Category: Economics

The New Financial Order

Like John Maynard Keynes and Milton Friedman before him, Robert Shiller is that rare economist who uses economic theory to design new and better ways of doing things. I highly recommend his book, The New Financial Order. (Indeed, I hope that Shiller will one day receive a Nobel prize for his work in economic design.) For some time, I’ve also been wanting to recommend The Atlantic magazine. This month’s issue is superb and includes the best piece on the state of the American economy that I have read (the link will take you to the online version but the magazine itself contains a number of useful charts and much else – buy it!). From that piece comes this quote on Shiller’s work:

A more radical variation on this concept comes from Robert Shiller, an economist at Yale, who believes that continuing financial-market innovations may soon enable private insurers to offer “livelihood insurance” that could protect workers from potential declines in their occupations (though not against an individual worker’s underperformance within a flourishing field). Similar products might insure against the eventual devaluation of specific academic degrees in the United States (such as those in software engineering or Russian language), or even against declines in the performance of the U.S. economy as a whole, relative to the rest of the world. (As Shiller notes, the fact that the past century was a good one for America does not necessarily mean that the next one will be.) Collectively, these products might lessen the large and arguably increasing risks inherent in the U.S. capitalist system.

These are bold ideas; it may be hard at first to wrap one’s mind around them. And it is perhaps ironic that financial markets–which are regarded by many people as amoral if not immoral–might ultimately solve some of the problems that socialist and utopian thinkers have been trying for centuries to address. But as improbable as livelihood insurance may sound, advances in data collection, data analysis, and financial-risk theory are lowering the technical barriers to such a system. Government action could help the creation of livelihood insurance on a large scale. Part of the government’s role would be technical–for instance setting the standards for the collection and sharing of personal income data that are necessary if livelihood insurance is to work. But two equally important tasks would be the articulation of a new vision of society–one where people are protected against the unexpected shocks that accompany rapid economic change–and the promotion of financial-services products that can sustain that vision. Without large markets covering a wide range of occupations, carriers offering livelihood insurance might have difficulty hedging their risk sufficiently.

Addendum: Robert Shiller’s homepage has lots of useful information.

The case for lifetime savings accounts

Glenn Hubbard, former chair of the CEA, argues that we should not tax savings:

While the Lifetime Saving Account (LSA) offers substantial simplification benefits, it also offers a vehicle to save more easily for a downpayment on a home, children’s education, or for medical expenses. With no withdrawal penalties, the account’s greater liquidity will encourage individuals to save, particularly moderate-income households worried about tying up funds for a long period of time. Like the president’s proposal to eliminate investor-level taxes on dividends, the LSA lays claim to the idea that income should be taxed only once. Indeed, given the generous contribution limits, most households could avail themselves of a consumption tax akin to the Flat Tax. They would pay taxes once when they earned wages or business income, but not again on returns to saving. This is an important step toward fundamental tax reform, particularly if the administration continues its recognition of the costs of double taxation of corporate income.

How much would capital accumulation go up?

To assess the impact on capital formation, one should compare the present value of additional private capital formation to the present value of lost tax revenue. Jonathan Skinner of Dartmouth College and I estimated that with even 25 cents of each dollar contribution as new saving, IRA contributions generate $2.21 of new capital per dollar of net revenue cost. If, as suggested by Harvard economist Martin Feldstein, one includes corporate income tax revenue from the higher capital stock made possible by the saving incentives, the ratio rises to $4.84 of net capital per dollar of new revenue cost. If each dollar of contributions contains 40 cents of new saving and one incorporates higher corporate income tax receipts, the savings incentives are actually self-financing.

My take: I’m totally on board kind of sort of. Until we address runaway government spending, tax changes will only bust the budget in the shorter run. Even with elasticity optimism, we won’t ever arrive at the self-financing equilibrium. Furthermore I will never have that much faith in any particular numerical projection. My main worry is stopping the current drain of resources from the private sector. And no, a trip to Mars is not just what the doctor ordered. Right now U.S. fiscal policy needs credibility and needs it badly. Won’t markets just think that any revenue boost will fly out the window as quickly as it comes in? Isn’t politics, and thus economics, first and foremost about subjective perceptions? Hubbard’s proposal, for all its merits, doesn’t address the core problems.

Addendum: Here is Brad DeLong’s recent post on the fiscal costs of social security privatization plans.

Hayek and the Reconstruction of Germany

At first, the U.S. POW camps for captured Germans were dominated by Nazi’s who threatened and even killed anti-Nazi “traitors.” But as American thoughts turned to the post World-War II era the camps were cleaned up and a reeducation plan was begun. In other countries, this might have been a euphemism for torture and forced labor but in the U.S. camps it meant libraries filled with books that the Nazi’s had banned and open discussion sessions led by professors from Harvard, Brown, Cornell and elsewhere. The story is told in The Washington Post Magazine article, Learning Freedom in Captivity.

Here is one interesting quote:

By mid-1944, new leadership had been installed at Concordia and many of the worst Nazis had been removed. Concordia’s canteens and library were filled with books that had been banned by the Nazis. Treichl read and reread the American bestseller The Road to Serfdom by Friedrich Hayek, which detailed the flaws in socialism and contrasted it with democracy.

Treichl went on to become head of Austria’s largest bank and honorary president of the Austrian Red Cross. To this day he has kept his beloved copy of The Road To Serfdom.

I find this story heart-warming and a fascinating tidbit of history but it also troubles me. What are we to make of a reeducation camp with The Road to Serfdom as text? Clearly, we cannot dismiss such a thing as a contradiction in terms because apparently it did some good. More broadly, Hayek warns against the hubris of social engineering – yet what was the post WWII reconstruction of Germany and Japan but social engineering on a grand scale? How do these lessons apply to Iraq? Could we fail in Iraq precisely because we do not have the power to reeducate?

Why can’t you find your favorite song?

… fans who venture onto any of the pay music sites will not find the most popular band ever, the Beatles. They will not find other top-selling acts, such as the Dave Mathews Band, Garth Brooks, the Grateful Dead, AC/DC and the Cars.

They will find that top-selling acts Madonna and Red Hot Chili Peppers sell their songs by the album, but not as singles.

They will find some musicians on one service, but not on others. They will find puzzling choices: Led Zeppelin fans can buy a 47-minute spoken-word biography of the band online, but no Zeppelin songs because the band has not licensed them for sale on the Internet.

Why are these potential gains from trade not being exploited?

1. Some artists are holding out for a higher price or better terms. This can mean either a better cut for the artist, or the artist does not like the “all songs for 99 cents” model of iTunes.

2. Many artists feel that selling songs on an individual basis takes them out of proper context or cannibalizes sales for the album.

3. Pre-1998 contracts do not specify Internet rights to the songs. Assignment of Internet rights can require the underlying contract to be renegotiated.

4. Renegotiations must involve both the performer and the songwriter.

5. Often the relevant parties cannot be found or are otherwise difficult to deal with. One executive said: “You can be sure the heirs are a son and daughter who aren’t talking to each other and one of those two is getting divorced.”

Here is the full account. You will find stories of high transaction costs, poorly defined property rights, and stubborn holdouts, all the classic predictions of institutional failure theories.

The bottom line: Selection, not just price, remains a big advantage for non-legal downloading. If iTunes and related services are to make it in the long run, they will need to offer near-universal choice of music.

Crime, cocaine, and marijuana

Serious and violent crimes dropped more than forty percent during the 1990s, more than can be explained by demographic shifts. One reason for the crime drop has been the shrinking trade in crack cocaine, here is one account and a more detailed treatment. For whatever reasons, crack has turned out to be a one-generation drug. As crack fell in popularity, crime rates have fallen in turn.

Richard Rosenfeld, writing in the February Scientific American, raises but does not answer the question why crack markets have bred so much violence compared, say, to marijuana markets. I have thought of several possible and related hypotheses:

1. Cocaine supply, which requires processing in Colombia labs, is more centralized in nature. Centralization leads to monopoly profits and thus a greater incentive for violence to protect territory. There will be mobs and mafias at the top of the supply chain. They will feel threatened if anyone invades their turf, and the tendencies for violence work their way down to the retail level.

2. Marijuana is closer to a constant cost supply drug. You can always grow some in your backyard. The power of mobs is limited correspondingly and the incentive to invest in marketing and addicting your customers is weaker.

3. Marijuana is more of a depressant than is crack. Users are less likely to turn violent when deprived of the drug. Marijuana is less addictive in the sense of inducing total desperation.

4. Crack, which was essentially a new drug, required greater marketing than did marijuana. Marketing led to fights over turf and to violence.

5. Marijuana is used by many members of the middle and upper middle classes. Crack has been more popular in ghettos and with lower income groups, in part because it is potent and cheap. The reasons for the violence differential are found in the nature of the respective clienteles, rather than in the nature of the drugs per se. For instance, when drug carriers walk through a ghetto to supply their customers, they are at greater risk, more likely to carry a gun, more likely to meet with a gang, and so on.

Further ideas from readers are welcome.

The bottom line: When it comes to crime, it matters a great deal which drugs people are taking. Furthermore, if we are able to legalize some but not all drugs, we should consider legalizing the most objectionable drugs, not the tamest ones. Legalizing marijuana, whatever its merits and demerits, would not make a huge dent in the crime rate.

Addendum: Ed Lopez adds the following:

1. Crack is split up a lot more than marijuana so it has (had) far higher markup once it hit the street.

2. The early profiteers were the street distributors who discovered how to multiply the number of doses from the uncut cocaine. That gave suppliers higher up the chain something to grab at.

I think a lot of the violence question boils down to risk-takers competing for rents that weren’t protected by contract.

3. Crack is more ephemeral than pot and used with greater frequency, so users are more prone to commit crimes to acquire additioanl doses.

What are the Democrat health care plans?

Dr. Rangel offers a summary:

1. Universal coverage with the Federal government as the single payer. Proponents; Braun, Kunicinch, and Sharpton. Cost; over a Trillion per year at least. Needless to say, none of these candidates are anywhere near the front runners in the polls. Do these people even remember Hillary Clinton and the early ’90s? Under such a system costs would be contained via price controls, restrictions, and rationing and for all this reduced care most Americans will be hit with either higher taxes and/or higher consumer prices (in order to raise most of the trillions needed to pay universal health care many of these plans would target businesses and investments with massive tax increases and these costs would in turn be passed on to the consumer).

2. Universal coverage via employers. Proponent; Gephardt, who would mandate that all employers pay for health insurance for their employees. Employers would be able to deduct 60% of the costs of the insurance premiums (the 60% would also be for the self employed and for government workers). Requiring all employers to provide for some type of health insurance for their employees is a great idea but in it’s current form as proposed by Gephardt it is potentially the most disastrous as far as containing health care costs is concerned.

What he is essentially proposing is that we massively expand the same system that has effectively insulated patients from the real costs of health care, prevented any type of competition or market forces from controlling costs and allowed health care expenses and usage to get out of control in the first place (see my post on this issue)! Without any market forces or direct governmental restrictions to control costs, usage of health care resources would expand ad nauseum and ultimately bankrupt the system. Cost; $215,000,000,000.00 a year assuming that health care costs remain level (likely to be several hundred Billion above these estimates).

3. Expansion of current programs or new government programs. Proponents; Clark, Dean, Edwards, Kerry, Lieberman. Costs; Anywhere from about $50 to $100 billion a year. With minor differences most of these proposals would expand coverage for children, provide for more coverage for people in between jobs, and increase tax relief for employers providing health insurance coverage (though not as much as Gephardt’s plan).

What is the bottom line?

None of these plans would institute any meaningful market reforms that may help to control health care costs. They claim their plans would make health care “more affordable for all Americans” but it all amounts to little more than political slight of hand. Health care wouldn’t be made cheaper nor more affordable. The costs would just be shifted and spread around. Higher costs for employers would be passed off to consumers and the rest would be paid by taxpayers in one form or another.

The danger of many of these plans is that the more money they pour into the system the more they will stimulate health care usage and this will lead yet again to large cost increases. I would be willing to bet that any one of these plans to expand health care coverage will be costing two or three times as much as projected in the next few years alone.

Government, when it simply transfers money (e.g. Medicare), can face lower marketing and administrative costs than does a private insurance company. Or government can save money by simply getting out of the way. These cases aside, the only way government can save real resources on health care is to restrict access, typically through some form of rationing. See also my earlier post on who are the uninsured.

Interview with Brad DeLong

Courtesy of Norman Geras. My favorite part:

What philosophical thesis do you think it most important to disseminate? > That science works.

My least favorite part:

What is your favourite song? > ‘Five Variations on a Theme of Dives and Lazarus’, by Ralph Vaughan Williams.

I’ll sympathize with Brad’s loyalty to Beethoven, but as for a favorite classical song I might opt for “Im Fruehling” or “Der Hirt auf dem Felsen,” both by Schubert. If we expand the domain I would consider the Beatles’s “Rain” or “You Won’t See Me,” or perhaps the Byrds’s “Eight Miles High.”

Kristoff on sweatshops

In a hard-hitting NYTimes op-ed, Nicholas Kristoff writes:

I’d like to invite Richard Gephardt and the other Democratic candidates to come here to Cambodia and discuss trade policy with scavengers like Nhep Chanda, who spends her days rooting through filth in the city dump….Here in Cambodia factory jobs are in such demand that workers usually have to bribe a factory insider with a month’s salary just to get hired.

Along the Bassac River, construction workers told me they wanted factory jobs because the work would be so much safer than clambering up scaffolding without safety harnesses. Some also said sweatshop jobs would be preferable because they would mean a lot less sweat. (Westerners call them “sweatshops,” but they offer one of the few third world jobs that doesn’t involve constant sweat.)…

The Democratic Party has been pro-trade since Franklin Roosevelt, and President Bill Clinton in particular tugged the party to embrace the realities of trade. Now the party may be retreating toward protectionism under the guise of labor standards.

That would hurt American consumers. But it would be particularly devastating for laborers in the poorest parts of the world. For the fundamental problem in the poor countries of Africa and Asia is not that sweatshops exploit too many workers; it’s that they don’t exploit enough.

Be sure and look at Kristoff’s heartbreaking audio-slide show, the Realities of Labor available at the above link, halfway down the right hand side. Hat tip to Life, Liberty, and Property.

Empire and Capital Flows

Brad DeLong laments that international capital in the late twentieth century did not flow to poorer countries the way it did in the late 19th century. Tyler comments here.

The key point that I think Brad and Tyler both miss is that in the late 19th century a lot of the capital was flowing within the structure of the British Empire. Whatever its faults (and there were many), the Empire did provide investors with the rational expectation that their property would not be expropriated. More broadly, the capital flows of the 19th century were accompanied by flows of intellectual capital – in the form of the rule of law and similar institutions. Japan and the East Asian tigers show that it is possible for a country to adopt these institutions without the imposition of Empire but it is not easy.

Where is our economy headed?

The ever-interesting Brad DeLong is on a real roll lately. Read his post on current economic trends. Here is my favorite part:

…more important than the short-run cycles are the long-run trends. Labor productivity growth in the United States rose from 1.2% per year from the mid-1970s to the mid-1990s to 2.3% per year in the late 1990s to 4.2% per year–so far–in the 2000s. How much of that second jump-up in productivity growth will be sustained? We do not know, but it is safe to bet that some of it will. (Me, I don’t believe those numbers: I prefer to look at the income rather than the product side of the National Income and Product Accounts, and say that the three economy-wide productivity numbers are 1.2%, 3.1%, and 3.2% respectively, with the difference between the income and product side blamed on an erratic “statistical discrepancy.”) When will the rapid productivity growth that we have seen in the United States and ascribed to information technology spread to the rest of the rich countries? We do not know, but we do know that one of these years it will make itself visible. How long will it take world trade in information-services like form-processing, accounting, and customer service to truly boom as a result of the internet and the fiber-optic cable in the same way that the iron-hulled ocean-going steamship and the submarine telegraph made world trade in staple goods–not just luxuries and preciosities–boom in the late nineteenth century? Once again we do not know, but once again we do know that one of these years it will make itself visible.

It is time for governments, firms, investors, workers, and parents worldwide to begin betting on the long-run trends that have become visible over the past decade. Such bets probably won’t pay off in the next year, or two, or three. But they surely will start to pay off sometime in the next ten.

I will direct your attention again to Brad’s recent post comparing Bob Rubin and Paul O’Neill. I think it is one of the finest things an economist has written on bureaucracy, ever.

Risk aversion, immortality, and science fiction

Jacob Levy, following up on my earlier discussions (click here, here, and here) considers how immortal characters in fiction have behaved. Many but not all are extremely risk-averse. Part of the basic thread is how immortality would change our behavior. Randall Parker argues that immortality would not alter our behavior much, at least not until we could alter our genetic programming.

Who Needs Progressive Taxation?

Apparently not the Swiss residents of the canton of Schaffhausen, in the northern part of Switzerland. Schaffhausen is in fact moving to a system of “degressive” taxation. That’s right, lower tax rates for the rich:

Beginning in January 2004, Schaffhausen will replace its system of increasing marginal tax rates on income with a system of degressive marginal rates. The cantonal tax rate will be set at just under 8 percent for income of SFr 100,000. It will rise to a peak of 11.5 percent for income between SFr 600,000 and SFr 800,000. Thereafter, the marginal rate declines with each incremental chunk of income: 10 percent at SFr 1,300,000; 8 percent at SFr 3,000,000; and just over 6 percent for income more than SFr 10,000,000. This is a true incentive-based tax system–the larger one’s income, the lower one’s marginal rate.

Declining marginal tax rates will also apply to wealth taxes, further enhancing the degressivity of cantonal taxes.

Schaffhausen has its own legislative parliament, which contains eighty deputies representing all regions within the canton. Eight political parties compete for these seats. Evidently Schaffhausen’s voters support a tax cut that gives the greatest benefits to the richest people. They believe that attracting wealthy individuals to reside in their midst is good for everyone.

Here is the full story. I don’t expect to have any data on this soon, but I am pleased to see the experiment. One question, of course, is whether cross-canton migration effects (as opposed to labor supply effects) are beneficial for Switzerland as a whole, or just for Schaffhausen. It does not create aggregate value to shuffle rich people from one canton to another. In any case I am amused to see an idea that finally weakens Alvin Rabushka’s loyalty to the flat tax.

Addendum: I am embarrassed to admit that co-blogger Alex tells me he posted on this topic some time ago, read his coverage as well.

Deirdre McCloskey’s Sins

Deirdre McCloskey has made a name for herself by critically examining the logic and rhetoric of economic arguments. She has a nice pamphlet summarizing her claims called “The Secret Sins of Economics.” It’s written for non-economists and nicely makes three points:

1. Some alleged problems of economics are virtues. For example, using math to describe and analyze economic behavior is actually good because math allows you to clearly deduce conclusions from premises.

2. There are some drawbacks to economics that are annoying, but acceptable. For example, economists assume people are always chasing profits. Her response is to say that this narrow focus tends to yield interesting insights. McCloskey identifies other drawbacks of economics and economists, such as professional arrogance, but asks that we forgive those because they really aren’t that bad.

3. McCloskey identifies two horrible, unforgivable economic sins – (a) economists tend to prove qualitative mathematical theorems whose conclusions depend on arbitrary, qualitative premises and (b) statistical analyses routinely confuse statistiscal and substantial significance.

These are pretty weighty charges – that much theoretical economic work is just a useless game and economists (among others) make routine statistical errors no decent statistics undergrad would ever make.

How to respond? I’m not a professional economist – so I can’t speak for the economics profession, but I think the second charge – misunderstanding of significance – is right on target. I’ve told students and colleagues many times that “not significant” does not mean “no effect.” It simply means that you can’t automatically reject the hypothesis that, according to an arbitrary standard, there is no effect, which is different than saying there really is no effect. As McCloskey says, significance is simply a measure of confidence in the effect’s measurement. The whole situation is quite bad. For a summary of anti-significance test views, see the book “What if there were no significance tests?”

This first charge doesn’t bother me too much. All academic endeavors must engage in thought experiments. In fact, bizarre, unrealistic thought experiments can lead to some great insights. But what McCloskey, I think, really focuses on is the lack of empirical discipline. That is to say, when you come up with the premise of your theorem, it should be well justified.

When I studied math, there was a real difference between how mathematicians did it and how physicists did it. Math people are purely concerned with what is logically possible (does B really follow from A?) but physicists employ “physical intuition” – a sense of what assumptions were appropriate, a gut feeling developed from doing lots of experiments and observation. That’s why a lot of physics seems mysterious to mathematicians – the math looks familiar, but why did the physics people choose mathematical model X over Y? McCloskey’s point could be rephrased as saying that economists should move away from the mathematician’s style of modelling (proving what is logically possible) to the physics style of modeling (developing models inspired and constrained by observation and experiment).