Tim Harford's Blog, page 110

Scarce tactics

A frustrating and intriguing study of how shortages change the way we think

Scarcity: Why Having Too Little Means So Much, by Sendhil Mullainathan and Eldar Shafir, Allen Lane, RRP£20 / Times Books, RRP$28, 304 pages

Here is a flawed but intriguing book with a compelling thesis: being short of time is fundamentally similar to being short of money, or friends, or food, or indeed being short of space when packing for a trip. In each case, the feeling of scarcity comes to the front of the mind. It makes us focus on the immediate problem, which can make us remarkably effective – but also over-anxious, short-termist or blinkered.

We learn on the very first page of Scarcity that Sendhil Mullainathan – professor of economics at Harvard and one of my favourite economic thinkers – is extremely busy: “the past-due pile of life was growing dangerously close to toppling.” In the 300-odd pages that follow, he and his co-author Eldar Shafir, professor of psychology and public affairs at Princeton, explain that people in that sort of situation make hasty, distracted and ill-advised decisions, which may explain certain curiosities about the book itself.

Let’s get the criticism out of the way first: the book is full of chatty attempts to coin new buzzwords. We discover that people who suffer from lack of “slack” have to pay the “bandwidth tax”. As a consequence, they may start “tunneling”, and if they “tunnel” repeatedly then the “tunneling” will turn into “juggling”.

Scarcity is also poorly balanced. More than half the book outlines the psychological effects of scarcity, and what at first is a fun jaunt through some intriguing experiments soon feels lengthy, repetitive and confusing. The concluding chapters, with suggestions for policy, management and self-help, are interesting but brief and often half-baked. We measure gross national product, write the authors, so “Why not also measure Gross National Bandwidth?” To ask that question is to answer it.

Yet while Scarcity frustrates, it also fascinates. The idea that there’s a basic similarity to all forms of scarcity, and that similarity manifests itself in the way we think, has a touch of Gladwellian genius about it: somehow it manages to be obvious yet original at the same time.

In one experiment, the authors asked Princeton undergraduates to play a TV gameshow under controlled conditions. Some were made “rich”, with three times the time allocation to answer questions. The “poor” used their resources more effectively, scoring more points per second than the rich.

Then the experimenters introduced a wrinkle: both rich and poor were given access to the equivalent of payday loans, borrowing time from future rounds to use immediately, at punitive rates. The “rich” hardly bothered; the “poor” made extensive use of this loan-sharkery and earned far less as a result.

This is the kind of result – Scarcity is full of them – that should make us think differently about poverty. The “poor” relied on the payday loans not because of fecklessness or stupidity (they were Princeton undergrads, exactly the same as the “rich”) but because of the context in which they found themselves. And they managed to be penny-wise and pound-foolish because of the way scarcity forced them to focus too closely on the problem at hand.

Mullainathan and Shafir point out that the scarcity perspective explains the effectiveness of fashionable “nudge” approaches, which minimise the cognitive demands on people whose attention is elsewhere. It also explains the failings of over-broad policies such as a lifetime limit on welfare claims, introduced in the US: the cap simply seems irrelevant to most claimants, until suddenly it looms and it’s too late. The policy “penalizes but fails to motivate”.

The authors offer some alternatives. For instance, they suggest a payday loan and savings account rolled into one: the high fees from the payday loan would be split between the lender and a savings account in the name of the borrower. Each hasty grasp for short-term cash builds long-term financial resources. Clever – but would it work? Mullainathan has run rigorous trials of such policy interventions before; it’s not clear why he hasn’t tried this one. Did he run out of time?

The case of the St John’s Regional Health Center, an acute care hospital in Missouri, is particularly memorable: always short of operating-theatre space, always rearranging scheduled operations when emergency cases came in, the hospital’s fortunes were transformed when it switched to a policy of always leaving one theatre empty in case of emergencies. Suddenly, the interruptions to scheduled operations stopped, and with it the endless cycle of rearranging and catching up.

While the example is striking, it also somewhat undermines the book’s thesis: that scarcity makes its presence felt through the way we think. That hospital’s experience suggests that the issue may not be psychological at all, but a topic in operations research.

As the authors admit, this whole scarcity business is new and somewhat speculative. But one cannot help feeling that they are on to something. Scarcity made me think differently about money, food, and how I manage my own time. And for all its flaws, a book that changes the way you see the world is valuable – and scarce.

Also published at ft.com.

Free-riding a la carte

A study shows most people would have paid their share of the bill, given the choice. And yet in social settings, splitting remains the default option

The difficulties involved in splitting a restaurant bill are the stuff of legend or, at least, the stuff of Life, the Universe and Everything by Douglas Adams. Adams introduced the concept of Bistromathics and the Bistromathic Drive: the mathematics generated by people’s odd behaviour in restaurants is apparently so powerful and strange, he declared, that it can fling a starship across a galaxy in seconds.

Bistromathics emerge from the interaction of two powerful forces in social science: freeriding and social pressure. Eating out is a social occasion and your behaviour will affect how others see you. Yet the opportunity for freeriding is obvious: if six diners split the bill equally, the additional cost to any one diner of ordering that £12 starter will be just £2, with his companions picking up the balance. The split-the-bill rule offers an excellent opportunity to try the fancier options at little extra cost. Of course everyone else is likely to reach the same conclusion – but then they’d be a fool to do otherwise.

Do people really freeride in this way? A large number of laboratory experiments, typically involving students sitting at computers and interacting anonymously, have found that we freeride less than textbook economic theory would predict. We care about other people, it seems – either about their wellbeing or what they think of us.

But there’s an alternative explanation for this curious outbreak of human decency: perhaps people are just confused by the laboratory setting and the laboratory games. There’s some evidence, for instance, that people in these free-rider games start to take advantage of each other after a few practice runs.

In 2004, three researchers, Uri Gneezy, Ernan Haruvy and Hadas Yafe published an intriguing study in The Economic Journal. Gneezy and his colleagues had conducted an experiment in a real restaurant, in Haifa, Israel, inviting groups of six diners to order food – but giving them different systems for settling the bill.

The idea wasn’t to simulate the real restaurant experience, when one dines with friends and can expect social consequences for good or bad behaviour: the researchers had invited complete strangers to eat together, ostensibly for the purposes of researching the effect of food on emotions.

What was the point of creating such an odd dining experience? Instead of trying to understand how people behave in restaurants, the researchers were trying to use the restaurant as a better kind of laboratory. Laboratories can be confusing, but everybody understands that if you’re sitting in a restaurant and you’ll be splitting the bill, you have an incentive to order the lobster.

Diners were, at random, offered three different billing rules: split-the-bill, pay-your-share, or on-the-house. They were also asked to order food by writing their choices down, without discussion. This odd request was made less odd by the fact that they were all filling in questionnaires at the time.

Homo economicus immediately emerged: diners ordered, on average, 37 shekels worth of food when paying their own way, 51 shekels when splitting the bill, and 82 shekels when the experimenter picked up the tab for everyone. (A small follow-up experiment hinted that people splitting the bill six ways behave similarly to those paying one-sixth of their own bill.)

We freeride in restaurants, then – at least, we freeride in the odd circumstance of having lunch with total strangers and filling in questionnaires. But there’s a twist to this: the experimenters asked, out of curiosity, whether people would prefer to split the bill or pay their share. Most people would have paid their share, given the choice. And yet in social settings, splitting the bill remains the default option. Is there a deeper or more fascinating subject than Bistromathics?

Also published at ft.com.

Low pay and the rise of the machines

Labour could organise a Luddite revolution against technology

‘4.6 million Britons (20 per cent of all employees) earn below the Living Wage – a leap from 3.4 million (14 per cent) in 2009’

The Resolution Foundation – 4 September 2013



4.6m Britons don’t earn a living wage – are they dead?

Very droll. For “living wage” read “decent wage”. The Living Wage (with capital letters) is a target set by campaigners for a good solid hourly wage – currently £8.55 an hour in London and £7.45 an hour elsewhere. That’s 20 per cent above the legal minimum wage rate. A lot of people don’t make that much money. Some of them will be doing just fine – £7 an hour isn’t bad if you’re 17 years old, living with mater and pater and saving up for a gap year somewhere sunny – but others will not.

I feel like I’ve heard about all this before. Why are we talking about it now?

It’s the new narrative for the Labour party. Here’s the awkward thing for Labour: the economy is slowly picking up steam. So how to attack George Osborne, the chancellor? Ed Balls, shadow chancellor, could argue that Mr Osborne deserves no credit for the upturn – that government austerity made the depression longer and deeper than necessary. To an economist that’s pretty plausible. To the voting public it doesn’t seem to have much bite. And so the new story – pushed by Mr Balls and his deputy Rachel Reeves this week – is that while it’s welcome that the economy is recovering, the problem is that hard-working families aren’t benefiting.



Why is it always “hard-working families”? The phrase conjures up images of a family with six kids, all chained together and sent down a coal mine.

Can we skip the stylistic criticism for a moment and talk about the economics?

OK . . .

What is powerful about this story is that there’s a lot of truth to it, and little Mr Osborne can do is likely to change it. And if Mr Balls were chancellor, little he could do would change it either. There are forces at work in the world economy that are making it hard for people with traditionally valuable skills to prosper.

Such as?

As technology becomes cheaper and better, people are replacing “labour” with “capital” – that is, employing fewer people, or paying the people they do employ less, and replacing them with machines or computers. Research published by two economists at the University of Chicago, Loukas Karabarbounis and Brent Neiman, has documented this trend: it’s global, it’s been going on for three decades, and it is happening in many different sectors of the economy. Some people can get more done in an automated world – but others find themselves shoved out of skilled work and into poorly paid alternatives. So inequality increases. The arrival on the scene of China and other major low-wage economies has also played a part.



We need to fight back!

Maybe. Ed Miliband, the Labour leader, could organise a Luddite revolution against the machines. I don’t think that’s what he and Mr Balls have in mind when they talk about “predistribution”.

What do they mean when they talk about “predistribution”?

It means fixing inequality without the need to resort to redistributive taxation. Which raises the question of how. Improving education is one idea – but then who is in favour of worse schools? It also seems to mean bullying big companies to pay better wages to their most junior staff. But pressure has the same consequences as a too-high minimum wage: it can increase wages but it can also destroy jobs.

Perhaps we should look to Germany for answers: they seem to have solved their economic problems and have a strong manufacturing sector.

Germany has been reliant on low-wage jobs and flexible working conditions as much as anyone – perhaps more than most, as the economist Adam Posen has argued. Even employment in China’s manufacturing sector is in structural decline: it was at its highest back in 1996. And you’re missing one important thing about this argument.



Which is what?

Throughout this long recession, economists have been puzzled by the fact that so many people have managed to keep their jobs – or find new jobs. A key part of the answer: falling wages and flexible hours. The UK’s flexible labour market kept the show on the road in the dark days; now it is being blamed, quite reasonably, for the fact that people have jobs that don’t pay very well. Politicians may talk out of both sides of their mouths – but they can’t have it both ways.

Also published at ft.com.

More or Less wins the Royal Statistical Society award for excellence in broadcast journalism

I’m delighted about this:

The winners of the 2013 awards for statistical excellence in journalism have been announced. Journalists at The Times, The Detail and BBC Radio 4 have been commended for their work. The awards, now in their seventh year, are made in three categories – print, broadcast and online – and recognise work first published or broadcast in the preceding calendar year.

…In the broadcast category, BBC Radio 4’s “More or Less” programme presented by Tim Harford is the winner. The judges considered this to be a really informative exploration of the contentious issue of waiting times at UK borders during the Olympics and the contrasting estimates of different agencies. They particularly highlighted how choice of data can have a big impact on the story that is told.

It’s the fourth year in succession that the More or Less team has been commended by the Royal Statistical Society for its excellence in journalism. We won outright this year and in 2010. Very chuffed for the team.

The Financial Times reviews The Undercover Economist Strikes Back

The full review, by Pietra Rivoli, is here. Here’s the introduction:

For years economics professors had little competition in their own market, and shamelessly bored generations of students with dusty graphs of wine and cloth. Thankfully, the past decade or so has brought some variety and colour to the enterprise… if there is an undisputed leader in this spoonful-of-sugar approach, it must be the Financial Times columnist Tim Harford. His 2005 book The Undercover Economist cleared the muddy windshield of microeconomics for more than a million readers. Now, in The Undercover Economist Strikes Back, Harford’s target is macroeconomic policy. He tackles this using, well, a gimmick: putting a hypothetical reader in the driver’s seat of the economy and offering guidance in a book-long series of Q&As.

And the conclusion:

So should I buy the book?

Without question. Reading Harford is like finding yourself next to the funniest, smartest fellow at the party. It is such fun that readers will hardly notice that, by the end, they’ve mastered macroeconomics through perhaps the intermediate level. Economics professors everywhere should be very afraid.

You can buy the book, or find out more, here.

 

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 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  - including photograph of me gazing at the Manchester skyline as if in need of divine inspiration.