Behavioural economics has received the ultimate accolade.
Richard Thaler of the University of Chicago Business School has been awarded the Nobel Prize in economics for his work in this area.
Economics over the past 20 to 30 years has become far more empirical. Leading academic journals do still carry purely theoretical articles, but far less than they once did.
This shift towards the empirical takes two forms. Major advances have taken place in the heavy duty statistical theory of analysing large scale databases containing information on individuals and their decisions. This was recognised when James Heckman and Daniel McFadden were awarded the Nobel Prize in 2000.
Behavioural economics is much less technical. In any given situation, the decision which a purely rational person would take is identified. We then look how people actually behave, and see if there are any deviations from the rational way of doing things.
Perhaps the main finding of behavioural economics is so-called prospect theory, first set out nearly 40 years ago by Daniel Kahneman. In essence, prospect theory says that people dislike making losses more than they like making gains of the same amount.
Another important discovery is that, when weighing up how to value future costs and benefits, people often place much more weight on the present and very immediate future than standard economic theory assumes. Last month I wrote about how this helps to explain the reluctance of electorates to deal with climate change.
These two results are backed by large amounts of evidence obtained in a range of different contexts. So now they are being integrated into economic theory.
But many economists are altogether less sure about much of the rest of behavioural economics. One of the issues is that it often gives the impression of being rather ad hoc. No reason is given as to why people in one situation appear to behave rationally, but in another they do not. Very few guidelines have emerged as to when we can expect to see deviations from rationality.
Another issue is that many economists are prepared to accept that non-rational behaviour might be observed at a point in time. But in a reasonably stable situation, people will learn over time to be rational.
Behavioural economics is not just about advancing knowledge on the workings of the economy. Policy-makers have become interested.
Cass Sunstein, Thaler’s colleague, served in the Obama administration as head of the Office of Information and Regulatory Affairs. David Cameron set up the so-called “Nudge Unit” in his government based on Thaler’s ideas. Thaler claimed 10 years ago that a “nudge” could lead to “better investments for everyone, more savings for retirement, less obesity, more charitable giving, a cleaner planet, and an improved educational system”. In his 2016 book Misbehaving, he has backed off the extravagance of these claims.
Still, whatever the doubts and qualifications, behavioural economics has made a big impact. An economist can no longer be said to have a good training if he or she is not familiar with its main themes.
As published in City AM Wednesday 11th October 2017
Image: Richard Thaler by Chatham House is licensed under CC by 2.0
A red-hot topic in economics is randomised controlled trials (RCT). Esther Duflo, the MIT academic who has really driven this idea, has surely put herself in pole position for a Nobel Prize at some point.
The idea of RCTs has been imported from medicine.One group of people are selected at random to be subject to a particular policy, and the outcomes in this set are compared to the rest of the population, which are not.
The studies have been almost exclusively carried out in developing countries. Evaluating RCTs often involves some subtle statistical points, but they are a powerful way of identifying what really works. Their policy impact has already been substantial.
Over 200m people worldwide have been reached by the scaling up of programmes evaluated by the J-PAL network, in which Duflo is the leading light. The RCT studies themselves are carried out on a small scale, evaluating very particular policies. If they succeed, they can be expanded. Examples include encouraging the take-up of school-based deworming, chlorine dispensers for safe water, and free insecticidal bed nets.
A closely related concept is known as a natural experiment. This is when we observe two contrasting policies which have been carried out in the past, either at the same time on different populations or at different times on the same one.
The policies in this case have not been deliberately designed as part of an experiment. They have been introduced as part of the political process.
But good natural experiments can be just as informative as RCTs. Indeed, they can reach the parts which RCTs cannot get to, because we can observe natural experiments which have taken place on very large scales.
By far the most important of these is the series of natural experiments on the performance of market-oriented economies compared to their centrally planned socialist rivals.
The current tensions highlight the differences between North and South Korea. In the 1950s, the latter had living standards similar to African countries. Now, they are at Western levels.
Other countries which were poor in the mid-twentieth century and which have adopted the principles of market-oriented economics have also prospered.
The fall of the Berlin Wall at the end of the 1980s brought into sharp focus the contrast between East and West Germany. The Trabant was a popular car in the East, but it was of such poor quality that its value dropped to almost zero as soon as Western cars could be imported.
The major economic contest of the twentieth century was between the US and the Soviet Union, won easily by America.
India and China practised different forms of socialism until the late 1980s. The Chinese was the most extreme – resulting, for example, in the deaths of at least 60m people in the self-induced famines around 1960. After adopting market principles, both countries have flourished.
The outcomes of these major natural experiments are decisive. Belief in socialism in 2017 is equivalent to believing the sun goes round the Earth.
The German elections on Sunday went pretty much according to the polls. Another victory for Chancellor Merkel.
Much of the commentary has focussed on the success of the far-right Alternative fur Deutschland (AfD) party. One of its leading candidates eulogised the German armed forces during the Second World War – a topic even more sensitive topic there than it is here.
The AfD took nearly 13 per cent of the vote and 94 seats in the Bundestag. This puts them within striking distance of the Social Democrats (SPD). The SPD share of the vote collapsed to just over 20 per cent, barely half the support it attracted only a decade ago.
The Social Democrats – the German equivalent of Labour in the UK – were annihilated not just in areas like Bavaria where traditional centre-right parties have always been strong. They lost very heavily in the old East Germany, where the AfD secured its highest level of support.
It is no accident that the rise of the AfD and the fall of the SPD go hand in hand.
A popular myth among the liberal elite in Britain is that our country has an exceptionally high level of inequality compared to the rest of Europe. This far from being the case.
The same forces which have widened inequality here have operated in Germany, in some ways even more powerfully.
The opening up of Eastern Europe in the early 1990s has had a strong effect. Employers soon realised that economies such as Poland and the Czech Republic possessed educated labour forces, whose productivity potential had been suppressed by the gross inefficiencies inherent in planned economies. German companies opened up new production plants in the old Soviet bloc countries in Europe rather than at home.
This has been combined with the impact of both globalisation and mass immigration.
The effect on wage rates of this increase in competition in the labour market has been dramatic. Christian Dustmann at UCL has examined the evolution of wage rates in the former West Germany.
The fifteenth percentile of the wage distribution is the level at which only 15 per cent of wages are lower. In West Germany, at the fifteenth percentile, real wages have fallen almost continuously since the mid-1990s.
At the fiftieth percentile, where half get more and half get less, the reduction has been less sharp. But the fall had set in by the early 2000s.
At the eighty-fifth percentile, we see the mirror image of the fifteenth: real wages grew strongly, reaping the benefits of the recovery of the economy.
In the states of the old East Germany, the problems are even worse.
The sharp rise in inequality is a key reason for the collapse in support for the social democratic parties across Europe. Their traditional voters have been the ones who have been hit the most by static or falling real incomes. They have not been defended by social democrat parties, which now represent the interests of the public sector urban professional classes.
The fact that Jeremy Corbyn’s Labour did not suffer the same fate as Germany’s SDP is a clear indictment of the Conservative campaign in the election.
As published in City AM Wednesday 27th September 2017
Image: Martin Schultz by Olaf Kosinsky is licensed under CC by 3.0
I have supported Rochdale Hornets, the Rugby League team of my home town, for many years.
I continue to enjoy my association with the team as President, and it was with pleasure I attended the annual Hornets End of Season Dinner on Friday.
Pictured with me is Rob Massam, who received the the Top Try Scorer Award for crossing the line 18 times! Rob, the ‘tank on the flank’, plays not in the forwards but on the wing, yet he towers over me and is twice as broad!
The UK jobs market is booming, as the latest ONS figures show. Unemployment is at its lowest for over 40 years. A record 32.1 million people are in employment, a rise of over 3 million since the financial crisis.
Apart from in a few scattered pockets, Britain is at full employment. Usually in such circumstances, wages would start to outpace inflation. Labour shortages would lead employers to start bidding for workers, who would themselves feel more confident about demanding pay increases.
Perhaps this is starting to happen, with the TUC voting for a campaign to raise public sector wages by 5 per cent.
But a combination of immigration and a concerted government campaign to get people off benefits means that the supply of labour has risen sharply. This holds down the price of labour, the wage, in the bottom half of the labour market.
Instead, full employment manifests itself in different ways. A few anecdotes might illustrate the key points.
I recently bought a new phone, which has proved to have an intermittent fault. The Richmond branch of EE advertises both on the internet and on its doors that it opens at 9.30am. I turned up at 9.40 to find the place in darkness. I went to another EE branch, where a listless young woman informed me that she could not replace it. I asked what she could do. She replied that she could take it in for repair, but that this “would take three weeks”. I left, and she slumped back to her stupor.
Later that day, I went to see someone at a leading London university. The department receptionist asked if I had the extension number. When I said I was rather hoping he might have it, he responded that he probably did, but that it would be “hard to find”. We looked at each other in silence. Then a light bulb came on in his mind. He winked at me, and pronounced “I’ll take you up there”.
These experiences are not confined to the dynamic capital city. A few weeks ago, I visited the maths department at Durham and left my glasses behind. They offered to post them guaranteed next day delivery. I tracked the parcel on the Royal Mail website. 39 hours later, it had arrived at the Newcastle sorting centre, all of 15 miles away.
These examples of appalling service arise for two reasons. First, the very high demand for labour means that some people now in jobs are scarcely able to perform work at all. Second, many low paid workers realise they can easily get another job, so why bother making an effort in your current one?
Here is part of the answer to the so-called productivity puzzle. During the recovery from a recession, productivity, output per worker, usually rises quickly. But it has been flat.
Whether due to limited ability or a lack of incentive, the output of some workers taken on in the jobs boom is close to zero. And this drags the average down.
As published in City AM Wednesday 20th September 2017
The devastating storms in America have kept the issue of climate change firmly in the public mind.
But so far, it has proved very difficult for politicians to persuade electorates to change consumption patterns in ways which many scientists would like to see.
More expensive air travel, steeper energy bills – these are not very popular.
People are being asked to accept lower increases – or even outright reductions – in their living standards now, in exchange for escaping potentially large costs in the future.The problem is easy to state. But it raises some difficult issues in economic theory.
An obvious one is how to analyse uncertainty. Suppose, for example, you are offered odds of four to one on a horse in a particular race. You can then judge whether you think the true probability of it winning is more or less than the odds suggest.
But the uncertainty around the whole climate change issue is much trickier to deal with. It is as if you are offered these odds on a horse, but you do not know which other horses it will be running against.
A simple illustration is given by Geoff Heal of Columbia University in a paper in the latest Journal of Economic Literature. We face both scientific and socio-economic uncertainty: uncertainty about the underlying science of climate change, and about the economic and social impacts of an altered climate.
Heal points out that scientists working on climate change take it almost for granted that a rise in global temperature of two to three degrees would inflict massive costs on our societies.
However, he goes on to say that “nothing in the emerging econometric studies of the impact of climate on economic activity confirms these dramatic concerns”.
So even the different groups of experts disagree.
A second challenge is that people value benefits received and costs incurred in the present and the immediate future more than they do the same benefits and costs in the more distant future.
The Bank of England is rock solid and has never defaulted. So when it issues debt, you can be as certain as possible that you will get your money back. But the Bank still has to offer you interest – more money in the future – to persuade you to buy it now.
A key question is then: how do people discount the future? What rate of interest do they use when they think about it?
Behavioural economics has provided a large amount of evidence on this question. It is not at all good news for climate change activists. In the jargon, people often use “hyperbolic discounting”. Translated, this simply means they place far more weight on small rewards or costs which occur now than on much larger ones in the more distant future.
A non-obvious implication of this is that they make choices today that their future self would prefer not to have made, despite knowing the same information.
Economics cannot solve the problem of climate change. But it can explain why electorates are so reluctant to do anything about it.
As published in City AM Wednesday 13th September 2017
Image: Hurricane Irma Rescue by US Air Force is licensed under CC by 2.0
The great Harvard economist Joseph Schumpeter, writing in the 1940s, predicted the eventual demise of capitalism. He did not want this to happen. But he envisaged that the “intellectual class” would eventually develop values which were hostile to free markets and private property.
Schumpeter’s definition of “intellectuals” was very wide. He meant people in a position to develop critiques of the economy and society, but who were themselves not responsible for running them.
The social science and humanities departments of almost all British and American universities fit this description perfectly. Even though capitalism offers them a standard of living far superior to that of any alternative system, they appear only too keen to undermine it.
The idea pervades these departments, for example, that the prosperity of the West depends upon slavery. It is this which underpins the current fashion for wanting to pull down statues of historical figures, including Britain’s greatest naval hero, Admiral Nelson.
One of the things on which the success of the West actually does depend is what we might call the empirical mode of thought. Put more simply, a theory is only any good if it is tested successfully against real life evidence.
Slavery still exists even today. In Mauretania, slavery was not abolished until 1981. Today, 1 in 25 of the entire population are estimated to be slaves. Yet Mauretania is not rich. Indeed, it is one of the poorest countries of the world.
For thousands of years, slavery has been widespread. The economy of the Roman Empire was essentially based upon stupendously large estates, all worked by slaves.
Yet none of these societies ever became rich. It is only under capitalism that this has happened. So the idea that slavery makes a society prosperous is rejected very decisively by the evidence. But this does not stop it from being almost an article of faith amongst many British academics.
Ludicrously, many of these people describe themselves as “socialists”.
The point simply cannot be made too frequently that we have seen several major natural experiments, which contrast the empirical performances of economies based upon market oriented principles with those based upon the planned economy principles of socialism.
The United States and the Soviet Union, West and East Germany, South and North Korea, India and China under different forms of socialism until the 1980s and India and China under different forms of capitalism since then. Venezuela is but the latest example. Capitalism wins decisively in every single case.
Countries such as South Korea which were very poor in the mid-20th century and which have adopted the principles of market oriented economics have since flourished.
Economists enjoy arguing amongst themselves. But the profession in general believes in private property and markets as the basis for prosperity. Empirical studies, rather than pure theory, have become much more important within economics in the past 20 to 30 years.
Economists need to take a bit of time out to confront their common enemy. Namely, the unscientific output of many social science departments in British universities.
As published in City AM Wednesday 6th September 2017
Image: Berlin Wall by US Dept of Defense is licensed under CC by 2.0
The announcement that experiments will take place with driverless lorries on UK motorways ought to be a cause for celebration. Once again, human ingenuity is pushing out the frontiers of technology.
But the general reaction in the media has been one of anxiety and concern. Wholly contradictory arguments have been advanced against them.
Driverless cars it is argued, for example, do not mean that you can summon one to your front door and be taken to and from the pub with impunity. The drink driving laws, the opponents of progress pronounce with confidence, will still apply to the humans being transported. Yet it is also claimed that the concept of responsibility for accidents involving driverless cars does not yet exist. Until it is, they cannot legally be used.
As with the introduction of railways, the law around a revolutionary technology will take some time to evolve. But the idea that a man should walk in front of the train carrying a red flag was soon given short shrift. The new technology was far too convenient to have it impeded in this way.
The opposition to driverless cars and lorries seems almost Luddite in its intensity. People currently employed in and around the activity of driving vehicles will become unemployed. Where will the new jobs come from?
I am writing this in a country house hotel in Aberdeenshire. In the room is a magazine dedicated to weddings. This, a eulogy to expensive popular culture, tells us a great deal about how the labour market evolves.
Many of the activities around modern weddings involved jobs which were either completely non-existent only a few decades ago, or only catered to a tiny number of ultra-rich individuals.
The adverts for venues, for example, usually stress that a dedicated wedding co-ordinator will be assigned to you during the planning stages. And a dedicated wedding events manager will ensure the day itself goes smoothly. Bridalwear experts can be hired to advise on the choice of costumes. People can, and do, pay substantial fees to be told that “if you plan to marry at the height of summer in Spain, a heavy material such as velvet is inadvisable”.
Special courses of dance lessons are available so that the bride and groom can perform a “full-on choreographed, fabulous first dance”. The potential activities around hen and stag events know no bounds. An adventure activity day is offered involving “Segways or zorbing”.
Specific fitness courses are offered to ensure that not only the bride and groom but their entire supporting cast look suitably “toned and sculpted”. Even your faithful pooch can be groomed for the occasion, and look glowing through consuming organic dog food. What a pity there was no advert for vegan canine sustenance.
This is a snapshot of how innovation impacts the economy. Technology enables a product or service to be provided more cheaply and at a higher quality. Some people directly involved lose their jobs. But everyone else is made better off, and their extra spending creates entirely new types of jobs.
As published in City AM Wednesday 29th August 2017
Image by Pxhere used under CC0 attribution.
The A-level results have come and gone yet again. Underneath all the hype and excitement, we can see the reliable old friend of economists at work.
Namely, the impact of incentives.
Michael Gove, in his previous Cabinet incarnation as education secretary, decided to restore the meaning of grades in A-level and GCSE exams. Until the middle of this decade, the average exam grade had risen every single year for over 20 years. A rise which was wholly implausible to anyone outside the state education sector.
The course content and the exams were to become harder. This was the first year in which the full effect of the Gove reforms were to be seen.
But he did not appreciate the strength of the incentives facing educational professionals to produce high exam grades. Good grades make everyone involved look good, not just the students. The incentives to generate them had not been altered.
The exam regulator, Ofqual, adopted the simple expedient of lowering the threshold marks required to meet grade criteria. The work may have become harder, but you could get the same grade as before with a lower mark.
When the government increased tuition fees, now at £9,250 a year, they believed that different levels of universities would set different rates. The weaker ones would have lower ones, reflecting the cost of delivering their courses and degrees.
But price – the tuition fee – was not determined by cost in this textbook way. Instead, it had a signalling function. Who was going to announce to the world that you had cheap, low value courses by setting the price at anything other than the maximum permitted? No-one.
Most summers, the fields of Southern England are filled with the lurid yellow of rape seed. A few years ago, the subsidy on linseed was higher, and the altogether more agreeable lavender flowers of that plant proliferated. From a subsidy perspective, all students are currently the same, just like a crop.
Each student you can corral through your doors carries a fixed amount of money for the university, whether paid for through a loan or by the bank of grandma and grandad. So universities are ruthlessly predatory. Some will accept students with absolutely minimal qualifications, who should never be there in the first place.
Perhaps one solution is to set the tuition fee in proportion to the grades a student obtains. Those who do well have a high price on their head. In return, they can go to the best places, where the premium on earnings of graduates still exists.
But weaker students would carry a lower price. Low grade universities would have to adapt to this new set of incentives.
They could provide courses to match the price. Or they could still charge £9,250 and students would have to top up their loans in the open market, should anyone be willing to lend for, say, sociology at Liverpool Edge Hill. Either way, this would indicate very clearly to students the potential value of the course and the university.
As published in City AM Wednesday 23rd August 2017
Image: Exam Tables by David Hawgood is licensed under CC by 2.0
Gender issues in the workplace are currently a hot topic.
First, we had the furore about male and female pay at the BBC. Next, the notorious memo from a Google employee which alleged that women are less biologically suited to be software engineers than men.
A paper in the latest American Economic Review (AER) provides an intriguing perspective on the issue.
Tim Besley of the LSE and two Swedish colleagues carried out a very detailed empirical analysis of elections in Sweden over a 20 year period. The title effectively summarises their work: Gender Quotas and the Crisis of the Mediocre Man.
To publish in the AER you have to have a theoretical model. This might have been developed with Jeremy Corbyn and his shadow cabinet team in mind. To quote the authors “the model predicts that less competent leaders pick less competent followers”. A leader who promised he would deal with outstanding student debt without realising this would cost £100bn feels at home with colleagues who are, if anything, even less numerate.
Competence is measured in a neat way from detailed micro data on factors such as an individual’s occupation, education, location, and so on, across the wider population. It is strongly correlated with the cognitive scores and leadership qualities assessed in the Swedish military draft.
In 1993, the Social Democratic Party introduced a gender quota for their candidates, who are elected on a list system. Men and women had to alternate on the list. Despite Sweden’s reputation of equality, in 1991 men were in first place on the list, and hence almost certain to be elected in 82 per cent of the elections. Such quotas are of course a sensitive issue, even within the British Labour Party in its more traditional areas.
Besley and his colleagues come to a conclusion which is as strong empirically as it is perhaps surprising. They find that the introduction of gender quotas drove out substantial numbers of mediocre male politicians. Not only that. In the areas where female representation was increased the most by the quota, the competence of the men who were elected also rose decisively.
The findings, they claim, have a relevance which goes beyond politics. For example, the chairman or chief executive usually have an important influence on the selection of board members. One of the motivations for incompetent leaders picking low quality candidates is that they feel less threatened by them. This creates a vicious circle of mediocrity.
The analysis also finds that the higher the competence of its leaders, the more likely a party was to win an election. Instead of trying to portray Corbyn as an extremist, perhaps the Tories should just point out that he is dim and useless. Of course, it is a leap of faith to go from a study of Swedish elections to FTSE boards or British election strategy. But the paper certainly gives food for thought.
It is yet another example of increased competition leading to an improvement in product quality, in this case the competence of politicians.