiologist who was familiar with her QJE paper. And Larry Katz, the QJE editor who published Oster’s paper, acknowledges that the epidemiologists would not typically agree to review papers for the QJE.

Different academic disciplines should talk to each other more – but that is easy to say. “Every discipline develops a different set of things they care about,” says Michael Kremer, a Harvard economist.

Kremer has studied the impact of aid on the performance of schools, and that meant working with education experts. He focused on the statistical robustness of the research; they were worrying about whether the tests being given to students were valid. “Both are right, but the difference in areas of concern means that it takes a lot of work to communicate.”

It is not just the economists who struggle to collaborate. I recently read a book by the physicist Neil Johnson who believes physics is a better tool than economics for understanding financial markets. I was disappointed to find no evidence that Johnson cared what economics actually said about financial markets, which would have been helpful if he aimed to refute it.

Still, there are reasons for optimism. Princeton economist Alan Krueger is working with the psychologist (and winner of the Nobel prize in economics) Daniel Kahneman. The “neuroeconomists” talk to the neuroscientists, if only to beg the use of their brain-scanners. And Gary Becker, another Nobel laureate and the economic emperor himself, also holds a sociology professorship.

It is not so easy for younger economists to be taken seriously by others. Something tells me that is not going to curb their ambitions.

As the queues formed down the street outside branches of Northern Rock this week, it was obvious enough to a game theorist what was going on: people had decided to hunt rabbits. Bear with me – this will make sense in a moment.

Game theory is the study (by economists, mathematicians, biologists and others) of situations where what you do may affect what I choose to do, and what I do may affect what you choose to do. The theory is big on catchy stories with memorable names, but ultimately it is all about mathematical representations of interactive decisions, called “games”. The most famous game of all is the “prisoners’ dilemma”, in which two prisoners must each decide whether to plea-bargain by giving evidence against the other.

But another game, the “stag hunt”, languishes in relative and undeserved obscurity. In the stag hunt, two hunters must each decide whether to hunt the stag together or hunt rabbits alone. Half a stag is better than a brace of rabbits, but the stag will only be brought down with a combined effort. Rabbits, on the other hand, can be hunted by an individual without any trouble.

There are two rational outcomes to the stag hunt: either both hunters hunt the stag as a team, or each hunts rabbits by himself. Each would prefer to co-operate in hunting the stag, but if the other player’s motives or actions are uncertain, the rabbit hunt is a risk-free alternative.

Northern Rock’s customers have decided to hunt rabbits. If they had confidence that other depositors would stay with the bank, there’s not much doubt that their money would be safe. When they lost that confidence, the stag hunt was abandoned. And despite all the talk about panic, it was abandoned for perfectly sensible reasons.

Continued at ft.com, subscription free.

I am writing this column in one of my favourite London haunts – the Great Court at the British Museum. I’ve just been to see one of the museum’s most famous and controversial exhibits, the Parthenon Sculptures – also known as the Elgin Marbles. These carvings were taken from the Acropolis in Athens more than 200 years ago by the Earl of Elgin. But while there’s a predictably long-running argument over whether the carvings should ever have been removed, the trade in antiquities remains very much alive today.

This trade is almost inevitable. In a poor country, such as Mali or Cambodia, foreigners are likely to be willing to pay more for artefacts than the locals would.

The logic of the market would pull the choicest objects into foreign collections and foreign museums. Many see this as undesirable, and so most countries maintain some form of ban on trading antiquities.

But such bans have some unpleasant side-effects. They replace the logic of the market with the logic of the black market, which means that smugglers would try to conceal the locations of new archaeological sites, to erase or forge the historical records surrounding objects, and to excavate and ship objects without the care that could be lavished on an operation that was legal. Beyond these purely archaeological considerations, illegal objects are less likely to end up in the top museums and may be relegated to private collections, which is in itself a shame. It’s enough to make an archaeologist weep – and an economist too.

Michael Kremer, a Harvard economics professor with a track record of inventive ideas, and Tom Wilkening, a graduate student at the Massachusetts Institute of Technology, published a possible solution earlier this year. Instead of flatly banning the export of antiquities, why not ban their sale but allow them to be rented?

Continued at ft.com, subscription free.

I intend to break a record with this column, and publish what must surely be the FT’s longest ever correction. It’s not that I enjoy self-flagellation in public. But the manner of my error offers a lesson about economics as well as journalism.

First, the error. In the “Dear Economist” column, I recently described the research of Harold Hotelling. But I attributed to Hotelling an anecdote that is widely used but was probably never used by Hotelling himself.

Ron Johnston, a geography professor at the University of Bristol, was kind enough to point out my mistake. “You are, I fear, by no means the first person to incorrectly cite Hotelling’s classic 1929 paper as using the example of two or more ice-cream sellers locating on a beach. [It] did not: his much more prosaic example was of two ‘places of business’ serving ‘buyers … supposed uniformly distributed along a line of length 1, which may be Main Street in a town or a transcontinental railroad’.”

So why did I slip up? I know Hotelling’s model fairly well, but I wrote my answer while travelling and unable to access the Economic Journal of 1929. Wondering whether the ice-cream anecdote really was Hotelling’s, I checked accounts of his model on the internet and found the anecdote attributed to him again and again. (As Johnston correctly pointed out, I am by no means the first to make the mistake.) The stakes in this case being rather low, I drafted my column and then forgot about my doubts.

I was a victim of what economists call “informational herding”. Imagine a series of perfectly rational but somewhat lazy economics professors posting accounts of the Hotelling model on the internet. Each professor is unsure of whether the ice-cream story is true or not so each makes his best guess rather than taking the time to make that trip to the library.

If the first two professors are wrong, and include the ice-cream anecdote in their course notes, they set a precedent that it is irrational to ignore. The third professor may recall that Hotelling did not mention ice cream, but rationally doubts his memory when he sees what his colleagues have written. Since he is unsure and reckons that two heads are better than one – and also prefers not to trek to the library – he also includes the anecdote.

Despite the errors and the laziness, everybody involved has behaved rationally. The third professor is correct to believe that his two colleagues are more likely to be right together than he is to be right alone. But the curious thing is that any number of professors may now follow suit, suspecting that the anecdote is bogus but deferring to the collective wisdom of their predecessors.

The same reasoning could apply to people responding to a fire alarm in a large office. Seeing that nobody else is moving, each person is likely to suppress their doubts and stay put. Once the exodus does begin, everyone may pour towards the same exit.

Or consider the success of books such as the Harry Potter series. Millions of people buy such books because millions of other people have bought them. The assumption is that all these other readers can’t be wrong; but the theory of rational herds suggests that only the first few of those readers made an informed decision. Everybody else was relying on the early adopters.

Yet rational herds can quickly change their minds. Everybody knows that the early movers effectively decided the behaviour of the entire herd, because nobody who came later felt confident enough to depart from their decision. That means that if a single commentator did his homework and felt confident enough to dissent, all future professors, book-buyers or office workers would feel similarly confident in following that lead. Just one FT columnist could correct a long-standing myth – if he did his homework properly. SorryFirst published at ft..com.

My colleague, Isabel Berwick, recently mourned the closure of her fondly remembered all-girls private school, and regretted “a slow societal shift away from girls-only schools and colleges”. As the father of two young daughters, I am paying attention.

Yet “slow” is the operative word. Girls’ schools are clinging on tenaciously in the state sector: more girls go to single-sex schools than boys. In inner London, parental preferences for girls’ schools are particularly pronounced. The Guardian has reported that more than half of inner-London girls attend girls’ schools, and just over a quarter of boys attend boys’ schools. The result, of course, is that the mixed schools contain a disproportionate number of boys.

Parents make these choices because of a widely held belief that girls thrive in single-sex schools. But is that true? And what are the implications for the girls left surrounded by emotionally retarded adolescent males?

We are in the realm of so-called “peer effects” here, and they are notoriously hard to measure. Girls’ schools produce good academic results, but that could be because particular types of parent favour such schools, because those schools have a strong historical record, or because of selection.

I was lucky enough to go to a state-funded, single-sex, selective school in a prosperous neighbourhood. My classmates did well in their exams, but there is an embarrassingly large range of explanations as to why.

A new working paper from the economists Victor Lavy of the Hebrew University of Jerusalem and Analia Schlosser of Princeton attempts to unpick the peer effects associated with gender, using data on nearly half a million students passing through Israel’s school system in the 1990s. They compared consecutive year groups passing through the same school, figuring that if one year group was 55 per cent boys and the next year was 55 per cent girls, that difference was likely to be random and thus susceptible to meaningful number crunching.Their answer chimes perfectly with the conventional wisdom: boys benefit from being in a classroom with girls, but girls do not benefit from being taught with boys. What is interesting about Lavy and Schlosser’s work is that it uses survey data provided by the children to work out what causes the effects. They were asked, for example, about violence in school, respect for teachers, classroom distractions, and relations among students.

Boys pollute the education system, it seems, for a number of unmysterious reasons: they wear down teachers, disrupt classes and ruin the atmosphere for everyone. And more boys are worse than fewer boys, not because they egg each other on but simply because more of them can cause more trouble in total.

It is all rather worrying, especially for the parents of little angels such as my daughters. Evidently, it is impossible to satisfy the – apparently justified – parental demand to educate girls in single-sex schools and boys in mixed classes. (Not for the first time in my life, I conclude that the world doesn’t have enough girls in it.)

Researchers from the University of London’s Institute of Education have asked a related question, comparing mixed with single-sex schools (from the 1970s, when non-selective single-sex schools were more plentiful) rather than the varying gender balance within mixed schools. Their conclusions, published last year, were subtly different. They found that boys disrupt mixed classrooms, but did not do any worse if locked up in a single-sex school.

A social planner might thus conclude that all education should be single-sex. The difficulty is to combine this perspective with the principle of parental choice. I have the answer: a congestion-charge-style tax on parents who insist on polluting girls’ education with their testosterone-fuelled little monsters. The money could go towards hiring extra teachers – and riot police.

Originally published at ft.com.

What is the perfect rate of inflation? It is the kind of odd question that economists like to ask each other for fun, but which central bankers have to decide for real.

You might think that the answer was, obviously, zero, but nobody has told the central banks. The Bank of England has an inflation target of 2 per cent, the European Central Bank aims to keep inflation below, but close to, 2 per cent, and the Federal Reserve has a “comfort zone” of between 1 and 2 per cent. Japan’s inflation rate is about zero – but when I visited Tokyo in May, one senior official told me: “We envy you your inflation.”

These are only targets: most would concede that inflation is impossible to control perfectly. But why do central bankers aim to keep it above zero, rather than trying to eradicate it?

One reason is that relative prices need to change frequently to reflect changes in the economy: this year, British peas will be expensive because the crop was ruined by floods. But clothes have been getting cheaper for years, thanks to low-cost manufacturers in China. And yet the evidence suggests that it is usually easier to raise nominal prices than to lower them. So a little bit of inflation, which ensures the typical price change is up rather than down, means that those relative price adjustments can happen more quickly and easily. This can have a substantial effect on the real economy.

Professor Peter Sinclair of Birmingham University, when a research fellow at the Bank of England, concluded that moderate inflation could have other benefits: creating more room for policymakers to stimulate the economy if necessary, a steadier banking system and slightly lower average unemployment.

Of course, you can have too much of a good thing. While some inflation may help relative prices to adjust, too much requires such frequent price changes as to become a real burden. According to a credible 1990s estimate from the economist Daniel Levy, the typical American supermarket spent $100,000 a year changing the labels on its products: at high inflation rates it would have spent much more.

At a certain point – which Zimbabwe is well past – hyperinflation renders all prices meaningless. When Robert Mugabe ordered shopkeepers to halve prices in June, one of the most remarkable features of the pointless edict was that it would only have reduced them to their level less than a fortnight earlier.

In such circumstances, it is all but impossible to get a sense of the price of a beer versus a meal versus a shirt. The whole purpose of the price system – to convey information about the relative cost of different items – is lost.

One often hears that during periods of hyperinflation, people switch to barter, trading cigarettes or coffee for other products. That is not quite correct. Instead, during hyperinflations people look for alternative currencies. Cigarettes and coffee are portable and standardised, and so are decent candidates. So while the price of a shirt in terms of Zimbabwean dollars may be hopelessly volatile; the price of a shirt in packets of cigarettes or pounds of coffee is more stable.

Meanwhile, Japan is still trying to work out how to reach the “enviable” inflation the UK enjoys. Another economists’ conversation piece is the helicopter drop: the Bank of Japan could produce inflation by printing billions of yen and showering them over Tokyo.

Self-respecting central bankers try to expand the money supply using more sober methods.

Or do they? Japan has recently been gripped by an epidemic of mysterious cash gifts – bundles of yen left in mailboxes, public lavatories and even raining from the roof of a convenience store in Tokyo. Could the Bank of Japan finally be calling in the helicopters?

First Published at ft.com.

If economics can tell us something useful about crime, marriage or car-pooling – as I believe it can – then other academic disciplines should have something to tell us about economies. Last month, Science published an example that may turn out to be important. Two physicists, Cesar Hidalgo and Albert-Laszlo Barabasi, and two economists, Bailey Klinger and Ricardo Hausmann, have been drawing unusual pictures of economic “space” that promise a deeper understanding of the biggest question in economics: why poor countries are poor.

There are many explanations, but some are easier to test than others. One very plausible account of why at least some poor countries are poor is that there is no smooth progression from where they are to where they would be when rich. For instance, to move from drilling oil to making silicon chips might require simultaneous investments in education, transport infrastructure, electricity and many other things. The gap may be too wide for private enterprise to bridge without some sort of co-ordinating effort from government – a “big push”. That is an old and intuitive idea in economics, but as an informal argument it leaves a lot to be desired. For a start, while plausible, it might not be true. If it is true, it might be far more so for some kinds of economy than for others. And if there is to be a big push, in which direction should it go?

Continued at ft.com, subscription free.

Let others worry about the oil price or China’s current account surplus. On this page, I am celebrating a vintage summer for the economist as personal improvement guru. The “Dear Economist” column, first penned by Alan Beattie and Chris Giles (now FT trade and economics editors, respectively), has celebrated its fourth anniversary. Then Esquire magazine, of all places, was persuaded to publish my full-length feature on what economics could teach its readers about getting a date.

Now Tyler Cowen, an economics professor and prolific blogger at marginalrevolution.com, has published a self-help book called Discover Your Inner Economist.

I have myself long harboured a shameful desire to write a self-help book based on the basic principles of economics, but Cowen got there first. (One of those basic principles is that money doesn’t get left lying in the street for long.) I recommend his book very highly to anyone who enjoys reading this page: it’s relentlessly creative and I loved reading it.

Still, the economics of self-help is a difficult business. This is not for the obvious reason, which is that economics appears to be a narrow subject focused only on money. Economics is far broader than that: two decent definitions of the subject are that it is the study of scarcity (and what could be scarcer than Mr Right?) or that it is the study of rational behaviour.

It’s this second definition that hints at trouble…

Continued at ft.com, subscription free.

I feel that it is time to share a secret. When I left on my holiday just over a week ago, I was fighting a battle with a deep-rooted addiction. I feel able to admit this, since over the course of my holiday I was able to go through cold turkey, conquer the addiction, and face the world clean.

It’s decaffeinated coffee for me from now on. Addiction – even to something as benign as filter coffee – is an unlikely topic for an economist to tackle, because most economic theory is predicated on rational behaviour, and addiction seems to be quintessentially irrational.

The logical response appeared in 1988. A Theory of Rational Addiction was published by Kevin M. Murphy and Nobel laureate Gary Becker, and has defined economists’ approaches to addiction ever since. The theory is easy to state: it is that addicts choose their poison despite knowing that it is habit-forming and dangerous, and they do so because they expect the highs to outweigh the lows.

Even other economists are sceptical. “They don’t know what they’re talking about,” opined Thomas Schelling when I met him shortly after he, too, was awarded the Nobel prize in economics…

Continued at ft.com, subscription free.

If I don’t finish this column today, I’m in big trouble: I’ll be writing it on holiday, and my wife is likely to club me to death with a rolled-up copy of the FT’s glossy ‘How to Spend It’ magazine. She’s always telling me that I work too hard, and she may well be right. But what would happen to the economy if we all took life a little bit easier?

The simple answer is that we’d all produce less, which would mean more time to relax and fewer material goods to enjoy. The economy, as measured by gross domestic product, or GDP, would shrink. That would be just fine, of course.

GDP measures the total financial value of all the goods and services produced in an economy over the course of one year. Evidently, therefore, it leaves a lot out. For instance, sex in the context of a loving relationship is generally regarded as a good thing. Yet it would not show up in the GDP figures; sex with a prostitute would do just that, at least in principle. For such reasons, I often see proposals for superior measures of national welfare that allow adjustments for many things, ranging from environmental degradation and arms trading to time spent commuting.

I find such proposals very odd.

When a hatter measures the circumference of your head, he’s trying to work out what size of hat would fit you. It’s true that he has failed to gauge accurately your intelligence, but if you made that complaint he’d be puzzled. He’d be even more puzzled if you started proposing various adjustments. The same with GDP: it was only ever intended to measure economic transactions and there’s not much point in accusing it of failing to measure something else.

But if GDP leaves out so much that matters, why do my fellow economists lavish so much attention on the latest quarterly GDP growth figures?

Continued at ft.com, subscription free.