Tim Harford The Undercover Economist

Articles published in June, 2008

An anti-stagflation strategy: move back home

For us, the financial journalists, the credit squeeze is a lot of fun to write about. For you, the honest newspaper subscriber, it may not be so much fun to read about. This stagflation business – inflation and low growth all at once – is so depressing. You cannot look to the authorities for comfort. Your government blew all the cash in the good times, unless you happen to live in the Gulf or in China. Your central bank, desperately trying to sound both sympathetic and hawkish, is changing position more frequently than a presidential election candidate. Learn More

28th of June, 2008HighlightsOther WritingComments off

It’s up to you…

I am about to leave university and have received employment offers from management consulting firms in both London and New York. I have to say that I like the idea of living in either one of these global cities – the question is which one should I plump for?
R. A., Cambridge, UK

Dear R.A.,

Congratulations on asking the right question. Too many people relocate based on a nice job offer – or love affair – without considering the significance of the geographical decision. The economist and urbanophile, Richard Florida, argues that your choice of city is the most important decision you can make, because it determines job options, the quality of your everyday life, your love life and much else.

That said, you seem to have made this decision already. Cities such as Seattle, Berlin, Dar es Salaam, Hong Kong and Moscow each offer something unique, but it is hard to see much difference between New York and London. In fact, London has more in common with New York than any British city.

If you must restrict your choice, you are at least taking advantage of the trend for the big global cities to become ever more dominant. Perhaps you should consider New York: you have a network of friends in the UK; New York would diversify your life experiences and expand your networks. And apparently, if you can make it there, you can make it anywhere.

Also published at ft.com, subscription free.

28th of June, 2008Dear EconomistComments off

Why the rural idyll doesn’t come cheap

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

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

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

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

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

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

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

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

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

Also published at ft.com, subscription free.

Business Life: Are you an idiot?

First published in Business Life magazine, April 2008

Are you an idiot, or not? I expect you have a view on the matter. Most economists have a view on the matter, too: the mainstream view in economics is that people behave more or less rationally.
Yet an influential minority of economists think that, at least when it comes to some kinds of decision, you are an idiot after all. They’re called “behavioural economists”; one of them, Professor Dan Ariely of MIT, recently published a book called Predictably Irrational – the title may give you a hint at what he thinks of you.
The behavioural economists are inventive and their experiments tend to be a lot of fun. But there’s another reason to study behavioural economics: its insights are already being used by expert marketers to slurp money from your pocket.
Dan Ariely gives a simple example: a subscription to a magazine. If the choice is between “Print and web” for £100 or “Web only” for £50, a lot of people will pick “Web Only”. But add a new and unattractive option of “Print only” for £100, and suddenly many people will choose “Print and web”. Nobody wants the new option, of course, but its mere existence makes “Print and web” suddenly seem like a better deal, and the marketers know it.
Another trick has been spotted by Richard Thaler of the University of Chicago, one of the founding fathers of behavioural economics. Thaler points out that we are irrationally nervous about small risks such a losing a mobile phone that would cost £50 to replace, or facing a £70 repair bill for a washing machine that breaks down. These possible losses are annoying, but relative to the larger financial risks we run (will you get a raise at work? Will the value of your home rise or fall?) they are trivial. Most of us should take them on the chin.
But that is not what happens. Instead, we buy extended warranties for washing machines or insurance for mobile phones. And because we buy them from the same person selling the washing machine or the phone, we don’t enjoy the benefit of competition. Such insurance is usually hugely overpriced. Insurance buyer, beware.
There is some good news from behavioural economics, though. Sometimes, when marketers work out a way to jack up the price, they end up improving the quality of the product as a side-effect. Overpriced products can look better, taste better – even work better, just because they are overpriced. Dan Ariely showed that, for example, when he gave people fake painkillers (actually vitamin C tablets), the painkillers were effective anyway, just as long as people thought they were expensive. Perhaps a high price is a price worth paying, after all.

28th of June, 2008Other WritingComments off

Fare’s fair

I often share a taxi home with friends, and wonder how best to split the bill. When dropping a friend off first, I have received contributions varying from nothing to the full fare. If I get out first, what should I pay? As a woman with a large collection of frivolous shoes, walking home is a last resort.
Frances, Brussels

Dear Frances,

Of course contributions vary.

In a bar with friends, haven’t you noticed that sometimes somebody pays for your drink, and at other times you buy a round for everyone?

But in the long run, the saving should be divided fairly – a word with many interpretations. If three friends would have paid €4, €8 and €12 for taxis along the same route, and now must pay €12 in total, the total saving is €12.

That saving could be divided equally, €4 apiece, meaning fares of zero, €4 and €8. Or it could be divided in proportion to the original fares, meaning fares of €2, €4 and €6. Or the first leg could be split three ways, the second leg halved, and the third leg paid by the final passenger, implying fares of €1.34, €3.34 and €7.34.

There is no magic formula.

That is why no economist would share a cab without agreeing terms beforehand.

Also published at ft.com, subscription free.

21st of June, 2008Dear EconomistComments off

The profits of political connections

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

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

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

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

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

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

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

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

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

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

Also published at ft.com, subscription free.

Condo Quandary

I am about to be married, and have no doubts about the relationship. But there is one nagging worry: my fiance co-owns a condo overlooking the Pacific Ocean near San Francisco – with an ex-girlfriend, who lives next door to it. She is not in a position to buy him out of his investment, and although they rent it out, the mortgage is steep. I believe the condo is an investment specific to the former relationship and would like it divested – but the housing market is a shambles.

Dear Mary,

While I sympathise with your problem, I must correct you. A relationship-specific investment is one that is worth more within a relationship than outside it, such as a set of wedding photos. The condo is not relationship-specific, just unprofitable and illiquid.

The condo can therefore be disposed of without destroying value – but not, it seems, by either side buying the other side out.

If your fiance sold his share to a stranger, he’d sell at a loss. But in truth, the loss has already happened; his reluctance to sell suggests he’s pig-headed as well as an incompetent investor.

So I recommend that you buy out your fiance’s share, at a fire-sale price. Subsequent negotiations about the condo would then be between you and the ex. Should your marriage work out, you can share the profits with your fiance. And if not, at least you will have prearranged some compensation.

Also published at ft.com, subscription free.

14th of June, 2008Dear EconomistComments off

How can I tell if I’ll have a decent pension?

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

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

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

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

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

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

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

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

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

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

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

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

Also published at ft.com, subscription free.

Rain or shine

The offer of a new job means I have the chance to move from sunny Assisi, the home of Saint Francis, to Luxembourg, one of the rainiest and cloudiest places in Europe. Of course the move will mean I have a better salary, but how much value should I place on the weather?

Dear Simone,

Lacking a hedonimeter, I cannot tell how much you love the sunshine. But I can tell you what others in your position have done.

Superficially, it seems that many people seek sunny climes, especially now that air conditioning is available. For example, long-run population growth in the “Sunbelt” – the US South – is often attributed to a demand for, well, sun.

Harvard economists Ed Glaeser and Kristina Tobio think otherwise. They argue that before 1980, the boom in the South was thanks to the region’s growing productivity. After 1980, population continued to grow, but house prices lagged behind those elsewhere in the US, suggesting that the driving force was not high demand but permissive planning rules. Certainly balmy California, with its tighter restrictions on building, did not enjoy the same population growth.

All of this tends to suggest that people don’t value sunshine quite as much as is supposed. In other words, don’t expect too much compensation for moving to Luxembourg: your more weatherproof rivals will do the job for less.

Also published at ft.com, subscription free.

7th of June, 2008Dear EconomistComments off

Maybe our pension worries are overdone

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

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

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

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

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

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

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

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

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

Also published at ft.com, subscription free.


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