Tim Harford The Undercover Economist

Articles published in November, 2008

Another chance for another ‘workaholic’?

I was recently stood up on a first date. The guy sent me a message four hours after we were supposed to meet, saying he hadn’t made it because he’d had to work and had been unable to call because his phone battery was dead. I was disappointed and angry. When he apologised and proposed meeting up later that week, I said no.

I found these excuses all too familiar. Using “working” as an excuse without respecting my time was exactly what my ex-boyfriend did to me. I always forgave him, and tried to be understanding. But he did this repeatedly and each time he knew that I was going to forgive him. Never again!

However, maybe everyone needs a chance to make things right. Am I punishing this guy for my ex’s behaviour?


Dear BC,

This is an experimentation problem: how much do you need to see of a man’s behaviour before deciding you’d be better off without him? It is also a signalling problem: you need to ensure you don’t appear to be a doormat.

With your ex-boyfriend, you made both mistakes: ignoring plentiful evidence of his selfishness, while encouraging him to walk all over you by forgiving his abuse. (Economists call this latter problem “moral hazard”.)

Yet I think you have been harsh on the new chap. Admittedly, he got off to a poor start. If you have a queue of suitors, by all means move on. If not, it would be wise to allow him one chance. Your “no second chances” policy gives him the right incentives in future, but that is irrelevant unless you give him another try.

You should make the price of a second date high but not infinite. Insist on lobster and champagne. If he complies, he has made it worth your while. He will also have learned to keep his phone charged in future.

Also published at ft.com.

29th of November, 2008Dear EconomistComments off

What will we buy to help us through hard times?

Anyone wondering how consumers behave in a recession need simply trawl the tabloids for inspiration. According to The Sun, sales of aphrodisiacs are up and so are sales of maternity dresses: not everything turns down in tough times, it seems. Elle Macpherson’s underwear is said to be doing well; so too is the budget store Poundland. Some stories seem contradictory: one newspaper claims that Ryanair is set to make a profit, while another reports that weekend breaks to European cities are no longer in demand. Other stories are frankly bizarre: the crunch is alleged to have given a fillip to sales of cake, wooden “gravestones”, West End musicals and tickets to see the film Mamma Mia!

The quality press has not resisted the temptation to join in the guessing game: The Economist imagined the return of the nutritious fish snoek, while this paper found evidence that physiotherapists were in demand to perk up stressed City workers.

All this speculation is an engaging diversion, but tells us little. Even the more solid reports are often based on anecdotes; many are simply spin or wishful thinking. I’ve heard a food retailer muse that Fairtrade-branded goods are recession-proof, because once people have seen the light about the importance of fair trade, they never turn back. A travel industry expert told me that the worse things get, the more people feel in need of a holiday. Perhaps he is right. I wouldn’t bet on it.

I doubt that these early reports will tell us much about what will happen in the trough of this recession. One of the reasons people curtail their spending is because they lose their jobs. But unemployment is not yet especially high: it was higher in late 2006 than in September this year. There is plenty of scope for things to worsen on that score.

Economic theory tells us that consumers should cut back their spending if they believe that their earning power will fall for an extended period of time, but if they believe the hard times are temporary – say, a short period out of work – they should “smooth” by borrowing in hard times and paying back when things pick up. Because of smoothing, consumption should not shrink as much as the economy does. That sounds reassuring, but Ray Barrell of the National Institute of Economic and Social Research has two pieces of bad news.

The first is that this is the wrong sort of recession: because it was precipitated by a banking crisis, consumption may well fall much more dramatically. That’s plausible. Consumers who want to smooth consumption can’t borrow to do so. This is what happened during the 14 banking crises in various high-income countries that Barrell and his colleagues have studied.

The second piece of bad news relates to the first. Because consumers were already borrowing heavily in the good times, both credit constraints and a long overdue realism are likely to bite all the more deeply. That, too, is a tendency Barrell finds in the data.

Of course, as the sellers of herbal Viagra are said to be discovering, when consumer spending falls, some products do well and others do very badly. Nervous retailers looking for clues might wish to pick up research from the 1990s by the economists Martin Browning and Thomas Crossley, called “Shocks, Stocks and Socks”. They found that when people are unemployed they save money in a logical way, by not buying “small durables” such as socks, and indeed clothes in general. In the short term, people get by and save about 15 per cent of their household budget. When they find a new job, they replace the tired old socks. Bad news for Marks & Spencer; good news for sellers of needles and thread.

Also published at ft.com.

Should we take a pay cut?

Should my co-workers and I accept a pay cut to preserve our jobs?
David A, London

Dear David A,

In principle, of course you should: this is so obvious that I’m not even sure why you bothered to ask. Another way of phrasing this question is to ask whether you would rather have most of your old salary or none of it.

You might object that unemployment has one big advantage over a pay cut: it means that you don’t have to work. For most people, however, this is not an advantage. The economist Andrew Oswald, one of a growing clan of “happiness economists”, has found that unemployment is extremely distressing, far more than could be explained by mere financial loss. If he is right, jobs bring happiness and self-respect, and even a severe pay cut is worth taking on the chin if that’s what it takes to stay in work.

It is true that taking a pay cut may result in a lower salary for many years, but losing your job, especially in a recession, is worse: your skills depreciate rapidly and you are quite likely to be worse off for the rest of your life.

You might reasonably ask why it isn’t more common to see swingeing pay cuts in place of redundancies. They are preferable for employees and probably preferable for employers, too. After all, sacking people is costly, as is going short-staffed and re-hiring people when things pick up. Far better just to squeeze salaries.

But that’s too easy. I suspect that there is a strong bias against salary cuts because otherwise employers would be demanding them every couple of weeks, with the flimsiest of excuses. Sacking somebody, in contrast, is not something an employer will tend to do lightly.

That is why “either pay me properly or sack me” is a good negotiating position. But, like many good negotiating positions, it may occasionally backfire.

Also published at ft.com.

22nd of November, 2008Dear EconomistComments off

Africa’s route to prosperity is not just a rocky road

Any first-time visitor to Africa is faced with a whirl of new experiences, but the awful roads are guaranteed to make an impression. That is true even in many cities – when I visited Douala, the commercial hub of Cameroon, I was appalled to realise that a four-wheel-drive vehicle was all but a necessity.

Cameroon’s roads also made an impression on Robert Guest, author of The Shackled Continent. Guest once hitched a ride on a Cameroonian beer truck travelling the equivalent of London to Newcastle upon Tyne – about 300 miles. The journey, detouring around a collapsed bridge on unpaved rainforest roads, took four days.

More rigorous studies have also found that the cost of transporting goods around west Africa is astonishingly high. One, albeit 15 years old, went so far as to conclude that road transport in Francophone Africa was six times more expensive even than in Pakistan.

Pity the entrepreneur who wants to do business under such conditions. If goods travel at 75 miles a day, as Guest’s beer truck did, it is almost impossible to import materials or export products profitably from Africa’s backwaters. The economic geographers Nuno Limão and Tony Venables have estimated that high transport costs explain almost all of Africa’s economic isolation. Certainly, exporters have not been able to take full advantage of US and EU trade concessions.

Since the 1970s, the World Bank has been pouring money into improving African roads. That seems to make sense but, puzzlingly, transport costs do not seem to have fallen in the way one would hope.

Guest’s experience suggests why. His beer truck was stopped 47 times at police roadblocks, sometimes for hours, while the police tried to find fault and extract bribes. At one point, he protested; the gendarme patted his holster and pointed out: “I have a gun, so I know the rules.” Clearing away such corruption may not be easy, but at least it requires no great expenditure on roads.

In fact, pure extortion is not the only bureaucratic obstacle to imports and exports. The World Bank’s annual “Doing Business” project collects data on the time and expense involved in meeting official demands for signatures, permits and licences. Cameroon’s regulations require nine documents, 27 days and almost a thousand dollars in official fees to export a shipping container; and Cameroon is by no means the worst offender. “Doing Business” data suggest that about two-thirds of the time taken to import or export products is thanks to paperwork such as customs clearance.

A new World Bank study of Africa’s transport corridors has found yet another obstacle to exporters that could, in principle, be cleared away without much expense: trucking cartels in west and central Africa. The study’s authors, Supee Teravaninthorn and Gael Raballand, believe that reducing transport costs would do little to bring down transport prices: better roads, swifter customs clearance and cheaper fuel would all simply add to the profits of the trucking companies.

If this view is correct, what west and central Africa’s exporters need to reach the world’s markets is a deregulated trucking industry. And, indeed, when landlocked Rwanda did deregulate, transport prices fell quickly.

This is good news: it is easier to scrap daft regulations than to build new roads, and, according to ”Doing Business”, sub-Saharan African countries have been leading reformers of customs regulations. With more such progress, it may even become worth worrying about the roads themselves.

Also published at ft.com.

How do I calculate an appropriate salary?

I have worked full time for six years and presently earn £40K. I am also about to attain chartered engineer status, which sounds good. However, I stumbled on an old letter the other day that confirmed my admission into nursery aged four, 29 years ago! Looking back at all the money invested in my more than 20 years of formal education, I feel short-changed by my income and quality of life.

Do you know how I can calculate a “fair” figure that will reflect my master’s degree and international experience? I want to use this as the minimum salary for my next job.

Dear G,

I’m not going to attempt to calculate your “fair” figure: it would do you no good. Employers care very little about what salary would be a fair reward for your background; instead, they want the best possible people for the lowest possible cost. Competition from other employers typically leads them to compromise on both counts.

Your fair figure might eat away still further at your fading happiness. It seems that you were satisfied until you reflected on your education and inflated your aspirations. This is sad but typical, if the economist Andrew Oswald is to be believed.

Oswald has compared people’s circumstances with their happiness. He finds that, other things being equal, happiness rises with money, good health and a successful marriage, but falls as a person’s “expected income” rises. Expected income is the income that another person of the same age, sex and education level would typically earn. In other words, more educated people have richer peers and so tend to be less satisfied.

What is especially sad is that your income would comfortably put you in the richest 10 per cent of UK citizens, who are themselves relatively rich. As for being short-changed, I doubt that you personally paid for your nursery education. Put away your admission letter, and forget about it.

Also published at ft.com.

15th of November, 2008Dear EconomistComments off

How to win the Nobel prize by a whisker

The Nobel memorial prize in economics is typically awarded to researchers who have jointly advanced some important method or idea. When the 2008 prize was awarded to Paul Krugman alone, for his contributions to trade theory and economic geography, other candidates who might have shared the prize – but didn’t – must have counted themselves one small step further away from receiving the call from Stockholm.

Among them are Jagdish Bhagwati, Krugman’s teacher and champion, and a giant in the field of international trade; and Elhanan Helpman, who wrote an influential book with Krugman on the new trade theory.

But I thought in particular of Avinash Dixit, without whom Krugman might have abandoned economics 30 years ago and so never formulated his new trade theory. Krugman has said he left graduate school “directionless … I was not even sure whether I really liked research.”

That was changed by what is now known as the “Dixit-Stiglitz” model. In 1977, Dixit and Joseph Stiglitz – one of the Nobel laureates in 2001 – published a new way of modelling how companies compete. The Dixit-Stiglitz model described “monopolistic competition” between many products in a particular market.

Monopolistic competition sounds like an oxymoron, and Dixit-Stiglitz certainly addressed a longstanding tension. Adam Smith had emphasised the importance of competition, but also the power of specialisation and the division of labour. His famous account of a pin factory, in which 10 men produced thousands of times as many pins as could one man, illustrated this point and thus the significance of economies of scale.

That poses a conundrum. Economies of scale push towards larger and larger companies. Logically, a monopolist should be the lower-cost provider. The tension between economies of scale and competition is obvious.

Yet while obvious, it is hard to model mathematically in a useful way. Dixit and Stiglitz resolved the problem by observing that consumers have a taste for variety as well as a taste for low prices. In the market for cars, for instance, Volvos compete with Fords and Ferraris. It would be cheaper if there was only one model of car; it would be nicer if there was an infinite variety. Somewhere in the middle is the equilibrium where economies of scale are balanced by customers’ desire for variety.

The elegant mathematics of the Dixit-Stiglitz model was new, even if the tension it described was as old as Smith’s Wealth of Nations. Krugman described it is as “beautiful”. It quickly became a workhorse, pulling economists to new frontiers of trade theory, growth theory and economic geography. Dixit later said he and Stiglitz had not realised the model would have so many uses – “obviously, otherwise we would have written all those subsequent papers ourselves!”

That is typically generous of a man who has often praised others, especially Krugman. He once told young economists that a good place to have ideas was in front of the shaving mirror. Krugman has a beard. Imagine, quipped Dixit, how much he could have achieved if he shaved!

Although the Nobel now seems overdue, Dixit hardly languishes in obscurity. He is president of the American Economic Association. He is a brilliant game theorist whose book with Barry Nalebuff, Thinking Strategically (now revised as The Art of Strategy) is a model of popular economics. And he may yet win the Nobel for his research with Robert Pindyck of MIT on “real options”, which describes how economic uncertainty can delay the most promising of business investments. It is a body of work that looks alarmingly relevant today.

Also published at ft.com.

The stock-market generation game and how to win it

Here are the chief investment lessons of the financial crisis for today’s young people: they should be buying more shares and running up debts to do so. I’m not saying that the market is undervalued – how would I know? I am merely suggesting a way of reducing risks.

If that seems strange, reflect for a moment. We know that stocks can be very volatile. We also know that some generations have been luckier than others when it comes to the performance of the stock market. The baby boomer who started regular purchases of US stocks in 1970 and sold up in 2000 would have felt pretty sick after the awful bear market of 1974, but in retrospect his timing would have been perfect, filling his boots with bargain late 1970s and early 1980s shares, and selling out right at the top. His daughter, entering the stock market in 1995 and aiming to retire in 2025, would have spent the past 13 years buying shares at prices that now seem to range from high to extortionate. We could call this “generational risk”.

Now, think about the current prevailing wisdom on investing in shares, which reflects the fact that shares tend to produce high but risky returns. It is to start by putting most of one’s savings into the stock market, and as retirement approaches, increasingly shifting one’s portfolio to bonds and other less volatile investments. That seems to make sense. In fact, it is nonsense.

For one thing, there is nothing particularly safe about holding stocks for the long term. Whether you plan to sell a portfolio of stocks next week, or hold them for another 40 years, a 20 per cent fall in the stock market this week reduces the eventual value of that portfolio by 20 per cent, relative to where they would have been had you sold them the day before the crash and reinvested afterwards.

Further, a long-term investor following the consensus advice is exposed to stock-market risk in a very strange way. When young, he has almost no exposure. Although his tiny pot of savings is largely invested in stocks, that tiny pot contains almost none of the shares he eventually plans to own. That’s too conservative. In middle age, he is overexposed in a desperate attempt to enjoy the high returns on stocks. Then as he approaches retirement he becomes too conservative again as he pours his portfolio back into safe assets. It is this bizarre pattern that produces generational risk.

The logical way to fight generational risk is to borrow money to make large, regular investments in shares while young, then use a proportion of later savings to pay back the loan rather than to pile into the stock market in middle age. That sounds risky, but it is in fact exactly what people do in the housing market. Knowing that they will need a place to live all their lives, they tend to buy a small house and gradually trade up to a bigger one, only paying off their mortgages late in life.

Most of us need a retirement fund as well as a place to live; there is nothing intrinsically risky about regular borrowing to get that fund off to an early start.

Not only does the concept make sense, it has paid off in the past. The Yale academics who proposed it, Ian Ayres and Barry Nalebuff, have looked at historical stock market data covering 94 cohorts who retired between 1913 and 2004. For every single cohort, the early leverage strategy beat the conventional wisdom; it also almost always beat the gambler’s strategy of investing every penny in stocks until the moment of retirement. Only the blessed cohorts who retired in 1998 and 1999 did better. Such gambles rarely pay off, so if you’re 20 years old and want to spread your risks, mortgage your retirement today.

Also published at ft.com.

Does theory support the paterfamilias?

I am a father of three teenagers and happily married for almost 20 years. In my opinion the secret to my success is a traditional one, which is that there is no doubt about who wears the trousers. I am wondering whether there is any support in economic theory for my view?
Harry R, Surrey

Dear Harry,

There is ample support in economic theory for your view – it is just a shame there is little support for it in practice. Economists have always tended to use a “household” model of decision-making, which treats domestic decisions as being made by one person – the kind of benign dictator with whom you, as paterfamilias, identify yourself. This had the chief virtue of simplicity.

Gary Becker, a Nobel laureate, then advocated treating the household as if it had more than one decision-maker. This helped to explain rococo details such as the existence of divorce lawyers.

Changes that increased the bargaining power of women, such as the introduction of “no fault” divorce, turned out to have the logical consequence that women became less likely to be physically abused by husbands. They also reduced the likelihood that couples would invest in each other – for example, by financially supporting one partner through a professional course.

The plot now thickens. The economist William T. Harbaugh, with colleagues, has discovered that children as young as 11 seem to make rational consumption choices as well as adults do. And a team including the economist Anyck Dauphin has demonstrated that British teenagers do influence household consumption, especially if they have access to their own income. The paterfamilias household is no more.

How, then, should we reconcile this with your own situation, which seems comfortably wedged in the 1950s? My guess is that your wife and children have decided that it suits them to maintain your delusions of control.

Also published at ft.com

8th of November, 2008Dear EconomistComments off

What’s the best way of sharing the petrol bill?

My sister and I both use the same car. When we started to share, we were both students and never had more than £10 to pay for petrol. Now that neither of us are students, we still only put a tenner’s worth of petrol in because we figure, “What is the point of one filling the car up for the other to get the benefit of driving it?” – commonly known as “sisterly love”. Of course, this means that we are endlessly having to stop to put in petrol.

Is there an optimal amount to put in the car in our situation, or, perhaps, a better way to deal with the predicament, bar getting a car each?

Dear Lucy,

It might sound strange, but your letter reminded me of Somalia. Your method of ensuring equitable payment for fuel works, but is quite a hassle. Living in a quintessential failed state, Somali entrepreneurs also have to go to great lengths to ensure payment in a situation where the rule of law has broken down.

For example, electricity is locally generated using second-hand equipment from Dubai. The suppliers offer a simple menu of choices: daytime (good for businesses), evening or 24-hour electricity. They charge per light bulb. The costs of collecting payment are probably as high as the costs of producing the electricity, but at least the lights tend to stay on.

Clearly there is a superior solution for the two of you: leave a notepad and pen in the glove compartment, and each of you note both your mileage and your petrol expenditure. If the two fall out of sync with each other, the heavy driver can compensate the heavy filler. This is time-consuming, but not as time-consuming as incessantly stopping for petrol.

This system assumes that you and your sister would not lie to each other. Perhaps this is not true, and family tensions call to mind downtown Mogadishu. If so, it is time to buy another car.

Also published at ft.com.

1st of November, 2008Dear EconomistComments off

The future? Your guess is as good as mine

The stock market is efficient.

It might seem a strange time to be making that claim, but despite its apparent absurdity I am now convinced that it is by far the most sensible way for an investor to look at the world. It may even be broadly true.

The efficient market hypothesis states that historical information provides no help in forecasting share prices. That would mean that examining graphs of a share’s performance, even reading this morning’s FT, would not produce a reliable strategy for judging the price of a share tomorrow or next year. That is because all useful information would already have been assimilated in today’s price. Paul Samuelson, perhaps the most influential economist of the 20th century, summed it up in 1965 in the title of his article: “Proof that Properly Anticipated Prices Fluctuate Randomly.” Since all available information is already reflected in the price, future prices will move only as news arrives. News itself arrives unpredictably, otherwise it is not news.

If the efficient markets hypothesis is true, then sensible economists will admit that they simply do not know what the outlook is for the stock market. How dull! It is much more fun to have somebody predict the future.

Yet it would explain the recent edition of FT Money in which the two star columnists offered precisely opposing views on the outlook for the stock market: Anthony Bolton anticipating recovery and Merryn Somerset Webb arguing that the market is still too optimistic about the future. Are they then both charlatans? Not at all. In an efficient market, disagreements between well-informed people are exactly what one would expect. Both are equally likely to be right.

The hypothesis is affectionately lampooned by a famous old joke about two economists who pass a $100 bill on the street. One reaches to pick it up, and his friend tells him not to be absurd. There couldn’t possibly be a $100 bill lying in the street because someone would already have picked it up.

The joke is a good one, but nobody has convincingly proved or disproved that the efficient markets hypothesis is true.

Nevertheless, investors should act as if it is. Belief in efficient financial markets suggests a three-pronged investment strategy. First, ignore advertisements (and newspaper articles) that tout the past performance of particular sectors or funds. In an efficient market, past performance is not only no guarantee of future performance, it offers no clue whatsoever. Second, don’t try to pick stocks and don’t ask others to pick stocks for you: in other words, choose a low-cost index tracker. Third, don’t try to time the market: get in and out gradually.

This third point is not widely appreciated enough. While many investors now realise the attractions of tracker funds, few realise that the typical fund does much better than the typical investor. This is because investors tend to buy high and sell low. Ilia Dichev of the University of Michigan has recently calculated “dollar-weighted” returns for major stock indices – a good adjustment for the tendency of investors to plunge into the markets as they are about to turn bearish. Dichev found that such returns were lower than “buy and hold” returns by 1.3 percentage points annually – 8.6 per cent instead of 9.9 per cent – between 1926 and 2002 on the New York Stock Exchange and American Stock Exchange. For a long-term investor this is a big difference. The same picture holds true since the early 1970s for international markets, and dramatically so for Nasdaq.

Perhaps the market is not efficient after all. All I know is that those of us who act as though it is have a substantial advantage over the typical investor.

Also published at ft.com.


  • 1 Twitter
  • 3 RSS
  • 5 Podcasts
  • 6 Facebook


  • Fifty Inventions That Shaped the Modern Economy
  • Messy
  • The Undercover Economist Strikes Back
  • Adapt
  • Dear Undercover Economist
  • The Logic of Life
  • The Undercover Economist

Free Email Updates

Enter your email address to receive notifications of new articles by email (you can unsubscribe at any time).

Join 188,947 other subscribers.