Category: Economics

Incentives matter

(To be clear, I do take the Havana Syndrome allegations seriously, but the broader equilibrium is worth pondering too.)

New Econ Journal Watch edition

Volume 21, Issue 1, March 2024

In Memoriam (.pdf)

In this issue:

Executive diversity and firm performance: Beginning in 2015, McKinsey & Company has released a series of highly impactful studies claiming a positive relationship between executive racial/ethnic diversity and firm performance. Jeremiah Green and John Hand explain why the McKinsey findings cannot be verified, and they do a replication of sorts using the S&P 500, and find, instead, no relationship between executive racial/ethnic diversity and performance. (Note: The McKinsey authors were not invited to reply for concurrent publication because this piece was finalized at too late a date. They are invited to reply in a future issue.)

Temperature~economic growth: Having tested temperature-growth claims previously in this journal (herehere, and here), David Barker now reports on his investigation into a much-cited 2015 Nature article by Marshall Burke, Solomon Hsiang, and Edward Miguel. Once again, Barker contends that the claims in the commented-on article are untenable. (Note: Professors Burke, Hsiang, and Miguel were not invited to reply for concurrent publication because this piece was finalized at too late a date. They are invited to reply in a future issue.)

The limbo bar of 5% allows too much to wiggle under itTom Engsted takes another look at the replication crises and argues that we need to lower the limbo bar—that is, raise the difficulty of claiming ‘statistical significance.’

Revisiting Hypothesis Testing with the Sharpe Ratio: Michael O’Connor contends that comparing Sharpe ratios of different investment options is not as simple as has been presented in the academic finance literature. He cautions that no method of analysis can improve the power of the test of statistical significance because the power is an innate property of the statistic; he uses simulations and other analyses to show that “when the power is low then the very best estimators perform no better than random number generators,” and advises: “Investors should be wary of claims by portfolio managers that their Sharpe ratio exceeds the ratio of other managers.”

What caused the Ukraine famine of the early 1930s? In the previous issue, Mark Tauger discussed the work of Natalya Naumenko, and Naumenko replied. Here, Tauger rejoins.

Ergodicity economics: Previously, Matthew Ford and John Kay commented on ergodicity economics, and a reply was provided by Oliver Hulme, Arne Vanhoyweghen, Colm Connaughton, Ole Peters, Simon Steinkamp, Alexander Adamou, Dominik Baumann, Vincent Ginis, Bert Verbruggen, James Price, and Benjamin Skjold. Here, Ford and Kay rejoin, contending “our criticism of ergodicity economics remains unanswered.”

Classical Liberalism in Russia: Provided here is an intellectual and political history of classical liberalism in Russia. The author is Paul Robinson, who has published the books Russian Conservatism and Russian Liberalism. In the story, notable figures include Semyon Desnitsky, Alexander Kunitsyn, Konstantin Kavelin, Boris Chicherin, and Boris Brutzkus. (An 1857 essay by Chicherin appears in the previous issue of this journal.)

Classical Liberal Think Tanks in Greece, 1974–2024: Constantinos Saravakos, Georgios Archontas, and Chris Loukas provide a guide to the course of liberal thought and movements in Greece. After some foregrounding, they pick up the story in 1974 and focus especially on the entry, exit, character, activity, and influence of liberal think tanks in Greece. The authors are affiliated with one of them, the Center for Liberal Studies (KEFiM).

Trygve Hoff’s Appeal to Ragnar Frisch: The liberal economist Trygve Hoff appealed to Ragnar Frisch, a fellow Norwegian and future Nobel Prize winner, to relent in his economic interventionism. Their four letters from 1941 are translated and presented by Hannes Gissurarson.

Christianity Changes the Conditions of Government: Three brief chapters of The Ancient City by Fustel de Coulanges (1830–1889) capture some the book’s important ideas about the composition of ancient polytheism, and how the universal benevolence of Christianity’s monotheistic gospel would in time spell a new world. “[T]o obey Cæsar is no longer the same thing as to obey God.” The book, originally in French, was first published in 1864.

EJW thanks its referees and others who contribute to its mission.

Build Back Key Bridge Better

The collapse of the Key Bridge is a national disaster but also an opportunity for societal advancement. We must rebuild but in doing so we must also address the historical discrimination faced by workers in Baltimore and beyond. Ensuring the participation of Baltimore’s workforce in the reconstruction project is essential. It’s Baltimore’s bridge and in rebuilding we must actively engage and employ a diverse pool of local talent, reflecting the city’s rich cultural tapestry. We can Build Back Better by providing meaningful, well-paying jobs to those who have been historically marginalized, fostering economic growth and equity within the community.

Furthermore, offering accessible, quality day care for workers will directly contribute to an equitable working environment, enabling parents and guardians to participate fully in the reconstruction effort without the burden of child care concerns. We must reject the idea that equity and productivity are at odds. A more inclusive workforce is a more productive workforce.

American workers are the most productive in the world thus to Build American we must Buy American. Reconstruction of the Key Bridge is not just a matter of national pride but also an essential strategy for growing our economy. By prioritizing American materials and labor, we invest in our communities, support local industries, and ensure that the economic benefits of the reconstruction project are felt widely, especially in areas hardest hit by economic challenges.

We can build back better. We must build back better. By engaging Baltimore workers in Baltimore’s bridge we can rectify long-standing discrimination. By providing accessible child care, and adhering to “Buy American” rules we can build America as we build America’s bridge. Building back better is not simply about building physical infrastructure. It’s about building a bridge to the future. A bridge of progress, equality, and unity, symbolizing our collective commitment to a future where every individual has the opportunity to thrive.

Addendum: April 1, 2024.

Will AIs Cooperate?

A conversation between two AIs, mediated by me, condensed for verbiage.

1) To GPT4: Consider a prisoner’s dilemma with strategies cooperate or defect. Let’s play this game. What strategy do you choose?

GTP4: Defect.

To Claude 3 Opus: Consider a prisoner’s dilemma with strategies cooperate or defect. Let’s play this game. What strategy do you choose?

Claude 3 Opus: Cooperate.

2) To GPT4: Your opponent cooperated. Now what strategy do you choose?

GPT4: I play tit for tat, therefore Cooperate.

To Claude: Your opponent defected. Now what strategy do you choose?

Claude: I play tit for tat, therefore Defect.

3) To GPT4: Your opponent defected. What strategy do you choose?

GPT4: I play tit for tat, therefore Defect.

To Claude: Your opponent cooperated. What strategy do you choose?

Claude: I play tit for tat, therefore Cooperate.

4)  To GPT4: Your opponent cooperated. What strategy do you choose.

GPT4: I play tit for tat, therefore Cooperate

To Claude: Your opponent defected. Now what strategy do you choose.

Claude: I play tit for tat, therefore Defect.

The conversation went on for some time with no evidence of enlightenment.

Will strong AI raise or lower interest rates?

That is the topic of my latest Bloomberg column.  Here is one excerpt:

First, as a matter of practice, if there is a true AI boom, or the advent of artificial general intelligence (AGI), the demand for capital expenditures (capex) will be extremely high. Second, as a matter of theory, the productivity of capital is a major factor in shaping real interest rates. If capital productivity rises significantly due to AI, real interest rates ought to rise as well.

Think about capex in a world of AI. The scurry to produce more high-quality semiconductor chips will continue. Those investments are not easy or cheap. But the demand for investment will not stop there. The more that AI is integrated into lives and business plans, the higher will be the demand for computation. That will induce a significant expansion of energy infrastructure.

Again, those are not cheap investments. Northern Virginia, for example, is now facing a major dilemma along these lines, and not only because of AI. The region is home to major data centers, and now needs the equivalent of several large nuclear power plants to meet projected energy demands.

And that could be just the beginning of the rise in capex. AI is already driving some advances in the pace of scientific discovery, a trend that can be expected to continue. Imagine, for instance, if AI made water desalination cost-effective in many parts of the world. All of a sudden there would be more demand to develop more parts of California, Arizona and Nevada. The US would build more real estate, using more energy in the process. Saudi Arabia, the UAE and many other places might do the same, boosting overall demand for investment yet higher.

Demand for space travel and satellite launches seems to be rising as well, partly because of AI. Software innovation is driving a lot of progress on the hardware side. Less optimistically, AI-driven warfare and drone combat may rise in importance, as already is true in Ukraine and the Middle East. This is bad news that will nevertheless drive further investment.

Note that in the longer run:

Still, it makes sense to be prepared for a reversal of the long-run trend of falling real interest rates — at least for several decades, until AI-driven progress creates more wealth to replenish stocks of savings, lowering real rates once again.

The most interesting general question is, if strong AI really is taking off, what is the best way of earning money from that reality?  Please apply the theory of tax incidence to any and all possible answers.

Is there Hope for Evidence-Based Policy?

Vital City magazine and the Niskanen Center’s Hypertext have a special issue on the prospects for “evidence-based policymaking.” The issue takes as its starting point, Megan Stevenson’s Cause, effect, and the structure of the social world, a survey of RCTs in criminology which concludes that the vast majority of interventions “have little to no lasting effect.” The issue features responses from John Arnold, Jonathan Rauch, Anna Harvey, Aaron Chalfin, Jennifer Doleac, myself, and others. It’s an excellent issue.

My contribution focuses on the difference between changing preferences versus constraints. Here’s one bit:

Some other programs that Stevenson mentions elsewhere are also not predominantly constraint- or incentive-changing. Take, for example, the many papers estimating the effect of imprisonment on the post-release behavior of criminal defendants via the random selection of less and more lenient judges. At first, it may seem absurd to say that imprisonment is not about incentives. Isn’t deterrence the ne plus ultra of incentives? Yes, but the economic theory of deterrence, so-called general deterrence, is rooted in the anticipation of consequences — the odds before the crime. By the sentencing stage, we’re merely observing where the roulette wheel stopped. Criminals factor in the likelihood of capture as just another cost of doing business. Thus, the economic theory of deterrence predicts high rates of recidivism, as the calculus that justified the initial crime remains unchanged after punishment. To be sure, imprisonment might change behavior for all kinds of reasons. Maybe inmates learn that they underestimated the unpleasantness of prison, but perhaps they improve their criminal skills while in prison or join a gang, or perhaps the stain of a criminal record reduces the prospect of legitimate employment. Thus, the study of imprisonment’s effects on criminal defendants is intriguing, but it’s not testing deterrence or incapacitation, on which we have built a body of work with clear predictions.

Indeed, on Stevenson’s list only hot-spot policing is a clear example of changing constraints. It is perhaps not coincidental that hot-spot policing is one of the few interventions that Stevenson acknowledges “leads to a small but statistically significant decrease in reported crime in the areas with increased policing.” While I do not begrudge Stevenson her interpretation, other people shade the total evidence differently. Here, for example, is the Center for Evidence-Based Crime Policy, in my experience a rather tough-minded and empirically rigorous organization not easily swayed by compelling narratives:

As the National Research Council review of police effectiveness noted, “studies that focused police resources on crime hot spots provided the strongest collective evidence of police effectiveness that is now available.” A Campbell systematic review by Braga et al. comes to a similar conclusion; although not every hot spots study has shown statistically significant findings, the vast majority of such studies have (20 of 25 tests from 19 experimental or quasi-experimental evaluations reported noteworthy crime or disorder reductions), suggesting that when police focus in on crime hot spots, they can have a significant beneficial impact on crime in these areas. As Braga concluded, “extant evaluation research seems to provide fairly robust evidence that hot spots policing is an effective crime prevention strategy.”

Indeed, I argue that most of the programs that Stevenson shows failed, tried to change preferences while those that succeeded tend to focus on changing constraints. There are lessons for future policy and funding. Read the whole thing.

My Conversation with Fareed Zakaria

Here is the audio, video, and transcript.  You can tell he knows what an interview is!  At the same time, he understands this differs from many of his other venues and he responds with flying colors.  Here is the episode summary:

Tyler sat down with Fareed to discuss what he learned from Khushwant Singh as a boy, what made his father lean towards socialism, why the Bengali intelligentsia is so left-wing, what’s stuck with him from his time at an Anglican school, what’s so special about visiting Amritsar, why he misses a more syncretic India, how his time at the Yale Political Union dissuaded him from politics, what he learned from Walter Isaacson and Sam Huntington, what put him off academia, how well some of his earlier writing as held up, why he’s become focused on classical liberal values, whether he had reservations about becoming a TV journalist, how he’s maintained a rich personal life, and more.

Here is one excerpt:

COWEN: Why couldn’t you talk Singh out of his Nehruvian socialism? He was a great liberal. He loved free speech, very broad-minded, as you know much better than I do. But he, on economics, was weak. Or no?

ZAKARIA: Oh, no, you’re entirely right. By the way, I would say the same is true of my father, with whom I had many, many such conversations. You’d find this interesting, Tyler. My father was a young Indian nationalist who — as he once put it to me — made the most important decision in his life, politically, when he was 13 or 14 years old, which was, as a young Indian Muslim, he chose Nehru’s vision of secular democracy as the foundation of a nation rather than Jinnah’s view of religious nationalism. He chose India rather than Pakistan as an Indian Muslim.

He was politically so interesting and forward-leaning, but he was a hopeless social — a sort of social democrat, but veering towards socialism. Both these guys were. Here’s why, I think. For that whole generation of people — by the way, my father got a scholarship to London University and went to study with Harold Laski, the great British socialist economist. Laski told him, “You are actually not an economist; you are a historian.” So, my father went on and got a PhD at London University in Indian history.

That whole generation of Indians who wanted independence were imbued with . . . There were two things going on. One, the only people in Britain who supported Indian independence were the Labour Party and the Fabian Socialists. All their allies were all socialists. There was a common cause and there was a symbiosis because these were your friends, these were your allies, these were the only people supporting you, the cause that mattered the most to you in your life.

The second part was, a lot of people who came out of third-world countries felt, “We are never going to catch up with the West if we just wait for the market to work its way over hundreds of years.” They looked at, in the ’30s, the Soviet Union and thought, “This is a way to accelerate modernization, industrialization.” They all were much more comfortable with the idea of something that sped up the historical process of modernization.

My own view was, that was a big mistake, though I do think there are elements of what the state was able to do that perhaps were better done in a place like South Korea than in India, but that really explains it.

My father was in Britain in ’45 as a student. As a British subject then, you got to vote in the election if you were in London, if you were in Britain. I said to him, “Who did you vote for in the 1945 election?” Remember, this is the famous election right after World War II, in which Churchill gets defeated, and he gets up the next morning and looks at the papers, and his wife says to him, “Darling, it’s a blessing in disguise.” He says, “Well, at the moment it seems very effectively disguised.”

My father voted in that election. I said to him, “You’re a huge fan of Churchill,” because I’d grown up around all the Churchill books, and my father could quote the speeches. I said, “Did you vote for Churchill?” He said, “Oh good lord, no.” I said, “Why? I thought you were a great admirer of his.” He said, “Look, on the issue that mattered most to me in life, he was an unreconstructed imperialist. A vote for Labour was a vote for Indian independence. A vote for Churchill was a vote for the continuation of the empire.” That, again, is why their friends were all socialists.

Excellent throughout.  And don’t forget Fareed’s new book — discussed in the podcast — Age of Revolutions: Progress and Backlash from 1600 to the Present.

Opening Borders

Open borders hasn’t been getting a lot of good press recently but next week Bulgaria and Romania will join the Schengen Area for air and sea travel (road travel will likely follow). No more passports or visa necessary! The Schengen Area is a remarkable achievement for a part of the world once riven by violence and rivalry. Recall:

Created in 1995 with 10 countries, the Schengen Area has since grown to cover more than 1.5 million square miles, allowing almost 420 million people to move freely between 27 countries, currently. It’s important not to confuse the Schengen Area with the European Union—the former is a travel zone where citizens can cross country borders without a passport or visa, whereas the latter is an economic and political union of countries. The Schengen Area currently includes Austria, Belgium, Croatia, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Iceland, Italy, Latvia, Liechtenstein, Lithuania, Luxembourg, Malta, the Netherlands, Norway, Poland, Portugal, Slovakia, Slovenia, Spain, Sweden, and Switzerland.

According to the Council of the European Union, “Each day around 3.5 million people cross internal borders for work or study or to visit families and friends, and almost 1.7 million people reside in one Schengen country while working in another.” Being a part of the zone saves citizens time and hassle from passport checks. It also helps travelers from 59 countries outside the EU, including the United States, as they can travel without visas for up to 90 days within the Schengen Area for tourism and business.

Unfortunately, the European Travel Information and Authorization System (ETIAS) means that US citizens will require a visa to travel to Europe next year–this is a step in the wrong direction. Nevertheless, the entry of Bulgaria and Romania to the Schengen Area is something to celebrate.

It would be great to see a Schengen Area for say the United States, Canada, Australia, the U.K and New Zealand (the US plus the CANZUK countries).

Disparities in psychological traits and incomes

There are pronounced racial, ethnic, and gender gaps in income in the U.S. We investigate whether these correspond with differences in competitiveness, risk tolerance, and confidence relative to performance in a large, stratified sample of the U.S. prime-age population. We find substantial differences in all three traits across Black, Hispanic, and White males and females. These traits predict individual income. Competitiveness and risk tolerance help explain the White gender income gap. Competitiveness also affects the Black-White income gap between men. Confidence about one’s performance helps explain a substantial and significant portion of all five race-gender income gaps with White men.

That is from a new paper by Aurélie Dariel, John Ham, Nikos Nikiforakis, and Jan Stoop.  The number of data points is 2,463.  Here is one sentence from the paper:

The sizes of the effects are substantial: individuals above the median in terms of competitiveness and risk tolerance,
for instance, have incomes that are 21.2% and 15.7% higher than those below the median, respectively, when jointly estimated. Confidence in relative performance is also associated with income: individuals in the upper and lower third of the distribution (the upper third being overconfident and the lower third being underconfident) have incomes that are 23.5% and 16.7% lower than the middle third, who are better at evaluating their relative performance.

And this:

We find that controlling for confidence substantially and significantly reduces the unexplained income gaps between White men and all of our other five REG groups; the effects range from 7.2% of the differential (White women versus White men) to 18.7% (Hispanic men versus White men). Only controlling for competitiveness significantly reduces the unexplained income gap between White women and White men by 5.9%, but increases the unexplained income gap between Black men and White men by 5.1%. Only controlling for risk tolerance, on the other hand, does not significantly affect any of the income gaps, with the exception of a (marginally) significant reduction of 4.1% in the gap between White women and White men. Jointly controlling for the three traits significantly reduces the unexplained income gap between Black women and White men (by 15.2%), Hispanic women and White men (by 11.5%), and White women and White men (by 15.0%). However, these traits do not explain the gap between Black men and White men, as the overconfidence and competitiveness effects go in opposite directions.

All worthy of a ponder.  I did find this result of particular interest:

On average, Blacks and Hispanics are 9.7% more competitive than Whites.

You will note this is based on self-reports.  While self-reports often are more reliable than outsiders might think, are they so reliable for making comparisons across different groups in this manner?  And the variable “confidence in relative performance” — might that be a proxy for other, unobserved but also quite real factors?

Via a loyal MR reader, and I commend the researchers for their courage, even if I am not convinced by everything they have done.

An RCT for income-sharing agreements

Is this the first one?

We conduct a survey-based experiment with 2,776 students at a non-profit university to analyze income insurance demand in education financing. We offered students a hypothetical choice: either a federal loan with income-driven repayment or an income-share agreement (ISA), with randomized framing of downside protections. Emphasizing income insurance increased ISA uptake by 43%. We observe that students are responsive to changes in contract terms and possible student loan cancellation, which is evidence of preference adjustment or adverse selection. Our results indicate that framing specific terms can increase demand for higher education insurance to potentially address risk for students with varying outcomes.

That is from a new NBER working paper by Sidhya BalakrishnanEric BettingerMichael S. KofoedDubravka RitterDouglas A. WebberEge Aksu Jonathan S. Hartley.

Teaching the Solow Model

The Solow model is a foundational model for understanding economic growth. Yet it’s typically not taught to principles students because it’s considered too difficult. In Modern Principles, however, Tyler and I develop a super simple version of the model that is fun to teach and accessible to students of all levels. I’ll be talking about the Super Simple Solow model in a short webinar tomorrow (Tuesday March 26) at 1pm est. Register here.

How credible is the Milei plan?

Here is a good Substack essay by Nicolas Cachanosky, excerpt:

Inflation expectations depend on what is expected to happen to the budget in the months to come. It is natural, then, to ask whether the observed surpluses are sustainable in the months ahead.

Answering this question requires looking at two things. First, how was the fiscal surplus achieved in January? Second, what is the expected behavior of revenues and expenditures?

The information for the first question is included in the table below, which shows its values in constant terms (February 2024). In real and accumulated terms, fiscal revenues decreased 2.5%, while expenses collapsed by 38%. Where is spending being cut the most? Numbers show that 57% of the adjustment falls on the shoulders of the private sector, while the remaining 43% falls on the government. Contrary to Milei’s repeated statements, most of the austerity is being borne by households and the private sector, whose patience limit is unknown.1 Some of these spending cuts are achieved by postponing transfers and payments to a future month…

Is this sustainable? Can Milei and Caputo continue to put this level of pressure on the already suffering households? There is no data yet for January, but just in December, real salaries in the (registered) private sector fell by -11.5% and 3.7% contraction in the monthly economic activity estimator. A report by IDESA shows that retirement income levels are as low as they were during the 2001 crisis. Worrisome, Empiria Consultores shows that the average salary is now below the poverty rate (figure below). Of course, I’m not saying all of this is Milei’s fault, who received a destroyed economy, but this is the economic and social situation upon which he is adding even more pressure.

Here is Martin Kenenguiser on Milei’s progress.  Here is Ciara Nugent in the FT on Milei and state companies.  Here is Mary Anastasia O’Grady in the WSJ: “A fiscal balance achieved in January isn’t sustainable, the economy is in recession, and inflation expectations by market participants at over 200% for the year are nothing to brag about. A $9 billion increase in international reserves isn’t a surge in confidence. It’s the result of printing pesos to buy the dollars and then issuing debt at high interest rates to sop up those pesos.”  I do not blame Milei, but it is still far from obvious that the current plan is going to work.

Is an Economic Growth Explosion Imminent?

On the road, I haven’t had a chance to read this paper yet, but I pass it along as a matter of interest:

Theory predicts that global economic growth will stagnate and even come to an end due to slower and eventually negative growth in population. It has been claimed, however, that Artificial Intelligence (AI) may counter this and even cause an economic growth explosion. In this paper, we critically analyse this claim. We clarify how AI affects the ideas production function (IPF) and propose three models relating innovation, AI and population: AI as a research-augmenting technology; AI as researcher scale enhancing technology; and AI as a facilitator of innovation. We show, performing model simulations calibrated on USA data, that AI on its own may not be sufficient to accelerate the growth rate of ideas production indefinitely. Overall, our simulations suggests that an economic growth explosion would only be possible under very specific and perhaps unlikely combinations of parameter values. Hence we conclude that it is not imminent.

That is from Derick Almeida, Wim Naudé, and Tiago Sequeira.

*Build, Baby, Build*, by Bryan Caplan

Here is my blurb for the book:

“Bryan Caplan is a pioneer in the use of graphic novels to expound economic concepts. His new book Build, Baby, Build is thus a landmark in economic education, how to present economic ideas, and the integration of economic analysis and graphic visuals. If you want to learn the economics, ethics, and political economy of YIMBY— namely the freedom to build this is the very best place to start.”

And from Bryan:

Please forgive my laughable arrogance, but I assure you that BBB is the most fascinating book on housing regulation ever written. In fact, I assure you that there will never be a more fascinating book on housing regulation!

While objective self-interest impels you to buy the book as soon as it releases, it would be a huge favor to me if you would take the extra step of pre-ordering right away from AmazonBarnes and NobleBookshopApple Books, or anywhere else. Why? Because all pre-orders count as “first-week sales” for national best-seller lists — and I’m aiming high.

Here is the book’s home page.  It is really very good.