Tim Harford The Undercover Economist

Undercover EconomistUndercover Economist

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

Undercover Economist

Don’t blame statisticians for counting the wages of sin

Officials used to size up economies like butchers size up cows, writes Tim Harford

The good news is that the UK economy is about to surge by 5 per cent. The bad news is that this surge does not actually reflect economic growth but a change in statistical definitions. And the weird news is that this is happening in part because EU statistical guidelines demand that spending on cocaine and hookers be reflected in the UK’s official statistics.

Feel free to raise one eyebrow at this point. Recall that Greece’s economy grew overnight by 25 per cent after the country’s official statisticians included sex work and illegal drugs as part of their estimates of economy activity – a move that, by an astonishing coincidence, flattered the country’s budget deficit. That was in September 2006; the story has not gone well since then.

It is certainly true that the Office for National Statistics has only the vaguest sense of what is going on in the British economy’s nether regions. (Individual statisticians with a sense of adventure may know more, of course, but their observations are unlikely to be statistically reliable.) Most recreational drugs are illegal in the UK, while sex work is on the margins of legality. One suspects that not every transaction for sex or drugs is faithfully recorded on a tax return.

The ONS has made valiant assumptions in estimating that 60,879 sex workers are each employed 1,300 times a year at an average rate of £67.16. If true, that is an industry big enough to allow every man in the country between the age of 15 and 64 to visit a sex worker every three months. We might quibble that the ONS has no idea, really, how big these black-market businesses really are. Dr Brooke Magnanti, author of The Sex Myth – and pseudonymously of various memoirs of her time as a sex worker – is not impressed with the ONS’s methodology. “Why not ask escorts themselves? It’s not as if we’re hard to find,” she has written.

She may be right – but even if the ONS does not know exactly how big the sex industry is, we can be pretty sure that the answer is not “zero”. The ONS estimates are surely an improvement on what went before.

Critics will feel this is missing the point. Why should we celebrate drugs and sex work by immortalising them in the national accounts? Are politicians now to subsidise Rizla and Durex in the hope of boosting our economy further? But such criticism is confused in a way that affects far more than this particular statistical revision.
“The critics of GDP give it too much credit. It is not the guiding star for economic policy, public morality, or anything else”

We need to understand three things about gross domestic product statistics. First, GDP itself is ineffable – an attempt to synthesise, for practical purposes, something that defies description. Second, the national accounts are not designed to give a round of applause to the good stuff and a loud raspberry to the bad stuff. They are supposed to measure economic transactions. And, third, anyone who thinks politicians try to maximise GDP has not been paying much attention to politicians.

A hundred years ago, if you had asked someone, “how is the economy doing?”, nobody would have understood what you were saying. Back then economists might have tried to track the production of coal or the number of people with jobs. Yet the idea of putting all economic transactions into one big conceptual pile and trying to measure how big the pile was – that is a newer and quite radical invention. When economists such as Simon Kuznets first tried to calculate national income back in the 1930s, they were trying to understand the malfunctions of the Great Depression, and to measure the productive potential of an economy that was gearing up for war.

This number-crunching has always had a purpose. Governments used to size up economies like a butcher sizes up a cow; suddenly they were taking measurements the way a doctor takes a pulse. William the Conqueror’s Domesday Book, the definitive record of land ownership in Norman times, was replaced with the ONS’s Blue Book of national accounts. The organisation’s new efforts are designed to figure out how much money is being earned and spent – partly for the purpose of international comparison – and it is perfectly right that this includes all voluntary transactions, even undeclared or outright illegal ones. Let others argue over whether sex work and drug taking should be prosecuted or liberalised.

This error goes back at least as far as a speech given by Robert Kennedy in March 1968. The presidential candidate pointed out that official measures of economic output include napalm, nuclear warheads, cigarette advertising and jails – but not “the beauty of our poetry or the strength of our marriages”. It is a wonderful speech but like many wonderful speeches contains a rhetorical bait-and-switch. If poetry is dying and divorce is too common, that is not the fault of the statisticians.

If politicians truly aimed to maximise GDP, George Osborne, UK chancellor of the exchequer, would never have launched an austerity drive, there would be no subsidies for renewable energy, unemployment benefits would expire quickly if they existed at all, and everybody would be clamouring to increase immigration. There is more to life than mere prosperity and there is more to prosperity than GDP growth – and much as our politicians are a woeful gaggle of incompetents, even they seem to grasp that, both in their words and in their actions.

The critics of GDP give it too much credit. It is a painstaking attempt to try to measure the total production of the economy. It is not the guiding star for economic policy, public morality, or anything else.

Sex work and mind-altering substances have been around a long time. After this statistical tweak, it cannot be long before someone starts pointing at the pimps and the pushers, and blaming their existence on the Office for National Statistics.

Also published at ft.com.

Undercover Economist

Gary Becker – the man who put a price on everything

The Nobel Prize winner believed that no matter what the subject, economics always had something insightful to add

Perhaps it was inevitable that there would be something of the knee-jerk about the reaction to the death of the Nobel Prize-winning economist Gary Becker. Published obituaries acknowledged his originality, productivity and influence, of course. But there are many who lament Becker’s economic imperialism – the study of apparently non-economic aspects of life. It is now commonplace for those in the field to consider anything from smoking to parenting to the impact of the contraceptive pill. That is Gary Becker’s influence at work.

Becker makes a convenient bogeyman. It did not help that he could be awkward in discussing emotional issues – despite his influence inside the economics profession, he was not a slick salesman outside it. So it is easy to caricature a man who writes economic models for discrimination, for suicide and for the demand for children. How blinkered such a man must be, the critics say; how intellectually crude and emotionally stunted.

The criticism is unfair. Gary Becker’s economic imperialism was an exercise in soft power. Becker’s view of the world was not that economics was the last word on all human activity. It was that no matter what the subject under consideration, economics would always have something insightful to add. And for many years it fell to Becker to find that insight.

Consider his first book, still one of his most famous works, on the economics of discrimination (1957). There’s a lot to say about discrimination and Becker doesn’t even begin to claim that economics says it all. Instead, he heads straight to where an economist can make a difference. Assume that some people have a prejudicial distaste for others, says Becker. Assume bigoted workers would rather turn down a pay rise than work in a racially mixed environment. Bigoted employers would prefer to employ a white worker for much the same reason that lecherous employers prefer an attractive young personal assistant: because office life is about satisfying desires other than purely financial ones. Some other employers may prefer to hire a white worker because they know their other workers might be prejudiced against a non-white colleague; or because their customers don’t want to look at a non-white face or talk on the telephone to someone with the wrong accent.

Assume for a moment that we live in this wretched world – which we do, and did so even more in the 1950s. In which case, Becker asks: what happens? How do markets unfold? What happens to the wages for the victims of discrimination? Will competitive forces eliminate the wage gap between whites and non-whites, as non-bigoted employers see a chance to make money? In short, how is a social or psychological prejudice translated into economic outcomes?

These questions are neither reductive nor simplistic, and economics is well placed to provide some answers. Bigots can make life upsetting and dangerous for minority groups even if the bigots themselves are not numerous. But Becker showed that to have an impact on minority wages, bigotry would have to be widespread – otherwise unprejudiced companies would simply hire all the minority workers. Market forces tend to separate the bigots from the victims of their bigotry. Relative wages for minorities are determined not by the average level of prejudice in the population but by the most prejudiced employer who nevertheless ends up hiring someone from a minority.

Four decades after Becker’s original book, two economists Kerwin Kofi Charles and Jonathan Guryan published a research paper examining his theoretical predictions. They concluded: “We find strong support for all of the key predictions from Becker about the relationship between prejudice and racial wage gaps.”

The research paper from Charles and Guryan is one of many to have looked at Becker’s theories over the decades. He had a tendency to inspire or to provoke others to respond. In 2003 Steven Levitt and Pierre-André Chiappori conducted a survey of recent papers in empirical economics, looking for the economic theorists who had inspired the most empirical research. It was Gary Becker who topped their list – and his nearest rivals weren’t close.

Superficially, Becker appears to stand for the opposite of modern behavioural economics, which these days seems to be the acceptable face of the economics profession. After all, while the behavioural economists bring psychological insights into an analysis of markets, Becker did the opposite, imposing a rational-choice model on non-market situations such as marriage and parenting. Behavioural economists love empirical data but Becker was a theorist. Is he not, then, the opposite of all that is cool and forward-looking in economics?

That criticism only survives the most casual acquaintance with Becker’s work. His Nobel speech, for instance, opens with the comment: “I have tried to pry economists away from narrow assumptions about self-interest. Behaviour is driven by a much richer set of values and preferences.”

Or consider a research paper from the prehistory of behavioural economics (1962) with the title “Irrational Behaviour and Economic Theory”. The paper looks at what impact an “extremely wide class of irrational behaviour might have on some of the key theorems of economics”. The paper also declares that the ultimate defence of economic theory “is an empirical one”. Theories are powerful but in the end it is the facts that are definitive. These are key questions in behavioural economics literature today.

The author, of course, was Gary Becker.

Also published at ft.com.

Undercover Economist

When a man is tired of London house prices

‘Since Londoners cannot seem to stop asking, “Is there a bubble?”, I’ve been trying to figure out the answer’

I predicted the UK house price slump of 2007. I was even planning to devote an episode of my BBC2 series to the subject back in 2006, until my producers demanded a different topic. They argued that house prices would assuredly keep rising, so I would seem silly. The replacement theme was “It’s hard to predict the future”; prices duly fell by 15 per cent in real terms.

This triumph should be set in context: I had been forecasting a slump in 2002, 2003, 2004 and 2005. Nevertheless, since Londoners cannot seem to stop discussing the question, “Is there a house price bubble?”, I’ve been trying to figure out the answer, both for Londoners and others.

This isn’t an easy question for economists to answer – bubbles are a matter of psychology, and psychology is not our strong suit. But we can attempt a diagnosis by looking at economic fundamentals. The price of any investment asset should be related to the future income you can derive from that asset, whether it’s the rent you can earn as a landlord, the dividends from corporate shares, or the interest payments on a bond.

A good working definition of a bubble is that the price of an asset has become detached from fundamentals, which means the only way to make money in a bubble is to find a bigger fool to take the thing off your hands.

What are fundamentals telling us? The most straightforward comparison here is of the price of buying a house versus the price of renting one. In the UK, both prices and rents are at high levels relative to income. This is no surprise: everyone knows that the UK has been building too few houses for many years.

But have prices outpaced rents, suggesting a bubble? It seems so. US house prices are at historical norms relative to rents, and German and Japanese prices are unusually cheap to buy rather than rent. Yet in the UK, house prices are one-third above their long-term value relative to rents. And in London, gross rental yields are lower than in other UK regions at a slim 5-ish per cent. Such returns look low, given the costs of being a landlord. Logically, either rents should soar or prices should fall.

Yet London prices have lost touch with London earnings and with the price of houses in London’s commuter belt, and they continue to rise quickly. All this seems unsustainable, and when interest rates finally rise, surely the distressed sales will begin?

But there are three counter-arguments. The first is that housing is different. The second is that London itself is different. The third is that this time around is different.

Let’s dispense with the argument that housing is somehow bubble-proof. Bricks and mortar seem reassuring but there is no law of economics that says money is safe in housing. Real Japanese house prices have almost halved since 1992. Real house prices in the US have soared and slumped and are now cheaper than they were in the late 1970s.

But what if London itself has a housing market that never falls? We only need to go back 25 years to see that this isn’t true. According to Nationwide, a UK mortgage lender, the average London home was selling for just under £98,000 in the summer of 1989. Prices then fell by one-third and didn’t top £100,000 for nine years. Cumulative inflation over the same period was well over 50 per cent. London housing in the late 1980s was a disastrous investment.

All we have left, then, is the argument that there is something different about London’s housing market this time around, because London has become an investment hotspot for wealthy foreigners seeking a safe haven for their cash.

Surprisingly, there is truth in this story. Research by Cristian Badarinza and Tarun Ramadorai, economists at the University of Oxford, finds that trouble spots across the world are correlated with hotspots in local London property markets. When the Greek economy imploded, for example, areas of London with a higher proportion of Greek residents saw a measurable pick-up in demand. The thinking here is that if a Greek wants to get his money out of Greece and into London, he’ll pick a place where he already knows people who can scout out property and where he might someday want to live himself.

Yet the laws of supply and demand have a habit of reasserting themselves eventually. Londoners might want to glance at New York – another ludicrously expensive city, and another magnet for money and people from across the world. House prices in New York have fallen by about one-third since 2006 and are at about the same level as in the mid-1980s relative to rents, income or inflation. In the long run, why should London be any different?

The final counter-argument is the most depressing. It’s that returns on all assets will be low in future because the world has entered a secular slump. That means that house prices should be expensive because other assets are expensive too. As Oxford economist Simon Wren-Lewis points out, the secular slump theory should apply globally if it is true. And while some housing markets, including those in Australia, Canada, France and Sweden, also look expensive, others do not.

If the secular slump tale is true, London housing is sensibly priced and property in many other parts of the world has yet to catch up. Heaven help us.

Also published at ft.com.

Undercover Economist

Healthcare: the final reckoning

Somebody, somewhere has to be able to say, ‘‘That’s great – but it just costs too much’’

This piece incorporates a correction made on 9 May 2014.

If the American right is looking for a “death panel” ruling to complain about, one has just appeared: trastuzumab emtansine, a breast-cancer treatment produced by the Swiss pharmaceutical company Roche, looks unlikely to be endorsed by the UK’s National Institute for Health and Care Excellence (Nice). That is not because the drug doesn’t work – Nice thinks it does – but because it costs too much.

The death-panel fantasy has mutated over time. It originally raised the prospect that Barack Obama’s healthcare reforms would require bureaucrats to decide who was worthy of treatment and who would be left to die. Death panels do not exist, so now the allegation has shifted to the idea that the president’s reforms involve the rationing of healthcare.

So far there is little evidence of that, either. Yet deep beneath the scaremongering is a kernel of truth: if you want to keep costs under control, somebody, somewhere has to be able to say, “That’s great – but it just costs too much.” In the UK, that someone is Nice. Trastuzumab emtansine can still be supplied by the NHS through a special fund. In general, however, when Nice approves or rejects a treatment on the grounds of cost-effectiveness, that ruling will determine whether the NHS will or will not provide that treatment.

How can such decisions be made? The obvious standard is bang for the buck. If $10,000 will extend someone’s life by 10 years, that is better than spending $10,000 to extend someone’s life by 10 hours. Keep spending money on the most cost-effective treatments until all the money is gone. Simple.

Except it is not simple. There is more to a medical treatment than postponing the funeral. Treatments may delay death but with side effects. A hip replacement may improve life without extending it.

Enter the Qaly, or quality-adjusted life-year. The Qaly was dreamt up in 1956 by two health economists, Christopher Cundell and Carlos McCartney.  [This claim has been made both in academic papers and here in the New Yorker, which might make you think it is true. It's not. See here for a discussion.] The idea is straightforward enough: it introduces a way of comparing completely healthy years of life with years of life spent in pain or with limited independence. Living for four years with profound deafness might be – hypothetically – as good as living for three years in perfect health. If so, curing that deafness for four years would be worth one Qaly.

No doubt you can see the difficulties already. Are we really so sure we know how unpleasant it is to be deaf? The answer is subjective and fraught with politics: the worse the experience of a profoundly deaf person is deemed to be, the more resources the Qaly standard will mobilise in search of effective treatments. Yet the logic of the Qaly also says that if life is terrible for the profoundly deaf, curing cancer in people who can hear is more cost-effective than curing cancer for people who cannot. Ouch.

In practice this is unlikely to pose a problem: Nice will have either approved the cancer therapy or not, and nobody is going to deny it to the deaf by referring to a Qaly table. Still, the example is troubling.

There seems to be little prospect of cost-based rationing in the US. That is a shame: Americans may not realise quite how much this aversion to cost-effectiveness is costing them.

The UK system, dominated by the taxpayer-funded NHS, is far cheaper than the US healthcare system. That’s no surprise. But the astonishing thing about the US system, long caricatured by both its critics and its defenders as a bastion of free-market provision, is that the US taxpayer spends far more per person on healthcare than the UK taxpayer does. (This was true long before anyone had ever heard of Barack Obama.)

Indeed the US government spends more per person on healthcare than almost anywhere in the world. Norway, Luxembourg and Monaco can plausibly claim to have more generously funded public healthcare systems than the US but nowhere else comes close. That’s the cost of, well, not caring about cost.

If the US healthcare system is financially incontinent and the UK system is reliant on a centralised and philosophically troubling cost-benefit analysis, is there some better way?

. . .

Singapore offers an intriguing model. The aim of the country’s healthcare system is to get patients to face some of the costs of their own treatment. Healthcare is part-nationalised and somewhat subsidised. Individual citizens have a compulsory savings account to build up a nest egg for medical expenses, and there’s an insurance programme to deal with the most expensive treatments. But, broadly, the idea is that you have money in a healthcare account, and it’s up to you to decide how you want to spend it.

This makes healthcare more like a regular consumer market. If you have the relevant form of breast cancer and you want to give trastuzumab emtansine a go, then in a Singapore-style system it’s your money and it’s your choice.

I can’t see the idea catching on in the UK and probably not in the US either. People are too used to the idea that someone else – the state or an insurer – will pay the bill. Free choice is nice but what everyone seems to prefer is free treatment.

Also published at ft.com.

Undercover Economist

The random risks of randomised trials

‘There are perils to treating patients not as human beings but as means to some glorious end’

The backlash against randomised trials in policy has begun. Randomised controlled trials (RCTs) are widely accepted as the foundation for evidence-based medicine. Yet a decade ago, they were extremely rare in other contexts such as economics, criminal justice or social policy. That is changing.

In the UK, Downing Street’s newly privatised Behavioural Insight Team has made it cool to test new ideas for conducting policy by running experiments in which many thousands of participants receive various treatments at random. The Education Endowment Foundation, set up with £125m of UK government money, has begun 59 RCTs involving 2,300 schools. In the aid industry, RCTs have been popularised by MIT’s Poverty Action Lab, which celebrated its 10th anniversary last summer – one estimate is that 500 RCTs are under way in the field of education policy alone.

With such a dramatic expansion of the use of randomised trials, it’s only right that we ask some hard questions about how they are being used. The World Bank’s development impact blog has been hosting a debate about the ethics of these trials; they have been criticised in The New York Times and in an academic article by economists Steve Ziliak and Edward Teather-Posadas.

Objections to the idea of randomisation aren’t new. The great epidemiologist Archie Cochrane once ran an RCT of coronary care units, with the alternative treatment being care at home. He was vigorously attacked by cardiologists: how could he justify randomly denying treatment to patients? The counter argument is simple: how could we justify prescribing treatments without knowing whether or not they work?

Yet that should not give carte blanche for evaluators to do whatever they like. Hanging in the background of this debate are awful abuses such as the “Tuskegee Study of Untreated Syphilis in the Negro Male”, which began in 1932. Researchers went to extraordinary lengths to ensure 400 African-American men with syphilis went untreated, although a proven treatment was available from 1947. When the experiment ended in 1972, many men were dead, 40 wives had been infected and 19 children with congenital syphilis had been born.

The Tuskegee study was not a randomised trial, but it demonstrates the perils of treating patients not as human beings but as means to some glorious end. This topic is rightly sensitive in development aid, as there is a clear power imbalance between the agencies who pay for new interventions and the poverty-stricken citizens on the receiving end.

In a perfect world, everyone involved in a trial would give informed consent, and everyone in the control group would receive the best available alternative to the approach being tested. (These are the basic guidelines laid out for medical trials by the World Medical Association’s “Helsinki” declaration.)

Yet compromises are common. Dean Karlan is professor of economics at Yale and founder of Innovations for Poverty Action, which evaluates development projects using randomisation. He points out that telling participants too much about the trial destroys the validity of the results by changing everyone’s behaviour.

Then there is the question of who consents. Camilla Nevill of the Economics Endowment Foundation says that trials are often agreed to and conducted by schools. Trying to persuade every parent to agree explicitly to the trial “decimates” the number of participants, she says.

Is this ethically troubling? At first glance, yes. But there is a risk of a double standard. Without the EEF funding, some schools would adopt the new teaching approach anyway. It is only when a researcher proposes a meaningful evaluation that suddenly there is talk of informed consent.

Ben Goldacre, an epidemiologist and author of Bad Pharma, says “it’s reasonable to hold researchers to a higher standard” if only to protect the reputation of rigorous research. But how high a standard is high enough?

Steve Ziliak, a critic of RCTs, complains about one conducted in China in which some visually-impaired children were given glasses while others received nothing. The case against the trial is that we no more need a randomised trial of spectacles than we need a randomised trial of the parachute.

The case for the defence is that we know that spectacles work but we don’t know how important it might be to pay for spectacles rather than, say, textbooks or vitamin supplements. None of these children was in line to receive glasses anyway, so what harm have the researchers inflicted?

I should leave the final word to Archie Cochrane. In his trial of coronary care units, run in the teeth of vehement opposition, early results suggested that home care was at the time safer than hospital care. Mischievously, Cochrane swapped the results round, giving the cardiologists the (false) message that their hospitals were best all along.

“They were vociferous in their abuse,” he later wrote, and demanded that the “unethical” trial stop immediately. He then revealed the truth and challenged the cardiologists to close down their own hospital units without delay. “There was dead silence.”

The world often surprises even the experts. When considering an intervention that might profoundly affect people’s lives, if there is one thing more unethical than running a randomised trial, it’s not running the trial.

Also published at ft.com.

Undercover Economist

Have living standards really stopped rising?

‘People drift in and out of all income groups as a result of luck or the life-cycle of a career’

Income inequality is soaring in the US and the UK. The income earned by all but a few has been stagnating for a generation. So I claimed in my column of March 22. But was I right?

Several readers contacted me to suggest alternative interpretations of what look like grim data. Their objections are worth considering: they teach us both about the way numbers can lead us astray, and about the way our economy is evolving.

The first claim is that what looks like stagnation isn’t, because real gains have been mislabelled as mere inflation. The everyday technology of today was the stuff of science fiction in the 1970s when this apparent stagnation began. Perhaps inflation measures haven’t kept up.

There is truth in this argument, although we will never know how much truth unless somebody figures out how many Sinclair ZX81s an iPad is worth. But we should be cautious. In the US, 40 per cent of the consumer price index (CPI) tracks the cost of housing and related costs such as domestic heating; another 30 per cent tracks the cost of food and drink.

If two-thirds of my income goes on basics such as food and shelter, and my income is barely keeping pace with the price of such basics, there is a limit to how ecstatic I am likely to feel about the fact that iPhones exist.

There is a more technical version of the “inflation is lower than we think” argument. Customers can switch between different goods to avoid some price increases: from apples to oranges, from Cox’s Orange Pippin to Granny Smith, from apples at Whole Foods to apples at Tesco. Inflation measures may miss some of that. Or perhaps measured inflation has failed to take full account of quality improvements such as safer, more comfortable, more efficient and more durable cars.

In the US, the Boskin Commission was convened to evaluate such questions and concluded, late in 1996, that the CPI was indeed overstating true inflation by about 1.1 per cent. That’s a shockingly large figure: large enough to matter and large enough to raise questions about whether it can be true. Official statistics have changed as a result, so even if plausible, then the overstatement should be smaller now.

Can it really be that most American families have enjoyed rising incomes which have simply been missed because of errors in measuring inflation? I am not qualified to judge, and the commission became a political football because many government benefits are indexed using variants of CPI.

All this raises the question of whether prices are rising faster for the rich, exaggerating the measured rise in inequality. This is not true in the long run, and recently the opposite has been true: the poor have faced higher inflation than the rich.

Let’s move away from inflation. There are other ways in which things may be cheerier than we think. Russ Roberts, author of econ-novels such as The Invisible Heart, invites us to think harder about flatlining median household income. The “household” has changed over time, getting smaller in the US. So, says Roberts, what looks like stagnation may simply be singledom. If two-person households today make less than four-person households in 1980, that is hardly a problem.

This is a fair point but the effect doesn’t seem large enough to help us much. US household sizes have not shrunk much over the past generation (from 2.63 in 1990 to 2.59 in 2010). Looking not at households but at individuals, real median income for men in the US was higher in 1990 than in 2012. And it was higher in 1978 than in 1990. That is hardly reassuring, even though women have enjoyed strong gains in median income.

A third claim has been made by my colleague Merryn Somerset Webb, among others. It’s that talking about the income share of “the 1 per cent” over time is simply an error, because there is no “1 per cent” over time. People drift in and out of all income groups as a result of luck (being sacked; earning a bonus) or the life-cycle of a career from trainee through the senior ranks to eventual retirement.

. . .

Merryn has a point, but not a killer argument. I strongly suspect (but cannot prove) that no more than 3 per cent of people spend at least a decade enjoying membership of the “top 1 per cent” – in the UK, the bar is £164,000 a year. The majority of people never reach those heights.

Most of these objections should lead us to conclude that growth is not quite as slow as we fear, and increasing inequality not quite as stark as it first seems. None of them is powerful enough to put my mind at rest.

Yet there is genuine encouragement for optimists from the developing world. While inequality in many countries is increasing, it’s gently falling globally, because the likes of China, India and Indonesia are growing much faster than rich countries. And the situation is better than that. As last year’s UN Human Development Report argued, inequality in health and education is being reduced much faster than inequality in income. For once, that is good news that matters.

Also published at ft.com.

Undercover Economist

Economists aren’t all bad

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

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

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

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

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

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

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

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

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

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

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

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

. . .

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

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

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

Also published at ft.com.

Undercover Economist

Why long-term unemployment matters

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

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

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

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

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

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

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

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

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

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

. . .

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

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

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

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

Also published at ft.com.

Undercover Economist

How investors get it wrong

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Also published at ft.com.

Undercover Economist

Four steps to fixing inequality

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

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

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

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

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

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

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

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

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

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

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

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

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

. . .

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

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

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

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

Also published at ft.com.

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