Tim Harford The Undercover Economist

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

Undercover Economist

The refugee crisis — match us if you can

‘However many refugees we decide to resettle, there’s no excuse for doing the process wastefully’

Writing in the 1930s, Lionel Robbins, head of LSE’s economics department, defined economics as “the science which studies human behaviour as a relationship between ends and scarce means which have alternative uses”. It’s the study of who gets what and why.

That typically means that economists study conventional markets: how prices work, how people respond to them and how the whole system might function or malfunction. But sometimes a market simply will not do. We don’t allocate children to state school places based on their parents’ willingness to pay. Most countries don’t sell passports to the highest bidder. We do not have a legal market in iced kidneys.

Whether we like it or not, the problem of who gets what and why remains. Sometimes it is grubbily resolved by the emergence of parallel markets — for example, children can be placed in desirable schools at taxpayer expense if their parents buy or rent expensive homes in the right areas.

Over the past few decades a small group of economists — most notably Nobel laureate Alvin Roth, author of Who Gets What — and Why (2015) — has been designing “matching mechanisms” to address allocation problems without resorting to traditional markets. A typical problem: matching teaching hospitals with trainee doctors. The doctors want good hospitals and the hospitals want good doctors. Each side will also have a focus on a particular field of medicine, and the doctors may have preferences over location. Some doctors may be dating fellow medics, who are themselves searching for a teaching hospital.

A good matching mechanism tries to satisfy as many of these preferences as possible. And it ends the need for people to second-guess the system. Bad matching mechanisms reward people who say that a compromise option is really their top preference. Such mind-games are alienating and unfair; in a well-designed matching system, they can be eliminated.

Roth and a growing number of his students and colleagues have designed matching mechanisms for schools and hospital placements, and even mechanisms to ensure the best match for donated kidneys. In each case a market is socially unacceptable but ad hoc or lottery-based allocations are also poor solutions. Nobody wants a random kidney, or to be assigned a place on the whim of a well-meaning bureaucrat who doesn’t really understand the situation.

By balancing competing demands, good matching mechanisms have alleviated real suffering in school systems and organ donation programmes. Now two young Oxford academics, Will Jones of the Refugee Studies Centre and Alexander Teytelboym of the Institute for New Economic Thinking, are trying to persuade governments to use matching mechanisms in the refugee crisis.

Most popular discussions of the crisis focus on how many refugees we in rich countries should accept. Yet other questions matter too. Once nations, or groups of countries, have decided to resettle a certain number of refugees from temporary camps, to which country should they go? Or within a country, to which area?

Different answers have been tried over the years, from randomly dispersing refugees to using the best guesses of officials, as they juggle the preferences of local communities with what they imagine the refugees might want.

In fact, this is a classic matching problem. Different areas have different capabilities. Some have housing but few school places; others have school places but few jobs; still others have an established community of refugees from a particular region. And refugee families have their own skills, needs and desires.

This is not so different a problem from allocating trainee doctors to teaching hospitals, or children to schools, or even kidneys to compatible recipients. In each case, we can get a better match through a matching mechanism. However many refugees we decide to resettle, there’s no excuse for doing the process wastefully.

There is no perfect mechanism for matching refugees to communities — there are too many variables at play — but there are some clear parameters: housing is a major constraint, as is the availability of medical care. Simple systems exist, or could be developed, that should make the process more efficient, stable and dignified.

One possibility is a mechanism called “top trading cycles”. This method invites each refugee family to point to their preferred local authority, while each local authority has its own waiting list based on refugee vulnerability. The trading cycles mechanism then looks for opportunities to allocate each family to their preferred location. The simplest case is that, for example, the family at the top of the Hackney waiting list wants to go to Hackney. But if the family at the top of Hackney’s list wants to go to Camden, the family at the top of Camden’s list wants to go to Edinburgh, and the family at the top of Edinburgh’s list wants to go to Hackney, all three families will get their wish.

Right now, the UK is a promising candidate to pioneer the use of one of these matching mechanisms to place refugees. The government has pledged to resettle 20,000 Syrian refugees now in temporary camps. Local authorities have volunteered to play their part. But to make the best possible matches between the needs of the refugees and the capabilities of these local authorities, it’s time to deploy a little economics.

Written for and first published at ft.com.

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Undercover Economist

A billion prices can’t be wrong

‘A “big data” approach to inflation is helping us understand the fundamental question of why recessions happen’

In the dying days of 2015 came news to set any geek’s pulse racing: the declaration of a “statistical emergency” by Mauricio Macri, the new president of Argentina. Macri’s move enabled Jorge Todesca, head of the statistics bureau, to suspend publication of some basic economic data. That might seem extreme but Argentina’s inflation numbers were widely discredited.

The International Monetary Fund censured Argentina in 2013 for its implausible numbers under previous president Cristina Fernández de Kirchner. Government statisticians say they were leaned on by her administration to report low inflation. Todesca himself used to be a private-sector economist, and, in 2011, his firm was fined half a million pesos for publishing numbers that contradicted the official version. (Half a million pesos was about $125,000 at the time; it is $35,000 these days, which rather proves the point.)

But one economist found a way to publish plausible inflation statistics without being prosecuted. His name is Alberto Cavallo, and he realised that by gathering price data published by online retailers, he could produce a credible estimate of Argentine inflation from the safety of Massachusetts. Cavallo’s estimate averaged more than 20 per cent a year between 2007 and 2011; the official figure was 8 per cent.

So began the Billion Prices Project and its commercial arm PriceStats, both collaborations between Cavallo and fellow MIT economics professor Roberto Rigobon. “Billion Prices” sounds hyperbolic but that is the number of prices collected each week by the project, from hundreds of retailers in more than 60 countries.

While the project confirmed that Argentina’s inflation numbers could not be trusted, it also showed that the US inflation numbers published by the US Bureau of Labor Statistics could be. Several maverick commentators had argued that hyperinflation would be the inevitable consequence of money printing at the Federal Reserve. When hyperinflation plainly failed to materialise, some critics suggested the BLS was hiding it — as if nobody would notice.

A second advantage, swiftly noted, was that the daily flow of data from PriceStats was a good predictor of official inflation statistics, which are typically published once a month. Cavallo and Rigobon like to point out that their US online price index started to fall the day after Lehman Brothers declared bankruptcy; the official Consumer Price Index took a month to respond at all, and two months to respond fully.

The BPP is also shedding light on some old economic mysteries. One is the problem of adjusting inflation for changes in quality. To some extent this is an intractable problem. The Edison phonograph cost $20 at the end of the 19th century; an iPod Nano costs about $145 today. What inflation rate does that imply over the past 117 years? There is simply no good answer to that question.

But statistical agencies are always wrestling with smaller slices of the same problem. A new model of washing machine is introduced at a premium price, gradually discounted over the years and eventually sold at clearance prices and replaced with a swankier model. The same thing is happening over differing timescales with computers, summer dresses and cars. If the economic statisticians mishandle these cases, they will get their measure of inflation badly wrong; usually they rely on careful substitutes and clever theory, but success can never be assured.

Cavallo and Rigobon argue that the sheer volume of prices collected by the BPP helps resolve the problem. Every day, the project gathers the prices of hundreds of washing machines. By observing that the availability of the Scrub-O-Mat 9000 overlaps with that of the Cleanado XYZ, it’s possible to adjust as new products are introduced and old products discounted and then phased out.
This “big data” approach to inflation is also helping us to understand the fundamental question of why recessions happen. Without opening a big bag of macroeconomics at this stage in the column, one influential school of thought is that recessions happen (in part) because prices don’t adjust smoothly in the face of a slowdown. Like a small rock that starts an avalanche, this price rigidity causes big trouble. Unsold inventory builds up, retailers slash their orders, and manufacturers go bankrupt.

The trouble with the idea that price stickiness causes recessions is that, according to official inflation statistics, prices routinely change by amounts large or small, which suggests no price rigidity.

But it turns out that many small price changes are statistical illusions. For example, if a product is missing from four monthly inflation surveys and is 1 per cent more expensive when it returns in the fifth month, official statisticians will quite rightly smooth over the gap by imputing a 0.2 per cent rise per month. But it would be a mistake to take this as evidence that retailers did, in fact, repeatedly raise prices by 0.2 per cent. Collecting billions of prices removes the need to fill in these gaps, and in the BPP data very small price changes are rare. Prices will move by several per cent if they move at all. One might guess that in physical stores the cost of relabelling products is higher, and small price changes are even rarer.

The BPP’s big data approach has rescued the important macroeconomic idea of price stickiness. It is a reminder that we often gain from having a second opinion — or a billion of them.

Written for and first published at ft.com.

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Undercover Economist

The odds are you won’t know when to quit

‘The truth is that there are no foolproof methods for knowing when to hold ’em and when to fold ’em’

There is a strong case to be made for persistence. As a child I was told the legend of Robert the Bruce. Cowering and hiding in some dank cave in Scotland, he felt like giving up his struggle against the English. Then he noticed a spider repeatedly failing to spin a web before eventually succeeding. Heartened, King Robert returned to give the English a sound thrashing in 1314. Even for an English boy, it was an inspiring tale. If at first you don’t succeed, try again.

But there is an equally strong case to be made against being stubborn. When Irving Fisher and John Maynard Keynes failed to predict the Wall Street Crash of 1929, the two great economists reacted differently. Fisher stuck to his guns; Keynes shrugged and changed direction. Fisher was ruined; Keynes died a millionaire. If at first you don’t succeed, do something different next time.

Do we tend to quit too soon or quit too late? Are we too stubborn or not determined enough? There has been much excitement recently around the idea of “grit” — a personality trait representing commitment to and enthusiasm for long-term goals, championed by psychologist Angela Duckworth. She argues, plausibly, that grit is more important than talent in predicting a successful life.

The idea is appealing in principle but one must ask what Duckworth’s brief “grit” questionnaire is really measuring. (Perhaps I am just sore because I took the questionnaire and discovered I have less grit than the average marshmallow.)

While Duckworth’s work suggests that perseverance is vital, other psychological research suggests that we sometimes persevere when we should not. Nobel laureate Daniel Kahneman, with the late Amos Tversky, discovered a tendency called “loss aversion”. Loss aversion is a disproportionate dislike of losses relative to gains, and it can lead us to cling on pig-headedly to bad decisions because we hate to stop playing when we’re behind.

My favourite study of loss aversion concerns players of the TV game show Deal or No Deal, in which players must periodically decide whether to keep gambling or accept an offer from the mysterious “Banker” to buy them out of the game. In one notorious Dutch episode, a contestant named Frank was offered €75,000 to stop; he kept playing and lost his next gamble. The Banker’s next offer was just €2,400, which was actually a fair offer. But at that point loss aversion kicked in. With the lost €75,000 in mind, Frank refused all further deals, kept gambling and kept losing. He eventually won just €10.

A study of Deal or No Deal by behavioural economists including Thierry Post and Richard Thaler found that while Frank’s fate was spectacular, his behaviour was statistically typical. People hate to quit if they feel they’re losing.

Loss aversion warps investment strategies in a similar way. We happily sold our stocks in Google and Apple but clung on to those in Enron and Lehman Brothers. The same tendency affects house prices: we hate to sell for less than we paid. Recent research by Alasdair Brown and Fuyu Yang finds that the same thing is true when people are offered the opportunity to cash in a bet on a sporting event that is still in progress. They are happy to cash out if their team is a goal up, even though that will cut their possible gains, but they will cling on if their team is a goal down even though they could cut their losses.

I was struck by a recent FT article by equity analyst Daniel Davies describing how a portfolio based on expert research recommendations would tend to do badly, but if the same portfolio had a “stop-loss” rule that simply jettisoned stocks after a 10 per cent loss, it would tend to do very well. The stop-loss rule cancelled out the instinctive tendency to hold on stubbornly to losers. Yet Warren Buffett seems to do very well by buying and holding.

The truth is that there are no foolproof methods for knowing when to hold ’em and when to fold ’em. But I have three suggestions. The first is to look resolutely away from sunk costs and towards future prospects. Whether you paid $70 or $130 for your Apple shares should be irrelevant to your decision to sell them today for $100. Bygone profits and losses are a distraction.

The second is to persevere flexibly rather than stubbornly. Angela Duckworth’s family follows a “hard thing” rule: the children have to choose an activity, such as music or athletics, that requires dedication and practice. They’re allowed to quit but only at a natural break point and only if they find an alternative “hard thing”. That seems to steer a course between the Scylla of obstinacy and the Charybdis of laziness.

The third is to view decisions as experiments. Signing up to learn the violin is an experiment; so is moving cities or careers. Of course, one can end an experiment too early or doggedly persist too long. But viewing a decision as an experiment gives a useful perspective because experiments are always designed to teach us something. We can keep asking: what have I learnt? And am I still learning? If a new project or activity keeps teaching us new things, it is probably worth continuing — even if the lessons are sometimes painful.

Written for an first published at ft.com.

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Could an income for all provide the ultimate safety net?

‘Though the idea of a basic income is far from mainstream, it has had astonishingly broad support’

Last week, I pondered how society should protect or compensate people whose jobs have been lost to the forces of globalisation or technological change. I did not, however, discuss the most obvious idea of all: that we should simply give people money — a basic income for everyone, regardless of what they do or what they need. It’s the ultimate social safety net.

For an idea that is so far from mainstream political practice, the payment of a basic income has had astonishingly broad support, from Martin Luther King Jr to Milton Friedman. It’s on the lips of the policy wonk community too: the Freakonomics podcast recently devoted an episode to the case for a universal basic income. The Royal Society for Arts, a venerable British think-tank, has published a report enthusiastically supporting the idea. Dutch journalist Rutger Bregman is just as keen, as outlined in his recent, eloquent book Utopia for Realists.

Policy experiments are also on the way. The charity GiveDirectly has just announced plans to run a randomised trial in which 6,000 Kenyans will receive a basic income for more than a decade. Various Silicon Valley types — with one eye on the looming Robot Job Apocalypse — are making serious-sounding noises about running experiments too. Pilots are planned in Canada and Finland, and the Swiss have a referendum on the topic in June.

Could a basic income really work? The answer is yes. But the plan may be more painful than some of its advocates are willing to admit.

First, let’s establish what we’re talking about. A universal basic income is a cash payment from the state, paid to everyone unconditionally. For the sake of being concrete, let’s call it £10 a day. That seems like a lot of money to be giving to absolutely everyone, but it’s within the bounds of reason. Such a payment would cost £234bn a year across 64 million UK residents, so it could be largely paid for by scrapping all social security spending, which is £217bn.

There are lots of other proposals that one might call a basic income. Leftwing advocates might want far more than £10 a day but that would require a huge expansion of the state, with much higher taxes. The more libertarian proponents of the idea might also approve of a higher basic income, in exchange for a rolling back of state-provided services. Privatising the entire health and education system in the UK would free up £240bn, easily enough to double the basic income to £20 a day for every man, woman and child. But that money would need to cover school fees and medical bills.

All this is within the bounds of affordability. But is it desirable? Here are two big question marks over the idea.

The first is whether people would simply stop working. Several large experiments conducted in the US and Canada in the late 1970s and early 1980s suggest that a minimum income would encourage people to reduce their hours a little. If such slacking-off undermined the tax base, the entire project could become both economically and politically unsustainable.

But the tax base is probably safe enough, because the people who might be tempted to quit work and live on £10 a day are not the people whose taxes pay for most state spending. In the UK, the richest 15 per cent of taxpayers — people who pay at least some tax at the 40 per cent rate — supply about two-thirds of income tax revenue. Few of these people are likely to find the basic income a tempting inducement to leave the labour force.

In some cases, we might celebrate a decision to stop work. Some people volunteer; others care for children or relatives; some might use the income to fund themselves as they stay in education or retrain. Some, alas, might use the money to stay alive as they write poetry.

The second objection is more worrying: if the welfare state is to be replaced by a basic income, it will provide far too little for some. A tenner a day is less than half the new UK state pension, so it’s hard to imagine pensioners embracing the idea with much gusto.

On the other hand, if the basic income is to be supplemented by a raft of special cases — people with disabilities, people with expensive rent, people who are elderly — then it may become as complex as the tangle of benefit entitlements it aims to replace, or hugely expensive, or both.

Andrew Hood of the Institute for Fiscal Studies says that compared with current welfare benefits, a basic income would “either be a lot less generous or a lot more expensive”. Take your pick.

In the end, the idea appeals to three types of people: those who are comfortable with a dramatic increase in the size of the state, those who are willing to see needy people lose large sums relative to the status quo, and those who can’t add up.

A basic income makes perfect sense once we arrive at an economy where millions work for low wages while automation produces a bountiful economy all around them. The debate turns on whether that world has already arrived.

Written for and first published at ft.com.

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3rd of May, 2016Undercover EconomistComments off
Undercover Economist

Tata Steel, Port Talbot and how to manage industrial decline

‘The wounds of a large industrial closure run deep. The entire economic ecosystem of an area can collapse’

The possible closure of Tata Steel’s operations in Port Talbot casts a deep shadow over the area. There’s something familiar about this depressing story. The shipyards of the Clyde and the cotton mills of Manchester have faded. The coalfields of Derbyshire, Nottinghamshire and South Yorkshire were all around me as I grew up in Chesterfield during the miners’ strike of 1984-85. Now the mining jobs are gone. Further afield, there are the job losses in the automobile production lines of Detroit, for the shoemakers of Kobe in Japan, or at Eastman Kodak in Rochester, New York.

So what should be done when communities are wounded by such blows? One tempting answer is “everything”; that the government should nationalise troubled operations or adopt similar big-bazooka tactics, such as high trade barriers or large subsidies. It’s easy enough to make the emotional case for this but the practical case isn’t so plausible. Would nationalisation have saved Kodak’s film business? Is Manchester the place for a 21st-century Cottonopolis?

Sometimes, government can help restructure a troubled business — as with the Obama administration’s interventions in the case of General Motors, or the long but ultimately successful nationalisation of Rolls-Royce in the 1970s.

However, taxpayers are always at risk of being saddled with the role of supporting industries in inescapable structural decline. The political economy of these cases is skewed towards preservation rather than creative destruction. Old industries under stress have much to gain from government support, and can point to people who need help. There is no constituency for jobs that have not yet been created.

So a different answer is that we should do nothing. This laissez-faire reasoning points out that economic change inevitably creates losers but, ultimately, society is better off. We cannot resist change, only adjust. Former autoworkers, steelworkers, and coalminers need to pick themselves up and move to where fresh jobs are available, or retrain.

There is a logic to this argument but it glosses over the deep wounds of a large industrial closure. It isn’t just that workers lose jobs. The entire economic ecosystem of an area can collapse. Newly jobless workers find that their homes are worthless, their pensions too sometimes.

And workers with the kind of skills that are under pressure from technology or trade may find that they move from one sinking lifeboat to another, with their new jobs under threat from the same forces that destroyed the old ones. More radically, retraining — maybe as a neurosurgeon or data scientist — would solve that problem, but then so would discovering a Rembrandt in the attic.

Between the ideologically pure answers of “do everything” and “do nothing”, we have the current consensus, “do something”. But what?

There are three broad approaches to looking after the losers from economic change: try to bring new jobs to people; try to help the people change to find new jobs; just send money.

Bringing new jobs to people is the most natural idea, but regional regeneration is difficult. Depressed communities often stay depressed. A Sheffield Hallam University study from 2014, The State of the Coalfields, found that 30 years after the miners’ strike, coalfield communities have lower employment rates and higher reliance on disability benefits. The track record of place-based regeneration policies is patchy and sobering.

If the jobs won’t move, perhaps the workers can? An influential 1992 study by economists Olivier Blanchard and Lawrence Katz found that the US labour market once worked this way. While a shock could have a lasting effect on a local economy, the unemployment rate itself would subside, “not because employment picks up, but because workers leave the state”.

But new research from Mai Dao, Davide Furceri and Prakash Loungani at the IMF finds that US workers move less than they did back in the 1980s. Instead of moving, they are more likely to stay put and stay jobless. (Mobility has improved in the European Union, albeit from much lower levels.)

We don’t really know why mobility is falling in the US. Maybe because dual-income households find it harder to move — but then the same pattern is seen for single people. Housing costs increasingly prevent poor people from moving to booming areas such as New York and London in search of work.

“My guess is that there’s no one reason for the fall in mobility,” says Betsey Stevenson of the University of Michigan, also formerly chief economist at the US labour department. Stevenson, like many economists, argues that education must be a huge part of the answer to economic shocks. The jobs have changed, and so must we.

Education is, indeed, a remarkable thing. Lawrence Katz has observed that between 1979 and 2012, the wage gap between a US household of two college graduates and a household of two high school graduates grew by around $30,000 — a sum that dwarfs most shifts in the economic landscape. But it is easy to be glib about retraining: governments are tempted to use training programmes as a way to make work and shift people off the welfare rolls.

So a final answer as to how to compensate the losers is the simplest: give them money. That is a strategy that offers both more, and less, than it might seem at first glance. But that is a topic for next week.

Written for and first published at ft.com.

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Why one size doesn’t fit all

‘The most notorious example of this “compromise effect” is our tendency to plump for the second-cheapest bottle on the wine list’

Most Tuesday afternoons, in the lazy late hour between the end of school and the start of Brownies, you can find me ensconced in the café of the local Marks and Spencer, sipping a hot chocolate with the younger Miss Harford.

Recently, the café has taken the unusual step of radically simplifying the drinks menu. All the standards are there, of course: tea, cappuccino, hot chocolate. But the size options have been covered over with masking tape. Gone are the “small” and the “large”. Now you can have any size of hot beverage you like, as long as it’s medium.

I did ponder registering a note of protest, since a medium hot chocolate contains more sugar than any Brownie can handle. (For reasons that escape me, hot chocolate dodged George Osborne’s much-vaunted new tax on sugary drinks.) But when I perused the comments book, I realised that my own complaint would barely register amid pages of objections from the café’s octogenarian customers.

Perhaps M&S hopes to save money by rationalising the crockery. Or perhaps they simply guess that simplicity is attractive. A few years ago, Debenhams, another British household name with a frumpy image, tried the slogan “Say goodbye to coffee confusion”. Debenhams rebranded cappuccino as “frothy coffee” and caffè latte as “really, really milky coffee”, winning headlines for the most patronising publicity stunt in living memory.

But simplicity can sell. A famous study by psychologists Sheena Iyengar and Mark Lepper offered samples of speciality jam to customers of a high-end supermarket. (Loyal readers may recall the column I wrote about this in November 2009.) Offered a choice of six types of jam, a third of customers went on to make a purchase. Offered a choice of 24, almost nobody did. Iyengar and Lepper concluded that choice can overwhelm and discourage us.

Yet it is unclear how widespread this “choice demotivates” effect is. The original Iyengar-Lepper results, like many in psychology, seem to be fragile. Several follow-up studies have failed to find evidence for the effect. (There is no shame in this; that’s science at work.)

Many successful businesses, from supermarkets to Starbucks, offer a vast range without scaring away their customers. A first-time visitor to Starbucks might be confused, but regulars work it out. And clever design can prevent choice seeming overwhelming. Starbucks offers about 100,000 drink combinations — millions, once the syrups are taken into account — but the menu seems much simpler than that.

What surprised me about M&S’s decision to serve only one size of drink was that it was giving up three advantages. The first is the simplest: offering more choice lets people get closer to exactly what they desire. I want a small drink for a small child — why not sell it to me?

The second advantage is subtler: a company can offer drinks with different margins, in the hope that they can present a bargain to price-sensitive customers, while hoovering up more from customers who are more carefree with their cash. Much of the input cost of a pricey large hot chocolate — staff time, rent, space in the dishwasher — is the same for the cheaper small hot chocolate. By offering more profitable larger drinks alongside the small ones, a café can attract bargain-hunters while still profiting from lavish spenders.

There’s a third advantage to offering a wide number of choices: the extreme choices frame the central ones and can influence what customers buy. The late Amos Tversky, an influential psychologist, once pointed to a Williams-Sonoma bread maker that went on sale for $279 and was a flop. When another bread maker hit the shelves, priced at $429, sales of the original model surged. Why? Well, customers weren’t sure that they wanted to buy a bread maker, nor what price might be reasonable, until they had a choice of two. Suddenly the choice became clear: if they did want to buy a bread maker, they wanted the cheaper one.

The pattern behind this behaviour was demonstrated more rigorously in research by Tversky and Itamar Simonson: you can boost demand for a £400 camera by placing it next to a £4,000 camera, or a £200 handbag next to a £1,000 handbag. Offer three options and people choose the middle one. Offer several and people avoid the extremes. The most notorious example of this “compromise effect” is our tendency to plump for the second-cheapest bottle on the wine list.

Starbucks seems to understand the compromise effect very well. Its menu includes the colossal “trente” — that’s 30 US ounces, more than one-and-a-half British pints or nearly a litre. It omits the far more practical 8oz “short” cappuccino. The effect is to change our sense of what the compromise choice is. A16oz “grande”, three times the size of a classic Italian cappuccino, no longer seems like a milky behemoth but a happy medium.

The curious thing is that the short cappuccino is available on request. Starbucks want to be able to offer a drink that is something close to a properly sized cappuccino, but they don’t want that option cluttering up their menu and pulling customers towards smaller, less profitable products.

M&S tells me that medium is the most popular size of drink. Of course it is. They’re experimenting with the simplification in a few locations to see how it works out. Good for them; you never know until you try. But the complaints book suggests the experiment may be short-lived.

Written for and first published at ft.com.

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Delusions of objectivity

‘“Naive realism” is the seductive sense that we’re seeing the world as it truly is, without bias or error’

“Have you ever noticed when you’re driving,” the comedian George Carlin commented, “that anybody driving slower than you is an idiot, and anyone going faster than you is a maniac?”

True enough. But when you think for a moment about Carlin’s quip, how could it be otherwise? You’ve made a decision about the appropriate speed for the driving conditions, so by definition everybody else is driving at a speed that you regard as inappropriate.

If I am driving at 70 and pass a car doing 60, perhaps my view should be, “Hmm, the average opinion on this road is that the right speed is 65.” Almost nobody actually thinks like this, however. Why not?

Lee Ross, a psychologist at Stanford University and co-author of a new book, The Wisest One in the Room, describes the problem as “naive realism”. By this he means the seductive sense that we’re seeing the world as it truly is, without bias or error. This is such a powerful illusion that whenever we meet someone whose views conflict with our own, we instinctively believe we’ve met someone who is deluded, rather than realising that perhaps we’re the ones who could learn something.

The truth is that we all have biases that shape what we see. One early demonstration of this was a 1954 study of the way people perceived a college-football game between Dartmouth and Princeton. The researchers, Albert Hastorf and Hadley Cantril, showed a recording of the game to Dartmouth students and to Princeton students, and found that their perceptions of it varied so wildly that it is hard to believe they actually saw the same footage: the Princeton students, for example, counted twice as many fouls by Dartmouth as the Dartmouth students did.

A more recent investigation by a team including Dan Kahan of Yale showed students footage of a demonstration and spun a yarn about what it was about. Some students were told it was an anti-abortion protest in front of an abortion clinic; others were told it was a protest outside an army recruitment office against the military’s (then) policy of “don’t ask, don’t tell”.

Despite looking at exactly the same footage, the experimental subjects drew sharply different conclusions about how aggressive the protesters were being. Liberal students were relaxed about the behaviour of people they thought were gay-rights protesters but worried about what the pro-life protesters were doing; conservative students took the opposite view. This was despite the fact that the researchers were asking not about the general acceptability of the protest but about specifics: did the protesters scream at bystanders? Did they block access to the building?

We see what we want to see. We also tend to think the worst of the “idiots” and “maniacs” who think or act differently. One study by Emily Pronin and others asked people to fill in a survey about various political issues. The researchers then redistributed the surveys, so that each participant was shown the survey responses of someone else. Then the participants were asked to describe their own reasoning and speculate about the reasoning of the other person.

People tended to say that they were influenced by rational reasons such as “attention to fact”, and that people who agreed with them had similar motives. Those who disagreed were thought to be seeking “peer approval”, or acting out of “political correctness”. I pay attention to facts but you’re a slave to the approval of your peers. I weigh up the pros and cons but you’re in the pocket of the lobbyists.

Even when we take a tolerant view of those who disagree with us, our empathy only goes so far. For example, we might allow that someone takes a different view because of their cultural upbringing — but we would tend to feel that they might learn the error of their ways, rather than that we will learn the error of ours.

Pity the BBC’s attempts to deliver objective and neutral coverage of a politicised issue such as the British referendum on leaving the EU. Eurosceptics will perceive a pro-Brussels slant, Europhiles will see the opposite. Both sides will assume corruption, knavery or stupidity is at play. That is always possible, of course, but it is also possible that passionate advocates simply don’t recognise objectivity when they see it.

But then how could the situation be otherwise? If any media outlet criticises a political position that you personally admire, there is a contradiction to be resolved, and an easy way to explain the disagreement is to conclude either that the media are biased, or that you are. You can guess which choice people instinctively make. Small wonder that careful studies of media bias in the US show that most newspapers and radio or TV stations don’t try to persuade their readers and viewers; instead, they pander to the biases of their audience.

It is hard to combat naive realism because the illusion that we see the world objectively is such a powerful one. At least I’ve not had to worry about it too much myself. Fortunately, my own perspective is based on a careful analysis of the facts, and my political views reflect a cool assessment of reality rather than self-interest, groupthink or cultural bias. Of course, there are people to the left of my position. They’re idiots. And the people on my right? Maniacs.

Written for and first published at ft.com.

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Trump, trade and ‘the China shock’

‘Freer trade has inflicted a more grievous toll than economists, myself included, had expected’

It hasn’t escaped the notice of pundits that the political iconoclasts Bernie Sanders and Donald Trump have something in common: they’re sceptical about trade. Trump, for example, has riffed expansively: “We don’t win any more. We don’t beat China in trade. We don’t beat Japan . . . We can’t beat Mexico, at the border or in trade.” Sanders expressed his concerns with a little more precision: “While bad trade agreements are not the only reason why manufacturing jobs in the US have declined, they are an important factor.”

Both men have vastly outperformed expectations in the primary campaigns. There are many reasons for that but perhaps the simplest explanation is that freer trade has inflicted a more grievous toll than economists, myself included, had expected.

Fifteen years ago, the conventional economic wisdom was that free trade was almost unambiguously a good idea. Here’s the basic logic. There are two ways for the British to get hold of wine. We can grow and press our own grapes, or we can make something that the French want and trade with them. If we’re good at making, say, computer games and the French are good at making wine, then trading is the better way to get what we want.

The idea that we might, Trumpishly, “beat the French in trade” sounds appealing but is incoherent. And while a British Sanders might point to the loss of jobs in the UK wine industry, that would miss the gains in the software industry. There is little economic difference between a tariff on the import of French wine and a tariff on the export of British software.

Here’s a parable beloved of economists. An entrepreneur announces a technological breakthrough: he has a machine that can disintegrate computer game discs and reconstitute the atoms into fine wine. He sets up a factory on the coast of Kent with the machine inside. Computer games go in, and cases of wine emerge. But then an investigative reporter from the Financial Times gains access to the factory and finds that there is no machine — just a dock where a forklift truck operator busily unloads French wine from a boat, replacing it with computer games for export to the French market. Should we care? From the point of view of the British, isn’t France merely a technology for converting computer games into wine?

With formal models to back up this sort of story, most economists took the view that when countries lower their trade barriers, even unilaterally, they prosper. What the British wine industry loses, the UK computer games industry gains. Meanwhile, consumers get better and cheaper wine into the bargain.

It was always clear that, despite the win-win nature of trade at the national level, freer trade could create losers — such as British vineyards and French computer game studios. But the conventional wisdom was that these losses were both small and fixable with the right policies of retraining or redistribution. Most importantly, people who lost their jobs could find new ones in booming export industries.

Admittedly, it was evident even 20 years ago that median household incomes were stagnating in the US, inequality was rising in anglophone countries, and manufacturing employment was steadily falling. But these trends seemed to owe more to technological change than to globalisation.

I’ve been phrasing all this “conventional wisdom” in the past tense but, for the most part, it stands up. However, it is acquiring an important and depressing footnote. A new research paper, “The China Shock”, from David Autor, David Dorn and Gordon Hanson, is part of a rethink under way in the economics profession.

Autor and his colleagues try to zoom in on the impact of China’s emergence as a trading power. China’s rise has been dramatic, driven almost entirely by internal policy changes inside China, and has had a differential effect on different regions and industries. For example, Tennessee and Alabama are both US manufacturing centres exposed to global competition. But Tennessee’s furniture manufacturing industry is much more exposed to China in particular than is Alabama’s heavier manufacturing industries. This helps the researchers to figure out with more confidence what the impact of the China shock has been.

Autor, Dorn and Hanson conclude that the American workers who have been hurt by competition with China have been hurt more deeply, and for a longer period, than many economists predicted. Employment has fallen in industries exposed to trade competition, as expected. But it has not shown much signs of rising in export-oriented sectors.

The US labour market is less flexible than we thought, it seems. In a simplified economic model, workers move smoothly to a new home, a new industry, even a new level of education. In practice, Autor and his colleagues find that communities hit by Chinese competition often do not adapt; they wither. It may take a generation or two, rather than a few years, to adjust.

In the long run, of course, that adjustment will happen — just as we have adjusted to the decline of agricultural labour or the need for typewriter repairs. But the long run is longer than many economists feared. It is easy to see why supporters of Trump and Sanders have run out of patience.

Written for and first published at ft.com.

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Capital ideas in a time of inequality

‘The wealthy do not simply wallow in bank vaults like Scrooge McDuck. They spend their money’

In January 1963, Warren Buffett included the following impish observation in his letter to his investment partners. “I have it from unreliable sources that the cost of the voyage Isabella underwrote for Columbus was approximately $30,000.”

Unreliable indeed; there was no dollar in 1492. But we get the gist. Buffett goes on to observe that while the voyage could be considered “at least a moderately successful utilisation of venture capital”, if Queen Isabella had instead invested the $30,000 in something yielding 4 per cent compound interest, the invested sum would have risen to $2tn by 1962. For her inheritors’ sake, perhaps Isabella should have said no to Columbus and simply found the 15th-century equivalent of a passive index fund instead.

Buffett’s thought experiment returned to me as I browsed through the latest list of billionaires from Forbes. None of the leading players had achieved their position by the simple accumulation of family wealth over generations. The top five — Bill Gates, Amancio Ortega, Buffett, Carlos Slim and Jeff Bezos — are all entrepreneurs of one form or another. According to economists Caroline Freund and Sarah Oliver, the proportion of billionaires who inherited their fortunes has fallen from 55 per cent two decades ago to 30 per cent today.

Is this absence of old-money trillionaires because Buffett’s 4 per cent compound interest was unavailable to the wealthy and powerful of pre-industrial Europe? Hardly. If anything, 4 per cent is conservative. According to Thomas Piketty’s bestselling book Capital in the Twenty-First Century (2013), the real rate of return on capital, after taxes and capital losses, was 4.5 per cent in the 16th and 17th centuries, then 5 per cent until 1913. Although it fell sharply between the wars, the effective average rate of return was very nearly 4.3 per cent across the five centuries. At that rate, $30,000 invested in 1492 would be worth $110tn today.

Not to get too technical, but $110tn is a lot of money. It’s more than 1,000 times the wealth of the richest man in the world, Bill Gates. It’s 17 times the total wealth of the 1,810 billionaires on the Forbes list — or, alternatively, nearly half the household wealth of every citizen on the planet. (According to Credit Suisse’s Global Wealth Report, total global household wealth is $250tn.) Queen Isabella’s investment advisers apparently let her down. Patient, conservative investments would have left her heir today with a fortune to tower over every modern plutocrat.

All this brought to mind Piketty’s “r>g”, a mathematical expression so celebrated that people started putting it on T-shirts. It describes a situation where “r” (the rate of return on capital) exceeds “g” (the growth rate of the economy as a whole). That is a situation that described most of human history, but notably not the 20th century, when growth rates soared while capital had a tendency to be nationalised, confiscated or reduced to rubble.

“r>g” is significant because if capital is reinvested and grows faster than the economy, it will tend to loom larger in economic activity. And since capital is more unequally distributed than labour income, “r>g” may describe a society of increasingly entrenched privilege, where wealth and power steadily accrue in the hands of heirs.

This is a fascinating, and worrying, possibility. But it is a poor description of the modern world. For one thing, when billionaires divide their inheritance, mere procreation can be a social equaliser. Historically, the great houses of Europe intermarried and concentrated wealth in the hands of a single heir. (No wonder: one of Queen Isabella’s grandsons, Ferdinand I, had 15 children.) But these days, disinheriting daughters and second sons is out of fashion. (That said, “assortative mating”, the tendency of educated people to marry each other, is back and may explain more about rising income inequality than we tend to realise.)

Another thing: the rich do not simply wallow in money vaults like Scrooge McDuck. They spend. According to Harvard economist Greg Mankiw: “A plausible estimate of the marginal propensity to consume out of wealth, based on both theory and empirical evidence, is about 3 per cent.” Instead of 4.3 per cent, then, wealth compounds at 1.3 per cent after allowing for this spending. Five centuries of compound interest at 1.3 per cent turns $30,000 into about $25m, a fine inheritance indeed but not the kind of money that will get you near the Forbes list.

Of course, inherited privilege shapes our societies not only among the plutocracy but down in the rolling foothills of English middle-class wealth. There, economic destiny is increasingly governed by whether your parents bought a house in the right place at the right time — and by the UK government’s astonishing abolition of inheritance tax on family homes.

But whether mega-wealth in the 21st century will be driven by the patient accumulation of rents on capital, rather than the disruptive entrepreneurship of the late 20th century, remains to be seen. After all, long-term real interest rates in advanced economies have fallen fairly steadily from 4 to 5 per cent three decades ago to nothing at all today. You don’t need to be Warren Buffett to figure out that if you want to get rich by accumulating compound interest of zero, you’ll be waiting a long time.

Written for and first published at ft.com.

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These are the sins we should be taxing

‘The UK already relies more than most rich countries on fuel, alcohol and tobacco duties’

Is it time to rethink the way we tax sin? The UK has long levied special taxes — “duties” — on products that pollute the environment, the lungs, the liver or the pocketbook: driving, flying, tobacco, alcohol and gambling. There are good reasons for these taxes. The government must raise revenue somehow, so there is much to be said for taxing products that are price-insensitive, socially harmful or, at the very least, unhealthy temptations.

But the way sin taxes are levied in practice is an incoherent muddle. Plenty of products that are bad for us (bacon, butter, sugar) get favourable tax treatment, attracting no value-added tax, although the standard VAT rate is 20 per cent. Heating and lighting our homes also attracts a concessional rate of tax, although a kilogram of carbon dioxide emitted from a power station or a gas boiler contributes to climate change just as much as a kilogram emitted from a car. Vehicle excise duty is a tax not on driving but on owning a car. And the rate of duty on alcohol varies depending on how we drink it.

It is easy to see how successive chancellors bodged their way to this point. Taxes on the pint or at the pump are eye-catching; raising them seems morally serious but cutting them is a crowd-pleaser. And so they bounce around like the political football they are.

George Osborne has an opportunity to fix the situation this Wednesday during his Budget speech. Here’s what he should do.

First, similar harms should attract similar taxes. The UK duty on 10ml of pure alcohol, roughly the amount in a shot of vodka or half a pint of beer, varies wildly. It is about 7p in strong cider, 18p in strong beer, or 28p in whisky and wine. A consistent price per millilitre would make more sense.

Second, he should broaden the sin tax base. UK duties are concentrated on tobacco, motor fuel and alcohol. As the Institute for Fiscal Studies showed in its “green budget” in February, revenue from duties has been falling for decades, from 4.1 per cent of national income in the early 1980s to 2.6 per cent last year. This drop is the net result of falling duties on fuel (back to the levels of 20 years ago in real terms), declining duties on alcohol and lower consumption of both tobacco and alcohol.

Should the chancellor, then, raise duties? Perhaps, but there are limits. The UK already relies more than most rich countries on fuel, alcohol and tobacco duties. Above a certain level, the smugglers and bootleggers take over.

A wiser approach is to tax sins that have thus far escaped attention. The most obvious is congestion: fuel taxes do not distinguish between driving along an uncongested country road and driving in rush-hour in a built-up area, which causes vastly more social harm. Congestion charges, which are now technically feasible, are fair and efficient, if the political case can be made.

Another obvious sin is sugar. While one can be too puritanical about nudging people to take care of their health and waistline, it seems strange that perfectly reasonable activities such as buying a T-shirt or earning a living attract tax, while sugar is tax-free. A sugar tax of a half-penny a gram would add about 18p to the cost of a can of Coke, more than that to a family pack of Bran Flakes, 25p to a 200ml bottle of ketchup and 45p to the price of a packet of chocolate digestives.

Third, Osborne should avoid arbitrary cut-offs where possible. In a bygone age it must have been simpler to slap a tax on an item in a particular category but this has led to the infamous “Jaffa Cake” problem. Are Jaffa Cakes — sponge discs with an orange jelly topping, partly coated in chocolate — cakes (zero VAT) or biscuits (VAT at 20 per cent)? A tribunal in 1991 mused that Jaffa Cakes are packaged much like biscuits, are sold next to biscuits, are the same size and shape as biscuits and, like biscuits, are eaten without a fork. However, it also noted that they are made of a cake-like dough, are soft and, like a cake, they go harder when stale. The tribunal eventually concluded that Jaffa Cakes are cakes, and thus they remain tax-advantaged, even as they nestle on the supermarket shelves next to their biscuitish rivals.

All of this is nonsense from any angle. In discouraging unhealthy eating, the relevant issue should not be whether food is circular or requires a fork but how much sugar, salt and saturated fat it contains. Sugar can be measured and taxed by the gram, whether it comes dissolved in oft-demonised soft drinks or added to bread, cereal, ready-meals, chocolate bars or anything else.

Finally, we should not worry too much about the distributional consequences of sin taxes. This isn’t because distribution doesn’t matter — it does. But, by some measures at least, alcohol and fuel duties hit the middle classes harder than they hit the poor. In any case, there are better ways to deal with inequality than by cutting sin taxes. People on low incomes need support but that help is better provided through tax credits, child benefit or good public services rather than cheap booze, sweets and tobacco. We are all free to buy vodka and cigarettes. Yet trying to make them cheaper would be a strange way to address social injustice.

Written for and first published at ft.com.

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