Tim Harford The Undercover Economist

Articles published in August, 2013

Do You Believe in Sharing?

While delivering his Nobel lecture in 2007, Al Gore declared: “Today, we dumped another 70 million tons of global-warming pollution into the thin shell of atmosphere surrounding our planet, as if it were an open sewer.”

It’s a powerful example of the way we tend to argue about the impact of the human race on the planet that supports us: statistical or scientific claims combined with a call to action. But the argument misses something important: if we are to act, then how? Who must do what, who will benefit and how will all this be agreed and policed?

To ask how people work together to deal with environmental problems is to ask one of the fundamental questions in social science: how do people work together at all? This is the story of two researchers who attacked the question in very different ways – and with very different results.

“The Tragedy of the Commons” is a seminal article about why some environmental problems are so hard to solve. It was published in the journal Science in 1968 and its influence was huge. Partly this was the zeitgeist: the late 1960s and early 1970s was an era of big environmental legislation and regulation in the US. Yet that cannot be the only reason that the “tragedy of the commons” has joined a very small group of concepts – such as the “prisoner’s dilemma” or the “selfish gene” – to have escaped from academia to take on a life of their own.

The credit must go to Garrett Hardin, the man who coined the phrase and wrote the article. Hardin was a respected ecologist but “The Tragedy of the Commons” wasn’t an ecological study. It wasn’t really a piece of original research at all.

“Nothing he wrote in there had not been said by fisheries economists,” says Daniel Cole, a professor at Indiana University and a scholar of Hardin’s research. The key idea, indeed, goes back to Aristotle. Hardin’s genius was in developing a powerful, succinct story with a memorable name.

The story goes as follows: imagine common pasture, land owned by everyone and no one, “open to all” for grazing livestock. Now consider the incentives faced by people bringing animals to feed. Each new cow brought to the pasture represents pure private profit for the individual herdsman in question. But the commons cannot sustain an infinite number of cows. At some stage it will be overgrazed and the ecosystem may fail. That risk is not borne by any individual, however, but by society as a whole.

With a little mathematical elaboration Hardin showed that these incentives led inescapably to ecological disaster and the collapse of the commons. The idea of a communally owned resource might be appealing but it was ultimately self-defeating.

It was in this context that Hardin deployed the word “tragedy”. He didn’t use it to suggest that this was sad. He meant that this was inevitable. Hardin, who argued that much of the natural sciences was grounded by limits – such as the speed of light or the force of gravity – quoted the philosopher Alfred North Whitehead, who wrote that tragedy “resides in the solemnity of the remorseless working of things”.

. . .

Lin Ostrom never believed in “the remorseless working of things”. Born Elinor Awan in Los Angeles in 1933, by the time she first saw Garrett Hardin present his ideas she had already beaten the odds.

Lin was brought up in Depression-era poverty after her Jewish father left her Protestant mother. She was bullied at school – Beverly Hills High, of all places – because she was half-Jewish. She divorced her first husband, Charles Scott, after he discouraged her from pursuing an academic career, where she suffered discrimination for years. Initially steered away from mathematics at school, Lin was rejected by the economics programme at UCLA. She was only – finally – accepted on a PhD in political science after observing that UCLA’s political science department hadn’t admitted a woman for 40 years.

She persevered and secured her PhD after studying the management of fresh water in Los Angeles. In the first half of the 20th century, the city’s water supply had been blighted by competing demands to pump fresh water for drinking and farming. By the 1940s, however, the conflicting parties had begun to resolve their differences. In both her PhD, which she completed in 1965, and subsequent research, Lin showed that such outcomes often came from private individuals or local associations, who came up with their own rules and then lobbied the state to enforce them. In the case of the Los Angeles water producers, they drew up contracts to share their resources and the city’s water supply stabilised.

It was only when Lin saw Hardin lecture that she realised that she had been studying the tragedy of the commons all along. It was 1968, the year that the famous article was published. Garrett Hardin was 53, in the early stages of a career as a campaigning public intellectual that would last the rest of his life. Lin was 35, now Ostrom: she had married Vincent Ostrom, a respected political scientist closer to Hardin’s age, and together they had moved to Indiana University. Watching Hardin lecture galvanised her. But that wasn’t because she was convinced he was right. It was because she was convinced that he was wrong.

In his essay, Hardin explained that there was no way to manage communal property sustainably. The only solution was to obliterate the communal aspect. Either the commons could be nationalised and managed by the state – a Leviathan for the age of environmentalism – or the commons could be privatised, divided up into little parcels and handed out to individual farmers, who would then look after their own land responsibly. The theory behind all this is impeccable and, despite coming from a biologist, highly appealing to anyone with an economics training.

But Lin Ostrom could see that there must be something wrong with the logic. Her research on managing water in Los Angeles, watching hundreds of different actors hammer out their messy yet functional agreements, provided a powerful counter-example to Hardin. She knew of other examples, too, in which common resources had been managed sustainably without Hardin’s black-or-white solutions.

The problem with Hardin’s logic was the very first step: the assumption that communally owned land was a free-for-all. It wasn’t. The commons were owned by a community. They were managed by a community. These people were neighbours. They lived next door to each other. In many cases, they set their own rules and policed those rules.

This is not to deny the existence of the tragedy of the commons altogether. Hardin’s analysis looks prescient when applied to our habit of pumping carbon dioxide into the atmosphere or overfishing the oceans. But the existence of clear counter-examples should make us hesitate before accepting Hardin’s argument that tragedy is unstoppable. Lin Ostrom knew that there was nothing inevitable about the self-destruction of “common pool resources”, as economists call them. The tragedy of the commons wasn’t a tragedy at all. It was a problem – and problems have solutions.

If Garrett Hardin and Lin Ostrom had reached different conclusions about the commons, perhaps that was because their entire approaches to academic research were different. Hardin wanted to change the world; Ostrom merely wanted to describe it.

That goal of description, though, was a vast project. Common pool resources could be found all over the planet, from the high meadows of Switzerland to the lobster fisheries of Maine, from forests in Sri Lanka to water in Nepal. Hardin’s article had sliced through the complexity with his assumption that all commons were in some sense the same. But they aren’t.

To describe even a single case study of governing a common resource is a challenge (Lin’s PhD was devoted to the West Basin water district of Los Angeles). Vincent Ostrom, Lin’s husband, had developed the idea of “polycentricity” in political science: polycentric systems have multiple, independent and overlapping sources of power and authority.

By their very nature, they are messy to describe and hard to compare with each other. Unfortunately for any tidy-minded social scientist, they are also everywhere.

Complicating the problem further was the narrow focus of academic specialities. Lin was encouraged that many people had been drawn, like her, to the study of common pool resources. But they were divided by discipline, by region and by subject: the sociologists didn’t talk to the economists; the India specialists didn’t talk to the Africanists; and the fishery experts didn’t know anything about forestry. As Ostrom and her colleagues at the University of Indiana looked into the problem they discovered more than a thousand separate case studies, each sitting in isolation.

Undeterred, they began to catalogue them, seeking to explain the difference between the successful attempts to manage environmental resources and the failures. There were the Swiss farmers of the village of Törbel, who had a system of rules, fines and local associations that dated from the 13th century to govern the use of scarce Alpine pastures and firewood. There were the fishermen of Alanya, in Turkey, who took part in a lottery each September to allocate fishing rights for the year ahead.

Over time, Ostrom developed a set of what she called “design principles” for managing common resources, drawn from what worked in the real world. She used the phrase hesitantly since, she argued, these arrangements were rarely designed or imposed from the top down; they usually evolved from the bottom up.

These principles included effective monitoring; graduated sanctions for those who break rules; and cheap access to conflict-resolution mechanisms (the fishermen of Alanya resolved their disputes in the local coffee house). There are several others. Ostrom wanted to be as precise as she could, to move away from the hand-waving of some social scientists. But there were limits to how reductive it was possible to be about such varied institutions. Lin’s only golden rule about common pool resources was that there are no panaceas.

Her work required a new set of intellectual tools. But for Ostrom, this effort was central to her academic life because knowledge itself – when you thought about it – was a kind of common pool resource as well. It could be squandered or it could be harvested for the public good. And it would only be harvested with the right set of rules.

Ostrom’s research project came to resemble one of the local, community-led institutions that she sought to explain. In 1973, the Ostroms established something called the “Workshop in Political Theory and Policy Analysis”. Why not a school or a centre or a department? It was partly to sidestep bureaucracy. “The university didn’t know what a workshop was,” says Michael McGinnis, a professor of political science at Indiana University and a colleague of the Ostroms. “They didn’t have rules for a workshop.”

But there was more behind the name than administrative guile. Vincent and Lin believed that the work they did was a kind of craft. (The couple had built their own home and made much of their own furniture, under the guidance of a local craftsman – the experience made an impression.) The students who attended didn’t call themselves students or researchers. They called themselves “workshoppers”.

The workshop under the Ostroms seems to have been a remarkable place, brightened up by Lin’s sparkling laugh and garish tops. (The laugh was a reliable sign that she was in the building, available to be buttonholed by students.) At reunions, Ostrom would lead the singing of folk songs; it was that kind of place. The Ostroms never had children but the workshoppers did – and those children called Lin “Grandma”.

. . .

The logic of Garrett Hardin’s 1968 essay is seductive but to read the text itself is a shock. Hardin’s policy proposals are extreme. He believed that the ultimate tragedy of the commons was overpopulation – and the central policy conclusion of the article was, to quote Hardin, that “freedom to breed is intolerable”.

In a 1974 essay, “Living on a Lifeboat”, he argued that it was pointless sending aid to starving people in Ethiopia. That would only make the real problem worse – the real problem being, of course, overpopulation.

Hardin robustly defended his views. In a 1987 interview with The New York Times, he opined, “There’s nothing more dangerous than a shallow-thinking compassionate person. God, he can cause a lot of trouble.”

But perhaps it was Hardin who was the one failing to think deeply enough. The logic of “The Tragedy of the Commons” worked well to frame a class of environmental problems. The danger was when Hardin leapt to drastic conclusions without looking at how other, similar-looking problems were being solved, again and again, by communities all over the world.

Nor has Hardin’s needle-sharp focus on overpopulation stood the test of time. When he published “The Tragedy of the Commons” in 1968, the growth rate of world population was higher than it had ever been – a rate at which population would double every 30 years. No wonder Hardin was alarmed. But birth rates have fallen dramatically. The world continues to face some severe environmental problems. However, it’s far from clear that “freedom to breed” is one of them.

There was no great public showdown between Lin Ostrom and Garrett Hardin, but Hardin did return to speak at Indiana University in 1976. The Ostroms invited him and some graduate students to dinner. Barbara Allen, now a professor at Carleton College, was one of them. She recalls that “the conversation was vigorous” as Hardin laid out his ideas for government-led initiatives to reduce the birth rate in the US, while Lin and Vincent worried about the unintended consequences of such top-down panaceas.

Allen recalls two other details: the way that Lin made space for her students to enter the argument and her joy in a new kitchen gadget she was using to make hamburgers for everyone. She loved “the odd delights of everyday life”, Allen later wrote, and loved to celebrate what worked.

Hardin, by contrast, seems to have been more of a pessimist about technology. “Technology does solve problems,” he told an interviewer in 1990, “but always at a cost.”

Lin Ostrom was a more optimistic character altogether. When she won the Nobel memorial prize for economics in 2009, she was the first woman to do so. She was quick to comment: “I won’t be the last.”

Some of her most recent research addressed the problem of climate change. Scientifically speaking, greenhouse gas emissions are a global pollutant, and so efforts have focused on establishing global agreements. That, said Ostrom, is a mistake. Common pool problems were usually too complex to solve from the top down; a polycentric approach was necessary, with people developing ideas and enforcing behaviour at a community, city, national and regional level.

Ostrom barely slowed down when she was diagnosed with pancreatic cancer in 2011. She kept going until the final days, leaving voicemail messages for Vincent who, at the age of 90, was deaf and beginning to become confused. (Her students would type them up and print them out in large fonts for him to read.) When Lin died last June, at the age of 78, she was reviewing a student’s PhD thesis. She’d been annotating the text, which lay on the table beside her hospital bed. Vincent died two weeks later. The couple left almost everything to the workshop.

Garrett Hardin and his wife Jane also died together, in September 2003. After 62 years of marriage, and both suffering from very poor health, they killed themselves. Perhaps strangely for a man who thought overpopulation was the world’s ultimate problem, Garrett Hardin had four children. But there may be a certain kind of logic in that. Hardin always felt that overpopulation was inevitable. He died the way he lived – a resolute believer in the remorseless working of things.

First published in the FT Magazine.

The big trouble in small print

Contracts are confusing in part because they are not natural-language documents at all

The feel-good story of the summer comes from Russia, where, we are told by the state-funded broadcaster RT, an enterprising fellow has turned the tables on his credit card company.

Dmitry Agarkov reportedly received an unsolicited offer of a credit card. Dissatisfied with the terms of the deal, he wrote his own amendments, signed the contract and mailed it back to the bank, which countersigned it and sent him his credit card – apparently not noticing that Mr Agarkov had proposed an interest rate of zero, an unlimited credit balance and a cancellation fee of nearly $200,000. So far the courts have sided with Mr Agarkov.

Well, as Tom Waits once sang, the large print giveth and the small print taketh away. But needless to say, we consumers are usually the ones who fail to read the small print. That can hardly be a surprise: the small print is usually unintelligible.

Take the example of reading the privacy policies of websites. Aleecia McDonald and Lorrie Cranor, two academics specialising in computer privacy, published a research paper back in 2008 estimating how long it would take to read all this stuff. With the typical policy weighing in at 2,500 words (that is four times the length of this column, and possibly even more full of jargon), and four new privacy policies to read per day, McDonald and Cranor reckon that the time it would take to read all these policies would be 244 hours a year. Put another way, if your job were to read privacy policies, you’d spend six weeks on the task.

Does any of this matter, and if so, can we improve the situation?

One famous economic idea throws a harsh light on the subject: George Akerlof’s “lemons” model, for which he won the Nobel Memorial Prize in Economics. (The lemons model is about cars, not citrus fruit.) If sellers can evaluate the quality of a used car but buyers www.topphentermineonline.com cannot, the likely outcome is that both buyers and sellers know that only the most awful cars will be traded in the market.

The same could apply to small print: customers naturally assume that all contracts contain weaselly clauses, and companies who might prefer to deal honestly know that they’ll never get credit for doing so.

A more hopeful economic model suggests that a few diligent shoppers will keep the worst corporate excesses in check. Many of us don’t check prices in supermarkets any more than we check the small print; we just assume that others are paying attention and so the prices will be fair. Maybe that is also true of contracts? Unlikely, alas.

A study in 2009 by Yannis Bakos and others called “Does Anyone Read the Fine Print?” tracked people as they shopped for software online. Out of 125,000 browsing sessions, only 55 involved looking at the “end user licence agreement” (EULA) for more than a second; even then, the median time looking at it was 29 seconds. It is barely an exaggeration to say that nobody reads the EULA.

We have some defences: courts refuse to enforce abusive terms, and companies restrain themselves to keep their reputations intact. But that’s a long way from a healthy market built on informed consumer choice.

One solution, which has been advanced both by computer scientists such as Lorrie Cranor, and by economists such as Richard Thaler, is to use our computers to help us. Contracts are confusing in part because they are not natural-language documents at all – they are a kind of algorithm designed to be interpreted by law courts instead of by computers. Why not, then, produce machine-readable privacy contracts, or pricing schemes? Our computers can advise us if we are about to make a bad choice, and suggest superior alternatives. The idea might seem like science fiction – but these days, what doesn’t?

Also published at ft.com.

Time for banking’s petulant toddlers to grow up

Like monstrous toddlers, the world’s banks have stumbled from manic exuberance, destroying all they touch with clumsy glee, to petulant refusal to get up off the floor. As any parent will tell you, round-the-clock supervision of toddlers is impossible and clearing up the crap is no fun. How can we force banking to grow up?
The fundamental problem is that governments – rightly, given the present set-up – regard certain banks as too big or too interconnected to fail. In the last resort, they must be rescued lest the financial system as a whole be destroyed.
From that single flaw springs all our troubles. Banks find it cheap to raise money as debt, rather than as equity. That makes banks fragile: any highly-leveraged company flirts with bankruptcy. In a more respectable industry (such as pornography or tobacco) that risk would encourage use of equity, a more resilient source of funds. But with the government acting as backstop, who cares?
Regulators, then, are forced to craft rules to oblige banks to use enough equity capital. These rules do not work. Complex risk-weighted systems have failed utterly: again and again, banks have failed despite meeting regulatory requirements. With hindsight, simpler rules gave better warning of banks in trouble, as the Bank of England’s Andrew Haldane pointed out in “The Dog and the Frisbee”. (This is the closest thing central banking has to a speech with a cult following.) But simpler rules would soon be exploited.
There’s much to be said for the idea that banks should just be forced to rely much more on equity than they do today. But while the costs of using equity in place of debt are often grossly exaggerated, they are not zero. And even with a large equity capital cushion, the perverse incentives of “too big to fail” will assert themselves: bankers will find new ways to snuggle up with bankruptcy.
Fragility isn’t the only problem here. Banking is pro-cyclical, fuelling every boom and deepening every slump. When times are good, banks are machines for sucking up cheap money and spraying it all over the place. Conversely, stressed banks find it hard to raise the capital they need, because new equity investors know they would stand behind debt holders in the queue to be repaid. Unable to raise equity, banks are reluctant to lend.
Once you have ruled out the unacceptable, whatever remains, no matter how odd, must be accepted. We need to return to a market-based system of banking regulation – one in which banks can be allowed to fail. In a market-based system, banks would need to reassure their backers that they were acting like grown-ups – a process likely to be more subtle and robust than ticking regulatory boxes.
The appeal of this is obvious. But the problem has always been that nobody believes a regulator could allow a big bank to fail, and so market discipline fails. But perhaps there is a way out, by changing the way that bank debt works. A new debt contract, the “equity recourse note” (ERN), is at the heart of a proposal by market veteran Jacob Goldfield and two economists, Jeremy Bulow and Paul Klemperer.
An equity recourse note would work like a traditional bond, except that at times of stress, the interest payments would be made in equity rather than cash. “Stress” is defined not by regulators, who might hold back for fear of causing alarm, but by the bank’s share price.
Let’s say the share price is $40 when the ERN is issued. The trigger price could be one quarter of that, or $10. At any point when payments were due but the share price was below $10, the payment would be made in shares instead, at a nominal price of $10. A $10,000 interest payment would instead be 1000 shares.
Now adopt a simple rule: all unsecured bank debt must be in the form of ERNs. (Depositors would be treated separately.) What then?
Banks do not “fail”. They can’t go bankrupt because it is always possible to issue new equity and satisfy the terms of the ERN contract. Stressed banks automatically acquire thicker equity capital cushions.
The process is gradual. There is no traumatic moment at which large chunks of debt convert to equity, possibly causing trouble elsewhere in the financial system. Payments only convert to equity when they come due, and not every ERN will convert at the same trigger price. If a bank’s shares recover, subsequent interest or principal payments will be made in cash again.
Mismanaged banks will not collapse, but will be slowly starved of funds by disgruntled investors. “Too big to fail” banks become small enough to drown in the bathtub – apologies to Grover Norquist.
Finally, banking becomes counter-cyclical. This is because of the way the ERN trigger price is tied to the current share price. Even a highly stressed bank can raise new funds to lend out by approaching ERN investors: the new tranche of ERN would have a very low trigger price and so it would be senior debt, at the front of the queue for cash repayments. Conversely, a bank with highly-priced shares might find ERN investors hesitate – their ERNs would have a high trigger price, and would be at the back of the queue for repayment if the bubble burst.
Of course, investors would prefer to receive cash, not shares, and for this reason bankers would have to work hard to prove their honesty and competence. All this sounds refreshingly like grown-up market forces in action. Banking regulators should give it a try.

This column was first published, in abbreviated form, in the Financial Times.

The Undercover Economist Strikes Back is out tomorrow

My new book, “The Undercover Economist Strikes Back”, is out tomorrow in the UK – a very exciting moment for me. Trying to make sense of macroeconomics turned out to be far more fun than I feared when I first decided to work on the book. For all its shortcomings, macroeconomics is a rich and fascinating subject. The early reviewers seem to agree.

You can find out more about the book here, and pre-order it online. Or pop to your local bookshop and see if it is in stock already – since I’m not J.K. Rowling, launch dates don’t tend to be rigorously observed and you may well find that it’s in the bookshops a day early. Enjoy!

The man who gives geeks a good name

The Independent on Sunday had a big interview with me, penned by Susie Mesure. Here’s a short extract (quote from me):

“People today don’t become economists to make the world a better place. Maybe that’s going to change because we’re facing this crisis. We may get a new generation of economists whose mindset has been shaped by this and they want to make the banking system safer and the world more equitable and, dare I say it, more efficient. After all, this stuff really matters, so there should be some room for some idealism and for people who want to make it work better because they think it matters.”

You can read the whole thing here  – including photograph of me gazing at the Manchester skyline as if in need of divine inspiration.

The Independent reviews “The Undercover Economist Strikes Back”

Here’s Hamish McRae:

Our chief economic storyteller turns his talents to the big picture of recession – and recovery
Tim Harford is trying to do for macro-economics what he – and a handful of others – have sought to do for micro-economics. That is to de-mystify the subject, explaining in simple language what we know and don’t know about the way the world economy works.


 The meat of the book is how to deal with recessions, the central question facing the Western world now. But there are also nice diversions into the baby-sitting co-op that workers on Capitol Hill in Washington founded, Henry Ford’s doubling of his workers’ wages in Detroit, and why cigarettes were a currency in Germany in PoW camps.


Economists will continue to attract opprobium. Indeed, by their wild assertions they bring a lot of it on themselves. But maybe, thanks to people such as Harford, the profession will gain a better-informed audience, and a more perceptive one for its real shortcomings.

The Undercover Economist Strikes Back is out on Thursday.

26th of August, 2013MarginaliaComments off

The Sunday Times Reviews The Undercover Economist Strikes Back

Dominic Lawson’s review from Sunday 18 August; he’s not so sure about the dialogue format of the book, but:

…it’s amazing what you can get used to; especially when the author is as clear-thinking and easy to read as Harford.

I thought this was a book by an economist?

It is; but Harford is also the presenter of such BBC radio programmes as Pop-Up Economics and More or Less, so he has mastered the art of dealing with this subject without the use of a single diagram or mathematical equation.

Doesn’t that mean he could be accused of over-simplification?

Perhaps academic economists would say so; but the original Undercover Economist book sold more than 1m copies worldwide, so they will just have to suck it up. And besides, the ability to express complex ideas in a straightforward fashion is invaluable in a field which has more than its fair share of impenetrable jargon … This is a studiously non-political book.

I’ll take that as a recommendation. 

The book is out on 29 August; you can find out more here.

A lesson from the other ‘sage’ of investing

John Maynard Keynes invented macroeconomics but chose not to anticipate macroeconomic trends as an investment innovator

In his famous letter to Berkshire Hathaway shareholders in 1988, Warren Buffett declared: “When we own portions of outstanding businesses with outstanding managements, our favourite holding period is forever.” Compare this statement, apparently from a kindred spirit: “As time goes on, I get more and more convinced that the right method in investment is to put fairly large sums into enterprises which one thinks one knows something about and in the management of which one thoroughly believes.”

Earlier, in 1984, Buffett had explained his view on diversification by approvingly quoting the theatre impresario Billy Rose: “If you have a harem of 40 women, you never get to know any of them very well.” Here’s that kindred spirit again:

“It is a mistake to think that one limits one’s risk by spreading too much between enterprises about which one knows little and has no reason for special confidence.”

In each case the second statement is from a man who is as quotable as the Sage of Omaha himself: John Maynard Keynes, writing to a colleague in 1934. The affinity between Buffett and Keynes isn’t a new discovery but a newly published study of Keynes’s investments for King’s College, Cambridge allows us to see whether Keynes took his own advice, and whether the results paid off.

Keynes had dabbled in currency speculation after the first world war, trading on margin and realising both large losses and large gains. But after assuming responsibility for the college’s investments in 1921, Keynes had to take a different approach. He persuaded the college to liberate part of its endowment from its traditional, highly conservative strictures, and it is this “Discretionary Portfolio” which has been tracked by David Chambers and Elroy Dimson of Cambridge’s Judge Business School.

At first, Keynes – who arguably invented the very idea of macroeconomics – relied on his gifts as an economist to time the business cycle, moving in and out of investments as economic trends dictated. It speaks volumes about macroeconomics that even for Keynes, this approach was not a success. By August 1929, the Discretionary Portfolio lagged behind the UK equity market by a cumulative 17.2 per cent. Worse, the stock market collapsed in September and Keynes had failed to see it coming.

Chambers and Dimson then document a change in Keynes’s approach. Instead of trying to anticipate macroeconomic trends, Keynes searched for undervalued stocks, bought substantial holdings and tended to hold on to them. He favoured companies that paid generous dividends and distressed companies that held out the possibility of recovery. This approach paid off handsomely, dragging Keynes’s lifetime track record with the Discretionary Portfolio up to a 16 per cent annual return, well above the 10.4 per cent of the market as a whole.

But Keynes was not just a successful value investor, he was an investment innovator. He appears to have developed the basic principles of value investing independently of Benjamin Graham, the man most closely associated with the approach. And he advanced the idea that equities were a fit investment for the likes of King’s College, at a time when any respectable investor would have stuck to property and bonds.

One note of caution, however: Keynes was very well connected, particularly in the mining sector, where he invested heavily and successfully. Insider trading was also legal in Keynes’s day.

Chambers and Dimson don’t think that the latter is the chief explanation of Keynes’s success. That said, he was so well connected that in 1925 he even received advance notice that the Bank of England’s interest rate was to change. Value investing is a fine idea – but perhaps a little easier to pull off if you are John Maynard Keynes.

Also published at ft.com.

How the rich are making sure they stay on top

When the world’s richest countries were booming, few people worried overmuch that the top 1 per cent were enjoying an ever-growing share of that prosperity. In the wake of a depression in the US, a fiscal chasm in the UK and an existential crisis in the eurozone – and the shaming of the world’s bankers – worrying about inequality is no longer the preserve of the far left.

There should be no doubt about the facts: the income share of the top 1 per cent has roughly doubled in the US since the early 1970s, and is now about 20 per cent. Much the same trend can be seen in Australia, Canada and the UK – although in each case the income share of the top 1 per cent is smaller. In France, Germany and Japan there seems to be no such trend. (The source is the World Top Incomes Database, summarised in the opening paper of a superb symposium in this summer’s Journal of Economic Perspectives.)

But should we care? There are two reasons we might: process and outcome. We might worry that the gains of the rich are ill-gotten: the result of the old-boy network, or fraud, or exploiting the largesse of the taxpayer. Or we might worry that the results are noxious: misery and envy, or ill-health, or dysfunctional democracy, or slow growth as the rich sit on their cash, or excessive debt and thus financial instability.

Following the crisis, it might be unfashionable to suggest that the rich actually earned their money. But knee-jerk banker-bashers should take a look at research by Steven Kaplan and Joshua Rauh, again in the JEP symposium. They simply compare the fate of the top earners across different lines of business. Worried that chief executives are filling their boots thanks to the weak governance of publicly listed companies? So am I, but partners in law firms are also doing very nicely, as are the bosses of privately owned companies, as are the managers of hedge funds, as are top sports stars. Governance arrangements in each case are different.

Perhaps, then, some broad social norm has shifted, allowing higher pay across the board? If so, we would expect publicly scrutinised salaries to be catching up with those who have more privacy – for instance, managers of privately held corporations. The reverse is the case.

The uncomfortable truth is that market forces – that is, the result of freely agreed contracts – are probably behind much of the rise in inequality. Globalisation and technological change favour the highly skilled. In the middle of the income distribution, a strong pair of arms, a willingness to work hard and a bit of common sense used to provide a comfortable income. No longer. Meanwhile at the very top, winner-take-all markets are emerging, where the best or luckiest entrepreneurs, fund managers, authors or athletes hoover up most of the gains. The idea that the fat cats simply stole everyone else’s cream is emotionally powerful; it is not entirely convincing.

In a well-functioning market, people only earn high incomes if they create enough economic value to justify those incomes. But even if we could be convinced that this was true, we do not have to let the matter drop.

This is partly because the sums involved are immense. Between 1993 and 2011, in the US, average incomes grew a modest 13.1 per cent in total. But the average income of the poorest 99 per cent – that is everyone up to families making about $370,000 a year – grew just 5.8 per cent. That gap is a measure of just how much the top 1 per cent are making. The stakes are high.

I set out two reasons why we might care about inequality: an unfair process or a harmful outcome. But what really should concern us is that the two reasons are not actually distinct after all. The harmful outcome and the unfair process feed each other. The more unequal a society becomes, the greater the incentive for the rich to pull up the ladder behind them.

At the very top of the scale, plutocrats can shape the conversation by buying up newspapers and television channels or funding political campaigns. The merely prosperous scramble desperately to get their children into the right neighbourhood, nursery, school, university and internship – we know how big the gap has grown between winners and also-rans.

Miles Corak, another contributor to the JEP debate, is an expert on intergenerational income mobility, the question of whether rich parents have rich children. The painful truth is that in the most unequal developed nations – the UK and the US – the intergenerational transmission of income is stronger. In more equal societies such as Denmark, the tendency of privilege to breed privilege is much lower.

This is what sticks in the throat about the rise in inequality: the knowledge that the more unequal our societies become, the more we all become prisoners of that inequality. The well-off feel that they must strain to prevent their children from slipping down the income ladder. The poor see the best schools, colleges, even art clubs and ballet classes, disappearing behind a wall of fees or unaffordable housing.

The idea of a free, market-based society is that everyone can reach his or her potential. Somewhere, we lost our way.

The Undercover Economist Strikes Back’ by Tim Harford is published this month in the UK and in January in the US.

First published in the Financial Times, 16 August 2012.

Pay-what-you-want pricing: playing tag with price tags

As a business strategy, ‘pay what you want’ translates as slim pickings. As a topic in psychology, it remains deliciously rich

It wasn’t so long ago that “pay what you want” was being touted as the hot new way to make money in an economy transformed both by the banking crisis and by digital commerce. In 2007, Radiohead released In Rainbows, inviting fans to download the album and pay what they chose. In 2010, Panera, a chain of bakery-cafés in the US launched Panera Cares, cafés with a social mission and PWYW pricing.

Peak PWYW may have come with a widely shared talk by the musician Amanda Palmer at this year’s TED conference. Palmer sprang to prominence after raising more than a million dollars on the crowdfunding website Kickstarter – and her TED talk hinted at how she’d achieved it. (In some ways, easy: just ask for money and make it straightforward for people to respond. In other ways, hard: Palmer’s intense and longstanding relationship with her fans sometimes verges on performance art itself.)

Where do we stand now with PWYW? Since textbook economic agents would choose to pay nothing, the idea defies economic assumptions. But those assumptions may be reasserting themselves. Panera introduced a PWYW meal in all its cafés in March, but axed the experiment in July. Some other high-profile PWYW restaurants have closed after a year or two, or switched to conventional pricing.

As for Radiohead’s In Rainbows, creative projects are released with voluntary pricing every day. But it has been a long time since I remember any such project hitting the headlines. And, since some of the PWYW appeal was surely publicity, the model was always reliant to some extent on novelty.

Tyler Cowen, a professor of economics at George Mason University in Virginia (also a thoughtful food critic and author of An Economist Gets Lunch) predicted in 2010 that the model would rarely work for restaurants. The novelty would wear off, and repeat customers might find the burden of choosing the right price discomfiting. The margin for error is small: musicians such as Radiohead or Palmer can carry free riders because the cost of distributing digital music is low. Restaurants will swiftly be wiped out if many customers pay little or nothing.

Experiments by marketing professors Ju-Young Kim, Martin Natter and Martin Spann found that PWYW schemes tended to reduce profits, particularly if marginal costs were significant – as with restaurant meals.

To make PWYW stick, perhaps retailers need to be a little more crafty. Ayelet Gneezy, Uri Gneezy, Leif D Nelson and Amber Brown, also marketing academics, experimented with different pricing schemes for people invited to buy photographs of themselves on a rollercoaster.

Some people were told that half the money they paid would go to a charity for sick children. Some were invited to pay whatever they wished. But it was those two options in combination that worked wonders: if patrons were invited to pay what they pleased, and told that half their payment would go to charity, revenues and profits surged.

But this scheme seems to rely on a cognitive illusion. It could equally be described thus: “we’ll grab half of your charitable donation and give you this photo in exchange; the more you give to the charity, the more we’ll take.” Not so appealing.

And there is a twist. Gneezy et al found that, while profits jumped, fewer people actually bought photos if they were told half the money was going to charity. Were the people who would have paid a little and taken the photograph afraid of looking cheap once the charity was mentioned? Perhaps they found it easier to walk away.

As a business strategy, “pay what you want” usually translates as slim pickings. As a topic in psychology, it remains deliciously rich.

Also published at ft.com.



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