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The politics of infrastructure

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Cape Town railway historic

What type of infrastructure would be best for South Africa’s future? The answer, of course, depends on your point of view. If you live and work in Gauteng, your answer might well be to expand the Gautrain network. Or if you reside in Cape Town, you might prefer investments in desalinization plants. Your occupation may also be relevant. If you’re a miner, you are unlikely to support the expansion of renewable energies. A trained software engineer? Well, you’re likely to support large investments in telecommunications infrastructure.

An important – but often underappreciated – role of government is to choose the type of infrastructure that is destined to shape the country’s future development path. This choice is never neutral though: for every decision, there are winners and losers. Choose to build a new coal-fired power plant? That will benefit coal mine owners and workers, while the users of electricity, were the costs of alternative sources to fall rapidly, will pay. Choose to build a high-speed train network across the country (a hyperloop, perhaps!), then users of this network, likely to be high- or middle-income South Africans, will benefit, while long-distance bus services, taxi operators and rental cars will pay. The government’s job, in theory at least, is to choose the projects that will maximize the benefits and minimize the costs.

But things are never that simple. A research paper that will soon appear in the European Review of Economic History, written by Alfonso Herranz-Loncan and myself, investigate the infrastructure in the Cape Colony built during the second half of the nineteenth century. Before the discovery of diamonds in 1867, the few railways that existed (in and around Cape Town) were privately-owned and largely unprofitable. But the discovery of diamonds and the rush to the mines meant the demand for fast, affordable inland transport increased exponentially. The Cape government had to react.

They did. They bought the few existing lines, and then began to the process of connecting Cape Town to Kimberley, finally achieved in 1885. The connection to the booming diamond region brought huge economic benefits: we estimate that the railway may account for 22-25 percent of the increase in income per capita in the Cape during the diamond-mining period (1873-1905). This is a massive share for a single investment and a clear indicator of the transformative power of railways during the first era of globalisation.

But these benefits were not equally shared by everyone. Surprisingly, the government itself earned a meager 3.7% average return on its capital. Had a private firm built the railways, far fewer branch lines would probably have been built. As Stellenbosch PhD student Abel Gwaindepi now shows, the government incurred huge debt to build this infrastructure, and although the government did benefit through customs duties and other tariffs, the main beneficiaries were the owners of the diamond fields. The railway link between Cape Town and Kimberley could now transport the machinery and foodstuffs required to feed the growing Kimberley population. Western Cape wheat farmers, who supplied the mines with food, was another group of beneficiaries. It is not entirely coincidental that it was also these two groups – mine owners and Western Cape farmers – who had formed a political alliance in Cape parliament.

Of course, it was not only mine owners and Cape farmers that benefited. As detailed reports of passengers show, Cape Colony residents from all walks of life used the railways. But, ultimately, it was tax payers who had to foot the debt that were incurred, and often these tax payers were spread across the entire colony (far from the direct benefits of the railways) – and after unification in 1910, the rest of the country. And the location of the railways meant that those with less political influence – like Basotho farmers, who were of course producing wheat much closer to the diamond fields – lost out. Here is one missionary report from 1886, the year after the railway line was completed: ‘Basutoland, we must admit, is a poor country… Last year’s abundant harvest has found no outlet for, since the building of the railway, colonial, and foreign wheat have competed disastrously with the local produce.’

The nineteenth-century Cape railways contributed significantly to economic growth, but it inadvertently also had distributional consequences: some benefited more than others, and some even suffered as a result of its construction.

The lessons for today? Politics shapes the type of infrastructure that’s built. And infrastructure shapes the direction of economic development. So the key question is this: Are we building the type of infrastructure that will put South Africa on a path of broad-based economic development, or is the choice of infrastructure determined by the self-interest of those with decision-making power, much like Cecil John Rhodes and his cronies during the late nineteenth-century?

Put differently, when we choose a new power-generating facility or national air carrier or telecommunications license, do we consider the benefits for society as a whole or the benefits for a specific interest group?

*An edited version of this first appeared in Finweek magazine of 5 October 2017.

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Policy uncertainty is killing investment in what matters

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microscope

Much has already been said about South Africa’s inefficient public sector. Not only has the public sector wage bill escalated beyond the realms of the sustainable, but this has come at almost zero public sector productivity growth. In other words, we are paying more for government to do less. Add to that the poor performances of state-owned enterprises like Eskom, the SABC and most notoriously, South African Airways, and it seems that there is little more that the South African government can do to hurt the prospects for economic growth.

But there is. A new NBER working paper, published by Jose Maria Barrero, Nicholas Bloom and Ian Wright, uses new data on about 4000 US firms to investigate the sources of uncertainty in the US economy. They first distinguish between short-term and long-term uncertainty, identifying the factors that cause each type of uncertainty. They then ask how each type of uncertainty affect firms’ behaviour.

Short-term uncertainty, they find, is caused by oil price volatility. In contrast, economic variables like the oil price has less of an effect on long-term uncertainty where political risk, like policy uncertainty, has a much larger effect. The important result is that short-term and long-term uncertainty have different consequences for firm behaviour. Short-term uncertainty affects employment; long-term uncertainty affects investment in research and development.

If we assume this is true for South Africa too, how would it play out? Volatility of several macroeconomic variables, like the oil price and exchange rate, cause higher short-term uncertainty. This would likely make firms unwilling to hire new workers, or make managers unwilling to offer higher wages. These are the consequences economic commentators typically cite when referring to an unstable macroeconomic environment.

But employment and wages are not the only variables affected by uncertainty. One of the key indicators of a thriving economy is businesses’ willingness to invest in research and development. Take R&D as a percentage of GDP, shown in the Figure below. There is large variation in the share that countries spend on research and development: Israel and South Korea, for example, spend more than 4% of their GDP on R&D. South Africa spend less than 0.8%. (This figure almost reached 0.9% in the 2006-2008 period, a period not surprisingly correlated with high growth rates.)

RDspending

There is a strong positive correlation between countries that grow fast and those that invest in research and development. South Africa, unfortunately, significantly lags those countries at the technological frontier. It is important, though, to understand why this is the case. It is not only government that invests in R&D; in fact, more than half of all R&D investment in South Africa comes from the private sector.

So what will encourage businesses to invest more in R&D? Well, according to Barrero, Bloom and Wright, political risk and policy uncertainty is the biggest determinant of private sector investment in R&D. In a political environment with little policy coherence, business are unlikely to make investments where the returns can only be realized in the long-run. Even if the possible returns are substantial, a rational investment response to a murky policy environment would be to sit back and see what happens. Lower investment in R&D means falling further behind international competitors.

There are some in the South African government who realise this. Minister of Science and Technology, Naledi Pandor, has committed to doubling R&D expenditure as a percentage of GDP by 2020. This is commendable, but in the current budgetary environment, unlikely to get the support from the Minister of Finance. Other initiatives to get the private sector investing in R&D, like a refundable tax credit that will benefit small businesses, have not been implemented.

These problems are not unique to South Africa. As the authors argue: ‘Our findings are significant in the wake of recent events like Britain’s vote to leave the European Union and Donald Trump’s assumption of the US Presidency, which have generated considerable uncertainty over future economic policy around the world. As we have shown, such policy uncertainty is particularly linked with long-run uncertainty and in turn with low rates of investment and R&D that can have significant consequences for the global economic outlook in years to come.’

R&D is the bedrock of future prosperity. Political risk that leads to policy uncertainty hurts not only economic growth and employment creation, but also deters firms from investing in the one thing that can create prosperity for all. If the ruling party is serious about its slogan, it better start by enacting more coherent economic policy.

*An edited version of this first appeared in Finweek magazine of 21 September 2017.

Writing a biography of an uncharted people

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Biography

Two weeks ago, early on the Tuesday morning while still in bed, I opened my laptop to start the day. I was staying in a guest house in Guelph, Canada, where I was on a short visit before heading off to the Economic History Association meetings in San José at the end of that week. Scanning through my mails, my eyes came to rest on an address I had expected – an email from our Development and Alumni Relations officer. It read only: ‘Geluk Johan!’ – ‘Congratulations Johan!’ Our Mellon application was successful. The Biography of an Uncharted People project had begun.

The idea for the Mellon project had started roughly a year earlier. South Africa’s individual-level census data for much of the period before 1948 has not been preserved, and economic history is increasingly moving towards understanding ‘history from below’, using large datasets to investigate the social, demographic and economic aspects of human behaviour in the past. Fortunately, large numbers of other types of individual-level records have been preserved in South Africa’s archives, and are increasingly being digitised by institutions such as FamilySearch.org. These records include things like marriage records, death notices, voters’ rolls, tax censuses and slave emancipation records. Using such source material, I believe, would have two main benefits: firstly, it would open many new avenues for historical inquiry and, secondly, it would help equip history students with the skills of the data revolution, something I’ve written about before.

Dyanti Ngcita

An example of a Cape province death certificate

But transcription is expensive. The Andrew W. Mellon Foundation, however, is a generous supporter of research in the humanities, and after a rigorous internal and external application process, with many excellent competing project bids, we received, on that wonderful Tuesday morning, the happy news of success – starting in January 2018, the project will be funded for five years.

This will not only be a South African project. We have brought together an impressive team of scholars, with a wide range of expertise. Now we are scouting for academically dedicated and enthusiastic students to join us in writing this new biography. We offer bursaries from postdoc to Honours level. More information is available on the project website.

I am excited about what the newly transcribed information, currently hidden away in millions of unused documents, can reveal. I am excited about building a team of dedicated and brilliant young scholars, a team that can continue long after the five years funding term. And I am also excited to join a new faculty and department, encouraging inter-disciplinary research that will, hopefully, provide new insights into the lives of South Africans, present and past.

How finance evolves

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Evolve

Why is it that stock markets tend to be depressed during winter months? Or that investors with too little emotional response (or too much) tend to be less profitable than those with just the right amount of emotion? Or that traders tend to make more money on days when their levels of testosterone are higher than average?

In a fascinating new book, Andrew Lo builds on the corpus of behavioural science research to outline a new theory of financial markets. His basic point: homo economicus is dead. The hyper-rational human that always optimized every decision, most famously portrayed in the Efficient Markets Hypothesis of Eugene Fama that has ruled the field of finance at least since the 1980s, does not exist. His new book, Adaptive Markets: Financial Evolution at the Speed of Thought, explicates his Adaptive Markets Hypothesis, first proposed in 2004 as a substitute for the Efficient Markets Hypothesis.

In short, the Adaptive Markets Hypothesis accepts that humans are biological beings, and that our biology limits our ability to optimize every decision as the Efficient Markets Hypothesis predicts. Most importantly, though, our ‘irrationality’ is not random. This means that we consistently make the same ‘mistakes’, something that behavioural scientists have known for quite some time. One of these mistakes, for example, is that we often link events together because they happen to occur close to each other. As Lo puts it: ‘We humans are not so much the “rational animal” as we are the rationalizing animal. We interpret the world not in terms of objects and events, but in sequences of objects and events, preferably leading to some conclusion, as they do in a story.’

Telling stories is one way we try to make sense of the world, even if those stories are sometimes false. We do this because, given the environments that we encountered, this was the most evolutionary successful behaviour. But that has consequences: If our environment change, our biological decision-making processes might not be equipped to deal with the new environment. In Lo’s words: ‘“Rational” responses by homo sapiens to physical threats on the plains of the African savannah may not be effective in dealing with financial threats on the floor of the New York Stock Exchange’.

Often the real world is not very different from the survival-of-the-fittest world our ancestors encountered on the African plains. Many times, humans do optimize their behaviour. This is why the Efficient Markets Hypothesis could hold for so long, treating ‘irrational’ behaviour as random outliers that will be averaged out in the marketplace. But as Low demonstrates in countless examples, often humans (and by implication traders) behave ‘predictably irrational’, reacting to fear systematically different than to reward, for example, and opening opportunities for windfall profits on the financial markets. That is why some famous investors, accounting for these predictably irrational heuristics of humans, can be consistently successful.

The good news, though, is that we are not like other animals. We do not have to wait for evolution to take its course, molding us to our environment through natural selection. We have the ability to learn and adjust through trial and error. High-frequency trading is a great example: speed is everything in financial markets, and automated trading programmes have replaced specialist human traders who are just too slow to recognize and respond to the predictably irrational human errors. But even this is changing, as Lo explains: ‘At first, these high-frequency traders made windfall profits, since human specialists were sluggish and inefficient in comparison. However, there ultimately came a point where high-frequency traders were mainly competing with each other. To succeed in this financial arms race, high-frequency trading firms had to invest in faster and more expensive hardware. At the same time, however, these firms were scouring the market for any trace of “juice” that might be left. In a very short amount of time, high-frequency trading was pushing against its natural evolutionary limits. It had unexpectedly become a mature industry, with low margins on trades and low overall profits.’ High-frequency trading is now on the decline, as more and more exchanges start implementing ‘no high-frequency trading zones’. The environment is changing, and those high-frequency traders that do not adapt, will perish.

The book presents not only a fascinating new theory that can explain why some investors continue to be successful despite the prediction of the Efficient Markets Hypothesis, but it also situates this theory within the context of broader developments in finance. We learn why the Efficient Markets Hypothesis was so appealing, why earlier attempts to use evolutionary thinking in finance never caught on, and what this new theory might say about the future of finance. It also has a cautionary word about how we train the next generation of finance gurus: ‘For the mathematically trained economist, it’s sometimes difficult to think in evolutionary or ecological terms, but sooner or later, this way of thinking will be domesticated (another biological metaphor), and will become another standard tool for economists to use, just as molecular biologists use it today.’

Just like the finance industry employed mathematically-inclined engineers and physicists in the last few decades, perhaps biology will be the training-of-choice for the next generation of investment firms. Perhaps. What we do know is that the environment is changing, and that means that traders will have to adapt too if they are to survive, and thrive. As Lo explains: ‘An evolutionarily successful adaptation doesn’t have to be the best; it only needs to be better than the rest.’ Let the games begin!

*An edited version of this first appeared in Finweek magazine of 7 September 2017.

What explains the rise of populism?

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Donald Trump

Consider the following thought experiment: Sibusiso and Thulani each own a firm that competes with the other. In each of the following scenarios, Sibusiso’s firm outcompetes Thulani’s. Which of the four do you consider unfair competition?

  • Sibusiso works hard, saves and invests his profits, and invents new techniques and products, while Thulani’s products change little and he loses market share.
  • Sibusiso finds a higher quality input supplier in the US, which makes his products better and he therefore takes market share from Thulani.
  • Sibusiso outsources some of his services to Bangladesh, where workers work 12-hour shifts under hazardous conditions, earning very low wages.
  • Sibusiso brings Bangladeshi workers into South Africa under temporary contracts, and puts them to work at lower than minimum wages.

From an economic perspective, each of these scenarios have a similar result: there are winners as well as losers as they expand the economy. But people generally react very differently to them. Most people are happy with scenario 1 and 2: even if someone loses (Thulani and his employees), this comes through what is perceived as fair competition from Sibusiso. It is scenario 3 and 4 that creates problems: when Sibusiso ‘breaks’ local laws (even though it may be perfectly legal in the foreign country), his competitive advantage, and by implication international trade, is viewed as unfair.

In a provocative new NBER Working Paper, Harvard University economist Dani Rodrik use this example to argue that too-rapid globalisation – the increasing use of scenarios 3 and 4, of outsourcing production to the developing world or of employing immigrants – is the underlying cause for the rise of populism across the developed world. The ‘losers’ from globalisation feel that foreigners – abroad or as immigrants in their own countries – have taken unfair advantage of then, stealing their jobs. They have chosen the politics of populism as a way to ‘punish’ this rapidly globalising world.

Economists know that free trade creates both winners and losers, and that the winners almost always gain more than what the losers lose. If the winners could perfectly compensate the losers, everyone would be better off from a free-trading world.

But Rodrik argues that such compensation is not always easy, and rarely happens. Aside from Europe, where an extensive social safety net was institutionalized to support ‘losers’, most countries failed to find a way to sufficiently compensate those that suffered the consequences of open borders. Make no mistake: open borders resulted in massive global gains, notably for the poor of China and India. But in each country, as trade theory predicts, there were losers. In Rodrik’s words: “People thought they were losing ground not because they had taken an unkind draw from the lottery of market competition, but because the rules were unfair and others – financiers, large corporations, foreigners – were taking advantage of a rigged playing field.”

There are many new studies to back up this claim. In a 2016 paper, David Autor and his co-authors show, for example, that the trade shock of China joining the World Trade Organisation aggravated political polarisation in the United States: districts affected by the shock moved further to the right or left politically, depending which way they were leaning in the first place. Analysing the Brexit vote, Italo Colantone and Piero Stanig show that regions with larger import penetration from China had a higher Leave vote share. They repeat the study for fifteen European countries, showing that China’s entry into the WTO had similar political consequences across Europe. In a 2017 working paper, Luigi Guiso and his co-authors use European survey data to draw even more precise conclusions: the more individuals are exposed to competition from imports and immigrants (the higher their economic insecurity), the more they vote for populist parties.

To summarise: because there were uncompensated losers from global free trade, argues Rodrik, there were political consequences. Rodrik then constructs a model to explain this populist rise on both the left and the right. According to the model, there are three different groups in society: the elite, the majority, and the minority. Says Rodrik: “The elite are separated from the rest of society by their wealth. The minority is separated by particular identity markers (ethnicity, religion, immigrant status). Hence there are two cleavages: an ethno-national/cultural cleavage and an income/social class cleavage. An important implication of this reasoning is that even when the underlying shock is fundamentally economic the political manifestations can be cultural and nativist. What may look like a racist or xenophobic backlash may have its roots in economic anxieties and dislocations.”

Populists who emphasize the identity cleavage target foreigners or minorities, and this produces right-wing populism. Those who emphasize the income cleavage target the wealthy and large corporations, producing left-wing populism. The large numbers of immigrants into Western Europe has resulted in the rise of right-wing populists, for example, while Latin America, because of large disparities between rich and poor, has seen more left-wing populism. The United States, argues Rodrik, falls somewhere in the middle – with Donald Trump on the right and Bernie Sanders on the left.

These findings have important implications for South Africa too. South Africa joined the WTO in 1995 and liberalised our complicated tariff schedule, opening our borders to foreign competition. There were many winners from cheaper imports, notably consumers, but some firms and industries struggled, leading to job losses, often concentrated in certain regions. And although South Africa rolled out an impressively comprehensive social safety net for a middle-income country, they could not compensate all the losers, especially as the global financial crisis hit in 2007 and unemployment began to worsen. It is not entirely coincidental that the first large-scale xenophobic attacks on foreigners happened in 2008 (what Rodrik would call right-wing populism) and that the ANC shifted left with the election of Jacob Zuma as South African president in 2009.

Even if globalisation creates more winners than losers, the losers, like Thulani and his employees, may feel that the system is rigged, and retaliate by voting for more populist parties. As South Africa stumbles into another recession, this may have profound consequences for the ANC’s December elective conference – and the national election in 2019.

*An edited version of this first appeared in Finweek magazine of 10 August 2017.

Written by Johan Fourie

August 14, 2017 at 16:47

How do we build a prosperous, decolonized South Africa?

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boys-plowing

I recently attended an academic conference at the University of the Free State on the topic ‘Decolonizing Africa’. Much of the debate was, understandably, about the past: about the lingering effects of the (Atlantic) slave trade, European colonization that included the imposition of largely artificial borders, and the post-colonial failures of independent Africa. But at the final keynote, delivered by Prof Alois Mlambo of the University of Pretoria, the discussion turned to the future. How do we build a prosperous, decolonized South Africa?

One unescapably emotive topic is land reform. The expropriation and dispossession of land in South Africa is the root, many agreed, of the severe levels of inequality that plague the region. But how to correct this past injustice was not so easy; in the audience, too, were several Zimbabwean scholars quite critical of that country’s land reform programme. Over lunch, one Zimbabwean student told me the tragic story of his grandfather, a former farm worker on a white farm turned successful tobacco farmer after land reform, only to lose his land because he was considered ‘too successful’ by the ruling ZANU-PF party. The farm is now dormant.

Getting land reform right is fraught with difficulty. Not everyone that suffered land expropriation wants to return to farming – by far the largest number of recipients of successful land claims in South Africa choose the cash instead of the land. (This is often ignored by politicians and commentators when simply taking the hectares transferred as measure of land reform success.)  And even when recipients choose to return to the land, they often struggle to support themselves because of the small size of land allocated, or a lack of capital investment, or a lack of technical or management skills. There are also political consequences: because land recipients, like those in Zimbabwe, often do not receive title deed to the land they are given, they become ensnared by the political party that gave them the land. Why do people still vote for ZANU-PF despite the state of the economy? Because they worry a vote for the opposition means that they might lose their land. Most worryingly, it is often the original farm workers who lose the most, like the Zimbabwean student’s grandfather.

This is not to say that some form of wealth redistribution is not imperative. But whereas land (and the minerals it contained) was clearly the most productive resource when it was expropriated in the nineteenth century (which is the reason it was expropriated), a valid question is whether it still is the most productive. Of course, people value land not only for its economic uses: there are a myriad of historic, cultural and religious reasons why the land of your ancestors are treasured. But as a redistributive policy aimed at creating a more equitable society, is land reform the best way to create prosperity for those who suffered historical injustice?

Think of the fastest growing companies globally: which of them still rely predominantly on land ownership? AirBnB is a great example: it is the world’s largest accommodation service, without owning any property! For AirBnB and the myriad other unicorns that have created incredible wealth for their founders and shareholders, it is not land or physical property that creates wealth, but science and technology. (Even farmers know this: that is why they are investing in science to improve their crops and in technology to mechanize production.)

In the twenty-first century, land is what you buy with your wealth, and not the reason for your wealth. A quip about Stellenbosch wine farmers summarize this well: How do you make R1 million farming in Stellenbosch? You spend R2 million.

Prof Mlambo remarked that India and China, both with a history of colonisation, is not growing at above 5% because they have redistributed land. They have prospered because they embraced science and technology. Consider this: in the 2015/2016 academic year, 328,547 Chinese students studied in the United States; only 1,813 South African students did. (If you account for population size, 7 times more Chinese than South Africans students study in the US.) Take South Korea, a country with roughly the same population size as South Africa: 61,007 South Koreans traveled to study in the US in 2015/2016, 33 times more than South Africa.

So how would a redistribution policy look that takes science and technology seriously? I don’t have the answers, but here are some suggestions. Most of us would agree that education is key, but the South African education system has not made much progress in the last decade and it is unlikely to do so in the next. Redistribution must start at the first year of life. Publicly funded but privately run nurseries will remove the gap between the rich and poor that has already emerged when kids arrive at school. For primary and secondary education, a voucher system that incentivize private schools for the poor is an option. At tertiary level, we need more and better-funded universities, notably in science and technology. (It would help to send more of our smartest students abroad to study at the frontiers of science – they will return with new ideas and networks to propel our industries forward.) Visas for and recruitment of skilled immigrants can boost research and entrepreneurship. Improve free wifi access and invest in renewable energies. The private sector, because that is where most innovation occur, can be incentivized through appropriate legislation to offer shares to workers – or to those living in communities where they operate. There are a myriad of innovative possibilities.

If Zimbabwe has taught us anything, it is that politics may triumph over economic logic. Land reform in Zimbabwe was not an economic strategy in as much as it was a strategy to keep the ruling party in power. It has had severe economic consequences, as anyone visiting Zimbabwe today can attest. The real radical economic transformations of our age – just in my lifetime, the Chinese has managed to reduce the share of people living in absolute poverty from 88% to less than 2% – have not come from redistributing an unproductive twenty-first century resource. It has instead been the result of investments in science and technology. Any attempt to redistribute with the purpose of building a more prosperous society should take this as the point of departure.

*An edited version of this first appeared in Finweek magazine of 29 June 2017.

How social status drives our consumption – and inequality

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louis-vuitton

A couple of years ago I attended a focus group for Finweek. The magazine was rebranding and it had invited a diversity of people to comment on the content it should offer. The conversation turned to investment options for young professionals: should young people invest their monthly savings in a new property, or stocks, or something else? The facilitator asked the thoughts of a young woman that had been quiet for most of the meeting. Her answer, and its consequences for many young South Africans like her, stunned me: I invest in expensive clothes, because I have to signal to a potential husband that I am wealthy. In other words: I buy brand names, because I want to improve my social status.

Economists have known since Adam Smith already that people buy luxury goods not only for the value they derive from consuming it, but because these goods offer something else: social status. Conspicuous consumption, as economist Thorstein Veblen coined our affinity for status goods, has helped explain economic phenomenon like our excessive expenditure on weddings or the difference between black and white incomes in America.

However, so far economists have struggled to differentiate between our affinity for nice things (in economics jargon: our unobserved consumption utility) and our affinity for the status that those nice things signal. In other words, I might buy a Ferrari not only because I really like fast and furious cars (consumption utility), but also because I want to signal to the everyone else that I am rich (status).

A team of five economists, in a new NBER Working Paper, has now found a way to test the importance of social status. They worked with a large Indonesian bank that distribute credit cards to clients. (Indonesia is a great place for a test like this, because it is in developing economies, as Veblen theorized, where you are most likely to see conspicuous consumption. Also, Indonesia has 74 million middle-class consumers, expected to double by 2020.) They used platinum credit cards, which come with a number of benefits like a higher credit limit and discounts on luxury purchases and is typically sold to high-income individuals, in their experiment.

How do they show that social status matter? They randomly offered a fancy-looking platinum and standard-looking credit card to their customers at the same price and with the same benefits. If customers only cared about the utility of the new card (like the benefits on offer), there should be no difference in the take-up of the fancy-looking or standard-looking card. And yet, there is a 7 percentage point difference: 21% purchased the fancier card versus only 14% for the standard card. The mere fact that the fancy-looking card was associated with a higher status meant that people purchased it.

Perhaps it is not that surprising that people purchase something because it conveys an additional status element, but what is surprising about the experiment is that poorer individuals bought more of the fancy-looking card. The rich, in contrast, showed no difference in demand for the fancy or standard card. The authors ascribe this finding to the fact that “richer individuals already have ways to signal their income, while the platinum credit cards are a more powerful signaling tool for those with comparatively lower incomes”. This also explains the behaviour of the young woman in our focus group; she was more limited in her ability to show social status and thus had to resort to clothing.

In a second experiment, the authors then look at how the customers use their cards. Consistent with their theory, they find that the customers that bought the fancy-looking card (remember: it had the same privileges as the standard-looking card) used the card more often in social settings, such as spending in restaurants, bars and clubs, where the card is more visible to others. Here, too, there is somewhat of a surprise: the use of this card comes at a cost, because in 48% of the cases the customers have another card that would have given them discounts on those purchases. In other words, they chose to ignore the discount just so that they can use the fancy-looking card that gives them social status! If this is true for credit cards where there is a limited audience (only your buddies who joined you for dinner can see you paying with a fancy-looking card), imagine what people are willing to forego for luxury products with a larger audience, like clothes and cars.

The authors conduct several other experiments, all of which support the authors’ theory that social status matter in explaining our consumption behaviour. We do not only buy luxury goods because they provide us with utility; we buy them because they signal something about our social status. And because poorer individuals tend to have fewer ways of signaling social status than richer ones, they are the most eager to grasp at opportunities for showcasing their status. (That is why direct marketing is never aimed at the wealthiest individuals!)

Such findings have implications for the distribution of wealth. The choice for a young person between investing your meager savings in stocks or a new car may not only depend on the financial returns they can get, but also the psychological returns they might get from purchasing a luxury good. If poorer individuals tend to buy more luxury goods to earn social status, like the young woman in the Finweek focus group, while the rich invest in assets that yield positive financial returns (because they already have assets that give them social status), the only logical conclusion is a widening wealth gap. There is little any policy, like a purported wealth tax, can do to prevent that instinctive human yearning for status.

*An edited version of this first appeared in Finweek magazine of 15 June 2017.

Written by Johan Fourie

July 12, 2017 at 11:02