Economics, a most difficult science.

In the Higher Ed supplement of The Australian, the following appears:

"Eminent Harvard University economic historian Jeffrey Williamson says Australian economics has forgotten its history and the Government's financial crisis rescue package may be suffering as a result."

Interestingly, in recent times, I have heard the same opinion expressed by other economists (not all economic historians). I believe they are right. I also believe that because economists can only rely on history it also makes our discipline a most difficult science, perhaps even the most difficult science.

Other sciences, such as chemistry, physics and biology, in general evaluate hypotheses using controlled laboratory experiments isolated from the real world. In contrast, economics does not have this luxury. Therefore we use history as our guide.

A major limitation of history is that it is never an exact match. Therefore, debates ensue as to which past experience is most relevant. For example, in relation to the current crisis, I have heard it suggested that the 1890s crisis is more similar than the 1930s depression.

Lindsay Tanner Goes Gaga Over Susan Boyle

Lindsay Tanner writes that he was "overjoyed" when he first read about Susan Boyle's performance on Britain's Got Talent. A recent post at Stumbling and Mumbling suggests why.

The economics of Susan Boyle ...... 1. The power of the contrast effect. Ms Boyle’s singing talent is magnified by the contrast between it and her ugliness and - yes - mild learning difficulties. ... This contrast effect is a powerful influence upon our perceptions. If you put your hand in a bucket of lukewarm water, it’ll feel cold if your hand had previously been in hot water, but warm if it had been in cold. And it has important implications. In Influence, Robert Cialdini cites research which shows that men shown pictures of average-looking women whilst watching Charlie’s Angels judged them to be uglier than they did if shown the same pictures during other TV shows; women suffered by comparison to Farrah. The damage done by the “beauty myth” is down to the contrast effect.....

2. The ubiquity of statistical discrimination. .... We were prejudiced against Ms Boyle because she was ugly.This is a widespread prejudice. Ugly people, on average and controlling for other things, earn less than good-looking ones, with the penalty for ugliness being generally larger than the premium for beauty. It’s for this reason that criminals are more likely to be ugly; munters have worse labour market prospects, and so are more likely to turn to crime.

However, this bias against the ugly is not pure spite. The audience’s low expectations of Ms Boyle were well-founded, because very few successful singers are ugly - even the ones who aren’t conventionally handsome have charisma; Celine Dion and Barbra Streisand come to mind precisely because they are rare exceptions. Similarly, there’s evidence that good-looking people are genuinely more productive than ugly ones - perhaps because teachers give them more attention in school and so develop their talents.

3. Efficiency vs. justice. The correlation between looks and ability suggests that the rule, “don’t hire the munter” will, generally speaking, be a useful one. It’s a fast and frugal heuristic that saves the decision-maker time and often works. It is, therefore, an efficient rule.But it can be an unjust one, because it penalizes the small number of Susan Boyles. If it’s expensive for these to demonstrate their talents - and it will be in many cases where they can do so only over time, or by working with costly capital - they will not get hired.

There’s therefore a trade-off between efficiency and justice

Behavioural economics and the Obama administration

Time Magazine had an interesting article earlier this month on how the Obama administration is making use of behavioural economics in policy formation.

... Obama is betting his presidency on our ability to change our behavior. His top priorities — the economy, health care and energy — all depend on it. We need to spend more money now to avert a short-term depression, then save more money later to secure our long-term economic future. We need to consume less energy in order to reduce our oil imports and carbon emissions as well as our household expenses. We need to quit smoking, lay off the Twinkies and avoid other risky behaviors that both damage our personal health and boost the costs of care that are ravaging the nation's fiscal health. Basically, we need to make better choices — about mortgages and credit cards, insurance and retirement plans — so we won't need bailouts down the road.

The problem, as anyone with a sweet tooth, an alcoholic relative or a maxed-out Visa card knows, is that old habits die hard. Temptation is strong. We are weak. We've got plenty of gurus, talk-show hosts and celebrity spokespeople badgering us to save energy, lose weight and live within our means, but we're still addicted to oil, junk food and debt. It's fair to ask whether we're even capable of changing.

But the latest science suggests that yes, we can. Studies of all kinds of human frailties are revealing how to help people change — not only through mandates or financial incentives but also via subtler nudges that preserve our freedom to make choices while encouraging us to make better ones, from automatic-enrollment 401(k) plans that require us to opt out if we don't want to save for retirement to smart meters that warn us about how much energy we're using. These nudges can trigger huge changes; in a 2001 study, only 36% of women joined a 401(k) plan when they had to sign up for it, but when they had to opt out, 86% participated.

It's no coincidence that Obama's budget proposes an ambitious program of automatic-enrollment pensions for workplaces that don't offer 401(k)s or that his stimulus package has billions of dollars for smart meters. Behavioral science — especially the burgeoning field of behavioral economics that has been popularized by Freakonomics, The Wisdom of Crowds, Predictably Irrational, Nudge and Animal Spirits, which is the new must-read in Obamaworld — is already shaping dozens of Administration policies. "It really applies to all the big areas where we need change," says Obama budget director Peter Orszag.

Orszag has been an unabashed behavioral geek ever since he read that 401(k) study. His deputy, Jeff Liebman of Harvard, is a noted behavioral economist, as are White House economic adviser Austan Goolsbee of the University of Chicago, Assistant Treasury Secretary nominee Alan Krueger of Princeton and several other key aides. (Cass) Sunstein has been nominated to be Obama's regulatory czar. Even National Economic Council director Larry Summers has done work on behavioral finance. And Harvard economist Sendhil Mullainathan is organizing an outside network of behavioral experts to provide the Administration with policy ideas.

The first sign of the behavioralist takeover surfaced on April 1, when Americans began receiving $116 billion worth of payroll-tax cuts from the stimulus package. Obama isn't sending us one-time rebate checks. Reason: his goal is to jump-start consumer spending, and research has shown we're more likely to save money rather than spend it when we get it in a big chunk. Instead, Obama made sure the tax cuts will be paid out through decreased withholding, so our regular paychecks will grow a bit and we'll be less likely to notice the windfall. The idea, an aide explains, is to manipulate us into spending the extra cash.....

Behavioral economics doesn't ignore the market forces that were all-powerful in Econ 101, but it harnesses forces traditionally consigned to Psych 101. Behaviorists have always known we don't really act like the superrational Homo economicus of the neoclassical-model world. Years of studies of patients who don't take their meds, grownups who have unsafe sex, and other flawed decision makers have chronicled the irrationality of Homo sapiens. Some of our foibles are quite specific, like overvaluing things we have, overeating food in larger containers and overestimating the probability of improbable events — the quirk that made the Meet Barack Obama fundraising lottery such a smart idea. But in general, we're ignorant, shortsighted and biased toward the status quo....

"We truly want to make better choices," explains Yale economist Dean Karlan. He's a co-founder of stickK.com, where users make binding "commitment contracts" to forfeit money to friends or charities — or even "anti-charities" they despise — if they fail to quit smoking, lose weight or meet other goals they set for themselves. "But we need help to get us there."

Did President Obama Violate Copyright Laws?

iPods, First Sale, President Obama, and the Queen of England by Fred von Lohmann, April 2nd 2009 ... President Obama reportedly gave an iPod, loaded with 40 show tunes, to England's Queen Elizabeth II as a gift. Did he violate the law when he did so?

You know your copyright laws are broken when there is no easy answer to this question.

Traditionally, it has been the job of the "first sale" doctrine to enable gift giving -- that's the provision of copyright law that entitles the owner of a CD, book, or other copyrighted work, to give it away (or resell it, for that matter), notwithstanding the copyright owner's exclusive right of distribution.

In the digital era, however, first sale has been under siege, with copyright owners (and even the Copyright Office) arguing that it has no place in a world where "ownership" has been replaced by "licenses" and hand-to-hand exchanges have been replaced by computer-mediated exchanges that necessarily make copies. But it's precisely because first sale is central to everyday activities like giving an iPod to a friend, selling a used CD on eBay, or borrowing a DVD from a library, that EFF and others have been fighting for it in case after case.

So, how does President Obama fare in this? It's nearly impossible to figure out. If he'd simply purchased a "greatest hits" CD of show tunes and given it to the Queen, the first sale doctrine would have taken care of it. But because digital technology is involved here, suddenly it's a legal quagmire. (And, for the remainder of this discussion, I am going to set aside the Presidential immunity issues and the UK copyright law issues, which make it even more of a quagmire.)

First, let's imagine that the President (or his staff) bought the 40 show tunes from the iTunes music store. Do you "own" the music that you buy from iTunes? The nearly 9,000 words of legalese to which you agree before buying don't answer that question (an oversight? I doubt it). Copyright owners have consistently argued in court that many digital products (even physical "promo" CDs!) are "licensed," not "owned," and therefore you're not entitled to resell them or give them away. (And the Amazon MP3 Store terms of service are even worse for consumers than iTunes -- those terms specifically purport to strip you of "ownership" and forbid any "redistribution.")

Second, even if the first sale doctrine applies to iTunes downloads, what about the additional copies made on the iPod? iTunes does not download directly to an iPod. So President Obama's staff made an additional copy onto the Queen's intended iPod. How are those copies excused? The iTunes terms of service say that downloads are "only for personal, noncommercial use." Is giving a copy to a head of state a "personal" use? Seems more like a "diplomatic use," doesn't it? So copyright owners could argue that the copy on the iPod was not authorized, because it was beyond the scope of the iTunes "license." And according to the typical rightsholder argument, any use beyond the scope of the "license" is a copyright infringement.

Perhaps it's a fair use? I'd certainly take that view. But does it matter here whether President Obama's staffer first deleted the copy that is still on her computer? Should that matter? (It does not matter for first sale purposes, which is one reason why the first sale doctrine answers questions so much more clearly.)

Third, what about a breach of contract? As I mentioned above, some might argue that this "use" of iTunes downloads breaches the "personal use" limitation in the agreement. And if it is a breach of the iTunes contract, can the copyright owners sue President Obama as "third party beneficiaries" of the iTunes contract? It's not clear. (In the Amazon terms of service, copyright owners are specifically made third party beneficiaries, which appears to be an attempt to clear a path for record labels to sue Amazon customers for breaches of the contract.)

And all of this even before you start asking what happens when the Queen connects her new iPod to her computer, thereby making even more copies (the UK, after all, lacks a fair use doctrine)... UPDATE: Prof. Michael Froomkin points out that the Queen enjoys sovereign immunity under UK law because she is, well, the sovereign.

Of course, no one thinks that copyright owners are going to send lawyers after either President Obama or the Queen over this. But none of us should want a world where even our leaders--much less the rest of us--can't figure out how copyright law operates in their daily lives.

Luck, income distribution and progressive taxation

Before Tea, Thank Your Lucky Stars, by Robert Frank, Commentary, NY Times: The link between success and luck is stronger than many people think. Analysis of this connection provides a useful framework for weighing ... recent “tea parties,” where orators ... bemoaned their “crippling” tax burdens. ...

Contrary to what many parents tell their children, talent and hard work are neither necessary nor sufficient for economic success..., some people enjoy spectacular success despite having neither attribute. (Lip-synching members of boy bands?...)

Far more numerous are talented people who work very hard, only to achieve modest earnings. There are hundreds of them for every skilled, perseverant person who strikes it rich — disparities that often stem from random events. ...

Malcolm Gladwell reports that a disproportionate number of pro hockey players owe their success to the accident of having been born in January, which made them the oldest, most experienced players in every youth league growing up. For that reason alone, they were more likely to make all-star teams, receive special coaching and eventually become professionals.

Although people are often quick to ascribe their own success to skill and hard work, even those qualities entail heavy elements of luck. ... People born with good genes and raised in nurturing families can claim little moral credit for their talent and industriousness. They were just lucky. ...

Even in markets where luck plays no role, minuscule differences in performance often translate into enormous differences in salaries. ... In law, consulting, investment banking, corporate management and a host of other occupations, the ablest performers are often paid hundreds or even thousands of times as much as others who perform nearly as well.

Another important message of recent research is that a person’s salary depends far more on where she is born than on her talent and effort.

For example, as a Peace Corps volunteer in Nepal long ago, I hired a cook who had no formal education but was spectacularly intelligent and resourceful. ... Yet his total lifetime earnings were less than even a very lazy, untalented American might earn in a single year. Well-paid Americans owe an enormous, if rarely acknowledged, debt to the social investments that supported their success.

The president’s proposal is modest: raising the top marginal tax rate from 35 percent to 39.5 percent, its level when Bill Clinton left office and well below the corresponding level in most other industrial countries. There has never been a shortage of talented people willing to work hard for success... And the president’s proposal would not cause such a shortage...

It would, however, promote more efficient provision of public services... For example,... when government levies higher tax rates on the wealthy, we can provide public services that the wealthy and others greatly value but that would otherwise be beyond reach. Under such a tax system, the heavier tax bill becomes payable only if we’re lucky enough to end up among life’s biggest winners.

Financially successful tax protesters seem blissfully unaware of how incredibly fortunate they are. To borrow from the late Ann Richards and her description of the first President Bush, they were born on third base and thought they’d hit a triple.

Luck, Skill, and Progressive Taxes:In the debate over tax policy, the power of luck shouldn't be overlooked, by Hal Varian, NY Times, 2001: President Bush's proposed tax cut has rekindled an age-old debate: how progressive or regressive should the income tax be? ...

Those who argue for a more progressive income tax emphasize equity: a tax dollar paid by a rich person causes less pain than a tax dollar paid by a poor person. Those who argue for a less progressive system emphasize efficiency: the most productive people should face lower tax rates to give them strong incentives to work harder and produce more.

These trade-offs have been examined in the economic literature... This formulation of the optimal income tax problem was first examined by the economist James Mirrlees... In the simplest version of the Mirrlees model, taxpayers differ only in their ability: how much they can produce with a given amount of effort. One striking result of this model is that those at the very top of the income scale should face low marginal rates.

This result emerges from a detailed mathematical analysis, but the intuition is not hard to explain. Let us assume, for the sake of argument, that Bill Gates made $1 billion in 2000, an amount larger than any other American taxpayer. Suppose further that despite the best efforts of his accountants, he ended up paying 40 cents of the last dollar he earned to the Internal Revenue Service.

Consider the following thought experiment: drop the marginal tax rate from 40 percent to zero for all incomes above a billion dollars. The I.R.S. won't lose any revenue from this reduction, since no one has an income larger than $1 billion. And who knows -- the lower marginal rate might encourage Mr. Gates to work a little harder in 2001, producing new products that would make him, and the rest of us, better off.

Of course, the fact that it pays to reduce the marginal tax rate for billionaires doesn't say much about what tax rates should be like for mere millionaires, a point that has been emphasized by Professor Mirrlees himself and confirmed by subsequent researchers, like Peter Diamond ... and Emmanuel Saez... But the intuitive argument presented above is pretty compelling: if income depends only on ability, those at the very top of the income-ability distribution should face low marginal tax rates.

But perhaps this model is too simple. One might well argue that Mr. Gates, as productive as he is, doesn't owe his success entirely to ability: there was a lot of luck involved, too. And, if truth be told, that's probably true even for mere millionaires.

So let's consider a different model: one in which differences in income are a result only of luck and have nothing to do with ability. In this case, the optimal income tax may well involve taxing billionaires at very high marginal rates. True, aspiring billionaires won't work quite as hard, since the after-tax reward from hitting $1 billion has been reduced. But the chances of becoming a billionaire are pretty low anyway, so taxing billionaires at a high rate won't really discourage much effort by those hoping to become one.

Thus a model where luck is the driving force tends to yield a more progressive optimal tax than a model where ability is the driving force. This is about as far as theory can take us, but it highlights the critical question: How much income results from ability and how much from luck?

It is safe to say that this question has not yet been completely resolved by the economics profession. Still, everyone seems to have an opinion about it: if you want to determine whether someone is a Republican or a Democrat, just ask that person whether differences in income come mostly from luck or from ability.

The preliminary evidence available from in-depth surveys like the Panel Study for Income Dynamics at the University of Michigan shows that income varies a lot from year to year for many households. Economists have found that random events like episodes of bad health, accidents, marital dissolutions and family emergencies play a large role in short-run year-to-year fluctuations in income.

A Harvard social policy professor, Christopher Jencks, and his collaborators pointed out many years ago that income inequality among brothers, who share similar genetic and environmental characteristics, is almost as great as for the population as a whole. This suggests that luck is an important factor in the long run as well.

If luck plays a substantial role in the determination of income, it makes sense to have a progressive income tax, creating a form of social insurance in which the lucky subsidize the unlucky. Perhaps the folk singer Phil Ochs had the best answer for why the upper half of the income distribution should pay so much more in taxes than the lower half: ''And there but for fortune, may go you or I.''

Link from Economist's View

Hayek's heritage

Peter Dorman posting at EconoSpeak blogs about the disproportionate impact Jews have had as academic economists. He writes "Jewish or half-Jewish economists come in all stripes, from Hayek and Friedman ..." Friedrich von Hayek (1974) is here, as elsewhere, misidentified as being Jewish. While he was the cousin of Ludwig Wittgenstein, and was involved with von Mises (who was Jewish) in leading the heavily Jewish Austrian School of economics, and was closely involved with the Jewish intelligensia in Vienna, in Hayek on Hayek Hayek states that "my family is on the purely Christian group" (p. 52) and that he was unable to find any Jewish ancestors through genealogical research (p. 53) .

Emmanuel Saez Wins Clark Medal

Expert on Wealth Wins a Top Economics Honor, WSJ, April 25, 2009 .. Emmanuel Saez, a leading researcher on the causes of wealth and income inequality, has won the John Bates Clark medal, awarded to the nation's most promising economist under 40 by the American Economic Association.

Mr. Saez, a 36-year-old professor at the University of California, Berkeley, focuses on the very top of the wealth pyramid. He earned his Ph.D. from the Massachusetts Institute of Technology in 1999 and joined Berkeley's economics department in 2002.

Of the 30 other economists who have won the Clark medal, 12 have gone on to win the Nobel prize in economics, including last year's winner, Paul Krugman of Princeton University.

Other past winners include White House National Economic Council director Lawrence Summers and Steve Levitt, co-author of the best-seller "Freakonomics."

Since it was first awarded in 1947, the Clark has been given out every two years, but beginning next year it will be awarded annually.

Mr. Saez and Thomas Piketty of the Paris School of Economics examined income-tax figures from the U.S. and other countries to derive historic estimates of income inequality. Among their findings: Before the onset of the financial crisis, the top 1% of families by income accounted for nearly a quarter of U.S. income -- their largest share since the late 1920s.

Messrs. Saez and Piketty's work has stirred controversy. In a 2006 opinion piece in The Wall Street Journal, Alan Reynolds of the Cato Institute disputed their results on technical points, such as inconsistencies with official Census Department estimates.

The economists countered that Census estimates are based on survey data that can't capture the incomes of the very rich.

Mr. Saez, an easygoing Frenchman who loves surfing, has resisted overtures from the powerhouse economics departments at MIT and Harvard University. He has also made important contributions to tax theory, including how governments can optimally set tax policy and how households behave in response to taxes.

His recent papers are available at his webpage.

IMF interview

Olivier Blanchard is a co-author of perhaps one of the most influential papers ever written in macroeconomic modelling. He is currently the chief economist of the IMF. Last night he was interviewed on the 7:30 report (Danger as definitely passed) . He makes some very interesting comments. In particular:

1. About Fiscal policy.
2. Time bound tax cuts.
   

Pays to read beyond the headlines

The Age and The Australian have very, very different headlines related to today's release of March quarter CPI figures. From the headlines alone, you would not know that they are referring to the same set of figures.

The Age: Weak CPI opens way for RBA

The Australian: Inflation rise reduces chances of rate cut in May

We ARE in a recession.

Last month I posted a blog indicating that I believed we were in a recession. Yesterday, Mr Rudd stated that a recession is inevitable. As a result the media is in a frenzy.

I believe the statement made by Mr Rudd is technically incorrect. (Aside from the fact that the rule of two consecutive quarters of negative growth is a little dubious.) If Mr Rudd and his associates believe the next figures to be released will show Australia recorded negative growth for the first quarter of 2009, then, up until March Australia was in a recession. Furthermore, given the less than favourable outlook, it is more than likely that we will be in a recession for sometime yet.

Inflation Not Anticipated

More and more commentators are asking the question that has been bothering me for a few weeks now. Given the risk that the large US fiscal deficit will lead to an increase in the supply of money (as opposed to greater domestic or international borrowing or higher taxes as a way of funding expenditure), why does it appear that the market does not anticipate high rates of inflation in the future?

The Road Less Travelled

Stephen King at Core Economics links to an interesting article in The New York Times, Business Grads Looking Beyond Wall Street

.... For the last decade, a job at Goldman Sachs, Morgan Stanley or another investment bank has been considered the most coveted prize for many of the nation’s best and brightest college students. But the implosion of Wall Street — the vaporization of Bear Stearns and Lehman Brothers, the general humbling of investment banks — has not only shaken a generation’s ambitions, but also unleashed them.

“There was a real herd mentality to get into investment banking,” said Ms. Levy, noting that prestige, peer pressure and parents often channeled students to Wall Street. But because of the crisis, “there was suddenly permission to pursue something you were interested in that your parents three years ago would have said absolutely no to.”....

The optimistic bear

Consider the following headline: US STOCKS-Economic optimism, GE spur 6th week run-up

The link between "economic optimism" and stock prices is somewhat tenuous. Of course, stock prices increase when the probability of economic recovery increases unexpectedly, as cyclical recoveries are good for corporate profitability. However, this is where the link ends. There are many circumstances where economic growth would not necessarily translate into higher profits accruing to shareholders of existing firms:

- High rates of growth in developing economies resulting from relatively high savings rates coupled with the reallocation of labour away from agriculture.

- Higher rates of growth in developed and developing economies resulting from capital infusion into new firms.

- Higher rates of growth resulting from technological change in a competitive economy (where the benefits would flow to consumers, and the suppliers of labour).

There is also a distributional story to tell in regards to the link between stock prices and "economic optimism". The recent significant declines in stock prices and housing prices in many parts of the world are not good news for shareholders of existing firms or owners of the existing housing stock, but (assuming the declines were not entirely driven by "fundamentals") will benefit those individuals who are considering purchasing a stake in the economy's capital and housing stock, as they will see a better rates of return on funds invested.

Therefore, it is important not to generalise the link between optimism and stock prices beyond the obvious cyclical channel.

Alcopops again

The Federal Government is planning to introduce legislation into Parliament to restore the alcopops excise at the higher rate.

Putting both the politics and the process of the plan to one side, while I have already posted on the absence of any justification for taxing premixed drinks at a different rate to other spirits, a post this month at Angry Bear provides further food for thought.

It is useful to characterise the findings from analytical models on taxes on externality generating activities in terms of three distinct effects on economic welfare: the"primary welfare gain", a "revenue-recycling effect", and a "tax-interaction effect. The first is simply the familiar net (of costs) partial-equilibrium benefits from the reduction in alcohol related harm. In the presence of pre-existing tax distortions, the revenues that are raised by such taxes can be used to reduce the rates on existing distorting taxes (such as taxes on labour). Hence, there is a second source of welfare gain: the revenue recycling effect. The gain comes from the small reduction in the wedge between the gross and net wage with a resulting increase in the level of employment. The third effect, however, discourages work effort by reducing the real wage. This tax interaction effect reduces welfare.

The effect of the alcopos tax on economic welfare thus depends on the net impact of these three effects. Given that many of those who consume alcopops may not be in the workforce, the optimal tax on alcopops may be somewhat more that the marginal external damages from consumption, depending upon the way in which the revenues are recycled and the degree of substitution between alcopops and other externality generating goods.

Can we have confidence in the Business Confidence survey?

Earlier this week the NAB released the results of its latest business confidence survey. According to the survey, confidence rose for the second month in a row. However, it is still at very low levels.

Recently, the integrity of the survey was called into question for two reasons:
1. It does not publish a margin of error or say how it is calculated.
2. It is not clear what Business Confidence actually measures.

It seems to me that this is another example of misleading economic information. This is a real problem given we live in an information age. Especially as it seems information like this, more than ever, seems to be driving the economy.

New Mankiw chapter

The page proofs for a new chapter in Greg Mankiw's intermediate macroeconomics text are online. The chapter, A Dynamic Model of Aggregate Demand and Aggregate Supply, is well worth reading if you are interested in issues surrounding monetary policy design.

Social welfare and macroeconomic policy

What is the social welfare function that is implicitly being maximised by macroeconomic policy makers? Brad Delong's repost of A Non-Socratic Dialogue on Social Welfare Functions made me think about a March post by David Andolfatto, Multiplier Mischief, regarding government spending multipliers estimated to be greater than 1.

[1] What does this theory predict concerning the optimal level of Y? Is more Y always to be preferred to less? When Y was expanding rapidly above trend during WW2, were people really made materially better off? Were people made happier by their long hours employed in military manufacture and European adventures? Did people really enjoy the rationing of foodstuffs and gasoline associated with the increase in G? Was the general destruction of capital (both physical and human) during WW2 really associated with increasing wealth levels? .....

[6] Should we follow Christina Romer's advice and take employment as a metric of economic welfare? Has she not studied economic theory? (Actually, I know the answer to this last question--it is no). I recall reading an article from the TASS news agency, published in 1957 that "the unemployment rate in the Soviet Union, as in previous years, was equal to zero." Should we seek "full employment" along the old Soviet model? Is this how we are to measure success?

Ignore the obvious straw men. While the empirical literature on happiness reports that unemployment has a negative effect on subjective well being (see Chapter 5 here for the psychological evidence, and here), no policy maker would argue that simply maximising employment will maximise social welfare. Policy makers also need to take into account the value of government spending, the benefits of job search etc. While it is likely that at high levels of involuntary unemployment increasing employment through government spending will increase social welfare, at some point the contribution is likely to become negative.

Monetary policy transmission mechanism and the importance of new loans

Monetary policy — its all about new loans, by Sam Wylie, Core Economics .. The Big4 banks’ refusal to fully pass on the RBA’s 25 basis point (bp) cut on Tuesday “has blunted the effectiveness of monetary policy” , according to Wayne Swan. I don’t think the Treasurer’s statement is correct.

Through its monetary policy a central bank controls the interest rates, and volume of money in circulation, in an economy, with the objective of stabilising prices and/or economic growth. The conversion of liquidity into credit by commercial banks is the main mechanism of monetary policy. In Australia the banking mortgage channel is a large part of overall credit creation by banks. Ok, that is very standard. But the point I think the Treasurer misses is that monetary policy acts mostly through the creation of new loans, rather than changing the interest rate on existing loans.

Interest rates are the exchange rates between the present and the future. Reducing interest rates makes present consumption more attractive relative to delayed consumption (saving), so consumption spending rises.

Moreover, as the cost of debt and equity capital declines with interest rates, investment projects become more valuable (future cashflows get discounted less heavily) and investment spending rises. Increased consumption and investment occurs through new loans, and therefore monetary policy acts through new loans rather than existing loans.

Consider the effect of the banks not cutting rates on existing mortgages. By not passing on the full 25 bp, the banks are holding on to about $800 million per year ($500 billion of variable rate mortgages times 16 bp held across the four banks). That is, households pay $800 million per annum to the banks that they would otherwise hold onto. That is bad for the households, but why does it blunt monetary policy? The households would spend or save the money. But, the banks will simply lend it on, creating more credit in the economy, or pay it out as dividends. The repricing of existing loans is fairly neutral in monetary policy terms.

New loans are a different story. Lower housing interest rates stimulate demand for credit to buy and build houses. So long as that credit can be supplied (and as money volumes expand with lower rates credit should expand), then lower rates will stimulate economic activity.

The effect of monetary policy in the mortgage market is principally through new loans not existing loans. Existing loan rates are set by bank fiat, but the rates on new loans are negotiated with banks. Households shop for mortgages, and the acheivable discount on a new loan is determined by competition between the banks.

The banks’ pronouncements about passing on the RBA cut, are statements about rates on existing mortgages and therefore not closely connected to monetary policy. Those pronouncements are not statements about the rates on new mortgages because those rates are determined by competition.

Solving King Solomon's Dilemma

David Andolfatto at MacroMania, has a fascinating post on King Solomon's Dilemma

King Solomon's Dilemma and Behavioral Economics, MacroMania, March 29, 2009... When the tale of King Solomon's dilemma was first told to me as a kid, I was (like most people, no doubt) left marvelling at Solomon's brilliant solution to a rather difficult predicament.But then I grew up and made the unfortunate choice of pursuing a graduate degree in economics. My mind was left rotted to the point where I could no longer appreciate what most other people continued to believe was the self-evident wisdom of Solomon.

The problem with Solomon's "solution" is that it adopts what in modern parlance would be labeled a "behavioral approach." In other words, the solution relies heavily on the assumption that people are "irrational" in a particular sense. It turns out to be easy to be a wise philosopher king when one assumes that everyone else is irrational. Perhaps this is why so many aspiring philosopher kings today want to replace conventional economic theory with what they call "behavioral economics."

Let's think about this. The "mechanism" (game) designed by Solomon proposes to split the baby in two (sounds "fair" at least). One women screams out "No! Let the other have the whole baby instead." The other woman coldly agrees to the solution. The real mother is revealed in the obvious manner. What is not so obvious is why the false mother could not have anticipated this outcome; a more clever woman would have simply mimicked the behavior of the true mother. Instead, the false mother fails to make this calculation (and instead adopts a simple "behavioral" strategy; which is just a fancy label for irrational behavior).

Now, perhaps there really are "irrational" people like the false mother. But would you be willing to stake a baby's life on this assumption? Even if this mechanism worked out one time, could we reasonably expect it to work in the future (would people not learn from the outcome and tailor their strategies accordingly?). If you believe that people are fundamentally irrational in this sense, then you will make a fine behavioral economist (and a poor philosopher king).

So what is the solution to Solomon's dilemma?

One approach might be to adopt the Coase theorem, which states that if transaction costs are zero, then an arbitrary assignment of property rights will lead to the efficient solution. That is, Solomon could just have assigned the baby at random to one or the other woman. If it fell into the hands of the false mother, the true mother (who presumably values the baby more) could then purchase the baby (from the one who values it less). In other words, if there are gains to trade (as would obviously exist in this case), then these gains will be realized--if transaction costs are zero.

The problem with this approach is that transaction costs are obviously not zero (these costs could arise, for example, if the true value of the baby by both women is private information). Moreover, this "solution" violates what most people would consider to be a principle of "fairness" (why should the true mother pay for her own baby?). The Coase theorem is a fascinating theorem, but it should not be applied as a solution to the problem at hand; the theorem simply states what one could expect to happen IF transaction costs are zero. In fact, the Coase theorem should be interpreted as explaining precisely why various institutions emerge to handle the problem of resource allocation in a world where transaction costs are not zero.

One such solution was offered by Solomon. But I have already highlighted the problem with his proposed institution (or mechanism). Another possible solution was offered by William Vickery: a sealed-bid second-price auction (or a Vickery
auction). Assume, as seems reasonable in this case, that only the two mothers know the true value they attach to the baby. A Vickery auction would have both mothers submitting sealed bids for the baby. The woman with the highest bid would then win the auction, but pay the second-highest bid.

This solution is clever because the amount that either woman expects to pay is independent of their actual bid. Accordingly, neither one of them have an incentive to misrepresent how much they really value the baby. If the true mother values the baby more, she will win the auction (it would not be rational for the false mother to bid more than what the baby is worth to her).

Clever indeed. But there is still a problem associated with this solution. In particular, it requires that the true mother actually pay for her baby. Leaving issues of "fairness" aside, a more relevant problem may be that this mother does not have the resources to make the requisite payment. (It is absolutely critical that the payment be forthcoming; if Solomon could not credibly commit to collecting the payment, then rational players will understand this limitation and alter their strategies accordingly).

One solution might be to let the women offer themselves as indentured servants. This sounds feasible and has the desirable property that the true mother gets her baby (she would presumably be happy to offer herself as Solomon's servant, if it means getting her baby). While this solution has its drawbacks, it seems to dominate Solomon's solution--something that risks having the baby split in two.

But is it possible to design a mechanism that "does the right thing" without any cost to the true mother? Several solutions have been proposed in the literature; but each with its own peculiar drawbacks. But I recently came across one proposed solution that seems quite clever; see Bid and Guess: A Nested Solution to King Solomon's Dilemma, by Cheng-Zhong Qin of UC Santa Barbara.

The idea as presented in Qin's paper seems a little more complicated than it needs to be (but I could be wrong). The basic idea, as I see it, is to have the women play a "participation game" just before playing a standard Vickery auction. We could set up the mechanism as follows.

First, Solomon informs the women of the Vickery auction that will be used to allocate the baby. Second, he informs each woman that the price of participating in the Vickery auction will be a half-life of servitude in some miserable occupation. The women are then asked to submit envelopes with ballots that are marked "yes" or "no" (yes, I am willing to participate; no I am not). If both women submit "yes," then the Vickery auction is played. If only one woman submits "yes," then the baby is allocated to her for free (the auction is not played). If neither woman submits "yes," then the baby is disposed of in some manner (perhaps in the King's service).

Now, put yourself in the place of first, the true mother and second, the false mother. How would you play the game? Would you say "yes" or "no?"

Theory suggests that the true mother will say "yes" to the participation game (she knows that she will get the baby if the auction is played; she will pay one half-life of servitude for participation, and the other half-life in payment for the baby). Likewise, the false mother will say "no." Why submit to a half-life of servitude when she knows that she will inevitably lose the subsequent auction? The false mother will rationally bow out of the bidding; she will choose not to participate. And the baby is allocated for free to the true mother.

Of course, this assumes that the people playing this game are "rational" in the sense that they understand the rules of the game and in the sense that they can anticipate how others are likely to play it. One of the great strengths of assuming rationality in this form is that the assumption can be applied as a general condition that prevails in any resource allocation problem. Its weakness is that people may not always possess this assumed degree of rationality.

But the alternative--the "behavioral approach"--suffers from an even greater problem. In particular, the policymaker must be aware of precisely how people are irrational in each and every given circumstance (a great loss in generality). There are an infinite number of ways in which people might be irrational; and the behavioral theorist is forced to choose among an infinite number of "behavioral rules" that he or she believes captures this irrationality in a plausible manner. The only hope that a behavioral theorist has for developing a general theory is in discovering that people are irrational in some systematic manner. But if the theorist can identify this systematic pattern of irrationality, it seems hard to know why people cannot discover it for themselves too. But then, it seems clearly in the interest of aspiring philosopher kings prefer to think of themselves as being systematically more rational than the subjects they study.

Encouraging home ownership during a recession 2

There is concern in some quarters regarding government incentives to encourage home ownership during a recession. I have posted on this previously.

Bank gamble on first homes, by Eric Johnston, April 12, 2009, The Age ...New loans issued to first-home buyers rose 15.9 per cent in February compared with a year ago, to a record 14,484, according to figures released last week by the Australian Bureau of Statistics. The number of loans to owner-occupiers rose 0.4 per cent in February — the fifth consecutive increase in lending activity, with first-home buyers driving growth...

In October, the first-home owners grant was doubled to $14,000 for existing homes and $21,000 for new dwellings. At $21,000 this represents about 6 per cent of the average first-home buyer dwelling price....

Banks insist the boom in firsthome buyer grants does not represent increased risk. Banks do not count the first-home grant as part of the deposit while loan to valuation ratios — that measure the level of debt compared to the asset — are being reduced....

JPMorgan analyst Scott Manning believes first-home buyers are borrowing too much at high initial loan-to-valuation ratios at artificially low interest rates."(This) will ensure that Australian households remain highly geared and highly sensitive to any future increase in interest rates," he said.

Mr Manning said that despite housing prices being relatively flat in the past year, the first-home buyers' average loan size had increased 14 per cent to $283,000.

Unemployment Benefits

Peter Martin provides this graph comparing unemployment benefits to the single pension, from the Australia Institute's submission to the Henry Review.

The Unemployment benefit is indexed to CPI; the pension is inedexed to faster-growing wages....

Already Australians on disability pensions (already far too many) are afraid to look for work because if it doesn't work out they are cactus.

A further interesting point in relation to this graph is that, as we have seen in Australia and the United States, relatively low unemployment benefits limit the effectiveness of automatic stabilisers and require larger discretionary adjustments in fiscal policy during times of economic contraction.

Bicycle registration fees

Following on from the Oregon bike registration fee post on this blog earlier this week, The Age reports on a similar idea for Melbourne.

... (R)ecent talk suggests the boom in cycling is accompanied by a similar rise in people who think cyclists should have to pay — and be held accountable — for their time on the road.

In February, 3AW radio host Neil Mitchell called for a registration fee or tax at the point of sale to help pay for the State Government's new $115 million bike strategy.

His call echoed that of then Federal Opposition spokesman on sports, Pat Farmer, who last year said cyclists should pay registration to fund infrastructure and safety campaigns.

Ideally, bike riders should "pay their way" in terms of marginal social cost. Of course, marginal cost pricing does not generate sufficient revenue to cover all costs when there are substantial fixed costs in terms of infrastructure. In this regard, a distinction needs to be made between recreational and transportation bicycle use. In terms of recreational bike use, property owners pay council rates that are used to finance local bike tracks, and therefore local recreational riders probably already pay their way. Recreational riders who ride for longer distances (eg along Beach Road in Melbourne's bayside) do not finance infrastructure in the same way, nor do those riders who use their bicycles for transportation.

Economic theory, however, does not dictate that a rider registration fee should be set at a rate that ensures full cost recovery. While economic theory can assist to identify ways in which the required funds can be raised in a manner that minimises social cost, the ultimate choice as to who should bear the costs is an ideological one, reflecting one's vision of a "good society".

As a result, let's restrict the analysis to marginal social cost. If cyclists were charged a fee for road usage proportional to wear and tear their travel causes, it is likely that the fee would be less than it would cost to administer the charge. In terms of externalities, congestion costs which, on shared bicycle-car roads, can be substantial, need to considered against the benefits from improvements in rider health that are not internalised by the riders themselves (ie are accrued by society in general because of the nature of labour market institutions, the health care system etc).

An important point, however, is that given distortions in other markets (for example, tax benefits on company cars encouraging environmentally damaging car use), it may be inappropriate to set a rider fee equal to marginal social cost. Generally, the chances of government failure in the use of price instruments are considerably larger in a "second-best world" than in a "first-best world". This serves as a warning against the implementation of an ill-thought out cyclist registration fee.

Why is GDP typically revised upwards?

Philip Franses has recently published an article tackling the question: Why is GDP typically revised upwards? The article investigates revisions to GDP growth over a three year period beginning in 2005 for the Netherlands. The average revision over this period was 0.67.

This is a very interesting article as it reminds us that economic data is not as precise as some people think it is.

Philip Franses suggests two reasons for the imprecision, one, the behaviour of forecasters who have to fill in the missing values and two, the method of collection.

What does this mean for Australia? Can we expect the most recent GDP estimates to be revised up?

I don’t think the findings in this article infer anything about Australian GDP figures. Although, it is interesting to note, despite the overall average adjustment in Netherlands GDP growth being positive, the last two adjustments corresponding to the end of 2007 were negative. Interestingly, this period corresponds to onset of the GFC. Therefore, one may conclude that revisions are up in good times and down in bad times. Only time will tell whether this is also true for Australia.

Health Benefits of Recessions

A Downturn’s Silver Lining, by Andrew Leigh, Australian Financial Review, 7 April 2009 .. Australia has enjoyed a steady decline in the road toll over the past generation. Thanks to safer cars and tougher road rules, the road toll has fallen about 3 percent a year for the past few decades. But two years stand out from the data: 1983 (down 15 percent) and 1990 (down 17 percent).

Is it just a coincidence that the two biggest drops in the Australian road toll coincided with the last two recessions? Probably not, if research by University of North Carolina Christopher Ruhm is to be believed. In a series of papers, Ruhm and his co-authors have meticulously documented that mortality tends to rise in booms and fall in busts. Recessions make you live longer. With titles like “A Healthy Economy Can Break Your Heart”, “Good Times Make You Sick” and “Healthy Living in Hard Times”, Ruhm’s research challenges the meme that economic downturns are unambiguously bad. We know that losing a job can be a searing experience, so how can a higher unemployment rate improve overall health?

The answer is that losing your job probably is bad for your health, but most people don’t lose their jobs in a recession. If Australian unemployment were to rise to 10 percent, nine-tenths of the labour force would still be employed. Even in severe downturns, most people keep their jobs – they just work fewer hours and earn
less.

At least in the short term, shorter hours and a slimmer pay packet seem to be good for average health. On-the-job injuries fall when there is less work around. We also have robust evidence that there are more alcoholics and chain smokers in good times than in downturns. Even severe obesity seems to drop when the economy hits the skids (suggesting that belt-tightening might be literal as well as figurative). In recessions, families are more likely to eat at home, and there is more time to exercise. People also get more sleep, which may not make you wealthy or wise, but certainly contributes to good health.

To quantify these effects, let’s look at current predictions of unemployment. In early-2008, the Australian unemployment rate was around 4 percent. This February, Treasury’s Updated Economic and Fiscal Outlook forecast that unemployment would rise to 7 percent by June 2010. (Treasurer Wayne Swan has since hinted that it could be higher than this, but has not given an updated figure.) So what would a 3 percentage point increase in unemployment do to mortality in Australia?

To answer this, I used estimates from a cross-country analysis of23 OECD countries (including Australia) by Ruhm and co-author Ulf Gerdtham. Their headline result is that a 3 percentage point rise in unemployment would reduce mortality in Australia by about 1 percent – saving around 1,650 lives per year.Which categories of deaths are likely to fall? In proportionate terms, the largest reduction would be a 6 percent drop in vehicle accidents (about 80 fewer deaths), since less economic activity means fewer cars on the road. We can alsoexpect a 5 percent drop in deaths from liver disease (80 lives saved), partly as a result of reduced alcoholism. A slump would also reduce flu and pneumonia deaths by about 3 percent (90 lives saved).

In absolute terms, the biggest gain from a major downturn would be from heart disease. Although an economic slump would only cut deaths in this category by 1 percent, heart disease is the nation’s biggest killer, so that would represent around 500 fewer deaths per year. There might also be a small rise in suicide – though this was not statistically significant in Gerdtham and Ruhm’s analysis, and its magnitude was too small to offset the other improvements. Overall, those most likely to be kept alive by a downturn are prime-age men.

These results are provocative, but need to be kept in perspective. Physical health may improve in a recession, but mental wellbeing and self-reported happiness decline. Less money reduces the capacity of households to enjoy the good life. And compared with joblessness, the mortality magnitudes are fairly small: a 3 percentage point rise in unemployment might avert 1,650 deaths, but it means that 340,000 Australian workers need to lose their jobs.

As Ruhm firmly notes in one of his papers: “Evidence that health deteriorates when the economy improves is not an argument for inducing recessions, which have overwhelmingly negative consequences even if worse physical health is not one of them.” Or to put it another way, the cloud may have a silver lining, but we’re still going to get wet.

Oregon Bike Tax Proposal

A rather odd proposal if (1) riding a bike generates positive externalities (in net terms), and/or (2) we live in a second best world where drivers cannot be charged for the full cost of their actions.

Are Bicyclists Free Riders? By Freakonomics .....Do bicyclists contribute their fair share to the transportation network? An Oregon lawmaker thinks not, and has proposed a law requiring cyclists to pay a $54 registration fee every two years. A
Portland bike blog interviewed the lawmaker in question, who explained the proposal this way: “[B]ikes have used the roads in this state forever and have never contributed a penny. The only people that pay into the system are those people who buy motor vehicle licenses and registration fees.” Considering the enormous benefits of investments in bicycle infrastructure, can even a tax-hating bicyclist concede his point, at a registration cost of just over 7 cents a day?

Weekend Shopping Trip

Whilst walking around the shops this weekend, I encourage you to consider the following:

Do the recent retail sales data support or condemn the Rudd-Labor Government's cash bonus scheme?

I believe neither. I believe sales is only one side of the coin. The other side being profit margins. If Bourke Street is anything to go by, I suspect these profit margins are fairly thin!

A time to hold.

Earlier this week, I found myself contemplating what decision the RBA will make at its’ next board meeting. In theory there are three options, increase, decrease or hold. After considering the issue carefully I find myself concluding that the cash rate should remain unchanged. I have four reasons why I believe this would be the most appropriate decision.

First, on balance, recent economic news has been relatively good. Second, the full impact of recent rate cuts have still to take effect. Third, the effects of recent fiscal incentives (cash bonuses) have yet to be fully ascertained. Four, I believe it would have a positive effect on confidence.

Some may find my first reason puzzling, perhaps even crazy. However, I believe careful consideration of recent economic data suggests Australia is in a relatively favourable position. This is particularly true when compared to some of our major trading partners and past experiences. For example, Australia’s unemployment rate is no where near the heights of the 1990s recession, nor is it experiencing the gains of the UK or USA.

Sadly, many people appear to be unaware of how much time it takes for a change in the official cash rate to impact on the economy. Research suggests a lag in excess of 12 months. Importantly, much of this research was conducted using data corresponding to economic times. Arguably, cash rate changes have an even less effect in times of hardship. All this suggests that recent changes in the official cash rate have yet to filter through.

The Rudd-Labour Government has placed a big emphasis on cash bonuses. The most recent cash bonus was administered less than a month ago. Not enough time has passed to see whether these incentives have had their desired effect.

Lastly, I believe a decrease in the cash rate would send the wrong signal. Over the last year I have observed that the Australian economy as a whole has been less volatile. In particular, not characterised by the hysteria we see off shore. I think a decision to hold the cash rate would reinforce consumer and producer sentiment.

In conclusion, I confess that I also believe there are harder times ahead. It is my expectation that we will not bottom out for sometime yet. Therefore, I also suggest that it would be wise to preserve some arsenal, even if only for a precautionary measure.

Wall Street Journal watch - Australian edition

From the usually reliable WSJ, a misleading article.

Australia Retail Sales Fall - Gloomy Data Follow Huge Stimulus Plan and Interest Rate Cut APRIL 1, 2009 .... Australian retailers had their worst month in over eight-and-half years in February despite an aggressive interest rate cut and a mammoth fiscal spending package unveiled by the government.

Wow, sounds pretty serious. Tell us more.

Retail sales fell a seasonally adjusted 2% to 18.87 billion Australian dollars (US$13.10 billion) in February from A$19.26 billion in January, the biggest one-month drop since July 2000.

Consider the retail sales figures released by the ABS yesterday. What the WSJ article fails to mention is that retail sales in February remained close to their record high January levels. I doubt that retailers would consider February to be their worst month in almost a decade, as claimed by the WSJ.