Tim Harford's Blog, page 95

London’s turning . . .

‘London’s excruciating price tag is not just a vulnerability but also a sign of success’

What is happening to London? Is the city devouring itself, its street life disappearing as flat-pack apartment blocks metastasise in once-healthy neighbourhoods? Or are we simply witnessing a process of regeneration and renewal? Rohan Silva, a former adviser to David Cameron, recently told architecture magazine Dezeen that London might lose its creative class because of high rents. In The Observer, Rowan Moore wrote that London “was suffering a form of entropy whereby anything distinctive is converted into property value”.

It is natural that journalists find this an urgent topic: surely the gap between the price of a typical London house and the salary of a typical London journalist has never been higher. But the topic is genuinely puzzling, because London’s excruciating price tag is not just a vulnerability but also a sign of success. It is hard to see how the city can be written off when so many people are willing to pay such extraordinary sums to live there.

It’s worth dismissing some disaster scenarios. Many people fret that the infamous apartments of One Hyde Park stand for the future of London: joyless, unaffordable and empty most of the time. But London is not going to become a gigantic holiday park full of second homes for billionaires — there simply aren’t enough billionaires out there to turn a city of more than eight million souls into the equivalent of a weekend hideaway in Cornwall.

Another concern is that international investors will snap up new-build apartments as investments, then leave them empty. But rental property is a much better investment when one actually rents it out, so this makes sense only if one accepts that most international investors are insane.

Nor has London abandoned its social housing sector either — not yet. About a quarter of London’s households live in social rented housing, and many more than that in inner London. The prevalence of social housing has been falling since the 1980s — but slowly. Social housing is still on offer to almost a million households.

The vision of London as a ghost town can be disproved in an instant by the experience of actually being in London. Try to get on the Tube at Clapham Common at 8am, then tell me that London’s problem is underpopulation.

“London’s population is going up,” says Professor Christine Whitehead of the London School of Economics. “And there’s no indication that the new population is the wrong mix.”

“Mix” is an important word here. More than 50 years ago, in The Death and Life of Great American Cities, Jane Jacobs emphasised the merits of variety in city life. If a neighbourhood had a mix of homes, offices, factories, shops and nightlife, then the streets would be interesting, well used and, therefore, safe for many hours a day. More rigorous zoning might look tidy on a city map but would leave streets (and shops) unusably overcrowded at some times and deadly boring at others. Tedious and perhaps dangerous, such a neighbourhood would be fragile. Jacobs also advocated a mix of different industries so that ideas could spread from one to another. Her most famous example was Ida Rosenthal’s invention of the bra after working not in lingerie but in dressmaking.

Fundamental to all this, wrote Jacobs, was a mix of old and new buildings. Leaving aside unusual cases such as Venice, cities need a mix of higher-rent buildings and more decrepit low-rent buildings, because such buildings house different kinds of activity. Experimental projects, in particular, need somewhere cheap — the Silicon Valley garage, perhaps, or the east London warehouse. “Old ideas can sometimes use new buildings,” Jacobs wrote. “New ideas must use old buildings.”

This is London’s challenge: if only hedge-fund millionaires can afford to live there, then even the hedge-fund millionaires will not wish to. Artists, start-up hopefuls and hipster baristas need not only low-rent places to live but low-rent places to work. If London loses such places, then it will indeed lose its creative edge.

Still, London does not yet seem to be short of hipster baristas. Whitehead says: “I’ve heard that argument once a decade for the past 50 years.” It may yet come true — but so far, so good.

The trouble with creative destruction is that it is always easier to see what is being lost than what is being gained. Notting Hill seems pretty dull to me these days but Clapton Pond is on fine form: brothels have been replaced by bars; murderous dives have been replaced by gastropubs; fried-chicken joints have been replaced by coffee shops. The mix is changing but it’s still a mix, and it’s not obvious that the new mix is disastrous.

What would be disastrous would be if the lot were bulldozed to make way for apartment blocks in which nobody wanted to live because there was nothing to do outside. We must guard against the encroachment of such residential deserts, yet they remain rare in London. The city is, of course, a playground for the super-rich. But, for now, it remains much more than that.

Written for and first published at ft.com.

How to level the playing field

‘It costs something like a billion quid to turn a bottom-half Premier League club into one of the best teams in Europe’

They have dominated their national football league, winning 17 times in the past 50 years, far more than any rival. Indeed, only 10 other teams have managed to win the league at all since 1965. Can you guess the club?

You might be thinking Real Madrid — but no, Real have won 21 times in the past half century and Barcelona are not so far behind. Juventus would be a better guess — they have won 19 titles in the past 50 years, with rivals AC Milan boasting 10. Manchester United have 14, just ahead of Liverpool with 12.

But no. I am thinking of Havnar Bóltfelag. Affectionately known as HB, they are the Real Madrid of the Faroe Islands. The club is 111 years old — just a couple of years younger than Real — and just as dominant, albeit on a smaller stage. If Havnar Bóltfelag were ever to play Real, the entire population of the Faroe Islands could rattle around inside Real’s Bernabéu stadium with room to spare for some home fans.

The curious thing is that most European football leagues show a similar pattern of dominance. As sports economist Stefan Szymanski explains in his book Money and Football, looking at just the distribution of wins — typically 18-22 for the leading team over the past 50 years, and 11 or 12 champions in total — it is hard to tell the European leagues apart.

There are some exceptions (the French and Irish leagues have been more competitive, and the Scottish and Dutch leagues less so) but the regularity is striking. That might seem surprising given that the average revenue per top-tier club in England, Germany, Spain and Italy is more than $100m, while that in the Faroe Islands and Luxembourg is less than $1m. And, in case you were wondering, Luxembourg fits the pattern perfectly. The Real Madrid of Luxembourg (or should that be the Havnar Bóltfelag of Luxembourg?) is Jeunesse Esch, also just over a century old. It has won 20 titles in the past 50 years.

So what explains this widespread pattern in which one or two teams tend to dominate? Not the cost of fielding 11 players, certainly. As Szymanski points out, there are plenty of football teams around. Running a football club does not demand scale, like a mobile phone network or a nuclear power station. It’s more like running a soft drinks company: anyone can do it at any scale but Coca-Cola somehow manages to be the biggest around. (Coincidentally, Coca-Cola’s global market share is the same as Real Madrid’s share of the past 50 La Liga titles and Pepsi’s is the same as Barcelona’s.)

Here is a hypothetical question that might shed some light: why don’t Havnar Bóltfelag borrow some money and hire superstars such as Lionel Messi and Cristiano Ronaldo? Let’s assume that a sufficiently gullible bank could be found — the nearest banking centres, Reykjavik and Edinburgh, suggest that anything is possible.

The answer is that Havnar Bóltfelag is not the best place to showcase the talents of the world’s most expensive players. Partly this is a question of geography. But partly HB’s problem is its reputation: it doesn’t have one. Until the club had more name recognition, good players would be reluctant to join, and would have to be given extra financial incentives. Sponsors would feel the same. And while football spectators do like to watch big names playing attractive football, they are also loyal to their old clubs. Even if Real Madrid and Barcelona were somehow to become feeder clubs for Havnar Bóltfelag, it would take a while for their support to ebb and HB’s to grow.

Now apply the same logic to smaller clubs in large leagues, and the reason for big club dominance starts to become clear. Clubs such as Rayo Vallecano in Madrid or West Ham in London face no geographical handicap in challenging Real Madrid or Chelsea. But they would have to pay over the odds to attract players, staff and fans while simultaneously earning less from advertisers and global TV rights.

It is possible to bridge this brand-name gap if you are willing to lose enough money. “It costs something like a billion quid to turn a club from a bottom-half Premier League team to one of the best teams in Europe,” says Szymanski. Manchester City, Chelsea and Paris Saint-Germain have been transformed into top-flight clubs. They are all now in a position to make money — or at least, to lose no more money than any other top club — but nobody expects their owners to recoup the cost of that transition, at least not through the business of football.

The clubs with a large fan base, long history and global name recognition are the clubs with the most to gain from spending a lot trying to win football matches. For anyone else to challenge them requires very deep pockets. That is why winners keep winning.

But should we care about this sporting dominance? Szymanski points out that European football with its lopsided leagues has far outgrown American sports, which are carefully engineered to ensure competitive balance. Apparently, the global army of fans of Real Madrid, Manchester United and Bayern Munich don’t mind if they win a lot.

Written for and first published at ft.com.

Worming our way to the truth

‘Why does such a large policy push need to be based on a handful of clinical trials?’

It was one of the most influential economics studies to have been published in the past 20 years, with a simple title, “Worms”. Now, its findings are being questioned in an exchange that somehow manages to be encouraging and frustrating all at once. Development economics is growing up, and getting acne.

The authors of “Worms”, economists Edward Miguel and Michael Kremer, studied a deworming project in an area of western Kenya where parasitic intestinal worms were a serious problem in 1998. The project was a “cluster randomisation”, meaning that the treatment for worms was randomised between entire schools rather than between children within each school.

Miguel and Kremer concluded three things from the randomised trial. First, deworming treatments produced not just health benefits but educational ones, because healthier children were able to attend school and flourish while in class. Second, the treatments were cracking value for money. Third, there were useful spillovers: when a school full of children was treated for worms, the parasites became less prevalent, so infection rates in nearby schools also fell.

The “Worms” study was influential in two very different ways. Activists began to campaign for wider use of deworming treatments, with some success. Development economists drew a separate lesson: that running randomised trials was an excellent way to figure out what worked.

In this, they were following in the footsteps of epidemiologists. Yet it is the epidemiologists who are now asking the awkward questions. Alexander Aiken and three colleagues from the London School of Hygiene and Tropical Medicine have just published a pair of articles in the International Journal of Epidemiology that examine the “Worms” experiment, test it for robustness and find it wanting.

Their first article follows the original methodology closely and uncovers some programming errors. Most are trivial but one of them calls into question the key claim that deworming produces spillover benefits. Their second article uses epidemiological methods rather than the statistical techniques preferred by economists. It raises the concern that the central “Worms” findings may be something of a fluke.

Everyone agrees that there were some errors in the original paper; such errors aren’t uncommon. There’s agreement, too, that it’s very useful to go back and check classic study results. All sides of the debate praise each other for being open and collegial with their work.

But on the key questions, there is little common ground. Miguel and Kremer stoutly defend their findings, arguing that the epidemiologists have gone through extraordinary statistical contortions to make the results disappear. Other development economists support them. After reviewing the controversy, Berk Ozler of the World Bank says: “I find the findings of the original study more robust than I did before.”

Yet epidemiologists are uneasy. The respected Cochrane Collaboration, an independent network of health researchers, has published a review of deworming evidence, which concludes that many deworming studies are of poor quality and produce rather weak evidence of benefits.

What explains this difference of views? Partly this is a clash of academic best practices. Consider the treatment of spillover effects. To Miguel and Kremer, these were the whole point of the cluster study. Aiken, however, says that an epidemiologist is trained to think of such effects as “contamination” — an undesirable source of statistical noise. Miguel believes this may explain some of the disagreement. The epidemiologists fret about the statistical headaches the spillovers cause, while the economists are enthused by the prospect that these spillovers will help improve childhood health and education.

Another cultural difference is this: epidemiologists have long been able to run rigorous trials but, with big money sometimes at stake, they have had to defend the integrity of those trials against the possibility of bias. They place a high value on double-blind methodologies, where neither subjects nor researchers know who has received the treatment and who is in the control group.

Economists, by contrast, are used to having to make the best of noisier data. Consider a century-old intervention, when John D Rockefeller funded a programme of hookworm eradication county by county across the American south. A few years ago, the economist Hoyt Bleakley teased apart census data from the early 20th century to show that this programme had led to big gains in schooling and in income. To an economist, that is clever work. To an epidemiologist, it’s a curiosity and of limited scientific value.

As you might expect, my sympathies lie with the economists. I suspect that the effects that Miguel and Kremer found are quite real, even if their methods do not quite match the customs of epidemiologists. But the bigger question is why so large a policy push needs to be based on a handful of clinical trials. It is absolutely right that we check existing work to see if it stands up to scrutiny but more useful still is to run more trials, producing more information about how, where and why deworming treatments work or do not work.

This debate is a sign that development policy wonks are now serious about rigorous evidence. That’s good news. Better news will be when there are so many strong studies that none of them will be indispensable, and nobody will need to care much about what exactly happened in western Kenya in 1998.

Written for and first published at ft.com.

The rewards for working hard are too big for Keynes’s vision

The economist was right in that we are better off but at the cost of our free time

Working long hours pays off in monetary terms, but it means there is less time for pursuits

If John Maynard Keynes is looking down upon me now — he might make a good guardian angel for economists — then he is wondering why I am writing this column instead of lounging by the pool.

“Three hours a day is quite enough,” he pronounced in his 1930 essay Economic Possibilities for our Grandchildren. The essay offers two famous speculations: that people in 2030 will be eight times better off than people in 1930; and that as a result we will all be working 15-hour weeks and wondering how to fill our time.

Keynes was half right. Barring some catastrophe in the next 15 years, his rosy-seeming forecasts of global growth will be an underestimate. The three-hour workday, however, remains elusive. (Keynes was childless, but NPR’s Planet Money show recently tracked down his sister’s grandchildren and asked them if they were working just 15 hours a week. They were not.)

So where did Keynes go wrong? Two answers immediately spring to mind — one noble, and one less so. The noble answer is that we rather like some kinds of work. We enjoy spending time with our colleagues, intellectual stimulation or the feeling of a job well done. The ignoble answer is that we work hard because there is no end to our desire to outspend each other.

Keynes considered both of these possibilities, but perhaps he did not take them seriously enough. He would not have been able to anticipate more recent research suggesting that the experience of being unemployed is miserable out of all proportion to its direct effect on income.

Perhaps Keynes also failed to appreciate that there is more to keeping up with the Joneses than conspicuous consumption. We want to live in pleasant areas with good schools and easy access to dynamic employers. As a result, we find ourselves in ferocious competition for a limited supply of desirable houses.

There are subtler explanations for Keynes’s error. As the late Gary Becker observed in an essay with Luis Rayo, Keynes may have been led astray by contemplating the leisured elite of the 1920s. The income flowing to the “1 per cent” was not much different back then, but they owned much more of the wealth. A gentleman in 1920s Bloomsbury drawing income from capital was just as wealthy as a partner at a 21st-century New York law firm billing at a vast hourly rate. Yet it is no mystery that the gentleman spent his time at the club while the lawyer is working her socks off.

A few years ago, the economists Mark Aguiar and Erik Hurst published a survey of how American work and leisure had evolved between 1965 and 2005. Both men and women had more leisure time — although nothing like as much as Keynes had expected. But some people defied this trend. The best educated and the highest earners, both men and women, had less free time than ever. Starting in the mid 1980s, this elite began to drop everything and work ­furiously.

Perhaps the real story, then, is that we are trying to keep up not with the Joneses but with our work colleagues. By pulling the longest hours and taking the least leave, we climb the corporate ladder. It may be no coincidence that the collapse in leisure time began in the 1980s, at a time when inequality at the top of that ladder was surging. The rewards for working hardest are large.

We are still 15 years away from the world that Keynes imagined. If we are to live up to his laid-back expectations, much will have to change. We’ll need plentiful access to nice schools and neighbourhoods, and less of a rat-race culture in the office.

That sounds welcome. But perhaps the fundamental truth is that many of us enjoy working hard on something that feels worthwhile, or aspire to such work. John Maynard Keynes was a wealthy man, but that did not stop him working himself to death.

Written for and first published at ft.com.

It’s tough turning ideas into gold

‘If innovators make no money at all, they will end up creating for the love of creation rather than for any financial reward’

Alchemy, the ancient art of turning base metals into precious ones, was built on more than one misapprehension. The obvious error is that it is impossible to turn lead into gold. (Not quite impossible, actually. Chemistry will not do the job but a particle accelerator will, although not cheaply. In 1980, researchers bombarded the faintly lead-like metal bismuth and created a few atoms of gold. The cost was a less-than-economical rate of one quadrillion dollars an ounce.)

But there is a subtler mistake — not a scientific one but a matter of economics. “The alchemist fallacy” is the belief that once a simple method is found for turning lead into gold, gold will continue to be precious. We don’t have to rely on economic theory to refute this conclusion, because we have a fascinating case study of a close parallel.

Twenty-six million years ago, some cataclysmic event in the Eastern Sahara raised the temperature of silica sand to well over 1,000 degrees. The result was a large deposit of a lustrous material the colour of a lemon’s flesh. A fragment of this precious stuff was used to make jewellery for Tutankhamun’s tomb. (The story is well told in Steven Johnson’s book How We Got to Now.) The substance could be quarried but not manufactured.

While alchemists never figured out how to turn lead into gold, other craftsmen did develop a process with much the same economic implications. They worked out how to transform silica sand, one of the most common materials on earth, into the beautiful, versatile material we know as glass. It has an astonishing variety of uses from fibre optics to microscopes to aeroplane fuselages. But while gold remains highly prized, glass is now so cheap that we use it as disposable packaging for water.

When it was possible to restrict access to the secret of glassmaking, the guardians of that knowledge profited. Venetian glassmakers were clustered together on the island of Murano, where sparks from the furnaces would not endanger Venice itself. Venice had less success in preventing the secrets of glassmaking from spreading. Despite being forbidden on pain of death to leave the state of Venice, some of Murano’s glassmakers sought fortunes elsewhere. The wealth that could be earned as a glassmaking monopolist in some distant city must have been worth the risk.

That is the way of new ideas: they have a tendency to spread. Business partners will fall out and set up as rivals. Employees will leave to establish their own businesses. Time-honoured techniques such as industrial espionage or reverse engineering will be deployed. Sometimes innovators are happy to give their ideas away for nothing, whether for noble reasons or commercial ones. But it is very hard to stop ideas spreading entirely.

A few years ago, the economist William Nordhaus tried to estimate just how fallacious the alchemist fallacy is — how much of the social gains from innovation does the innovator manage to keep hold of? If the answer is anywhere near 100 per cent — even 50 per cent — then there is no fallacy at all. But if the answer is near zero, then innovations are swiftly copied, benefiting competitors and above all consumers.

Nordhaus was writing in the wake of the dotcom bubble, and pointed out that the valuations of “new economy” companies could be justified only if they were able to retain about 90 per cent of their value to society. This is a slice of the pie to make the most powerful and sophisticated monopolist dream. Nordhaus, pointing to the rapid demise of many dotcom firms and the tight margins of others, reckoned that the proportion was rather lower than that.

Looking at data from the United States between 1948 and 2001, Nordhaus estimated that corporations were able to keep about 3.7 per cent of the social value of their innovations. The remaining 96.3 per cent went to everyone else, mostly to consumers.

Nordhaus’s estimate is uncertain but has the ring of truth about it. Even a company such as Apple, which has a gift for holding on to a good proportion of the returns from innovation, has seen its iPad, iPhone and MacBook Air relentlessly chased down by competitors.

All this raises a question: should we wish that the innovator’s profit share was higher or lower? There is a balance to be struck. When innovators keep too much money, the benefit of using or recombining new ideas spreads too slowly. But if innovators make no money at all, then they will end up creating for the love of creation rather than for any financial reward. That may be fine for pop songs and poetry but less so for nuclear fusion or an HIV vaccine. Costly research programmes will not be funded.

The right balance depends on the innovation in question, and how expensive it is to develop. We probably need better incentives to create some new medicines. Yet our intellectual property system gives too much protection to ideas that would have been created anyway, such as simple software, business methods and Mickey Mouse. It is no surprise that the Venetian doges tried to keep the glassmakers in Murano. We should be grateful that they failed.

Written for and first published at ft.com.

Why wishful thinking doesn’t work

‘Careless nudges are no more welcome in public policy than at a domino-toppling event’

Three years ago, the University of Vermont in Burlington began to experiment with a few nudges towards a healthy, sustainable lifestyle. First, in 2012, campus outlets and the company operating the vending machines were required to make sure that at least 30 per cent of the drinks on offer were wholesome stuff such as vegetable juice, low-fat milk and water. A few months later, selling bottled water on campus was banned outright. The aim, pushed hard by student campaigners, was to encourage students to fill reusable bottles with tap water instead.

So, how did the Vermont experiment go? A study by Elizabeth Berman and Rachel Johnson (of the University’s own Department of Nutrition and Food Sciences) was recently published in the American Journal of Public Health. The researchers found that “per capita shipments of bottles, calories, sugars and added sugars increased significantly when bottled water was removed . . . As bottled water sales dropped to zero, sales of sugar-free beverages and sugar-sweetened beverages increased.”

In other words, the policy backfired with both barrels. Students didn’t switch to tap water, they switched to the likes of Coke and Diet Coke instead. All this would be just an amusing curiosity — one more example of student campaigners who are all heart and no brains — if it weren’t for the fact that more mature policy makers often commit similar blunders on much broader canvases. We would do well to learn some lessons from the University of Vermont’s experience.

The first lesson is that when it comes to saving the planet, people focus on what they can see. Type “environmental impact of concrete” into a search engine and you are likely to see a page filled with scholarly analysis pointing out that the impact is very large indeed, because cement production releases vast volumes of carbon dioxide. Type “environmental impact of bottled water” instead and your search results will be packed with campaigning groups seeking to persuade you to change your ways.

This is understandable: I can’t do much about concrete but I can stop drinking bottled water. But being a logical target for campaigners is not the same as being a logical target for policy action.

The second lesson is that we often struggle to deal with multiple goals. The University of Vermont wanted to reduce the flow of plastic water bottles to landfill but also wanted to encourage students to be healthy. There’s a clear conflict between these goals. Water is as healthy a drink as you can find, yet that was exactly what the University of Vermont was banning from vending machines. Wishful thinking provides a resolution — if everyone just drank tap water then there would be no problem. But wishful thinking is not an excuse for setting no priorities.

We see this sharply in the debate over nuclear power. We want to reduce the greenhouse gas emissions that result from burning fossil fuels. We also want to avoid radioactive waste and the risk of radiation leaks. In response to a genuine policy dilemma, politicians have tended to plump for wishful thinking every time, typically involving wind turbines.

The third lesson is that the much-vaunted notion of “nudging” doesn’t always help navigate a complicated policy maze. Nudging means using default options, information design and similar techniques to achieve policy goals. It can be very successful. But careless nudges are no more welcome in public policy than at a domino-toppling event. If you pick a questionable target (bottled water) and fudge a key policy dilemma (the environment vs health) then nudging isn’t going to solve your problems.

So what can be done? One approach is to try to reach policy goals with the help of market signals. The classic example of this is a carbon tax, levied on fossil fuels to reflect their carbon-dioxide emissions. The advantage of this approach is that it encourages everybody at any stage of production or consumption to take actions that reduce emissions, because those actions will save them money. A truck manufacturer might develop a cleaner engine, a logistics company might find a more efficient delivery algorithm, and the final consumer might decide to consume a little less.

The idea of using the price system to solve environmental problems is widely accepted by economists but, alas, it finds itself stranded in the policy doldrums. Ponder this: the Pope recently argued that climate change was a grave problem but he opposed market-based responses. Meanwhile the US Republican party likes market-based responses but isn’t so convinced about climate change.

One other advantage of using environmental taxes is that people can decide on their own priorities. A lot of what we do has consequences for the planet — including breathing — and so part of the problem we face is deciding what is worth doing anyway.

Perhaps it is time for a confession. I am writing this column on the hottest July day recorded in British history. At my left hand is a glass of chilled sparkling water, and next to the glass is a plastic bottle to top it up. If there had been a tax on that bottle, it is a tax I would willingly have paid.

Written for and first published at ft.com.

George Osborne’s Magic Has Us Fooled, For Now

The chancellor can alter the law but cannot make costly workers worth hiring, says Tim Harford

He has mastered the art of misdirection as well as any stage magician. Everyone knew George Osborne was going to butcher the tax credit system on Wednesday, more or less halving the income at which they begin to fall away. But few expected him to announce a much higher minimum wage, and he did it with such an extravagant flourish that no one clearly remembers seeing him wield the cleaver.

For most of the poorer working households who qualify for tax credits, the combined effect of Mr Osborne’s Budget will be to make them worse off financially, and to push them away from the labour force by raising the effective rate of tax they pay.

Monique Ebell of the National Institute of Economic and Social Research reckons that a single mother working 30 hours a week at the minimum wage will be more than a £1,000 a year worse off in two years’ time than she is today, despite the increase in the wage she must legally be paid.

That assumes, of course, that she keeps her job at all. This is the big question about the minimum wage: will it increase the earnings of low-paid workers, or price them out of the job market entirely? Should we expect to see these workers laid off and replaced with one-touch espresso machines, automatic checkouts and call-centre workers from India? The minimum wage is a delicate balance, and Mr Osborne has put his thumb on the scale.

The chancellor’s aim is to raise the minimum wage for those over 25 beyond £9 by 2020, from £6.50 today. That is dramatic, although not quite as dramatic as it first seems. Mr Osborne is setting the minimum wage where it might be if the economic crisis of 2008, and the long stagnation that followed, had never happened. He is hoping that employment will not suffer. He has a few other countries to look to as a precedent. France is one example, and it is not encouraging. Australia is a more hopeful case.

Mr Osborne’s move would once have been unthinkable from a Conservative chancellor. A quarter of a century ago, the conventional wisdom was that the idea of a minimum wage was absurd at any level. The logic of that position was simple enough. If the minimum wage was below the market-clearing wage — at which employees want to work the same number of hours that businesses want to hire them for — it would be irrelevant; if it was above, it would be worse than useless. Productive workers do not need a minimum wage because they will anyway be well paid. Less productive workers will be harmed by a minimum wage because employers would rather sack them than pay more than they are worth. One does not simply repeal the laws of supply and demand.

The world has moved on since then, and we know that while supply and demand matter, there is more to the labour market than the simple story above.

Some employers have market power and could pay higher wages if they were forced to; the higher minimum wage may simply redistribute from employers to low-paid employees. Another possibility is that if forced to pay higher wages, employers will invest in training and equipment to justify the labour expense. On this view, wages do not need to follow productivity; productivity can be led by wages.

A third explanation is that since many low wage jobs are in non-traded sectors such as retail, employers will simply put up prices, spreading the burden of the higher minimum wage across all consumers, and possibly reducing inequality.

There is also the argument that higher wages can encourage workers to show up more often and smile at the customers. This is true, but in most cases managers will have reached that conclusion by themselves without the need for a legal minimum.

A large body of empirical evidence suggests either that reasonable minimum wages do not destroy jobs at all, or that they do not destroy very many. The evidence is, of course, mixed and contested.

Much of it comes from the US and concerns the experience of teenagers, who — in the words of Alan Manning of the London School of Economics, “represent about 2 per cent of hours worked and 98 per cent of the studies of the minimum wage”. But it is clear enough that if modest increases in the minimum wage were disastrous for jobs, we would know that by now.

Whether the chancellor’s wage rise counts as “modest” is far more questionable. Professor Manning is guardedly optimistic: he thinks that the bold increase in the minimum wage is worth a try. But he is nervous, and so am I. We are at the edge of what the data can tell us. Mr Osborne is about to provide a fascinating new case study.

The best scenario is that the minimum wage helps to drive up British productivity, which has long languished. Employers invest in training, and rather than replacing workers with machines they give them the latest tools to do their jobs.

To the extent that productivity does not rise, employers absorb the costs or pass them on to consumers, equitably bearing the burden of giving hard-working people a decent wage.

A gloomier scenario seems more probable for some sectors, especially social care. The law of supply and demand turns out to matter after all. Faced with a sharp increase in the minimum wage that runs well ahead of what the Low Pay Commission has felt able to endorse, employers lay off many workers and reduce the hours of others. The welfare bill rises and — as so often in the past — it proves much harder to create jobs than to destroy them.

My own bet is somewhere in the middle. We will discover that Mr Osborne has pushed too hard, and that the minimum wage must be allowed to slip back again relative to median earnings. Some jobs will be lost, a lesson will be learned, and Mr Osborne’s political purposes will have been served. He will be hoping to have upgraded his own job to that of prime minister by then, which may be appropriate: he is a masterful politician but has never shown much grasp of economics.

Written for and first published at FT.com

George Osborne’s gamble with jobs

My response to the Summer Budget went up on the FT website yesterday:

The sharp hike in the minimum wage in the Budget was a shock, but it was true to form for the UK chancellor of the exchequer: clever politics and dubious economics. It is telling that, where the Low Pay Commission used to consider the evidence and carefully balance the risks and rewards of a higher minimum wage, it must now recommend whatever George Osborne tells it to recommend.

The risk is clear: forced to pay up to £9 an hour, many businesses will find that they would rather find other ways to conduct their affairs — buying robots, offshoring key functions or moving overseas entirely. Bankruptcy is, of course, another option.

 

Mr Osborne’s gamble is that some businesses will simply eat the cost of higher wages (unlikely), or train their workers better and give them better tools so that the higher wages can be justified with higher productivity. It is possible this may work. It is enormously risky, and if the move is the wrong one it will be hard to reverse. The lesson of the 1980s is that, once lost, jobs are not easy to find again.

One might ask why the chancellor is willing to take such risks and to order the Low Pay Commission to do his bidding rather than be guided by evidence. The answer is not hard to find: Mr Osborne needs political cover. He is hacking away at the welfare state, notably the system of tax credits that was designed to encourage people to work rather than stay at home.

One can only guess what Milton Friedman, one of the inspirations behind the Thatcherite revolution, would have made of all this. In place of a carefully designed system of incentives for people to go to work, we are to be offered a wage increase set by a politician’s whim. Friedman knew that, even in the complex market for jobs, one does not simply abolish the laws of supply and demand.

Mr Osborne promised a Budget for working people but reality does not match that sound bite. The biggest tax break was for people inheriting expensive homes from their parents; and, while benefits for the working poor were being squeezed, those for pensioners were — as always — protected. Those who hoped for radical and logical tax reform have been bitterly disappointed.

As for working people, many will thank the chancellor as their wages rise. Others will become unaffordable and will lose their jobs. No doubt they will be scapegoated as scroungers in some future Budget speech. It is possible that Mr Osborne’s gamble will pay off. It is even possible, although unlikely, that it will pay off spectacularly. But it is reckless, and it is not his job that is on the line.

In search of the perfect match

‘One algorithm had to cope with pairs of romantically attached doctors who wanted two job offers in the same city’

When it comes to finding the perfect match, nobody wants to be left on the shelf but the Arunta — a polygamous aboriginal tribe from the area around Alice Springs — used to take things to extremes. As described by anthropologists in the 1920s, the father of a newborn Arunta boy would get together with the father of a newborn girl to arrange a future marriage. The betrothal was not between the two babies, of course — that would be leaving things far too late. Instead, the engagement was between the baby boy and the first daughter that the baby girl had when she became a mother herself.

This astonishing process is called “market unravelling”, and it is not limited to the Arunta. As described in Alvin Roth’s new book, Who Gets What — and Why, hospitals make early offers to untried junior doctors. Law firms make early offers to law student freshers. Oxford and Cambridge make offers many months before the students in question sit their exams.

This is not a sensible situation because if everybody could agree to wait, then more information would emerge, allowing more compatible matches. Yet there is an incentive to break ranks and make early “exploding” offers. If those time-limited offers are any good, then students will often accept them rather than take the risk of waiting. The logic of the situation pulls these early offers ever earlier, sometimes absurdly so. Everybody loses but no individual can change things.

One response is to agree a rule banning early offers. That is what the US National Association for Law Placement did in the 1980s: it ruled that any job offer made to a first-semester law student had to remain open until the end of that semester. It wasn’t long before the lawyers had found the loophole: mediocre offers paired with massive time-limited signing bonuses.

Another possibility is to use a central clearing house. That is what the Boston school system did. Parents listed at least three schools in order of preference, and the clearing house put every child into their first choice school where possible. Any schools with spare places would then admit students who’d listed the school as second choice, then third choice, and so on. Four out of five students got their first choice, yet parents hated the system. Why?

The problem was that parents had just one shot at a good school. Popular schools filled instantly, making second choices almost irrelevant. Parents who didn’t understand the game might apply for several popular schools and get nothing. Those who understood the problem found themselves second-guessing the clearing house, using their precious first choice on a compromise school rather than the high-risk approach of saying what they truly wanted. The system produced cynical, alienated parents.

The problem is easier to describe than to solve. But there is a way to fix unravelling markets: call Alvin Roth. An engineer by training — albeit one with a Nobel Memorial Prize in economics — Roth designs markets with an engineer’s practical mentality. With his colleagues, Roth has designed stable clearing houses for doctors, fixed the school application systems in Boston and in New York City, and even created kidney donation networks.

At the heart of many well-functioning clearing houses is something called the deferred acceptance algorithm. The algorithm begins with the following input: each student submits a list of their preferred schools, from first choice to last, and each school submits a ranked list of their preferred students. Armed with these rankings, a computer can swiftly handle the rest. First, each school provisionally fills its places with the top students on its list; then each student provisionally accepts the best offer she has received and rejects the others; each school then extends further offers to fill the spaces that these rejections opened up. The process continues (inside the computer) with each student keeping only the best offer received so far, and with each school working down the list of students and making fresh offers as the rejections come in.

There are two important features of the deferred acceptance algorithm. The first is that people can safely tell the truth about their favourite schools — there is no disadvantage to aiming high. The second is that the algorithm’s allocation is stable. There will never be a pair of school and student who wish they were matched to each other but whom the algorithm sent elsewhere. This matters because if such pairs exist, they have an incentive to strike side deals, undermining the whole system.

The deferred acceptance algorithm is just the start of a successful market design, because details matter. In New York City, there are different application procedures for certain specialised schools. When assigning hospital residencies, the US National Resident Matching Program needed to cope with pairs of romantically attached doctors who wanted two job offers in the same city. These complexities sometimes mean there is no perfect matching algorithm, and the challenge is to find a system that is good enough to work.

Economists such as Alvin Roth are like engineers or doctors. They cannot settle for understanding a system in theory; they must solve practical problems too. It’s a hopeful direction for economics — and an essential one, if economists aren’t to be left on the shelf themselves.

Also published at ft.com.

The psychology of saving

‘There is one dramatic success for behavioural economics — the way it has shaped pensions’

“THERE ARE IDIOTS. Look around.” So began a famous economics paper by Larry Summers — a lauded academic before he became US Treasury secretary. It is perhaps the most concise expression of behavioural economics, the branch of economics that tries to take psychology seriously.

Behavioural economics is appealing not only because it is realistic but also because it is vastly more charming than the traditional variety. Championed by economists such as Richard Thaler (co-author of Nudge and author of a new book, Misbehaving ) and psychologists such as Nobel laureate Daniel Kahneman (author of Thinking, Fast and Slow), it has triumphed in the “smart thinking” section of the bookshop and exerted increasing influence in academia.

It can be hard to turn psychological insights into rigorous academic models, and even harder to turn them into good policy. But there is at least one dramatic success for behavioural economics — the way that it has shaped pensions. At a recent Financial Times event, Professor Thaler rightly celebrated this as the field’s greatest triumph.

Other than Thaler’s own evangelism, the reason for this success is twofold. First, when it comes to pensions there is a large gap between what we do and what we should do. Second, bridging that gap is fairly simple: we need to encourage people to save more, and in most cases those savings should flow into simple, low-cost equity tracker funds. The only comparable example that springs to mind is smoking: many smokers are making themselves unhappy and would be better off if they could find a way to stop. And as a classic research paper in behavioural economics concludes, taxes on cigarettes seem to make smokers and potential smokers happier by prompting them to quit, or never start.

Given the problem — people need to be nudged into saving more — the biggest pension policy breakthrough has been automatic enrolment, a cornerstone of modern UK pension policy and widely used in the US too. A typical defined contribution pension invites people to pay money into a pension pot, often enjoying tax advantages and matching contributions from an employer. Yet people procrastinate: money seems tight, retirement is a long way off, and who wants to fill in forms? Automatic enrolment reverses the default, deducting pension contributions from our payslips unless we take active steps to opt out. The process respects our autonomy — you can opt out if you wish — but makes it easy to do what we probably should be doing anyway.

A clever supplement to this approach is “Save More Tomorrow”, a scheme in the US whereby people make an advance commitment to redirect part of their pay rises into the pension. At a 50/50 ratio, for example, a 2 per cent pay rise becomes a 1 per cent pay rise and a 1 percentage point increase in pension contributions. It doesn’t take long for a 3 per cent contribution (which is inadequate but typical in the US) to become something more sensible, such as 10 or 15 per cent. Thaler has been a driving force behind both ideas.

Of course, these tactics do not work for everyone. I once spoke at a book festival in Australia and found that a slice of my modest fee had been automatically invested in an Australian pension for me. This benefited nobody except some administrators and the postman who delivered the letters from Australia, detailing the evaporation of my tiny pension pot.

A more serious difficulty is choosing the right level of default contribution. A default that is too aggressive — automatically deducting 25 per cent of salary — jolts most people into opting out. A default that is too low, such as 3 per cent of salary, could conceivably be worse than the old opt-in default of zero. Many people who might have taken an active choice to save 6 or 7 per cent rather than nothing end up settling instead for the default. As mentioned, 3 per cent is a common level for automatic enrolment in the US, for no good reason other than historical accident. Yet it is dangerously low.

There is also a painful conflict of interest at the heart of any corporate pension plan. From the perspective of classical economics, companies will offer generous pensions if they want to attract capable staff. It is expensive to subsidise a pension but staff value the subsidy, making it worthwhile.

From the more realistic perspective of behavioural economics, a tension emerges. A benevolent planner, armed with behavioural insights, would nudge people into a passive pension investment with almost no conscious thought. But a corporate human resources director would want to remind employees how generously their pensions are being subsidised. That means frequent reminders and ample opportunity to admire the pension pot — even if such admiration leads to anxiety about uncertain returns, or expensively trading shares within the pension.

There are approaches that might keep both the behavioural economist and the HR director happy. For example, a pension pot that is expressed in terms of daily or weekly income in retirement, adorned with photographs of cruise ships, seems more appealing than an abstract and rather meaningless lump sum.

We cannot blame behavioural economics for this tension but it is real. As automatic enrolment becomes the norm, it will be important to keep an eye on how corporations respond.

Written for and first published at ft.com.