Category: Economics

Not enough.  Here are a few simple relationships, noting in advance that theory and empirics sometimes conflict.

1. A high nominal interest on a currency "ought to" predict forthcoming depreciation of that currency, on average.  After all, market equilibrium has to offer you more to hold this asset precisely because investors expect it to fall in value.  This is known as uncovered interest parity. 

In other words, exchange rates should not be a random walk.  But returns on currencies should be a random walk.  This means that future exchange rate movements should be predicted by the nominal interest rate differential, but additional exchange rate movements, adjusting for that differential, should behave like a random walk.   

2. In reality these relationships are not obviously true.  Many investors believe that the market overestimates the risk of high nominal interest rate currencies.  If you simply slotted your money into high nominal interest rate currencies from, say, 1970 to 1990, you would have done very very well.  This view, however, is not as popular as it once was.  Starting with the Asian financial crises of the 1990s, investors have been burned speculating in high nominal interest rate currencies.

3. In a world of multiple currencies, nominal interest rates in fact serve as the true real rates of return.  Let’s say you live in America but hold Japanese yen.  (Are there always enough non-liquidity-constrained investors in this position and able to drive a market equilibrium?)  Your real rate of return in dollars depends on your nominal rate of return in yen plus your ability to convert yen into dollars.  Once you take the yen-dollar conversion rate into account, the rate of inflation in Japan should not matter.

4. Given #3, theory suggests that the real interest rate differential between Japanese yen and U.S. dollars should not, ceteris paribus (a daunting stipulation in this context), affect future exchange rates.  The nominal rates should be doing the work.  That being said, theory seems to be wrong.  Real interest rate differentials do have predictive power for future currency movements.

So the puzzle is this.  When it comes to future currency values, nominal interest rates do not obviously matter as much as they ought to, given theory.  Real interest rate differentials matter more than they ought to.  Also see my earlier post on microeconomic vs. macroeconomic perspectives on currency movements.

And how does this fit into social security reform?  Andrew Samwick has the lowdown, with all the appropriate links.

When I originally heard about First Contact, a trip offered by Woolford’s trekking company, Papua Adventures, I couldn’t believe he was really doing what he claimed to be doing. An easygoing American expat from Springfield, Missouri, who jokingly describes himself as a "hillbilly," Woolford marches into the jungle in search of uncontacted native tribes who have never seen outsiders–and who aren’t supposed to mind tourists barging into their lives. I had trouble buying the idea that, in the 21st century, there were still nomadic hunter-gatherers out there using stone tools and rubbing sticks together to start a fire. But there are, Woolford assured me. From his home in Ubud, Bali, he explained the strategy behind his First Contact trips.

"There are a handful of places in West Papua that are untouched–still Stone Age tribes, still cannibals," he said. "It’s just that a lot of people are too scared to go look for them."

Making contact with tribal people is a risky business–a simple flu could wipe them out. But Kelly Woolford insists that he’s mindful of such risks. "We don’t try [sic] to corrupt them," he says. "Five minutes is all we do."

Here is the story.  Here is the company’s website.  Thanks to the ever-useful www.politicaltheory.info for the pointer.

Polygamy makes perfect sense to many rich men in poorer countries but it is bad for the economy overall, according to a report called The Mystery of Monogamy by three economists.

The study, published recently by the Centre for Economic Policy Research, argues that mass polygamy, which still exists in sub-Saharan Africa, Egypt and Thailand, can make it hard for economies "to break out of the poverty trap".

The practice, it says, allows rich men "to spend their money on quantity rather than investing in child quality" and stretches a wealthy man’s resources across a larger number of children.

The authors also argue that the practice has only died out in the west because it no longer makes economic sense for the middle classes, who can no longer afford more than one wife.

Read more here.  Here is the paper in html, I can’t get the pdf versions to open (addendum: try this one).

My take: I am not convinced.  Polygamy does not contradict the idea of quality children, relative to available alternatives: the kids get papa’s good genes and full-time attention from mama.  Keep in mind if this is worse on average than other options, women won’t want the deal.  If there is a social cost from polygamy, it more likely stems from the young men who cannot find wives and resort to violence and risky behavior.  Polygamy ends when children cease to be a net economic asset.  As society progresses and urbanizes, there are cheaper ways of having sex with multiple women, if that is one’s goal. 

Elizabeth Anderson and other commentators misunderstand Hayek and in the process they fail to understand the sense in which market outcomes may be said to be just (Tyler comments also).

Hayek argued that the concept of social or distributive justice was "empty and meaningless."  Anderson tries to use this argument, which she explains well, to suggest that any idea of libertarian or free market justice must also be empty and meaningless.  Hayek, however, did not argue against rules of just conduct, "those end-independent rules which serve the formation of a spontaneous order."  Among such rules may be Nozickian or Lockean rules of voluntary exchange.

It’s quite possible, for example, to be a good Hayekian and also to say that I deserve my income because it was acquired by just conduct, e.g. by production and trade.

True, it is an accidental fact that I live in a time and place where my skills are highly prized.  In this sense, I do not deserve my income (i.e. my income is in part a function of things beyond my control).  But I do deserve my income in the sense that it was acquired justly and to take justly acquired earnings may be an injustice.

Here is part of Anderson’s argument:

Let’s consider first Hayek’s claim that prices in free market capitalism do not give people what they morally deserve. Hayek’s deepest economic insight was that the basic function of free market prices is informational. Free market prices send signals to producers as to where their products are most in demand (and to consumers as to the opportunity costs of their options). They reflect the sum total of the inherently dispersed information about the supply and demand of millions of distinct individuals for each product. Free market prices give us our only access to this information, and then only in aggregate form. This is why centralized economic planning is doomed to failure: there is no way to collect individualized supply and demand information in a single mind or planning agency, to use as a basis for setting prices. Free markets alone can effectively respond to this information.

It’s a short step from this core insight about prices to their failure to track any coherent notion of moral desert. Claims of desert are essentially backward-looking. They aim to reward people for virtuous conduct that they undertook in the past. Free market prices are essentially forward-looking. Current prices send signals to producers as to where the demand is now, not where the demand was when individual producers decided on their production plans. Capitalism is an inherently dynamic economic system. It responds rapidly to changes in tastes, to new sources of supply, to new substitutes for old products. This is one of capitalism’s great virtues. But this responsiveness leads to volatile prices. Consequently, capitalism is constantly pulling the rug out from underneath even the most thoughtful, foresightful, and prudent production plans of individual agents. However virtuous they were, by whatever standard of virtue one can name, individuals cannot count on their virtue being rewarded in the free market. For the function of the market isn’t to reward people for past good behavior. It’s to direct them toward producing for current demand, regardless of what they did in the past.

Now, I am torn between "strict philosopher" and "common sense morality" views.  In the former, I am a metaphysical determinist who doesn’t think much of desert arguments — whether pro-market or not — in any context. 

But for purposes of argumentation, let’s put on the common sense hat.  I then think that most voluntary transactions — at least in democratic market economies — are in fact reasonably just.  The biggest problem is fraud — Enron and the like — and that cannot be blamed on Hayek.  The share price of Enron — when it counted as the seventh largest firm in terms of capitalization — was a Hayekian obscenity if judged as an information aggregator.  The problem was that prices were tricked by inflated earnings estimates and did not perform their Hayekian duties properly. 

Another fairness problem is that some people are born into terrible neighborhoods and face unfair odds in life.  But the information aggregation function of prices is again far from the leading culprit in those cases.  In fact price floors and ceilings usually make poverty worse and less fair.

The complex concept of merit encompasses many values.  One of those values — but not the only one — is how much other people are willing to pay for what you have to offer.  Let’s start with that as a workable concept, and modify it whenever deviations will serve the general welfare.  Nozick goes wrong in thinking that no other notion of merit can override a prescription for laissez-faire, but consenting acts between capitalist adults should serve as the proper default.  If I buy a wonderful stinky cheese for $10, barring fraud, most likely all is well in the moral universe in this case.

Now the critiques are well-known.  Marginal products are determined in a broader social and economic context, plus the distribution of wealth may be unfair.  But the American public comes close to having the correct view here.  On one hand, it is widely recognized that taxation to finance public goods, including some degree of social insurance, is morally legitimate.  At the same time, people are seen as deserving what they earn, again fraud aside.  We ought to think twice before treating earned incomes as a "social pie" purely up for grabs.

But those judgments are piecemeal rather than foundationalist.  Few people agree with Robert Nozick in treating property rights as absolute.  More generally, we cannot justify all distributions, prices, and incomes from some set of first principles.  Rather we start with what we have and go from there.  And then the $10 for the cheese does in fact represent justice.  Furthermore we can believe this while admitting that the child born in the South Bronx does not receive a fair shake.

Anderson also confuses the manner in which prices are forward-looking.  A measured price for a consummated transaction reflects supply and demand from the past.  To the extent that a person’s merit was reflected by what she can get others to pay, this is OK.  There is no contradiction between backward-looking and forward-looking perspectives.  It remains true that such prices will not reflect, say, the purity of a person’s heart.  But this point stands without worrying about time frames.  Anderson writes as if "information aggregation" is some independent, ex ante functional purpose which causes prices to move in morally undesirable directions.  In reality information aggregation is an ex post property of a competitive bidding process, it does not on its own drive prices away from some pre-existing benchmark of moral merit.

Some of Anderson’s statements are hard to parse:

"the function of the market isn’t to reward people for past good behavior. It’s to direct them toward producing for current demand, regardless of what they did in the past."

OK, but past rewards will have come from efficacious past behavior in satisfying consumer demands.

Anderson also argues that even a productive and meritorious person cannot insure adequately against all possible future disasters.  It is well-known that markets do not produce many kinds of long-term insurance and indeed this remains a puzzle.  But here a dose of more Hayek — not less – would seem to be in order. 

The bottom line: A coherent notion of moral merit includes more than just your ability to serve others through the marketplace.  So market returns won’t coincide with personal merit, even putting aside the dilemmas of determinism.  But voluntary transactions — in many settings — provide a rough but non-absolute starting point for what is fair.  And if we are looking for causes of unfairness, the Hayekian informational role of prices is simply not a major culprit. 

Stephen Moore writes:

The central idea behind the Freedom to Choose Flat Tax is to create an optional post card flat tax, which would be offered to tax filers as an alternative to — rather than a replacement of — the current tax code.  There would be no deductions whatsoever, except for a generous personal deduction and child deduction.

The flat rate would, of course, be somewhat higher.  Might many people prefer to pay a little more to avoid the hassles of the current system?

I can think of some problems:

1. Many people might fill out two tax returns and pay the lower one, thereby raising tax filing costs.  That being said, the new and second return won’t take much time.

2. Let’s say everyone paid the higher flat rate.  How long will it stay flat for?  Won’t Congress auction off privileges and deductions as they have done in the past?  In the meantime our taxes have gone up, and in the long run we might return to tax complexity.  We are addressing symptoms rather than underlying causes of the problem.

3. The benefits of having a flat tax are often overrated.

Still, the idea has its virtues.  Transition costs would be low.  The relevant legislation would be relatively simple, and easy to explain to the public.  And it might lower tax filing costs significantly.

The quotation is from The Wall Street Journal Op-Ed page, 27 January 2005.  Here is more information.