Month: October 2010

The people are upset at Greg Mankiw

You could try Kevin Drum, Mark Thoma, or Brad DeLong, or some of the comments on MR, among other commentators.  Various remarks are made to lower the status of George Bush, or Greg Mankiw, or to raise the relative status of Barack Obama and his fiscal policy.  Furthermore not everyone likes Greg's benchmarks, or accepts the typicality of his example. 

When I read Greg's piece, I see it as fair to compare current marginal rates to a zero taxation benchmark, without advocating the latter.  To understand a tax system you compare it to no taxes, as an exercise, and to avoid potential problems with the near-intransitivity of indifference. 

I also see that if a person runs a successful small business, has a long time horizon, has a strong bequest motive, and can earn eight percent nominal a year (make it reinvestment in a private business if you don't buy the equity premium story), that person faces a very high marginal tax rate.  In one of Greg's examples it's about ninety percent.

That some producers are motivated by ego does not change that fact.  Furthermore, many small businessmen don't receive Greg's global recognition and they really do work hard for the money above all else.  

Greg's column focuses on efficiency but I am more struck by the possibility that such marginal rates are morally wrong and I wonder if that is not his view too. 

Greg's scenario doesn't have to be a "typical" case and indeed the taxation – if nothing else — will ensure that it is not a typical case or not nearly as common a case as it ought to be.  Another way to put the point is to note that deviations from a progressive consumption tax may be less morally defensible than we had thought.

I also view Greg's column as a chance to learn.  What comes to mind are two possible defenses of our tax system-to-be:

1. In reality, eveyrone has a short time horizon, driven by short-term ego rewards and thus such high long-term tax rates can work.

2. The tax system will be an efficient means of price discrimination.  The people with truly long time horizons can work around some of the high rates, especially for estates.  The people with short time horizons will pay up and those are the same people whose labor won't be much deterred.  (There is an interesting discordance in that Greg claims to belong to one camp but some of his critics wish to put him in the other.)

The second claim seems more plausible to me, but they're both worth thinking about.  Neither, in my view, removes the moral issue.  

There are plenty of encoded status claims in Greg's initial piece, and perhaps that is one reason why it induced so much hostility.  I say keep your eye on the ball, filter out the analytically irrelevant social information, and consider that, even if you wish to raise taxes on the wealthy, that a ninety percent marginal rate — even at a non-universal margin — is a sign that something really is amiss.

Addendum: Andrew Gelman comments, and again.  And here is Reihan Salam.  And here is Ryan Avent.  And here is Greg's response.

Markets in everything

The 33 trapped Chilean miners have moved to stop any individual from profiting at the expense of the group, drawing up a legal contract to share the proceeds from the story of their ordeal.

The group have already rejected requests for interviews and have instead made plans to jointly write a book about the days spent trapped below the Atacama Desert following the mine collapse on August 5.

We'll see if that holds up.  The full story is here and for the pointer I thank Eric Hartley.  Is it unethical to pay an individual miner for the story of the group?

Some personal observations on the Prize

This is a prize for the importance of economic heterogeneity and the importance of second-order effects.  The cited labor market imperfections cannot be cured by reflating nominal demand, although that policy may be desirable for other reasons.  Mortensen and Pissarides have an explicitly Schumpeterian approach and their work represents one version of a "recalculation" argument.  (Peter Diamond in contrast does not draw out that aspect of the problem and I think of the three as each a quite different kind of economist.)  You can think of Mortensen and Pissarides as providing one reason why private recalculation takes longer than is socially optimal and how this might be fixed.  Their work shows how cyclical and structural phenomena operate together and must be analyzed together.  In the last twenty years their work on labor markets has been much more influential, and rightly so, than traditional Keynesian approaches.  Furthermore their work has dissolved the entire characterization of "Keynes vs. whomever" as out of date.  Their work has much influenced my blogging on the recent employment crisis.

Christopher A. Pissarides

See my Mortensen post for his work with Mortensen, which encompasses some of his most important contributions.  He teaches at LSE and his home page is here.  His Wikipedia page is here.  A brief bio is here.  His CV is here and he was born in Cyprus as a Greek Cypriot.  Here are some working papers.  

Here is Pissarides on Google Scholar.  Here is his book on equilibrium unemployment theory.  He has a very good paper on hysteresis and how originally short-term unemployment can worsen and persist.  He emphasized that point in today's phone interview.

Here is his 2003 paper praising British labor market policy:

Unemployment in Britain has fallen from high European-style levels to US levels. I argue that the key reasons are first the reform of monetary policy, in 1993 with the adoption of inflation targeting and in 1997 with the establishment of the independent Monetary Policy Committee, and second the decline of trade union power. I interpret the reform of monetary policy as an institutional change that reduced inflationary expectations in the face of falling unemployment. The decline of trade union power contributed to the control of wage inflation. The major continental economies failed to match UK performance because of institutional rigidities, despite low inflation expectations.

For the contrast with the Continent, see here and here.

Of the three winners, I think of Pissarides as the least Keynesian of the trio. This is a big victory for "not just Keynesian" visions of the labor market and macroeconomics more generally. Garett Jones called this a prize for "relationship macro" and it also can be said that sophisticated versions of real business cycle theory are alive and well.

Here is his very good 2009 Econometrica piece on wage stickiness, abstract:

I study the cyclical behavior of an equilibrium search model with endogenous job creation and destruction, with focus the model’s failure to match the observed cyclical volatility of unemployment. Job creation in the model is influenced by wages in new matches. I summarize microeconometric evidence on wages in new matches and show that the key model elasticities are consistent with the evidence. Therefore explanations of the unemployment volatility puzzle have to preserve the cyclical volatility of wages. I discuss some extensions of the model that can increase cyclical unemployment volatility through mechanisms other than wage stickiness.

A Prize for Unemployment

The 2010 Nobel Prize awarded to Peter A. Diamond, Dale T. Mortensen, Christopher A. Pissarides can be thought of as a prize for unemployment theory.

A key breakthrough was to realize that the problem was not how to explain unemployment per se but rather how to explain hiring, firing, quits, vacancies and job search and to think of unemployment as the result of all of this underlying microeconomic behavior.  Notice that the underlying behavior involves not just workers looking for jobs but also employers looking for workers so explaining unemployment would require a theory of job search, worker search and matching and each aspect of the theory would have to be consistent with every other aspect; i.e. how much workers search depends on how much employers are searching (e.g. advertising) and vice-versa and also on the quality of matching and all of these considerations need to be addressed together.  It was Mortensen and Pissarides in particular, building on work by Diamond, who built just such a consistent model.

A very surprising empirical fact helped to motivate this perspective: even in a recession millions of jobs are being created every month.  The figures we usually hear about the number of jobs created is the net figure but in the United States in August, for example, there were 4.1 million hires (and 4.2 million separations).  Thus, as noted above, understanding unemployment requires understanding these much larger flows of job creation and destruction.

Calibrating the (Diamond)-Mortensen-Pissarides model and embedding it in a dynamic real business cycle model to see if it can match the facts has been a key aim of recent work (see also here and Robert Shimer's work).

Search theory has been applied extensively to the labor market but the same type of theory can be used to understand any issue in which matching is important such as marriage markets and the housing market.  

See Tyler for many more details on Diamond, Mortensen and Pissarides.

Dale T. Mortensen

He has been on the Northwestern faculty since 1965 and he is a Carnegie-Mellon Ph.D. (I am surprised to read how old he is).  His Wikipedia page is here and his home page is here.  Here is a short bio.  Here is Mortensen on Google Scholar.

His seminal paper is: D. Mortensen and C. Pissarides (1994), 'Job creation and job destruction in the theory of unemployment.' Review of Economic Studies 61, pp. 397–415.

This is one of the best and most important papers in the last twenty years of economics (note that it builds upon the analysis of Diamond).  Here is the abstract:

In this paper we model a job-specific shock process in the matching model of unemployment with non-cooperative wage behaviour. We obtain endogenous job creation and job destruction processes and study their properties. We show that an aggregate shock induces negative correlation between job creation and job destruction whereas a dispersion shock induces positive correlation. The job destruction process is shown to have more volatile dynamics than the job creation process. In simulations we show that an aggregate shock process proxies reasonably well the cyclical behaviour of job creation and job destruction in the United States.

The key point in this paper is to show how unexploited gains from trade can persist in labor markets.  It seems odd that desperate workers would simply turn down jobs, even for lower wages, so why doesn't an economy move back rapidly to full employment?  One way of putting the point is that negative shocks alter search behavior by both workers and employers and so fewer favorable matches come about.  In particular, the rate of job destruction is extremely high.  There is also an asymmetry between job creation and job destruction, due to option value, and thus discrete cut-offs for job creation and job destruction, and that leads to a central result of the paper:

The dynamics of job destruction, however, are different, because the rise in the reservation productivity…leads to an immediate destruction of all jobs with idiosyncratic components between the two reservation productivities. Job destruction also rises for reasons similar to the ones that led to its decrease when price increased, since with higher reservation productivity firms are more likely to destroy jobs as they are hit by job-specific shocks. But the increase in job destruction immediately after the cyclical downturn has no counterpart in the behaviour of the job destruction rate when price increases, or in the behaviour of the job creation rate. This imparts a cyclical asymmetry in the job destruction rate and in the dynamic behaviour of unemployment. The short-run cyclicality of the job destruction rate increases, the job destruction rate leads the job creation rate as a cause of the rise in unemployment and the speed of change of unemployment at the start of recession is faster than its speed of change at the start of the boom…

That's explaining a lot of the observed time series behavior of unemployment, and in a strict rational model with no arbitrary assumptions about market imperfections.  (And the simulation supports the analysis and its relevance.)  You are, as an employer, quite willing to destroy a job because you still have the option of rehiring favorably later on; keeping a job going doesn't yield the same calculus of benefits.  Here is a good summary passage from the paper:

We have shown that at higher common components of labour productivity (alternatively when the aggregate price distribution translates to the right), the probability that an unemployed worker finds a job is higher and the probability that a job is destroyed is lower within given finite lengths of time. An examination of the dynamics of job creation and job destruction when it is known that labour productivity changes randomly has revealed that the anticipation of cyclical change reduces the cyclicality of job creation, and the short-run response of job destruction to shocks increases the cyclicality of job destruction…

As I read this work, it shows that "cyclical" and "structural" causes of unemployment are not always conceptually distinct but rather they interact in harmful ways.  An implication is that looking at the Beveridge Curve (which is stocks, not flows) won't necessarily identify the nature of unemployment at any point in time.

If there was ever a Nobel Prize given for a single very important paper, it is this one.

Here is a paper extending and defending his basic unemployment model.  Here is Mortensen's lengthy 1984 survey on seach and unemployment.  Here is his later, 1999 survey with Pissarides, which also recaps their own work.

In some of the policy applications of these models there are mixed employment effects from unemployment insurance (not necessarily negative, because waiting relieves crowding in the search queue) and positive effects from a job destruction tax.  Wage subsidies don't always work out well for job creation.  A key point is to analyze not just the first-order effect of the labor market policy but also its incidence, and thus its second-order effects on search and job matching.  Mortensen, along with Pissarides, has made the analysis of labor market policy considerably more sophisticated; here is one presentation of their main policy results.  Here is another version of the same.

Here is his piece on the importance of personal contacts in labor markets.

Mortensen has a whole book on wage dispersion, reviewed here.  The key question is why workers with similar characteristics often are paid differently and the answers lie in job search frictions.

Here is a recent paper on growth through product innovation (you can google to an ungated version, though the pdf has no link).  Both in this paper and in the job market work you can see the strong influence of Schumpeter, and the idea of creative destruction, on the research of Mortensen.  It's about time people stopped laughing at "recalculation" models of our downturn because one version of them just won a Nobel Prize.

In sum, picking Mortensen (and his co-author Pissarides) shows that the committee sees unemployment as a central issue of the day.  At the same time, there aren't always easy answers to this problem.

Peter A. Diamond

Here is Diamond's home page, here is Diamond on Wikipedia.  Diamond has been at MIT since 1970 and he is considered one of the bulwarks there, having produced many excellent students, including Bernanke and Andrei Shleifer.  Here is the bit of most current interest:

On April 29, 2010, Diamond was announced by Barack Obama as one of three nominees to fill the three vacancies then present on the Federal Reserve Board, along with Janet Yellen and Sarah Bloom Raskin.[5] On August 5 the Senate returned Diamond's nomination to the White House, effectively rejecting his nomination. Ben Bernanke, the current Chairman of the Fed, was once a student of Diamond.

Some of Diamond's early work was in capital theory, as he outlined the conditions under which, in dynamic growth models, the level of capital could be inefficient.  Read this paper, from 1965, which is still his most frequently cited work.  It helped produce a standard framework for thinking about national debt and economic growth.

Diamond has contributed plenty to the theory of optimal taxation, in particular when linear commodity taxes are optimal and how to use the tax system for redistribution.  See this paper with James Mirrlees (also a Nobel Laureate) and also this one.  One implication is that taxing inputs often leads to more distortion than taxing outputs and you can think of this as one possible motivation for a consumption tax.

Here is Diamond's 1982 paper on macro and search theory, which I think of as his most influential.  The abstract is classic Diamond:

Equilibrium is analyzed by a simple barter model with identical risk-neutral agents where trade is coordinated by a stochastic matching process.  It is shown that there are multiple rational expectations equilibria, with all non-corner solution equilibria inefficient.  This implies that an economy with this type of trade friction does not have a unique rate of natural unemployment.

The relationship to the current day U.S. is striking.  One point he stresses is that subsidization of production can make sense and also that there can be real costs of converging to the lowest possible rate of unemployment too quickly.  This remains an important "framework" paper for analyzing the interaction of search and aggregate demand.  His other 1982 search paper implies that labor mobility will be less than is socially optimal.  This paper on search theory shows that unemployment compensation can lead to better job matches, by limiting crowding externalities in the job market.

He and Olivier Blanchard wrote a classic piece on the Beveridge Curve, which is about the relationship between job vacacies and the unemployment rate.  Some commentators cite the Beveridge Curve as evidence for structural unemployment, although this is controversial.

Diamond has written a great deal on social security, often at the applied level.  Here is his paper criticizing social security privatization in Chile for its high costs.  Here is his survey on social security reform proposals.  Here is his paper on macro and social security reform.  Here is a very good European talk he gave on pension issues.  Diamond wrote a book with Peter Orszag on social security and he has been a major influence on Democratic Party thinking on this issue; the book looks closely at progressive price indexing rather than wage indexing of benefits.  Here is a CBO summary and analysis of the plan.  Much of Diamond's more formal social security analysis stresses risk-sharing issues and in general he often points out that social security proposals, including Bush's privatization idea, are not well-grounded in rigorous analysis.

Here Diamond tells us not to expect 7 percent stock returns for the ongoing future.

Diamond has many interests, here is his survey on contingent valuation and whether some number is better to use than no number at all.  He and Stiglitz wrote a famous paper on risk and risk aversion.

Personally, my favorite Diamond paper is this short gem on the evaluation of infiinite utlity streams; it will make your head spin, as it asks whether we have coherent means of thinking about prospects with infinite utility and in general how intertemporal utility streams should be ordered.  See also his related paper on stationary utility, co-authored with T.J. Koopmans.

Here is his short introduction on behavioral economics.

I think of Diamond as the classic MIT economist, especially of the earlier, pre-Acemoglu generation.  Lots of theoretical rigor, though sometimes his theory pieces don't have a simple or simply analytic punchline.  There is greater concern with risk, and stability conditions, and dynamic and border conditions, than you would see in a Chicago theory paper.  There is a strong emphasis on the ability of government to implement welfare-improving schemes of the sort found in social democracies.  The approach is quite technocratic — solve and advise.  Public choice and political economy considerations take a back seat.  High IQ.  Of the MIT economists, he has done the most to pursue the Samuelson tradition of having a universal method and very broad interests.  His papers remain central to public finance, welfare economic, intertemporal choice, search theory, macroeconomics, and other areas.  His policy impact on social security has been significant.

Addendum: Levitt comments on Diamond.

Peter A. Diamond, Dale T. Mortensen, Christopher A. Pissarides

They are the new winners of the Nobel Prize.  I'll be adding updated information for the next hour or two, so if you use RSS please visit the blog's home site for the latest!

This is a prize for search theory and labor markets and job matching, all very important ideas today, especially in the United States.  It is a well deserved prize and all authors have produced very well-cited and very influential papers.  It is a theory prize, although Diamond in particular also has some empirical papers.  I'll write a separate post for each economist.

Maurice Allais

French physicist and economic Nobel Laureate Maurice Allais has died at age 99.  Allais is best known among American economists for the Allais paradox but Allais was a polymath with contributions (and JSTOR here) in a huge number of areas many of which were often overlooked because his work was not translated into english (an unfortunate fact which is still true today).

One thing that few people know about Allais was that he was a big proponent of the gold standard and Austrian business cycle theory, even citing Mises and Rothbard in some of his work.  See in particular his paper in English, The Credit Mechanism and its Implications (1987) in Feiwel (ed), Arrow and the Foundations of the Theory of Economic Policy.  See also here for further citations in french.

As might be expected from a polymath, Allais's views are difficult to pigeonhole.  He was a strong proponent of private property and the market economy, for example, but to create the consensus necessary to produce such a society he also favored immigration restrictions and protectionism.

Amazingly, Allais also conducted ground breaking experiments on pendulums which earned him the 1959 Galabert Prize of the French Astronautical Society and which may have revealed an anomaly in general relativity that physicists refer to as the Allais effect.

Assorted links

1. David Byrne selects photos of Detroit, and here is the decline of the Battersea Power Station.

2. Some Friedmanesqe themes in the arts, by me, through the Dallas Fed.  At the end I discuss why the Friedmans (circa 1969) seemed to be more optimistic about the West Bank than about Bali.

3. Against (some) arbitrage (pdf).

4. Correlation and causation, a cartoon.

5. Joseph Schumpeter on the rationality of the voter.

Why do unions oppose merit pay?

Bryan Caplan asks:

I don't doubt that unions tend to oppose merit pay, but the reasons are unclear.  Profit-maximizing monopolists still suffer financially if they cut quality; the same should hold for unionized workers.  Why not simply jack average wages 15% above the competitive level, and leave relative wages unchanged?

Or to put the puzzle another way: Once you've secured a raise for all the workers in your union, why prevent employers from offering additional compensation for exceptionally good workers?

Earlier, Megan McArdle considered the topic.  One simple model is to invoke the median voter as either ruling the union or constraining it.  The implication is that most union members fear they will lose from greater accountability, even if the total size of the pie goes up.  As Megan noted, unions are set up to favor the bottom 55 percent of the workers; furthermore productivity can be very unevenly distributed.

Greg Mankiw’s marginal tax rate

Without any taxes, accepting that editor’s assignment would have yielded my children an extra $10,000. With taxes, it yields only $1,000. In effect, once the entire tax system is taken into account, my family’s marginal tax rate is about 90 percent. Is it any wonder that I turn down most of the money-making opportunities I am offered?

By contrast, without the tax increases advocated by the Obama administration, the numbers would look quite different. I would face a lower income tax rate, a lower Medicare tax rate, and no deduction phaseout or estate tax. Taking that writing assignment would yield my kids about $2,000. I would have twice the incentive to keep working.

The full column is here.  Perhaps Greg could do more to (legally) evade the estate tax, but that's hardly an argument for raising such a tax.

Alternatively, Dan Ariely asks:

Let’s say that your 1040 came with a little extra stuff: maybe a container with an alcohol content, or perchance something of the chocolate persuasion. What if your tax forms arrived in a gift box with some financial documents on the side? What if the instructions for filling out the form told you to type in your personal information and take a bite of chocolate, type in your W-2 information and drink some of the alcohol, add your deductions and try some of the nuts etc? What if we could live in a world where you actually looked forward filling out these forms?