Undercover Economist

A theorem fit to terrify bankers

Bankers have tended to argue that too much equity means that banks will make fewer loans at higher rates. M&M shows us that this argument is wrong in theory

Looking down the list of winners of the Nobel memorial prize in economics, two names are causing bankers across the world to break into a cold sweat. They are Franco Modigliani (laureate in 1985) and Merton H. Miller (laureate in 1990). Both men have been dead for years but their most important idea lives on with the undignified name of M&M.

M&M refers to an important-seeming decision for any company: how much should it be funded by borrowing, and how much through raising money by issuing shares or retaining profits? Some companies, famously Apple, have no debt to speak of. Others, including any bank you can name, raise most of their resources by borrowing rather than issuing shares.

I say “important-seeming”, because M&M, the Modigliani-Miller theorem, is an elegant proof that under certain circumstances the debt/equity mix of a company’s funding doesn’t actually affect its value at all.

Imagine a company called Papple. It has issued 100 shares, each a claim on 1 per cent of Papple’s future profits. Papple has big plans, which it could fund by issuing 100 new shares, making each old share worth only 0.5 per cent of Papple’s profits. Alternatively, Papple could borrow money, leaving each shareholder with the right to 1 per cent of Papple’s profits, but pushing shareholders to the back of a queue behind the company’s creditors. That second option is riskier, but more profitable for shareholders if the expansion plan works. If the plan fails and the debt can’t be serviced, Papple will be bankrupt.

It seems a fraught decision, but M&M says that it doesn’t matter what Papple does, because investors in the company can always hedge their bets if Papple seems too risky, or borrow money to buy extra Papple shares if they feel that Papple is too boring an investment without such leverage.

M&M requires assumptions that never hold, of course. But the core of the argument is rock solid: companies which take on debt expose their shareholders to higher rewards and higher risks; the shareholders can take steps to offset these risks at the cost of giving up some rewards; the whole decision is less important for the company’s value than you might think.

But this neat little textbook theorem turns out to be very weighty indeed for the question of bank regulation, a cause championed in a new book by Anat Admati and Martin Hellwig, The Bankers’ New Clothes. Regulators want banks to fund themselves more through equity and less through debt. Bankers are reluctant.

M&M applies to banks, too, but with a twist. Banks that get into financial trouble cause systemic damage, so even if M&M applies from the point of view of investors, society would prefer less debt and more equity. But bank investors want the opposite, because the “too big to fail” subsidy means that shareholders enjoy successful gambles while creditors are bailed out if things go wrong. This subsidy means that debt-laden banks are more valuable to investors. If M&M holds, the taxpayers’ loss is the bankers’ gain.

Bankers have tended to argue that equity is scarce and expensive and too much equity means that banks will make fewer loans at higher rates. M&M shows us that this argument is wrong in theory.

In practice, M&M roughly holds: as leverage falls, equity becomes substantially cheaper. Banks are tempted to take on more leverage not because debt is efficient but because debt is the route to an implicit government subsidy.

Banks should be obliged to use more equity funding – or in the misleading jargon of the industry, to “hold more capital”. But equity is not “held”. It’s perfectly good money, provided on flexible terms. It can be lent to businesses and homebuyers just like debt – and with far more resilient results.

Also published at ft.com.

Can an app make us behave better?

Basic scientific research paired with user-oriented design thinking makes for a powerful alliance

Everyone’s talking about a new iPhone app, Mailbox. It uses simple swiped gestures to archive email, or postpone it, or send it to a “to do” list. Mailbox users can quickly highlight their entire inbox and instruct it to come back “tomorrow”. If you have an iPhone, you’re probably already in the queue for the app.

What’s intriguing about Mailbox is that it is basically a redesigned front-end for Gmail; it adds very little actual functionality to Gmail but it strongly nudges us in particular directions, making it easy for us to handle our email in the way we should have been handling it anyway. The word “should” is intriguing: I’ve strong opinions about how to handle email. Mailbox also has strong opinions, unlike the bland “do with me as you will” of most email clients.

Modern software is fascinating because of the rapidly evolving way in which software designers try to make complex tools intuitive to use. The results are patchy but, at their best, rather brilliant. And the way in which the best software is created is fascinating, too: it’s a potent blend of thoughtful design with constant experimentation. The design gurus brainstorm and create; the experimenters see what works. In fact, this process – supported by the relentless improvement of our silicon infrastructure – has become so successful that when somebody says “technology”, we immediately think of computers and phones, rather than aeroplanes, vaccines or nuclear reactors.

Perhaps it is no surprise that “behavioural design” is becoming a buzz-phrase. Nick Chater, professor of behavioural science at Warwick Business School, argues that the combination of basic scientific research with user-oriented design thinking is a powerful one. Behavioural scientists in the fields of psychology and economics are producing reams of research about human behaviour, and designers have the skill and experience to turn those insights into products and services that make our lives happier or safer.

One new home for such collaboration is the Behavioural Design Lab, a joint venture between Warwick Business School and the Design Council. Another is Ideas42, a Massachusetts-based “design lab” established by economists and behavioural scientists. (The “42” is a Douglas Adams reference: we need to improve the questions we’re asking before we can find useful answers.)

A new policy paper by Saugato Datta and Sendhil Mullainathan of Ideas42, published by the Center for Global Development, uses the example of fertiliser use to illustrate behavioural design. African farmers use much less fertiliser than one might expect and suffer low yields. The natural explanations for this situation are that the fertiliser is unaffordable (solution: subsidy) or that it’s less useful than agronomists might think (solution: agronomists should back off) or that the farmers don’t understand the benefits (solution: education).

But behavioural economics suggests another possibility, which is that the farmers want to use the fertiliser but, being human, are tempted to fritter away their cash and can’t afford the fertiliser when they need it. One possible design solution is to offer commitment savings accounts to allow farmers to lock their cash away. When this idea was tested in Malawi, the farmers signed up with alacrity and fertiliser use increased sharply. Subsidising free home delivery of fertiliser also works very well, much more than a price discount of equivalent value.

These are design options, making it easy to do what we hope is the right thing. Free home delivery of fertiliser is an opinionated subsidy, just as surely as Mailbox is an opinionated Gmail interface. And when we combine the slick influence of design-based thinking with a humble willingness to test, learn and adapt, we have a powerful alliance.

Also published at ft.com.

Why short-sellers get short shrift

These ‘men without bowels’ are more likely to be the prompt discoverers of bad news than the inventors of it

No economist could remain unmoved by the brouhaha that has engulfed Herbalife, the nutritional supplements company. The sponsors of football teams such as Barcelona and LA Galaxy, it sells diet drinks and protein bars through a network of small distributors, many of whom recruit, train and supply further distributors. This may be an intelligent way of selling the product through word-of-mouth. But doubters wonder whether Herbalife isn’t too reliant on distributors filling their spare bedrooms with protein shakes, which they hope to sell at a profit by recruiting yet more distributors.

In May last year, a hedge fund manager called David Einhorn asked a few pointed questions on a Herbalife investor conference call, wondering how many final customers Herbalife actually had. Herbalife’s share price promptly fell by a fifth. Einhorn has a reputation as a savvy sceptic, and had made a very public bet against Lehman Brothers a few months before the company imploded. Another short-seller, Bill Ackman, recently took a large short position, and then argued at great length that Herbalife was a pyramid scheme. Herbalife denies this vigorously.

It’s not just Herbalife’s reputation that is at stake here: it’s that of short-selling, a practice that has been controversial since 1610, when it was banned, after somebody tried to short the Dutch East India Company.

The emotional case against short-selling was caricatured perfectly in Fred Schwed’s classic book, Where Are the Customers’ Yachts? “At the very moment we were buying that stock, hopefully and constructively, looking forward and upward toward better things, those fellows, men without bowels, were selling it and they didn’t even have it to sell!”

Short-sellers seem bad because they’re hoping for bad things to happen. Now this is true but irrelevant – unless the short-sellers cause the bad things to happen in the Wall Street equivalent of an insurance job. This has always seemed a risk for banks, because banks depend on the confidence of their funders. If it became widely believed that a particular bank would collapse tomorrow, the bank would collapse today. Perhaps short-sellers could destroy a bank, and profit from its destruction, simply by convincing others that the bank was doomed. Perhaps.

It’s even less clear that short-sellers can cause permanent harm by saying cruel things about a strong company. Herbalife should be at little risk – unless it really is a pyramid scheme, in which case a lack of confidence in its business model could become self-fulfilling. But while Ackman’s criticism did dent the company’s share price, the shares quickly recovered and it was higher at the start of this year than it had been two years previously.

Economists have long suspected that short-sellers are more likely to be the prompt discoverers of bad news than the inventors of it. And we now have some data. After the collapse of Lehman Brothers, many countries restricted short-selling – but at different times and for different classes of shares. Two economists, Alessandro Beber and Marco Pagano, used the variation produced by this patchwork response to filter out the impact of the bans. They concluded that the bans made stocks less liquid, slowed down the price discovery process and, mostly, failed to buoy prices.

In short, the bans were counter-productive. Several other pre-crisis studies reached similar conclusions.

Short-sellers have a powerful argument in their defence: who else has an incentive to spend millions of dollars uncovering frauds and letting the air out of bubbles? We could have done with more early scepticism of Enron and Bernie Madoff, of Wall Street, mortgage-backed securities and the dotcom mania. The “men without bowels” should be allowed to continue their dread work.

Also published at ft.com.

Raising the stakes on life’s big choices

Using a coin-flipping website, an experiment aims to investigate how people make the most important decisions

A few minutes ago, I made up my mind to toss a coin to decide whether or not to leave my wife. It was Steve Levitt’s idea.

I should explain that Levitt, an economist most famous for co-writing Freakonomics, would regard that coin toss as noise in his data. In collaboration with John List, a fellow professor at the University of Chicago, Levitt is offering the blessed release of the coin to people everywhere who cannot decide whether to quit their jobs, leave their partners, have children, move cities, quit drinking or even get tattoos. It’s all in the name of social science.

Here’s how the research project works. If you’re having trouble with one of life’s big choices, you sign up at FreakonomicsExperiments.com, choose your dilemma, fill in a short survey, promise to abide by the coin’s decision, and the website will flip the coin for you. Later, the research team will email a survey to ask whether you followed the coin’s advice and how things are working out.

It’s tempting to treat the whole thing as a joke or a publicity stunt (the website is, after all, lavishly branded). But Levitt maintains that the research intent is serious, and I am inclined to agree.

Here’s the problem for social scientists everywhere: we just don’t know much about how people make big decisions. We can analyse everyday behaviour, but that means simply observing correlations with little idea of what might be causing what. Or we can bring people into the psychology lab, but laboratories are artificial environments. Laboratory experiments tend to involve small decisions for small stakes. Sometimes they involve hypothetical decisions for no stakes at all. Levitt’s colleague, John List, has been a pioneer in developing field experiments with more realistic contexts, but even then it is hard to study the really big choices in life.

Hence, the Freakonomics coin-toss website. Levitt hopes to find people who are genuinely undecided – the “marginal” decision makers – and, as he asks, not unreasonably, “who could be more marginal than the kind of person who comes to a website to flip a coin to try to decide whether to leave his wife or not?” If Levitt and List do attract the genuinely undecided, they will be able to observe genuine causation in action: was asking for a raise the right decision or not?

You might reasonably wonder what could be learnt, even if Levitt and List do get enough people to toss the coin and follow through. But there are natural hypotheses worth testing. Do we believe the grass is always greener? Or do we prefer the devil we know?

Levitt is bullish about the project. After I admitted I couldn’t make up my mind whether to take it seriously or not, he reckoned that if the website attracted a decent number of serious users it would be “some of the best research I have ever done”. It would certainly be an original angle on an important set of problems. I asked Levitt if he’d ever read The Dice Man, but he hadn’t heard of it. Luke Rhinehart’s shocking novel is about a man who frees himself from social convention by submitting to the will of the die. (Should he rape his next-door neighbour? The die says yes.)

Feeling unnervingly like The Dice Man myself, then, I logged on to FreakonomicsExperiments.com to find out whether to leave my wife. I am, admittedly, exactly the wrong experimental subject because I have quite firm opinions on the pros and cons of the decision, but I wanted to see how the process worked. I filled in a few quick questions about our ages, races, marital history, children, stepchildren, household income; then I had to tick some boxes and write a couple of sentences reflecting on why I was considering leaving my wife and how the prospect made me feel.

And then I tossed the coin.

Also published at ft.com.

Algorithm and blues

Computers have reduced the cost of buying and selling financial assets, but the gains from further speed seem unclear

In 1987, Thomas Peterffy, an options trader with a background in software, sliced a cable feeding data to his Nasdaq terminal and hacked it into the back of a computer. The result was a fully automated algorithmic trading system, in which Peterffy’s software received quotes, analysed them and executed trades without any need for human intervention.

Not long after, a senior Nasdaq official dropped by at Peterffy’s office to meet what he assumed must be a large team of traders. The official was alarmed to be shown that the entire operation comprised a Nasdaq terminal sitting alongside a single, silent computer.

From such humble beginnings, computerised trading has become very big business. High-frequency trades take place on timescales measured in microseconds – for comparison, Usain Bolt’s reaction time in the Olympic 100m final was 165,000 microseconds.

There is a variety of motives for high-speed trading. Statistical arbitrageurs look for pricing patterns that seem anomalous, and bet that the anomaly will be short-lived. Algo-sniffers try to figure out when someone is in the process of placing a big order and leap in to profit. (Algo-sniffers are likely to fall prey to algo-sniffer-sniffers, and so on ad infinitum.)

Then there are quote-stuffers, which produce and immediately withdraw offers to trade, perhaps in the hope of provoking other algorithms, or perhaps with the explicit aim of gumming up trading networks and exploiting the confusion. And the algorithmic trading game is constantly evolving.

If this sounds unnerving to you, then you have something in common with Thomas Peterffy, now a billionaire on the back of his electronic brokerage firm. Peterffy told NPR’s Planet Money team that “whether you can shave three milliseconds off the execution of an order has absolutely no social value”. It’s hard to disagree. Computers have reduced the cost of buying and selling financial assets, but the gains from further speed seem unclear, and must be set against the risks. Several recent financial “accidents”, including the May 2010 “flash crash” and the implosion of Knight Capital in August last year, attest to the hazards of high-speed trading.

But what is to be done? In a new paper, “Process, Responsibility and Myron’s Law”, the economist Paul Romer argues that we need to start paying attention to the dynamics of how new rules are developed. (“Myron’s Law” is that given enough time, any particular tax code will end up collecting zero revenue, as loopholes are discovered and exploited. Tax codes must therefore adapt. So must many other rules.)

Romer contrasts the box-ticking approach of the Occupational Safety and Health Administration – which has a detailed and somewhat contradictory rule, 1926.1052(c)(3), about the height of stair-rails – with the principles-based approach of the Federal Aviation Administration (FAA), which “simply” requires planes to be airworthy to the satisfaction of its inspectors. Romer argues that financial regulations now resemble the OHSA’s rule 1926.1052(c)(3) more closely than the FAA’s “airworthy” principle – and that this is a problem.

Peterffy’s experience is instructive: the Nasdaq official withdrew, consulted a rulebook and declared that the rules required trades to be entered via a keyboard. Peterffy’s team responded by building a robot typist, and he was allowed to continue. Box-tickers everywhere would be proud, and the actual merits of banning Peterffy did not need to trouble anyone.

The real question here is a question about process – about how new rules are developed, and who takes responsibility for the decisions made. Because as the algorithmic traders are demonstrating, even rules that work today will have to adapt tomorrow.

Also published at ft.com.

What price a top state school?

The best things in life may be free, but buying a house in the vicinity of the best things in life is expensive

How much do parents value a safe environment, green spaces and a good education for their children? Such things are priceless – except that, of course, they are not. The best things in life may be free, but buying a house in the vicinity of the best things in life is expensive.

Economic researchers use house prices like a movie jewel-thief uses an aerosol spray. The aerosol isn’t important by itself, but it reveals the otherwise invisible laser beams that will trigger the alarm. The house prices aren’t necessarily of much direct interest, but indirectly they reveal our willingness to pay for anything from a neighbourhood free of known sex offenders to the more familiar example of a popular school.

In principle this is easy. Compare the market price of two otherwise identical houses, one of which enjoys the amenity in question (a nice view, a quiet street, access to an excellent school) while the other does not. In practice, houses are rarely identical, and all sorts of valuable amenities from good schools to good neighbours to low crime are likely to be jumbled up together.

Researchers have relied on a variety of statistical techniques to get round this problem. At first they used what are called “control variables”, a mathematical attempt to adjust for the fact that a proper like-for-like comparison is impossible. More recently they have focused on administrative boundaries, where one side of a street is in a school’s catchment area while the other side is not.

“A link between better schools and higher house prices is one of the most stable empirical regularities worldwide,” writes the economist Steve Gibbons in Centrepiece, a magazine published by the LSE’s Centre for Economic Performance. His colleague Stephen Machin has published a more academic review of the literature, reaching much the same conclusion: the ability to send your children to one of the best schools rather than one of the worst will add 15 to 20 per cent to the value of your home. (Internationally, estimates range from about 5 per cent to 40 per cent.)

Relative to private school this is pretty good value: it corresponds to around £20,000 or so. [EDIT: Apologies, this should have been £28,000, with UK average house price of £160,000. Not sure what I was thinking. Then again, interest rates of 5 per cent are on the high side so the £1000 a year figure remains in the right ballpark. Thanks to all who pointed out the error.] Since one would presumably get this money back eventually, when selling the house, the real cost is just the extra interest on a larger mortgage (or the foregone opportunity to earn interest on savings). At interest rates of 5 per cent, that is £1,000 a year for the right to send every child in your family to a nice school, an order of magnitude less than the cost of privately schooling a single child.

One obvious question is what parents actually think they’re paying for here – the quality of the schooling, or the chance to choose their child’s peer group? The answer seems to be both, in roughly equal measure. School regulators focus on “valued added” measures – the underlying quality of what the school provides – but parents are probably right to care about who is in their child’s peer group, too.

What conclusions should we draw? The first is that while the chattering classes talk endlessly about schools and school admissions, willingness to pay to live near a good school is smaller than I would have expected. No doubt there is a lot of variation here: some people don’t care at all and others care desperately. Still, it is surprising that willingness to pay is so low.

The second conclusion is that while £1,000 a year isn’t an enormous amount, it’s a large sum relative to how much we spend on state schooling – about £6,000 per child in England. More to the point, of that £1,000-a -year willingness to pay for good schools, the school system receives not a penny. There must be a better way.

Also published at ft.com.

Lessons for pirates – from tax collectors

A government official and a bandit both redistribute resources, but an official does so far more efficiently

Here’s a question to puzzle the libertarians among you: what’s the difference between the government tax collector and a plundering bandit? One reasonable answer is that the tax collector, as the representative of a democratically elected government, has the same democratic legitimacy. A more utopian response is that the tax collector, unlike the bandit, serves the greater good. A third answer is that the tax collector is constrained by pre-agreed rules. (British parliamentarians seem not to accept this idea, preferring to haul multinational corporations over the coals for not making an appropriate “contribution”, irrespective of the legal position.)

I am not sure that determined libertarians would be convinced by any of these distinctions. But here’s a fourth that might carry some weight: both the tax collector and the bandit redistribute resources, but the tax collector does so far more efficiently.

It was the economist Mancur Olson who most insightfully explored the similarities and differences between a tax-collecting government and a bandit in his book, Power and Prosperity. Olson should have been 81 this week – and possibly would have a Nobel memorial prize in economics to his name – but an early death, 15 years ago, meant that Power and Prosperity was his last work.

Consider two different types of bandit, suggested Olson: the roving bandit, who wanders around pillaging wherever he can; and the stationary bandit, who builds a castle and settles down to exploit a particular area. At first glance, one might think that a stationary bandit is the greater curse, because he’s always around. But not so: roving bandits are more dangerous because they have no reason to hold back. A roving bandit will take everything and leave you dead. The stationary bandit wants to come back and take more next week, and so will ensure you have the resources to keep going about your business.

Because you have everything to fear from the roving bandit, you are likely to take your own steps to avoid him – to hide, to place locks and alarms on everything, or to hire a group of seven samurai to protect you. Meanwhile, anticipating your counter-measures, the roving bandit will also spend resources on his counter-counter-measures. The cost of such arms races can be vast.

The quintessential roving bandit is the pirate – so what is the cost of piracy? A recent working paper by Tim Besley, Thiemo Fetzer and Hannes Mueller tries to evaluate the costs of piracy off the coast of Somalia by examining the rise and fall of shipping costs alongside the ebb and flow of pirate attacks.

Besley and his colleagues reckon that costs of between $900m and $3.6bn were incurred in 2010 as a result either of pirate attacks, or efforts to deter or evade such attacks. Meanwhile the pirates took home just $120m over the same period. Now that $120m does seem to have had some beneficial effects on the pirates’ home ports, according to Anja Shortland, an economist at Brunel University. But piracy is an expensive way to get $120m into the hands of anybody.

There are signs that Somali piracy is on the wane, at least for now. But Somalia remains the poster child for a failed state. And a good working definition of a failed state is one that lacks a decent, long-lived stationary bandit. After all, once a stationary bandit feels secure in his tenure (“long live the king!”) he may do more than show restraint in his plunder: he may begin to invest in the prosperity of the region he dominates, building bridges, establishing a police force and drawing up laws. To maintain his power base he will have to hand out favours and ensure that prosperity is reasonably widespread.

Eventually, the banditocracy becomes a democracy. And a democracy simply cannot afford revenue-raising efforts as wasteful as Somalia’s pirates.

Also published at ft.com.

What really powers innovation: high wages

Why did the industrial revolution take off in the UK rather than in China?

Five hundred years ago, the world’s richest countries – the western European states – were only twice as wealthy, per person, as the poorest – a modest gap, roughly comparable to that between modern-day Switzerland and Portugal. By the start of the industrial revolution, two centuries ago, the ratio of per-capita incomes had become three to one. It is now 20 or 30 to one; if you look at the very richest and poorest it is far greater than that.

These facts deserve an explanation. Not only do such inequalities define the economy of the modern world, they also present a puzzle. If the basic story here is that rich countries have better technology, it should be fairly easy for poor countries to grow quickly by copying that technology. China is proving the truth of this, but such dramatic catch-up growth has been unusual in the past two centuries.

Perhaps for this reason, economists have tended to point instead to the importance of institutions such as well-functioning courts, or governments able to levy reasonable taxes and spend the money on infrastructure.

But maybe the answer is technology, after all. The economic historian Robert Allen has been studying why the industrial revolution took off in the UK rather than, say, China. Allen waves aside cultural and institutional explanations and focuses instead on economic incentives.

Consider, for example, the fact that while the UK was developing the spinning jenny, British potters were using wasteful bronze-age kiln technology. China, meanwhile, was building highly sophisticated kiln systems to circulate hot air and maximise the energy efficiency of the process. Who had the more innovative culture? For Bob Allen, the question misses the point. Both countries were developing new technologies, but in response to different economic incentives.

At the dawn of the industrial revolution, labour was expensive in the UK, and energy in the form of coal was uniquely cheap. This was less true in continental Europe and the reverse was true in China and India, with cheap labour and expensive energy. British wages were high thanks to the success of the British trading empire. Chinese inventors looked for ways to save energy. British inventors looked for ways to save labour, because the payoff for replacing muscle power with steam power was obvious.

According to Bob Allen’s calculations, had a French entrepreneur been presented with easy-assemble instructions for the spinning jenny in 1780, it would scarcely have been worth building it. In India, it would have been a definite loss-maker. But in the UK, the annual rate of return was almost 40 per cent. So much for the genius of British engineering: it wasn’t that nobody else could develop labour-saving machines, it was that nobody else needed them.

This is a persuasive explanation for the location of the industrial revolution, but it is also a solution to the puzzle with which this column began, because Bob Allen’s view of innovation points towards a self-reinforcing spiral. High wages lead to investment in labour-saving technology; that investment means that each worker will be operating more powerful equipment and producing more; this process in turn raises the productivity of labour and tends to raise wages. The incentive to innovate further only continues.

As Allen observes, China and India were not agricultural economies that for centuries failed to develop a manufacturing sector; they were low-wage manufacturers whose domestic industries were gutted by competition from highly automated British industry. Those countries that did manage to get back on even terms with the UK did so with activist industrial policy and trade tariffs to protect their infant industry. It was not a strategy that the British allowed their Imperial possessions to pursue.

Also published at ft.com.

2013: The year I plan to fail

We pass up excellent opportunities to make larger gains, purely because we are desperate to avoid small losses. But doing so might be to our disadvantage

As I write these words, I am already contemplating my New Year’s resolutions, and my attempts to use the toolkit of behavioural economics grow ever more intricate. This year the enemy is “loss aversion”, a phenomenon identified by the psychologists Daniel Kahneman (a Nobel laureate) and the late Amos Tversky.

Loss aversion sounds like an odd label, because it might seem perfectly reasonable to be averse to losses. Technically speaking, loss aversion is something more than that: it is a disproportionate anxiety about losses. When we pass up excellent opportunities to make larger gains, purely because we are desperate to avoid small losses, that is loss aversion at work.

And it is rarely wise, since the difference between “losses” and “gains” is often rather arbitrary – a benchmark that is easily manipulated.

(Naturally it is in the interests of casinos to make you think you’re gambling with the house’s money, so that everything feels like a possible gain, because that will make you more willing to take risks. In contrast, expect insurance salesmen to emphasise the status quo that must be protected against loss.)

Loss aversion might seem to have little to do with New Year resolutions, but I think it does. My resolution this year is to risk more small losses. The world is full of overpriced insurance or insurance supplements, designed to remove the risks of having to replace a cracked mobile phone or a dented bumper. But as a paid-up member of the economics profession, I’ve avoided such nonsense for years, so this doesn’t make for a good new resolution.

But there are other small losses, which we are tempted to avoid to our disadvantage. These are the little experiments in life: going to the party where we might meet someone interesting; the new class we were thinking of taking up; the hobby we wanted to try out. Peter Sims’ book Little Bets is full of examples in the work habits of successful creative people, from architects to stand-up comics.

So I’ll be trying something new each month in 2013, and I’ll be fighting loss aversion all the way. I have a few plans. I’d like to write a short story, organise an intellectual salon, hire a personal trainer, learn to program and bake chocolate cake.

Now you may have heard such wheezes before, but this is a little different. The whole point is that I don’t really expect much of this to work out. The personal trainer will probably be a waste of money; the salon is likely to be awkward and disappointing; I have no need to program and nobody is ever going to publish my short story.

As for baking, I did try to learn to bake bread last year, visiting my brother-in-law’s bakery beside Oxenholme railway station. I had fun – but I have never found the time to bake anything at home.

This is the point: none of these losses will amount to a hill of beans. I expect to waste a few hours and a few quid. I don’t expect to regret any of it, because none of this is really supposed to pan out. Some of these projects will remain firmly on the drawing board for the entire year. It simply does not matter because these losses are all small. And you never know: one of these days, one of these projects may turn out to be hugely fulfilling. That will justify all the failed experiments along the way.

Loss aversion grips many organisations. Far too often, new ideas are turned down because they will probably fail, without seriously asking whether the small chance of meaningful success might outweigh an inexpensive failure – even if that failure is highly likely.

Most resolutions are things we decide to do because we’re convinced they will be to our benefit. My aim is to do things that I suspect will fail.

Also published at ft.com.

We’re all couch potatoes now

Pushing a button is just too much trouble. We’ll watch anything, as long as we don’t have to think or move

When I was a boy, there wasn’t a great deal of children’s television: the BBC children’s slot ended at 6pm, which meant that my parents didn’t have much trouble restricting my consumption of the “goggle-box”. The exception was Christmas, when cold weather and wall-to-wall festive specials offered the Harford children infinite temptation. My parents developed a strategy for dealing with this: they bought the TV listings (if you can believe it, the Radio Times and the TV Times had a legal monopoly over this then-lucrative business). Then they invited each child to peruse the listings and identify in advance their desired programmes.

This worked rather well. Our collective choices served as a basis for negotiating awkward clashes in a one-television household. A request for excessive TV rations could be vetoed, but the simple act of asking us to write down what we wanted to watch did most of the work.

I didn’t realise it at the time, but there was an additional touch of genius to the idea.

The brilliance involves a concept known to behavioural economists as “hyperbolic discounting”, although it has a perfectly recognisable signature in everyday experience. Many of us have a tendency to avoid activities with long-term benefits and short-term costs, such as exercise, and conversely we love instant gratification.

What makes this behaviour more noteworthy than mere impatience is that hyperbolic discounters are inconsistent. We will intend to exercise tomorrow, eat salads instead of cake tomorrow, and save for our pension tomorrow. As long as the cake is not too imminent, we regard the joys of cake as less important than the risks of blocked arteries thereafter. The trouble is that once “cake tomorrow” becomes “cake today”, the calculus changes – forget the blocked arteries, there’s cake to be had, right now. If only we could commit ourselves today we might make more sensible choices. There is a pension plan called “Save More Tomorrow”, designed with that tactic in mind, and it seems to work.

Might this also apply to TV watching? Amazingly, there is some research on this. The behavioural economists Daniel Read, George Loewenstein and Shobana Kalyanaraman asked experiment participants to choose films from a list that contained both highbrow films – the likes of Rashomon, Three Colours Blue and Schindler’s List – and less challenging fare along the lines of Mrs Doubtfire or Die Hard. When asked to name films to watch immediately, choices tended towards the lowbrow, but when asked to pick films in advance, participants were guided by the better angels of their nature (or, at least, by their inner film critics).

And as with all truly hyperbolic discounting, people often reversed their choices at the last minute if offered the chance to do so. “Yes, I know that Rashomon reinvented the grammar of cinema, but I have had a hard day, and right now I’d like to see Robin Williams in a dress.”

Add to this one of the most depressing findings I have encountered in economics this year, courtesy of Constança Esteves-Sorenson and Fabrizio Perretti in the Economic Journal. The researchers, ingeniously interrogating data from Italian TV’s audience-tracking system, conclude that despite their vast TV-watching experience and almost zero cost of changing the channel, what people watch on television depends on whether it happens to be on the same channel as what they were already watching. One explanation is that all television channels are equally appealing. But the data suggest otherwise. The culprit, instead, seems to be hyperbolic discounting. A world of televisual possibility is only the push of a button away, but pushing is just too much trouble. We’ll watch anything, as long as we don’t have to think or move.

My parents knew what they were doing.

Also published at ft.com.