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

The problem with sexed-up statistics

‘Statistics tell us nothing until we understand what is being counted in the first place’

Men think about sex every seven seconds. Eighty-four per cent of women are emotionally unsatisfied with their relationships. Single people in the United States have more sex than married people do. Sixty-nine per cent of people over the age of 35 have had extramarital affairs. People have 40 per cent less sex now than they did 20 years ago. Truth, or myth?

A new book by statistician David Spiegelhalter, Sex by Numbers, runs a statistical comb through our collective sex lives. His book is largely designed to teach us about sexual behaviour — who is doing what with whom and how often — but along the way he manages to impart some important statistical lessons too.

Lesson one is that statistics tell us nothing until we understand what is being counted in the first place. To ask how old people are when they start having sex, or when they stop having sex, or how many sexual partners people typically have, we need a generally agreed definition of “having sex”.

We should not take for granted that we all mean the same thing when we talk about sex. Just ask Bill Clinton, who notoriously declared “I did not have sexual relations with that woman, Miss Lewinsky.” When it later became clear that he had received oral sex from her, he apologised for giving a misleading impression but maintained that “my answers were legally accurate.”

Clinton’s carefully chosen words were in tune with the way most people used language. A survey of US college students conducted in 1991 found that only 40 per cent of them reckoned that oral sex counted as “sex”. (The US Senate implicitly reached a similar conclusion in clearing President Clinton of perjury.)

While Clinton exploited ambiguity, modern scientific surveys of sexual behaviour try to eliminate it. According to definitions used by the UK’s well-regarded National Survey of Sexual Attitudes and Lifestyles, Natsal, Clinton did have sexual relations with Miss Lewinsky.

A second lesson is that we should pay attention to whether statistical work has been done carefully or casually. Consider Time Out magazine’s finding that people have sex 10 times a month if they are in a relationship, though only five times a month if they are married. This is twice as much as more credible surveys have found. As Spiegelhalter observes, Time Out’s method can only tell us about the sexual claims of people who go out of their way to fill in sex surveys. Spiegelhalter is similarly dismissive of the “Trojan US Sex Census”, which announced that Los Angeles was the most sexually active city in America with 135 sex acts per person per year. While a great source of publicity for a manufacturer of condoms, the people who fill in Trojan’s survey don’t represent the rest of us.

Some of the most famous sex researchers are also limited by a lack of representative sampling. Alfred Kinsey found that 37 per cent of men had a homosexual experience resulting in orgasm; Shere Hite reported that 95 per cent of women experienced “emotional and psychological harassment” from their male partners. The underlying research here was politically groundbreaking but we cannot have too much confidence that these numbers are correct.

Hite, for example, distributed questionnaires through university women’s centres, abortion rights groups and other women’s groups; the response rates were less than 5 per cent, making it unclear whether respondents were typical of women as a whole. Kinsey was on the lookout for interesting sexual case histories and so sent his researchers to prisons and to bars famous for being gay meeting places. He may well have captured a broader range of sexual behaviour as a result but at the cost of a representative sample. As the great mathematician John Tukey once told Kinsey, “I would trade all your 18,000 case histories for 400 in a probability sample.” If the aim is to judge what is going on in the population as a whole, Tukey was right.

To revisit the factoids in the first paragraph: most are unproven, the results of unrepresentative surveys. The “seven seconds” claim is an urban myth and provably nonsense. But the final discovery — that we are having 40 per cent less sex — is true. According to the rigorously collected Natsal survey, heterosexually active people aged 16-44 typically had sex five times in the past month back in 1990. By 2010, the number had fallen steadily to three times. Perhaps the next Natsal survey will be able to figure out why.

Written for and first published at ft.com.

Undercover Economist

What a radical Conservative government could do

‘Scrap all mainstream benefit payments — jobseeker’s allowance, child benefit, housing benefit and even the state pension’

Last week I described Anthony Atkinson’s proposals for reducing inequality. Atkinson — a professor of economics at Nuffield College, Oxford — proposes substantially higher income tax rates for everyone earning more than £65,000, a much higher minimum wage, guaranteed public employment, an expansion of universal benefits and much else. It is the agenda one would expect of a courageous Labour party, which of course places it a long way from the agenda that the actual Labour party is proposing.

It seems only fair, then, to offer the same service to the Conservatives: on the off chance that we ever see an economically radical Tory party, what policies might I suggest they embrace?

Step one is to replace the benefit system with a more libertarian form of redistribution. Scrap all the mainstream benefit payments — for example, child benefit, jobseeker’s allowance, housing benefit, winter fuel allowance and even the state pension. Scrap the income tax allowance too. Give all long-term UK residents a taxable basic income of £8,000 a year and charge a flat 40 per cent income tax rate on every penny. The basic income can be phased in on a residency basis over 10 years, ensuring that recent immigrants pay a larger net contribution to the exchequer.

This policy targets poverty rather than inequality. It abolishes much of the bureaucracy that surrounds benefit eligibility, promotes individual responsibility and reduces the stigma of collecting money from the state. It gives everyone, rich and poor, a clear incentive to work. Compared to the current system, it redistributes to the working poor and to the highest earners — both groups of people who are likely to produce more taxable income in response. It is simple, discouraging tax avoidance. And, despite the flat headline rate, the average income tax contribution is progressive: negative for those on low incomes, 10-25 per cent for those on average incomes and approaching 40 per cent for the rich.

People with unusual needs — the severely disabled, for instance — would be helped by a multibillion-pound fund with considerable discretion to make direct cash payments or commission assistance from charities.
A second policy is to privatise the entire school system. Children would receive a £10,000 basic income in a tax-sheltered educational account controlled by parents but usable only for childcare, school or university fees. Compulsory schooling would end at the age of 14 and educational institutions would be competing to attract these pots of tax-free cash with engaging and practical training courses. Any unspent money would be taxed and handed over to the child at the age of 21.

Third, scrap the personal pension system. Both the logic for and the reputation of the existing system is in tatters. With the new flat tax and universal basic income it would also be superfluous. People can save for their retirement in more flexible Isa-style savings accounts and could be nudged into doing so by a default payroll deduction.

A fourth policy must involve the housing market. The current cluster of housing policies (“cluster” is a polite abbreviation for a more appropriate term) ensures slow growth, resentment of immigrants, a crippling housing-benefit bill, inequality growing through luck rather than hard work and innovation, and the direction of potentially productive savings into accumulating unproductive housing wealth. This is a multifunctional policy indeed.

Given that housing benefit is to be abolished by this radical government, there is an urgent need to build large numbers of houses. This would boost the economy and reduce the price of new homes. One possibility, proposed by the Centre for Policy Studies, is the establishment of “pink zones” with lighter planning regulation (the colour represents a dilution of red tape). In these zones, substantial increases in housing could be achieved by a coalition of local authorities, community groups and developers.

However the trick is pulled off, the government must create the conditions for a housing boom — 400,000 new homes a year for five years would do to begin with. It’s ambitious, but necessary after decades of insufficient building.

A final idea: look to broaden the tax base and lower tax rates. Abolishing all VAT exemptions would be a good start, and would provide substantial revenue. A carbon tax would also be well worth introducing, as would more proportionate taxation of housing wealth. The proceeds of these taxes would be needed at first to pay for the universal basic income but the aim would be to reduce universal income tax rate too. A future leftwing government could redistribute within the same framework by increasing the basic income.

That should do the trick for the first term but a Conservative government should also commit to staying in the European Union, which stands in favour of trade, business and hard money; and to leaving the National Health Service alone for a few years just to see how it performs when not being incessantly prodded by politicians.

There you have it: a smaller, less bureaucratic state, innovation in education, redistribution to the poorest, a lower but more transparent income tax to attract the rich, an economic boom on the back of much-needed home-building and affordable housing for all.

Conservative Central Office can thank me later.

Written for and first published at ft.com.

5th of May, 2015Undercover EconomistComments off
Undercover Economist

The truth about inequality

‘One myth is that inequality in the UK has risen since the financial crisis. In fact it has fallen quite sharply’

How serious a problem is inequality? And if it is serious, what can be done about it?

Myths abound. Many people seem to believe that Thomas Piketty’s Capital in the Twenty-First Century showed that wealth inequality is at an all-time high; instead, his data show that wealth inequality has risen only slowly since the 1970s, after falling during the 20th century. In Europe we are thankfully nowhere near the wealth inequality of the past.

Another common belief is that the richest 1 per cent of the world’s population own half the world’s wealth (almost true) and that their share is inexorably increasing (not true). The richest 1 per cent had 48.2 per cent of the world’s wealth in the year 2014, according to widely cited research from Credit Suisse, but that share has fallen and risen over the past 15 years. It is lower now than in 2000 and 2001.

Neither is it clear that global inequality is rising. Average incomes in China and India have risen much faster than those in richer countries; this is a powerful push towards equality of income. But inequality within many countries is rising. Research from Branko Milanović, author of The Haves and the Have-Nots, suggests that the two forces have tended to balance out roughly over the past generation.

One final myth is that inequality in the UK has risen since the financial crisis. In fact, it has fallen quite sharply. “Inequality remains significantly lower than in 2007-08,” said the Institute for Fiscal Studies last summer. That conclusion is based on data through April 2013. The IFS did add, though, that “there is good reason to think that the falls in income inequality since 2007-08 are currently being reversed.”

Given all this, why the sudden anxiety about inequality? The answer is partly political: incomes fell and then stagnated after the financial crisis, and the crisis also made it seem risible to claim that the entrepreneurial activities of the rich would indirectly help the poor. None of this is directly connected to rising inequality but it certainly changes the conversation.

Yet there is more going on than a change in the political wind. By most reasonable measures, inequality of incomes has risen substantially over the past 40 years in both the US and the UK, with a particular surge in the 1980s. That should clarify the issue: the problem is most clearly seen within boundaries of nation states rather than globally; in income rather than wealth; and over the past few decades rather than the past few years. And it is stark enough to need no exaggeration.

I recently attended the launch of Inequality: What Can Be Done?, a book by Anthony Atkinson. Professor Atkinson is the economist who set the stage for younger stars such as Piketty and Emmanuel Saez; his first major paper on the subject of inequality was published in 1970, before either of them was born.

One thing that can be done, says Atkinson, is to use the same old redistributive tools with more vigour. The UK already redistributes income extensively. As Gabriel Zucman of the London School of Economics points out, the UK’s richest fifth had 15 times the pre-tax income of the poorest fifth, but after taxes and benefits they had just four times as much.

For some people that will seem more than enough redistribution. Others will disagree, and Atkinson is one of them. He would like to see the current 45 per cent top rate of tax levied at a much lower level (about £65,000), a new 65 per cent top rate for those earning more than £200,000, a substantially higher minimum wage, a “minimum inheritance” paid to every 18-year-old, guaranteed public employment, more comprehensive taxation of inheritance and property and an expansion of universal benefits.

Like it or loathe it, this is ambitious stuff. I don’t know if a 65 per cent top rate of tax is likely to be counterproductively high and neither does Tony Atkinson. I suspect that it is, and the available evidence provides some support for that suspicion. However, there is a wide margin of uncertainty so Atkinson is right to say that the evidence doesn’t conclusively rule it out.

Atkinson also wants to make market incomes themselves more egalitarian, leaving the welfare state with less to do. Ed Miliband, the Labour leader, once talked of “pre-distribution”, which is an ugly word for the same idea. But neither Miliband nor Atkinson is entirely persuasive about how this might work. Atkinson suggests that competition policy, vetting mergers and breaking up or regulating monopolies, should be used to reduce inequality. Or possibly the state’s support for science and innovation — always important — could favour innovations that complement labour rather than replacing it? In theory all this is possible. But my imagination is not up to the task of figuring out what these labour-complementing innovations might be, nor how the government might help produce them.

The UK general election on May 7 might well produce a Labour-led government but it will be astonishing if that government embraces a redistributive agenda half as ambitious as Atkinson’s. The conversation about inequality has changed quickly — but what mainstream politicians are willing to countenance has not.

Written for and first published at ft.com.

Undercover Economist

The economists’ manifesto

If Britain’s top economists were in charge, what policies would they implement? Tim Harford sets the challenge

It’s often said that economists have too much influence on policy. A critic might say that politicians are dazzled by data-driven arguments and infatuated with the free-market-fetishising practitioners of the dismal science. As a card-carrying economist, I have never been convinced that politicians are the puppets of economists. Still, the idea seemed worth exploring, so I called up some of the country’s most respected economists and presented them with this scenario: after the election, the new prime minister promises to throw his weight behind any policy you choose. What would you suggest?

My selection of economists was mainstream — no Marxists or libertarians — but arbitrary. There is no pretence of a representative survey here. But there were common threads, some of which may surprise.

Let’s start with the deficit which, if we are to judge by column inches alone, is the single most important economic issue facing the country. Yet with the chance to push any policy they wished, none of my economic advisers expressed any concern about it. Indeed several wanted some form of increased spending and were happy to see that financed through borrowing or even printing money.

Economists have a reputation for being low-tax, free-market champions. Yet none of my panel fretted about red tape, proposed any tax cuts or mentioned free trade. Other untouched issues included the National Health Service, immigration and membership of the EU. Nobody suggested any changes to the way banks are regulated or taxed.

Less surprising is that several economists suggested structures that would put decision making at arm’s length from politicians, delegating it to technocrats with the expertise and incentives to do what is right for Britain. The technocracy already has several citadels: the Bank of England’s Monetary Policy Committee, the National Institute for Health and Care Excellence, the Competition Commission and the regulators of privatised utilities. My advisers wanted more of this. That is economics for you: when a political genie offers you whatever policy wish you desire, why not simply wish to have more wishes?

Nick Stern
Former chief economist of the World Bank, professor at the London School of Economics

Nick Stern will forever be associated with the Stern Review, a report into the economics of climate change published in 2006. He hasn’t stopped banging this drum but these days he is reframing the problem as an opportunity.

“I would launch a strategy for UK cities to be the most attractive, productive and cleanest in the world,” he says. Cities hold out the hope of being productive and desirable places to live as well as environmentally efficient ones. Consider Manhattan: it is rich, iconic and, with small apartments and a subway, it boasts a much smaller environmental footprint than most of sprawling, car-loving America.

That is the aim. But what is the policy? Lord Stern offers what he calls a “collection of policies”, including an expanded green infrastructure bank and more funding for green technology. His broadest stroke is to change the governance of British cities, devolving the power to raise taxes and borrow money but imposing strong national standards on energy efficiency.

Stern would introduce a platform for congestion charging to enable cities to develop areas connected by public transport and walking/cycling routes. He’d also raise the price of emitting carbon via a direct tax or an emissions trading system. Stern suggests £25/ton of CO2, and rising. That should add a penny to the price of 100g of airfreighted vegetables and £100-£200 to a household energy bill. It would raise £10bn, less than income tax or VAT but enough to narrow the deficit or allow other tax cuts.

But Stern doesn’t dwell on taxation. His policies are “long on UK strengths such as entrepreneurship, architecture and planning”, he says. While warning of the “deep deep dangers” of climate change, he claims his package “is attractive in its own right”.

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Tim’s verdict Developing these new green city centres is a challenge. Are our urban planners up to it?

  • Political feasibility 3 out of 5
  • Economic radicalism 3 out of 5

Jonathan Haskel
Professor of economics at Imperial College, London

“Some people think that scientists have their heads in the sky, and if you gave them more government money they would simply do weirder research,” says Jonathan Haskel. Science enthusiasts, however, would say that weird research can help: Sir Andre Geim of the University of Manchester won the Nobel Prize for his discovery of the revolutionary material graphene — but not before receiving the Ig Nobel Prize for levitating a live frog.

Supporting scientific innovation has long been an easy sell for politicians. Who could be against technological progress, after all? The more difficult question is how to encourage this innovation. For Haskel, the answer is straightforward: the government should simply spend more money directly funding scientific research. At the moment the government gives about £3bn to research councils and more than £2bn to the Higher Education Funding Council. For the sake of being specific, Haskel was happy to accept my suggestion of simply doubling this funding over the course of a five-year parliament.

Haskel’s research finds that government funding of science is the perfect complement to private, practically minded research funding. “This is an example of crowding in,” he says, meaning that if the government spends more on scientific research it is likely to draw in private funding too. There is a high correlation between the research scientists who receive government grants and those collaborating with or being funded by private sector companies. Haskel has found that sectors that attract government funding are also sectors with high productivity growth.

According to Haskel’s estimates, the rate of return on basic scientific research is around 20 per cent at current funding levels — a level that would not displease Warren Buffett himself. This would probably be less if science funding dramatically increased but, even at 15 or 10 per cent return, the case for spending more would be persuasive.

An extra £5bn is not trivial. Increasing all income tax rates by one percentage point, or raising VAT to 21 per cent, would cover the cost. But given current ultra-low interest rates, Haskel says he is happy for the government to borrow to fund this spending instead. “I would regard borrowing to fund the science base as a form of infrastructure investment,” he says. It may not be the traditional Keynesian infrastructure of roads and runways but it is investment for the future nonetheless.

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Tim’s verdict It’s hard to object to scientific progress and Haskel’s evidence is persuasive. Leave a bit of cash for the social scientists, please.

  • Political feasibility 4 out of 5
  • Economic radicalism 2 out of 5

Gemma Tetlow
Top pensions expert at the Institute for Fiscal Studies

A confession: I may have led Gemma Tetlow astray. We begin by discussing how employers can avoid national insurance contributions by diverting some of their workers’ salaries into a pension. This, she says, is an unwarranted subsidy for the comfortably off, and abolishing the rule is “not a bad way to raise £11bn”.

As we talk, a bolder thought forms in my mind: why not just abolish national insurance entirely and replace it with higher rates of income tax? That would close Tetlow’s pension loophole and many other inconsistencies besides. I wonder if I have missed something obvious. Apparently not. Tetlow is perfectly happy to endorse the idea of a merger.

In some ways this would be a huge change: national insurance raises more than half as much as income tax does, so merging the two would mean huge increases in headline income tax rates. But while the policy would make things simpler and more transparent, it would not greatly alter the tax that most people pay.

The idea is tempting to an economist because successive governments have discovered a feat of political arbitrage. They reduce the basic rate of income tax, which gets a lot of attention, while increasing national insurance rates, which do not. Since 1979 the basic rate of income tax has fallen from 30 to 20 per cent but national insurance rates have risen and so the marginal tax rate on much employment income is still above 45 per cent, much the same as ever. A bit more honesty about this would be welcome.

As Tetlow explains, national insurance was once a contributory system, designed to cope with a male workforce in conditions of near full employment. Now national insurance is more like an income tax, where people pay if they can afford to and receive the benefits in any case.

So Tetlow and I agree that the system could comfortably be scrapped — even if we might be looking to replace it with a basic rate of income tax at 40 per cent or so. The benefits? Transparency, administrative simplicity and the end of a few unwelcome loopholes. The risks are chiefly administrative, although a decision would need to be made about whether to have a special income tax rate for people above the state pension age, who currently pay no national insurance.

Could it happen? Tetlow says she would be “astonished” if it did. Perhaps governments are too fond of pretending that the true basic rate of income tax is just 20 per cent.

. . .

Tim’s verdict I bounced Tetlow into this so can hardly object. But for our politicians, the confusion over national insurance isn’t a problem, it’s an opportunity.

  • Political feasibility 2 out of 5
  • Economic radicalism 1 out of 5

Simon Wren-Lewis
Macroeconomist at Merton College, Oxford

Simon Wren-Lewis has a growing audience as a trenchant critic of George Osborne’s fiscal contraction. I had expected him to make the case that the incoming government should spend more but he has something more radical in mind.

“We’re passing the period when the damage was done,” he says. For Wren-Lewis, the policy error was to tighten the fiscal screws in 2010 and 2011 — he estimates that with lower taxes and higher spending the economy today would be about 4 per cent larger, while deficit reduction could wait until the economy was stronger.

Cutting spending in a severe but temporary downturn is macroeconomically perverse but makes good sense to voters, so Wren-Lewis feels that a future government would make a similar mistake in similar circumstances. What to do?

Economists have faced a related problem before. When politicians controlled interest rates they were always tempted to cut rates before elections, overheating the economy and leading to inflation once the election was safely gone. The solution was to delegate control of monetary policy to the technocrats, as when Gordon Brown gave the Bank of England this power in 1997.

“That was a good idea,” says Wren-Lewis. But, he adds, “it was always incomplete.” The missing piece of the puzzle was what the bank should do when interest rates are nearly zero — as now — and cannot be cut further to stimulate the economy. The usual solution is a fiscal expansion — cutting taxes and increasing spending, just what George Osborne has shied away from. Wren-Lewis’s response: in future, the Bank of England should print the money and hand it to the government on condition it be used for a fiscal expansion.

This is radical — but not without precedent. Economists from Adair Turner to Ben Bernanke (in 2003) and Milton Friedman (1948) have argued that deficits could be financed by printing money rather than issuing government debt. Funding real spending from paper money might seem like nonsense: if the economy is working well, creating too much money will produce inflation. But when the economy is slack, judicious money printing can turn the waste of a depressed economy into useful output, without dangerous inflation. This is a rare free lunch.

The radicalism of Wren-Lewis’s proposal lies less in the economics than the politics: the idea that the Bank of England would decide a fiscal expansion was needed, and shove a reluctant, democratically elected government into it.

Wren-Lewis calls his idea “democratic helicopter money”. He feels the government should decide whether the stimulus takes the form of tax cuts, increased benefits or new infrastructure. But the actual decision to cut taxes and raise spending to stimulate the economy? Not something one should leave to the politicians.

. . .

Tim’s verdict I sympathise with Wren-Lewis’s wish for more stimulus spending in the last parliament but outsourcing such a basic democratic responsibility feels too bold to me.

  • Political feasibility 1 out of 5
  • Economic radicalism 5 out of 5

Diane Coyle
Professor of economics at the University of Manchester

“My starting point is that the extent of income inequality has got too big,” says Coyle. She points to median annual full-time earnings of just over £27,000, while the average pay of FTSE 100 chief executives is — according to Manifest, a proxy voting service — about £4.7m. “If you were to ask me whether the productivity of chief executives is really that much higher, my answer is no. Something has gone wrong with the way the market is operating here.”

That market failure is easy to diagnose: it is hard for dispersed shareholders to monitor what is going on and to insist on a more rigorous approach. So Coyle would give them a little help.

The most eye-catching suggestion is that companies should publish the ratio between what the chief executive is paid and what the median worker in the company is paid. A review body would give a strong steer as to how high that ratio could reasonably go (“I don’t know what the right number is,” says Coyle) and companies who did not comply would face unwanted scrutiny from shareholders, employees, unions and politicians.

“Just talking about this much more would start to shift the social norm,” says Coyle, who in her term on the BBC Trust (soon to end) has seen the BBC start to publish these pay ratios, which have been falling. Coyle wants a binding rule, too, that companies should not be able to pay performance bonuses linked to share price. That is too easily manipulated. Instead, these must be linked to indicators such as customer satisfaction, sales or profits.

. . .

Tim’s verdict Shareholders and citizens alike should welcome pay that is tied more closely to good management decisions. But can any of this be legislated effectively?

  • Political feasibility 4 out of 5
  • Economic radicalism 4 out of 5

John van Reenen
Professor at the London School of Economics

“Low productivity is the number one problem Britain faces,” says Van Reenen. Even before the crisis, it lagged behind other rich countries. The latest data suggest UK output per hour worked is 30 per cent below US levels, and 17 per cent below the G7 average (at purchasing power parity).

Such a problem has no single solution but Van Reenen wants to focus on a lack of investment in the UK’s core infrastructure — housing, energy and transport. As the FT reported recently, government capital investment has fallen by a third between 2009-10 and 2013-14, despite repeated statements by the chancellor that infrastructure is at the heart of plans for growth.

Milton Keynes, the last of the “new towns”, harks back to 1967 and has 100,000 dwellings. That gives some perspective on recent proposals to build a “garden city” at Ebbsfleet of a mere 15,000 homes. If the Barker Review’s headline number of 245,000 new homes a year is to be achieved, we need an Ebbsfleet every three weeks and have done for the past 12 years.

The HS2 high-speed rail line was first examined in 1999 and is still unlikely to be finished 30 years after that date. An observer might feel the project should either have been cancelled or completed by now. And let’s not dwell on London’s airports: in 1971 the Roskill Commission proposed a major new airport north of Aylesbury after rejecting the idea of building one in the Thames estuary. We are still weighing up the issues.

“I would propose to radically change the whole way we deliver infrastructure projects,” says Van Reenen, “with a new institutional architecture for making decisions.” There are three elements to this. First, an infrastructure strategy board to recommend long-term priorities, which would be voted up or down by parliament. Second, an infrastructure planning commission to meet those priorities and arrange compensation to those affected by the march of progress. Third, an infrastructure bank to help finance projects by borrowing from capital markets and investing alongside private-sector banks.

If this seems anti-democratic, Van Reenen’s defence is that his approach “puts politics in the right place”. MPs are concerned with the short-term and the local, which causes problems with long-term investments of national significance. Like Simon Wren-Lewis, John van Reenen has more faith in technocrats than politicians.

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Tim’s verdict An approach that seems justified when facing such a chronic and serious problem. Sign me up.

  • Political feasibility 3 out of 5
  • Economic radicalism 1 out of 5

Kate Barker
Author of the 2004 Barker Review of Housing Supply

I am expecting Dame Kate Barker to propose something controversial but straightforward: that we should build more houses. It is, after all, her report that policy wonks have been citing for the past decade whenever they want a number for how many houses England needs. Instead, some of her solutions “are so unpopular I can hardly bring myself to suggest them to you”. This is music to my ears.

In 2002/2003, the private sector completed 125,000 houses in England; the Barker Review argued that number needed to almost double to reduce the growth in real house prices to the EU’s long-term average. But the number of private-sector housing completions in England has fallen to below 100,000 a year from 2009 through 2014. The trickle of new houses is manifestly failing to accommodate population growth.

So: more houses? Not necessarily. Barker lays out three options. The first is the status quo. It is not attractive. There will be an increasing divide between the housing haves (who enjoy capital appreciation) and the housing have-nots (who find it ever harder to buy a home).

Option two is a dramatic programme of house building, which seems logical. “We’ve built much less than the top-line number associated with my name,” says Barker. “I haven’t changed my view that we need to do more.” But she is sceptical about how feasible it is to expect house building on the scale needed, given the strength of opposition to development. She has had the ear of prime ministers before, after all, and not much changed.

And so to option three: resign ourselves to not building enough houses to meet demand, and use the tax system to soften the blow. Meaning what, exactly?

Consider someone with the finance and good fortune to buy a home in London in 1992. That person has enjoyed an enormous increase in the real value of her house. But she has paid surprisingly little tax on the windfall. Council tax is proportionately lower on expensive homes. Capital gains tax does not apply to people living in their own homes. If you become a millionaire through skill, effort or entrepreneurial spirit, you will be taxed. If you do it by buying a house in Islington at the right moment, your bounty is yours to keep in its entirety. That’s inequitable and the inequity is likely to last from one generation to the next.

Barker suggests two thrusts to the tax reform, and “ideally we would do both”. The first is to replace council tax with a land value tax. This would tax expensive homes more heavily, in line with their value, and encourage valuable land to be used intensively. But it would also weigh heavily on elderly widows living alone in large houses. The second is to charge capital gains tax on people’s principal residency. If you live in your own home and its price starts to soar, you will be taxed.

But both these reforms are complicated. A land tax would require frequent revaluations. The capital gains tax reform would require some sort of system for postponing the bill until death or entry into a retirement home. That is fiddly but the alternative might make it impossible to move house without a punitive tax charge.

As Baker admits, this is dramatic and unpopular stuff. The people who lose out are clearly identifiable and politically influential. But the same is true of the straightforward proposal to build many more houses. The UK’s housing problem seems to be the toughest of political tough nuts.

Tim’s verdict This makes sense despite the difficulties. But Barker identified the cure for unaffordable housing more than 10 years ago — build more houses. It’s depressing that she now has to advocate palliative measures instead.

  • Political feasibility 1 out of 5
  • Economic radicalism 2 out of 5

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Last word

So what would the UK look like with my board of economists in charge? We’d have more borrowing and considerably more investment — in housing, in big infrastructure, in science and in green cities. Taxes seem unlikely to fall but they would be rationalised, with a focus on energy efficiency and a transparent taxation of income and housing wealth. Inequality would be in the spotlight.

The economists seem happy to leave the politicians to their usual arguments about the EU, immigration, the price of beer and the problem of tax-dodging. Noting that every party makes similar promises about funding the National Health Service, the economists have let it be.

Perhaps that is for the best because if the economists have their way, one big thing will change after the election: politicians will be kept at a safe distance from the decisions that matter.

Written for and first published at ft.com.

Undercover Economist

Cigarettes, damn cigarettes and statistics

We cannot rely on correlation alone. But insisting on absolute proof of causation is too exacting a standard

It is said that there is a correlation between the number of storks’ nests found on Danish houses and the number of children born in those houses. Could the old story about babies being delivered by storks really be true? No. Correlation is not causation. Storks do not deliver children but larger houses have more room both for children and for storks.

This much-loved statistical anecdote seems less amusing when you consider how it was used in a US Senate committee hearing in 1965. The expert witness giving testimony was arguing that while smoking may be correlated with lung cancer, a causal relationship was unproven and implausible. Pressed on the statistical parallels between storks and cigarettes, he replied that they “seem to me the same”.

The witness’s name was Darrell Huff, a freelance journalist beloved by generations of geeks for his wonderful and hugely successful 1954 book How to Lie with Statistics. His reputation today might be rather different had the proposed sequel made it to print. How to Lie with Smoking Statistics used a variety of stork-style arguments to throw doubt on the connection between smoking and cancer, and it was supported by a grant from the Tobacco Institute. It was never published, for reasons that remain unclear. (The story of Huff’s career as a tobacco consultant was brought to the attention of statisticians in articles by Andrew Gelman in Chance in 2012 and by Alex Reinhart in Significance in 2014.)

Indisputably, smoking causes lung cancer and various other deadly conditions. But the problematic relationship between correlation and causation in general remains an active area of debate and confusion. The “spurious correlations” compiled by Harvard law student Tyler Vigen and displayed on his website (tylervigen.com) should be a warning. Did you realise that consumption of margarine is strongly correlated with the divorce rate in Maine?

We cannot rely on correlation alone, then. But insisting on absolute proof of causation is too exacting a standard (arguably, an impossible one). Between those two extremes, where does the right balance lie between trusting correlations and looking for evidence of causation?

Scientists, economists and statisticians have tended to demand causal explanations for the patterns they see. It’s not enough to know that college graduates earn more money — we want to know whether the college education boosted their earnings, or if they were smart people who would have done well anyway. Merely looking for correlations was not the stuff of rigorous science.

But with the advent of “big data” this argument has started to shift. Large data sets can throw up intriguing correlations that may be good enough for some purposes. (Who cares why price cuts are most effective on a Tuesday? If it’s Tuesday, cut the price.) Andy Haldane, chief economist of the Bank of England, recently argued that economists might want to take mere correlations more seriously. He is not the first big-data enthusiast to say so.

This brings us back to smoking and cancer. When the British epidemiologist Richard Doll first began to suspect the link in the late 1940s, his analysis was based on a mere correlation. The causal mechanism was unclear, as most of the carcinogens in tobacco had not been identified; Doll himself suspected that lung cancer was caused by fumes from tarmac roads, or possibly cars themselves.

Doll’s early work on smoking and cancer with Austin Bradford Hill, published in 1950, was duly criticised in its day as nothing more than a correlation. The great statistician Ronald Fisher repeatedly weighed into the argument in the 1950s, pointing out that it was quite possible that cancer caused smoking — after all, precancerous growths irritated the lung. People might smoke to soothe that irritation. Fisher also observed that some genetic predisposition might cause both lung cancer and a tendency to smoke. (Another statistician, Joseph Berkson, observed that people who were tough enough to resist adverts and peer pressure were also tough enough to resist lung cancer.)

Hill and Doll showed us that correlation should not be dismissed too easily. But they also showed that we shouldn’t give up on the search for causal explanations. The pair painstakingly continued their research, and evidence of a causal association soon mounted.

Hill and Doll took a pragmatic approach in the search for causation. For example, is there a dose-response relationship? Yes: heavy smokers are more likely to suffer from lung cancer. Does the timing make sense? Again, yes: smokers develop cancer long after they begin to smoke. This contradicts Fisher’s alternative hypothesis that people self-medicate with cigarettes in the early stages of lung cancer. Do multiple sources of evidence add up to a coherent picture? Yes: when doctors heard about what Hill and Doll were finding, many of them quit smoking, and it became possible to see that the quitters were at lower risk of lung cancer. We should respect correlation but it is a clue to a deeper truth, not the end of our investigations.

It’s not clear why Huff and Fisher were so fixated on the idea that the growing evidence on smoking was a mere correlation. Both of them were paid as consultants by the tobacco industry and some will believe that the consulting fees caused their scepticism. It seems just as likely that their scepticism caused the consulting fees. We may never know.

Written for and first published at ft.com.

Undercover Economist

Online ads: log in, tune out, turn off

How annoying does an ad have to be before a website should refuse to run it?

Online banner ads are not the advertising industry’s most glorious achievement. From the pop-up to the sudden blast of music, the clickbait to the nonsensically animated gifs, the stroboscope to the advert that simply appears to have a spider scurrying across it, there seems to be no end to the ways in which banner advertisements can annoy us.

Up to a point, this is part of the deal. Publishers offer something we want to look at, our attention is worth money to advertisers, and the advertisements help to pay for the content we’re enjoying. But how annoying does an ad have to be before a website should refuse to run it? While the question is obvious, the answer is not: it’s hard for publishers to know how much the adverts may be driving readers away.

Daniel Goldstein, Preston McAfee and Siddharth Suri, all now at Microsoft Research, have run experiments to throw light on this question. (They are, respectively, a psychologist, an economist and a computer scientist; do send in your suggested punchlines.)

The experiments are intriguing as much for the method as for the conclusion. Traditionally, much experimental social science has been conducted with all the participants in the same room, interacting on paper, face to face or through computers. Then the computer-mediated experiments moved online, with researchers such as Goldstein assembling large panels of participants willing to log in and take part in exchange for a modest payment.

Now there is an easier way: Amazon Mechanical Turk. The original Mechanical Turk was an 18th-century chess-playing “robot” which, in reality, concealed a human chess player. Amazon’s Mechanical Turk (MTurk) also uses humans to do jobs we might expect from a computer but which computers cannot yet manage. For example, Turk workers might help train a spam filter by categorising tens of thousands of emails; or they might decide which of several photographs of an item or location is the best.

From the point of view of social-science researchers, MTurk is a remarkable resource, allowing large panels of diligent experimental subjects to be assembled cheaply at a moment’s notice. It is striking and somewhat discomfiting just how little MTurk workers (“Turkers”) are willing to accept — a study in 2010 found an effective median wage of $1.38 an hour. Siddharth Suri says that, because of its speed, flexibility and low cost, MTurk is rapidly becoming a standard tool for experimental social science.

So, back to those annoying ads. First, Goldstein, McAfee and Suri recruited MTurk workers to rate a selection of 72 animated adverts and 72 static ads derived from the final frame of the animations.

It may not surprise you to know that the 21 most annoying adverts were all animated, while the 24 least annoying were static.

The researchers picked the 10 least aggravating and the 10 most excruciating and used them in the second stage of the study.

In this second stage, Goldstein and his colleagues hired Turkers to sort through emails and pick out the spam — they were offered 25 cents as a fixed fee plus a “bonus” that was not specified until after they signed up. The experiment had two variables at play. First, the Turkers were randomly assigned to groups whose workers were paid 10 cents, 20 cents or 30 cents per 50 emails categorised. Second, while the workers were sorting through the emails, they were either shown no adverts, “good” adverts or “bad” adverts. Some workers diligently plodded on while others gave up and cashed out early.

Usually researchers want to avoid people dropping out of their experiments. The wicked brilliance of this experimental design is that the dropout rate is precisely what the experimenters wanted to study.

Unsurprisingly, the experiment found that people will do more work when you pay them a better rate, and they will do less work when you show them annoying adverts. Comparing the two lets the researchers estimate the magnitude of the effect, which is striking: removing the annoying adverts entirely produced as much extra effort as paying an additional $1.15 per 1,000 emails categorised — and effectively $1.15 per 1,000 adverts viewed. But $1.15 per 1,000 views is actually a higher rate than many annoying advertisers will pay — the rate for a cheap advert may be as low as 25 cents per 1,000 views, says Goldstein.

 . . . 

Good adverts are much less destructive. They push workers to quit at an implicit rate of $0.38 per 1,000 views, for an advert that may pay $2 per 1,000 views to the publisher. Generalising for a moment: good adverts seem worth the aggravation but bad adverts seem to impose a higher cost on a website’s readers than the advertisers are willing to pay. It is no wonder that websites hoping for repeat traffic tend to avoid the most infuriating adverts.

A sting in the tail is that the animated adverts may not even work on their own terms. An eye-tracking study conducted in 2003 by Xavier Drèze and François-Xavier Hussherr found that people avoided looking at banner advertisements in general; in 2005 Moira Burke and colleagues found that people actually recalled less about the animated adverts than the static ones.

How could that be? Perhaps we have all learnt a sound principle for browsing the internet: never pay attention to anything that jiggles around.

Written for and first published at ft.com.

Undercover Economist

Highs and lows of the minimum wage

‘The lesson of all this is that the economy is complicated and textbook economic logic alone will get us only so far’

In 1970, Labour’s employment secretary Barbara Castle shepherded the Equal Pay Act through parliament, with the promise that women would be paid as much as men when doing equivalent jobs. The political spark for the Act came from a famous strike by women at Ford’s Dagenham plant, and the moral case is self-evident.

The economics, however, looked worrisome. The Financial Times wrote a series of editorials praising “the principle” of equality but nervous about the practicalities. In September 1969, for example, an FT editorial observed that “if the principle of equal pay were enforced too rigorously, employers might often prefer to employ men”; and the day after the Act came into force on December 29 1975, the paper noted a new era “which many women may come to regret”.

The economic logic for these concerns is straightforward. Whether because of prejudice or some real difference in productivity, employers were willing to pay more for men than for women. That inevitably meant that if a new law artificially raised women’s salaries, women would struggle to find work at those higher salaries.

The law certainly did raise women’s salaries. Looking at the simple headline measure of hourly wages, women’s pay has gradually risen over the decades as a percentage of men’s, although it remains lower. Typically, this process of catch-up has been gradual but, between 1970 and 1975, the years when the Equal Pay Act was being introduced, the gap narrowed sharply.

Did this legal push to women’s pay cause joblessness, as some feared? No. Women have steadily made up a larger and larger proportion of working people in the UK, and the Equal Pay Act seems to have no impact on that trend whatsoever. If any effect can be discerned, it is that the proportion of women in the workforce increased slightly faster as the Act was being introduced; perhaps they were attracted by the higher salaries?

The lesson of all this is that the economy is complicated and textbook economic logic alone will get us only so far. The economist Alan Manning recently gave a public lecture at the London School of Economics, where he drew parallels between the Equal Pay Act and the minimum wage, pointing out that in both cases theoretical concerns were later dispelled by events.

The UK minimum wage took effect 16 years ago this week, on April 1 1999. As with the Equal Pay Act, economically literate commentators feared trouble, and for much the same reason: the minimum wage would destroy jobs and harm those it was intended to help. We would face the tragic situation of employers who would only wish to hire at a low wage, workers who would rather have poorly paid work than no work at all, and the government outlawing the whole affair.

And yet, the minimum wage does not seem to have destroyed many jobs — or at least, not in a way that can be discerned by slicing up the aggregate data. (One exception: there is some evidence that in care homes, where large numbers of people are paid the minimum wage, employment has been dented.)

The general trend seems a puzzling suspension of the law of supply and demand. One explanation of the puzzle is that higher wages may attract more committed workers, with higher morale, better attendance and lower turnover. On this view, the minimum wage pushed employers into doing something they might have been wise to do anyway. To the extent that it imposed net costs on employers, they were small enough to make little difference to their appetite for hiring.

An alternative response is that the data are noisy and don’t tell us much, so we should stick to basic economic reasoning. But do we give the data a fair hearing?

A fascinating survey reported in the most recent World Development Report showed World Bank staff some numbers and asked for an interpretation. In some cases, the staff were told that the data referred to the effectiveness of a skin cream; in other cases, they were told that the data were about whether minimum wages reduced poverty.

The same numbers should lead to the same conclusions but the World Bank staff had much more trouble drawing the statistically correct inference when they had been told the data were about minimum wages. It can be hard to set aside our preconceptions.

The principle of the minimum wage, like the principle of equal pay for women, is no longer widely questioned. But the appropriate level of the minimum wage needs to be the subject of continued research. In the UK, the minimum wage is set with advice from the Low Pay Commission, and it has risen faster than both prices and average wages. A recently announced rise, due in October, is well above the rate of inflation. There must be a level that would be counterproductively high; the question is what that level is.

And we should remember that ideological biases affect both sides of the political divide. In response to Alan Manning’s lecture, Nicola Smith of the Trades Union Congress looked forward to more ambition from the Low Pay Commission in raising the minimum wage “in advance of the evidence”, or using “the evidence more creatively”. I think British politics already has more than enough creativity with the evidence.

Written for and first published at ft.com.

Undercover Economist

The pricing paradox: when diamonds aren’t on tap

‘Diamonds are costly because we desire them. But what if that isn’t true? What if they are desirable because they are costly?’

A glass of water costs very little; a diamond costs a lot. Yet there is nothing more useful than water, while the most prized uses of diamonds are decorative. This apparent paradox has tested some fine minds. Adam Smith’s answer to the paradox was that diamonds were expensive because it was hard work to find them and dig them up. That seems to strike close to the truth but it’s not the way that modern economics approaches the problem.

The usual name for this puzzle is the “paradox of value” or “the water-diamond” paradox but I now prefer to call it the “Button Gwinnett paradox”. (I hadn’t heard of Button Gwinnett until his life was described in a recent episode of the WNYC radio programme Radiolab.) The British-born Gwinnett moved to the colony of Georgia in the mid-1700s. He was a failed businessman, a serial debtor and a B-list politician in the independence movement. But, as it happened, he was one of the 56 signatories of the Declaration of Independence.

Gwinnett might seem a minor figure compared to some of the other men whose names sit beside his: John Hancock, Thomas Jefferson, John Adams and Benjamin Franklin. Despite that, a Button Gwinnett signature is vastly more valuable than a Jefferson or a Franklin. The simple reason for this is that collectors naturally wish to own the complete set of 56 signatures. Ben Franklin lived into his eighties and was a prolific correspondent, so there is no shortage of Franklin signatures.

Gwinnett died in a duel the year after signing the Declaration of Independence. His signature was recently discovered on the parish register of St Peter’s Church in Wolverhampton, where he was married. Most of the other signatures he left behind were on IOUs.

Benjamin Franklin may have been one of the most remarkable human beings in history but when collecting your set of Independence signatures, it’s the Button Gwinnett that will prove the final piece of the jigsaw. Anyone selling a Gwinnett will find few other sellers and many eager buyers.

Which brings us back to water and diamonds. Diamonds are expensive because at the point at which the supply of diamonds dries up, there are plenty of buyers willing to pay handsomely, and they compete with each other. Water is cheap in temperate climes because after satisfying our demand for drinking and cooking, then for washing and for irrigation, and finally for swimming around in, there is still plenty left. The value of the first litres of water may be incalculably high but the marginal value of one more litre is very low, and it’s this value that sets the price.

Everything so far has assumed that our desire for an object — a diamond, a glass of water, a Button Gwinnett signature — is a given. Diamonds are costly because we desire them, and not the other way around. But what if that isn’t true? What if diamonds are desirable because they are costly?

The economist Thorstein Veblen coined the term “conspicuous consumption” to describe situations where an object is attractive merely because it is expensive. The designer watch or car is valuable because, like a peacock’s tail, it is a credible indicator that you have resources to spare. What was the point of spending so much on that diamond engagement ring otherwise?

Another possibility is “pricing bias”. If we don’t really know a good suit or a good bottle of wine from a bad one, we tend to use the price to give us a clue. This is not strictly logical — after all, anyone can double the asking price of anything they are selling, so price is not by itself a reliable clue to quality. But pricing bias exists. Studies show that people will rate a wine more highly in a taste test if they think it is expensive; even placebo painkillers are more effective if the patients believe they are costly new drugs rather than cheap new drugs.

. . .

The final word on this should go to a team led by Laurie Santos at Yale’s Comparative Cognition Laboratory. Santos has spent some time teaching capuchin monkeys how to use money, to exchange it for food and to understand the idea that food can have a price that is high or low. In recent work with Robin Goldstein of UC Davis, Santos’s team has been trying to figure out whether the monkeys also display pricing bias.

It seems not. After a series of trials where monkeys were allowed to buy cheap or expensive jelly and ice lollies, they were then let loose on a free buffet to see if they gravitated towards the once costly items. They didn’t; unlike humans, the monkeys couldn’t care less what the item typically cost. They liked what they liked. In this, they differ not only from humans but also from starlings: Alex Kacelnik and Barnaby Marsh, zoologists at Oxford, have found that starlings prefer more costly food.

My guess is that the monkeys would have little interest in a Button Gwinnett signature. And those glossy advertisements for diamonds and designer handbags? They are evidently far too sophisticated for capuchin tastes.

Written for and first published at ft.com.

Undercover Economist

Man v machine (again)

‘The Luddite anxiety has been dormant for many years but has recently enjoyed a resurgence’

I’m writing these words in York, the city in which, two centuries ago, the British justice system meted out harsh punishments — including execution — to men found guilty of participating in Luddite attacks on spinning and weaving machines. By a curious coincidence, I’ve just read Walter Isaacson’s article in the FT explaining how wrong-headed the Luddites were. I’m not so sure.

“Back then, some believed technology would create unemployment,” writes Isaacson. “They were wrong.”

No doubt such befuddled people did exist, and they still do today. But this is a straw man: we can all see, as Isaacson does, that technology has made us richer while employment is as high as ever. (The least appreciated job-creating invention may well have been the washing machine, which helped turn housewives into women with salaries.)

The Luddites themselves had a more subtle view than Isaacson suggests, and one which is as relevant as ever. They believed that the machines were altering economic power in the textile industry, favouring factory owners and low-skilled labourers at the expense of skilled craftsmen. They wanted to defend their interests and they did so violently. As the historian Eric Hobsbawm put it, their frame-breaking activity was “collective bargaining by riot” and “simply a technique of trade unionism” in the days before formal unions existed.

To put it another way, the Luddites weren’t idiots who thought that machines would destroy jobs in general; they were skilled workers who thought that machines would devalue their specific jobs and their specific skills. They were right about that, and sufficiently determined that stopping them required more than 10,000 troops at a time when the British army might have preferred to focus on Napoleon.

The Luddite anxiety has been dormant for many years but has recently enjoyed a resurgence. This is partly because journalists fear for their own jobs. Technological change has hit us in several ways — by moving attention online, where (so far) it is harder to charge money for subscriptions or advertising; by empowering unpaid writers to reach a large audience through blogging; and even by introducing robo-hacks, algorithms that can and do extract data from corporate reports and turn them into financial journalism written in plain(ish) English. No wonder human journalists have started writing about the economic damage the robots may wreak.

Another reason for the robo-panic is concern about the economic situation in general. Bored of blaming bankers, we blame robots too, and not entirely without reason. Inequality has risen sharply over the past 30 years. Many economists believe that this is partly because technological change has favoured a few highly skilled workers (and perhaps also more mundane trades such as cleaning) at the expense of the middle classes.

Finally, there is the observation that computers continue to develop at an exponential pace and are starting to make inroads in hitherto unexpected places — witness the self-driving car, voice-activated personal assistants and automated language translation. It is a long way from the spinning jenny to Siri.

What are we to make of all this? One view is that this is business as usual. We’ve had dramatic technological change for the past 300 years but it’s fine: we adapt, we still have jobs, we are incomparably richer — and the big headache of modernity isn’t unemployment but climate change.

A second view is that this time is radically different: the robots will, before long, render many people economically valueless — simply incapable of earning a living wage in a market economy. There will be plenty of money around but it will flow to the owners of the machines, and maybe also to the government through taxation. In principle, all could be well in such a future but it would require a radical reimagining of how an economy could work. The state, not the market, would be the arbiter of who gets what. Such a world is probably not imminent but, by 2050, who knows?

 . . . 

The third perspective is what we might call the neo-Luddite view: that technology may not destroy jobs in aggregate but rather changes the demand for skills in ways that are real and troubling. Median incomes in the US have been stagnant for decades. There are many explanations for that, including globalisation and the decline of collective bargaining, but technological change is foremost among them.

If the neo-Luddites are right, then the challenge in front of us is simply to adapt. Individual workers, companies and the political system will have to deal with wrenching economic changes as old industries are destroyed and new ones created. That seems a plausible view of the near future.

But there is a final perspective that doesn’t get as much attention as it might: it’s that technological change is too slow, not too fast. The robo-booster theory implies a short-term surge in jobs, as all those lovely new machines are designed and built and installed, followed by a long-term surge in productivity as the robots make the economy ruthlessly efficient. It is hard to see much sign of either trend in the economic statistics. Productivity, in particular, has been disappointing in the US and utterly dismal in the UK. Where are the robots when we need them?

Written for and first published at ft.com.

Undercover Economist

Boom or bust for bitcoin?

Bitcoin appeals to libertarians on the basis that governments cannot arbitrarily make more of it

In a moment, I’ll gaze into the crystal ball and foretell the future of the world’s most famous cryptocurrency, bitcoin. I should first explain what’s happening now.

It was developed in 2008 by an unknown programmer or programmers. Confusingly, bitcoin is both a payment technology and a financial asset. The asset called bitcoin has no intrinsic value but it has a market price that fluctuates wildly. Like digital gold, it appeals to libertarians on the basis that governments cannot arbitrarily make more of it.

The payment technology called bitcoin is what you might get if you ran the Visa network over a peer-to-peer network of computers. In case that description doesn’t help, it’s a way of sending money anywhere in the world but instead of relying on the authority of a financial intermediary such as Visa or Western Union, it uses a decentralised network to verify that the transaction has occurred. The record of all previous transactions is called the blockchain; it, too, is stored on a decentralised network. The entire process relies on cryptographic techniques to prevent fraud, which is why bitcoin and other currencies like it are called cryptocurrencies.

This may all seem very esoteric but the internet was esoteric once and it turns out to have become important. So what lies ahead for bitcoin?

Here’s one scenario.

Bitcoin has enjoyed many booms and busts in value, and later in 2015, the price surges again. This will be the biggest yet, drawing more and more people into the market. As the dotcom bubble and railway mania proved, even revolutionary technologies can be overvalued; with Bitcoins selling for $2,000, $5,000 and eventually $10,000 each, nemesis is around the corner.

The first sign of trouble will be the scams. A recent research paper by computer scientists Marie Vasek and Tyler Moore identified almost 200 bitcoin scams, in which about 13,000 victims lost $11m. Such scams will only become more common as the stakes become higher and the pool of naive investors deeper. Soon they will be the stuff of mainstream consumer rights phone-ins.

Arguably, scams are a sign that Bitcoin has matured — after all, nobody proposes abandoning the dollar because con artists like to be paid in dollars. But they are just a foretaste of what is to come — Bitcoin will be gutted by predatory monopolists.

The Bitcoin system has always relied on a crowd of people putting their computers to work verifying transactions and writing them into the blockchain, a task which costs money and energy. In a rather confusing analogy with gold, these people are called “miners” and they are compensated in Bitcoins, of course. Yet there is a basic inconsistency at the heart of this system, as the economist Kevin Dowd has observed: Bitcoin mining needs to be done by a decentralised crowd but is more efficiently done by large arrays of computers owned by a few players. Or possibly just a single one.

Even today, Bitcoin mining is a game for the big boys. As the Bitcoin mining industry becomes a tight, self-serving oligopoly, the stage is set for Bitcoin counterfeiting on a massive scale. In 2018, 10 years after the invention of Bitcoin, the system collapses under the weight of its own contradictions.

It’s an intriguing story — but of course, it is just a story. We could give it a name: “BitCon”.

. . .

If you don’t believe that, I have another story for you. The title is “Daisy Chains”. Throughout 2015 and 2016, the price of Bitcoins continues to collapse. Speculators lose interest and some of the big miners sell off their computers at a heavy loss. The spotlight moves elsewhere but the true believers in the power of decentralised blockchain processing continue to develop the system.

Bitcoins aren’t the only things that can be transferred using a peer-verified network, after all — you could transfer the digital lock to a smart car; or a financial contract, with pay-offs and penalties automatically adjudicated and paid for by the blockchain. The question is whether the effort of doing all this is more efficient than the current centralised systems using interbank payments.

The answer is yes but only in certain circumstances. A blockchain is a ledger of every digital transaction ever made on the system. This proves far too unwieldy for a universal means of payment. Yet specialised niche systems evolve: by 2018, block-chain processing is common for remittances; by 2019, block-chain processing pays for and controls self-driving taxis. You can even download an out-of-the-box blockchain app for your local babysitting circle — or your prostitution ring. Blockchain approaches don’t replace Western Union and Visa everywhere but they squeeze margins and make inroads for certain applications.

The only disappointment for the true Bitcoin enthusiasts is that Bitcoin itself, the currency that started it all, fails to catch on. Most people prefer a trusted brand. When a standard of value is used on these disparate blockchain processes, the most popular by far is “FedCoin” — more commonly known by its correct name, the US dollar.

Two stories about the future, and most likely neither one will come true. These are interesting times for cryptocurrencies.

Written for and first published at ft.com.

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