An Insider's Guide to the Economy

Book Review:

Tim Harford, "The Undercover Economist: Exposing Why The Rich Are Rich, The Poor Are Poor -- And Why You Can Never Buy A Decent Used Car!", Oxford University Press, 2006.
~and~
Tim Harford, "The Undercover Economist Strikes Back: How to Run -- Or Ruin -- An Economy", Riverhead Books, 2014.

The last time on my blog that I reviewed two books together was more than a year ago, when I wrote "Of Animals and Machines". Both of those books (Animal Spirits and The Second Machine Age) were about economics; this time, both books are about economics again -- but by one author.

Tim Harford is an economist, journalist, TED speaker, and author of several books. His first book, The Undercover Economist, is probably his most famous. The sequel, The Undercover Economist Strikes Back, arrived almost a decade later. The main difference between these books is that the former focused more on microeconomics, whereas the latter focused more on macroeconomics. There is also a difference in style: while the original is written like a standard nonfiction book, The Undercover Economist Strikes Back uses a dialogue style. In any case, I think it makes sense to read these books together. Furthermore, both are listed on Conceptually's bookshelf as books that can improve one's "cognitive toolkit". (You may notice that there is a third Harford book on that list...)

To put it simply, The Undercover Economist is a popular exposition of (mostly mainstream) economics. It avoids mathematics and tries to explain, in plain English, the underlying logic of various economic "laws". And whence the title? As Harford explains in the Introduction:

"This is a book about how economists view the world. In fact, there might be an economist sitting near you right now. You might not spot him -- a normal person looking at an economist wouldn't notice anything remarkable. But normal people look remarkable in the eyes of economists. [...] My aim in this book is to help you see the world like an economist." (pp. 1-3)

Part of seeing like an economist is to understand that something as simple as a cappuccino from a bookstore café takes a complex system to produce -- a system which, despite having no single person in charge, works remarkably well. The economist can also apply lessons from the smooth-running bookstore to understand chaotic traffic jams, poor countries, and the mystery of why you supposedly can't buy a decent secondhand car. Harford starts off by asking: who pays for your coffee?

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Chapter 1 of The Undercover Economist explores the question of how Starbucks can get away with asking $2.55 for a cappuccino (in 2006 prices) when it costs less than a dollar to make. Part of the answer is that their cafés are often located nearby transit stations where commuters are willing to pay for convenience. But this also means Starbucks is making less profit than you might think, since they have to pay high rents to the landlord. This is the power of scarcity. (Note that the reason why rents are high in the first place is that rush-hour customers are willing to pay high prices for convenient coffee.) Scarcity power can also be the result of cartels trying to keep competition low, e.g. by lobbying politicians. How can we tell whether the scarcity is "natural"? Harford offers a rule of thumb: if it's fairly easy to set up a new company and compete, foul play is less likely to be the cause of high industry profits.

Speaking of getting ripped off, the next chapter exposes the tricks supermarkets (and other stores) use to target customers that are more or less price-sensitive. One way is to use "discount cards" to keep track of what the customer buys, and then offer coupons for specific products. Another way is to charge different prices for groups such as children, the elderly, or local workers. Finally, the firm can simply add pricey "extras" (like Fair Trade coffee with chocolate powder and whipped cream) so that customers who are willing to pay more can incriminate themselves. Supermarkets in upscale neighborhoods might place more expensive items (e.g. organic food) more prominently in view. In economics this is called price discrimination. If you don't want to be fooled, Harford's advice is to always notice and compare prices and pick the cheaper alternative (unless you have expensive tastes and don't need to save money). But price-targeting can be efficient if it opens up a new market without affecting the old market.

This brings us to the topic of Chapter 3: how can we obtain outcomes that are both efficient and fair? In a competitive free market, you don't have to buy something if you don't like the price -- which means that the system of prices reveals information: namely, how much the product is worth to you. Likewise, a shop won't sell something for a price that is lower than its cost of production. In this way, perfect markets "tell the truth", in the words of Tim Harford. Therefore, they can aggregate people's preferences and improve efficiency. A government cannot process such complex information. A government can make things fairer by redistributing income, but in theory one could also achieve a fair and efficient outcome by levying a one-time lump-sum tax to adjust the starting position.

Of course, economies in the real world often fall short of perfect markets. In the following chapter, Harford discusses a kind of market failure known as an externality. For example, traffic jams cause air pollution (as well as noise, accidents etc.) that negatively affect bystanders. And drivers do not pay for these costs, since they're not taxed per trip (so they have little incentive to use other options like cycling or walking). From the perspective of an economist, what matters is not the average price per journey, but the marginal price (i.e. the price for one extra trip). Ideally, this price should reflect the cost of the externality. Unfortunately, calculating and implementing this charge in practice is not always straightforward. Another kind of externality, discussed in Chapter 5, is missing information. When sellers of used cars have inside information about the quality of their cars, buyers are less willing to pay high prices for fear of acquiring a "lemon" (junk). But sellers of good cars ("peaches") won't sell if the price is too low -- so the outcome is that there is no market except for lemons. Similar situations can occur in the market for insurance (since insurers don't know the risk profile of their customers), and being insured may even cause people to get careless! (This is known as moral hazard.) Ways to address information gaps include credible signals, and government provision of goods (although both have drawbacks).

Chapter 6 talks about the "dot-com bubble" of 1998-2000 in which tech share prices took a roller-coaster ride. In theory, stock prices should follow a random walk, because any predictable movements are quickly exploited until they disappear. But one could also try to analyze stock prices in terms of the "fundamentals" of a company (i.e. predicted future profits), and see if the current price is over or under the value. Unfortunately, investors often follow the crowd, hence why bubbles happen. Tim Harford's advice for investing in the stock market is to (i) know what market insiders are ignoring; and (ii) look for the unique capability that gives a company scarcity power and therefore long-term profitability. Beware: the Internet "eats into scarcity power" (p. 153).

Next, the author tells the story of how economists in the 1990s helped design radio spectrum auctions using game theory. Governments wanted to grant the licenses to the telecom companies who would make best use of them, and auctions have the advantage of revealing who is most confident in their business plans and technologies. As a bonus, they also raise money for the government. The story in this chapter is closely related to the chapter on market design and auction theory from Niall Kishtainy's book, wherein economists are portrayed as engineers or dentists, rather than pure armchair theorists.

Departing somewhat from microeconomics, The Undercover Economist tackles the question of developing countries in Chapter 8. Places like Cameroon suffer from corruption, autocracy, extortion and so on, resulting in poor infrastructure, reduced investment, crime and excessive red tape. Systems like these often feature perverse incentives: for instance, farmers don't have an interest in maintaining dams unless doing so would benefit them, yet international donor agencies are incentivized to build big, expensive projects like dams in order to raise more money and look good -- with the result being less effective irrigation. Thus, simply importing technical infrastructure won't solve poverty; societies need to incentivize successful, productive business. On a brighter note, Chapter 9 examines the global economy and the trade that enables Americans to buy Belgian Duvel beer and the Chinese to buy American McDonalds fries. The economic idea of comparative advantage explains why trade barriers are counterproductive: not only do tariffs hurt foreign companies, they also hurt local consumers because people must pay higher prices. Trade barriers aren't even necessary to protect jobs -- we pay for imports through exports. Indeed, the Lerner theorem states that a tax on imports has the same effect as a tax on exports. On the other hand, free trade can lead to economic changes that might disadvantage some folks. But as Harford points out, even without foreign competition, an economy loses and creates jobs all the time. On balance, globalization reduces poverty, which can even lead to better environmental standards. For instance, Harford cites the following graph, adapted from Wheeler (2001):

Urban air quality and foreign investment in China

Finally, Chapter 10 is a case study of China, which has been transformed in the last couple of decades. After the failures of Mao, some liberalization occurred under Deng Xiaoping, leading to huge increases in agricultural productivity during the 1980s. The government was able to invest enormously in infrastructure thanks to high savings rates. Moreover, returns on investment rose due to increased competition (which generates better information than socialist central planning). China grew as an exporter, and opened itself to foreign investors -- the result being an influx of technology and expertise. China's commitment to education, and its connections to Hong Kong and Taiwan also helped. For all these reasons, China is now far richer than India. Many people can now open their own hair salons rather than work in sweatshops. As Harford puts it, economic growth is about "... more choice, less fear, less toil and hardship" (p. 252).

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While I read the first edition of The Undercover Economist, there is also an updated edition with a new chapter available for free here on Harford's website. The new chapter deals with the 2007-2008 financial crisis, explaining it as the result of bad gambles. Complex mortgage-backed securities (like collateralized debt obligations, or CDOs) were meant to provide steady sources of income for banks and investors, but the underlying risks were miscalculated. It was assumed that "subprime" loans would not go default in clusters -- but that's exactly what happened when the housing bubble burst. The repackaged CDOs that were designed to protect investors ended up magnifying the risk. Of course, the story is more complicated; a combination of lax regulation and the trading of credit default swaps (an intricate type of insurance against bad loans) encouraged banks to take on too much risk. When the crisis happened, most of the damage was caused by a lack of access to credit. But things could have been far worse if governments didn't bail out the banks.

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This offers an appropriate segue into the second book, The Undercover Economist Strikes Back. Like this century's recession, the Great Depression of the 1930s prodded economists to ask what was going on, why, and what could be done. Thus, macroeconomics was born: the bird's-eye view of the economy as a whole. Whereas the microeconomist looks at individuals' and firms' incentives and decisions, the macroeconomist looks at unemployment, systemic shocks, aggregate demand and more. Famous early macroeconomists include John Maynard Keynes, Simon Kuznets, James Meade, and Bill Phillips. It is with Phillips that we start our journey: in the Introduction, Harford tells the story of MONIAC, the "Monetary National Income Analog Computer". The machine built by Phillips (who was previously an engineer) was the first computer model of a country's economy, albeit using hydraulics. Two MONIACs could even be connected via pipes to represent imports and exports. The attitude that Bill Phillips had of the economy was that, like a machine, it can occasionally suffer malfunctions, which can be fixed. That's not necessarily easy, as Harford notes:

"Tempting as it is to think that it would be plain common sense to run a modern economy by extrapolating from our personal experiences of running a household or a firm, we shall see that such thinking can lead us badly astray. If keeping a major economy running smoothly were no more challenging than balancing a checking account, I wouldn't feel the need to write this book and you wouldn't have an interest in reading it." (pp. xxiv - xxv)

Starting in Chapter 1, the reader is placed in the "lead role" of the economy, with Tim Harford coming along as the advisor. One of the key indicators on the economic dashboard is the gross domestic product (GDP), the "total value of all the stuff that is produced in the economy" (p. 4). While GDP only measures monetary value, it happens to be the case that rich countries tend to have better environments, better education, less hunger, and so on. When the GDP shrinks for several months, we call it a recession -- and one of the consequences is unemployment (i.e. misery). Recessions may happen for various reasons. In Chapter 2, Harford uses the Capitol Hill Babysitting Cooperative as a case study in printing money to help raise the demand for goods and services to the level of potential supply. Members of the co-op in the 1970s could trade "scrip" for babysitting services. The problem was that families were not issued enough scrip to feel confident spending it -- and so there was little babysitting taking place, even though people were willing to babysit. So why didn't they just change the "price" of babysitting? Well, the phenomenon of sticky prices means that people tend to resist pay cuts. In this case, what did work was issuing more scrip. However, creating more money is not always a good idea, as Chapter 3 explains. It can lead to excessive inflation (rising prices), or even hyperinflation (a rate of inflation of over 50% per month). Under such conditions, your savings become worthless, banks are unwilling to lend money, and people generally don't have such a great time.

So, how much money should you print? Well, central banks tend to aim for an inflation rate of 2% because some inflation makes it easier to cut real wages when needed, and because deflation is a more serious threat than mild inflation. Deflation makes it harder for people to pay back loans, and people hold back on spending since they expect cheaper prices in the future. This is what contributed to the Great Depression. Of course, the 2% target isn't holy, and Harford suggests that 4% inflation might be even better for avoiding a liquidity trap (a recession where the nominal interest rate is zero, and printing money doesn't increase prices since people don't spend it). But in case you do end up in a trap, Chapter 5 explains how Keynesian fiscal stimulus can boost employment and income. The idea is for the government to spend on various projects (e.g. infrastructure) so that production increases and workers have more disposable income -- and this money will circulate through the economy, leading to a multiplier effect. Of course, these policies increase government debt. In contrast to fiscal policy, the so-called "classical economists" (inspired by Jean-Baptiste Say) argue that recessions are caused by incompetent policy or exogenous shocks such as earthquakes, war, new technology, or embargoes on oil exports. These shocks affect the supply of goods and services in the economy; the solution is simply to let the economy adjust itself. As explained in Chapter 6, Say's Law says that "supply creates its own demand". Many economists today combine the Keynesian (demand shocks) and classical (supply shocks) perspectives, and believe that Keynes is more relevant in the short run, while Say's Law holds in the long run.

Continuing in Chapter 7, Harford offers a way to diagnose the kind of recession: if there is an output gap between the actual and potential economic output, it's likely to be Keynesian. But how do you know if there is a "gap"? Well, if the economy grows more slowly than usual, and there is a sudden increase in unemployment, and companies say that they have spare capacity, and inflation is low... then you have signs of weak demand. Speaking of unemployment, Chapter 8 points out that unemployment makes people unhappy, so it probably doesn't happen because people are unwilling to work. Rather, economists theorize that there will be more job hunters than available jobs as long as firms pay efficiency wages -- i.e. wages that are higher than the competitive market wage (which firms do because it boosts productivity). Of course, other factors play a role too, including recessions, high legal minimum wages, and high unemployment benefits. Harford suggests one way to combat joblessness: subsidize job hunting (especially for young folks) and make relocating easier. In Chapter 9, Harford also suggests better management as a pathway to productivity. In this regard, competition helps to replace bad managers.

We return to Bill Phillips in Chapter 10. Phillips discovered that higher nominal wages (a proxy for inflation) go hand-in-hand with lower unemployment -- this relationship is known as the Phillips curve. But when people expect high inflation (e.g. following an oil shock), unemployment may not fall (resulting in so-called stagflation). Moreover, the economist Robert Lucas argued that whenever the government sets policy on the basis of some correlation, people's incentives change and so does the correlation. In other words: there aren't iron laws in macroeconomics, because the data can change. Therefore, Lucas said, economists needed to go back to microeconomic theory (e.g. using the frameworks of rational expectations and/or game theory). Game theory tells us that credibility is important, which is why people are more likely to expect low inflation if it's not the government but an independent central bank making the promise.

Tim Harford uses Chapter 11 to tackle a common critique of GDP: that it doesn't measure important things like happiness. It's true that GDP doesn't include unpaid housework or the value of environmental assets, but adding such things to GDP may not help governments make better decisions. Oftentimes, alternatives like the "Happy Planet Index" or the "Index of Economic Freedom" are attempts to promote a certain policy agenda. And even without us collecting GDP statistics, the economy would grow anyway. At the end of the day, GDP is just one statistic among others (like inflation and unemployment) that can help us make better policy decisions. In Chapter 12, Harford dives deeper into the idea of "happynomics". While he is not against gathering happiness data, he thinks it has been "oversold". Nonetheless, happiness economics has found some interesting results, for example the Easterlin paradox. The puzzle is that rich people tend to be happier than poor people within a society, yet richer societies don't tend to be happier than poorer societies. Perhaps people care about relative income, or status, more than absolute income. Work by Daniel Kahneman and others has found that richer people report greater satisfaction with life; but in terms of their moment-by-moment stream of emotional states, people don't spend more time in a good mood when their income rises above $75,000 a year.

Next, in Chapter 13, the author addresses the criticism that economic growth must ultimately have a limit. He notes that economic growth is not the same as physical energy consumption; indeed, energy use per person in the United States has decreased since 1978 (while GDP grew). Furthermore, the economy has been "dematerializing" (think of digital products), new technologies like LEDs tend to be more efficient, and when people get richer they don't necessarily buy more stuff (mainly fancier versions of stuff). For these reasons we don't have to worry about physical limits to economic growth in the short term; the more relevant problems right now include things like carbon emissions. There is still a lot of poverty and inequality, as Harford reminds us in Chapter 14. Poverty can be measured in absolute or relative terms, and inequality is often measured with the Gini coefficient (where 0 represents perfect equality of income, and 100 means that one person is making all the money). Some broad approaches to fighting poverty include direct cash transfers, improving schools, combating crime, and relaxing immigration policies (since poverty among foreigners also matters). Education may also help against inequality, since new technologies require specialized skills. However, in the future we may also have to think about competing with robots.

Finally, The Undercover Economist Strikes Back finishes with a chapter about the future of macroeconomics. Tim Harford emphasizes that economists' job is not to forecast crises, but to provide practical advice on how to keep the economy working well. Macroeconomics is hard, but that doesn't mean economists should always narrow their focus to elegant math models. They should consider the perspectives of banking, behavioral economics (e.g. how it relates to sticky prices, efficiency wages, and expectations), and complexity theory. There is a lot of work to be done in these areas. Harford even cites Akerlof and Shiller's Animal Spirits as a positive example! Most of all, macroeconomists should remember Bill Phillips's engineer-like mindset and diverse interests. Meanwhile, the rest of us should not be too harsh on them.

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Now you have a rough summary. It obviously leaves out many details and examples, but hopefully it conveys the gist of both books. As you can tell, The Undercover Economist and The Undercover Economist Strikes Back are basically "Econ 101" books without the math and graphs. There's nothing revolutionary here, but the books are good at fulfilling their purpose. Tim Harford is a talented writer, and he successfully explains tricky concepts in layman's terms. And while the view of economics he offers is predominantly orthodox, he at least pays lip service to behavioral economics, the welfare state, and financial regulation. When it comes to macroeconomics, he gives Keynesian policies a fair treatment. I suspect that some readers will still complain about it being too "pro-market". Some will be offended that he calls sweatshops better than the alternative (although Effective Altruists like Will MacAskill have also argued that the alternative means worse or no jobs). But ultimately, I think The Undercover Economist and its sequel contain lessons that people need to hear, because economics can sometimes be counterintuitive.

Scott Sumner explains this in a blog post about some basic principles of conventional economics: people respond strongly to economic incentives, immigrant labor does not increase the unemployment rate, most companies have little control over prices, the crowd can be smarter than experts, speculators don't necessarily make market prices more unstable, price gouging doesn't hurt consumers, and rent controls do not help tenants. Yet the public tends to be highly skeptical of these ideas. Likewise, when Harford the undercover economist writes about high unemployment benefits contributing to unemployment, globalization improving the environment, price-targeting improving efficiency in certain cases, and so on, the reader might get uncomfortable. But even if you don't agree with the ideas, they can at least provide some food for thought.

That being said, Harford does not address all of the questions for economists posed by Hill and Myatt's The Economics Anti-Textbook. For example, the issues of imperfect competition, social norms vs. market norms, workplace democracy, the Cambridge capital controversy, monopsony power, and free trade in toxic waste are barely touched. The attentive reader may have noticed that Harford does not even attempt to rebut Marx's work. Further, the book is also missing concepts such as conspicuous consumption, creative destruction, or Piketty's r > g (which are mentioned here) among others. Yes, The Undercover Economist is meant to be on an introductory level, but so is Kishtainy's A Little History of Economics, which covers more ground. Nevertheless, I'd give both the Harford books 4/5 stars, which is on par with Kishtainy's book, for the reason that the narrower scope is compensated by deeper (albeit not flawless) analysis.

For readers who are unfamiliar with economics, I can recommend The Undercover Economist and The Undercover Economist Strikes Back, perhaps as follow-ups to A Little History of Economics.