Category: Economics

My out of print 1997 book Risk and Business Cycles is now available on-line through the new Google search service.  They want $100 for the ebook, but you can search the book here.

The book has four core arguments.  First, rational expectations theory, as a methodological but not descriptive assumption, is the friend of Austrian Business Cycle theory, not its enemy.  Second, classic Austrian Business Cycle theory is not tenable (more on this some other time; the basic argument is that ABC requires an excessively particular theory of how individual investors err).  Third, the theory should be refocused around the category of risky investments, thereby leading to a viable synthesis of Keynes and Hayek.  Fourth, there is some (non-decisive) empirical evidence in favor of such a synthesis.

Here is my previous post on Austrian Business Cycle Theory and its relevance for current events.

"A growing body of literature suggests that additional riches do not make citizens in wealthy countries any happier, at least not above a certain level.  Using information taken from questionnaires, once a country has a per capita income of roughly $10,000 a year or more, the aggregate income-happiness link appears weak.  Helliwell (2002, p.28) argues that the curve flattens out at about half of current American per capita income, or roughly the standard of living in contemporary Greece.  These results might lead us to wonder whether economic growth is so important after all.

Despite this important body of evidence, I nonetheless wish to treat wealth and happiness as comoving in the broad sense.  Questionnaire evidence should not distract our attention from our primary institutional means of improving human well-being, namely economic growth.

The flat-lining of the happiness-wealth relationship may in part reflect a framing effect.  The literature usually focuses on aspiration or treadmill effects, whereby the wealthy expect more.  Their greater wealth therefore translates into less happiness than might have been expected.  But this is not the only adjustment occasioned by growing wealth.  The wealthy also recalibrate how they should respond to questions about our happiness.  If happiness itself is subject to framing effects, surely talk about happiness is subject to framing effects as well.  The wealthy develop higher standards for reporting when they are “happy” or “very happy.” 

So let us assume that both framing effects – concerning both happiness and talk about happiness – operate at the same time.  This will imply that even a constant measured level of reported happiness implies growing real happiness over time.  Life improvements do usually make us happier, while both our expectations and our reporting standards adjust upwardly.  This is the most likely interpretation of the aggregate data.  Most individuals strive to earn higher incomes, even after they have experienced the strength of “aspiration” and “treadmill” effects.    

Note that within a country wealthier people report unambiguously higher levels of happiness, on average, than do poorer people (Dieter 1984).  This result has not been challenged seriously.  Now to some extent this result may reflect a zero-sum relative status effect.  The wealthier people feel better at the expense of the poorer people, because they stand above them.   Nonetheless it is unlikely that the entire effect boils down to a zero-sum game; wealthier lives are easier and happier in absolute terms in numerous ways, as discussed above.  Even if my neighbor does not like the fact that I own a new car, the gainer’s gain exceeds the loser’s loss in many of these cases.  Again, some of the apparent “zero-sum” element will be a framing effect for “talk about happiness,” rather than happiness itself.  If a buy a Mercedes, my polled neighbor may express greater dissatisfaction with his Volkswagen.  That same neighbor, if he had a Lada in Moscow, circa 1978, might express greater satisfaction on the questionnaire.  Nonetheless in absolute terms he still prefers the Volkswagen in contemporary America.

It is also an open question whether the flattening point for the happiness-wealth relationship changes over time.  If the world as a whole became much wealthier, for instance, might the “point of flattening” shift out to a higher income level?  In this hypothetical future, people without access to limb regeneration and daily supersonic transport would feel deprived and thus less happy.  Most likely, this would mean that we had produced a way of shifting up the whole curve.  The standard of living found in contemporary Greece would not make people as happy as in the wealthier society of the future.  At any point in time the curve may have a large flat range, but over time the absolute level of the curve, and thus human welfare, increases nonetheless. 

The happiness literature also takes a limited view of what well-being, interpreted as broadly as possible, consists of.  The contemporary empirical literature on happiness starts with the operational definition of whether an honest, self-aware person would report himself or herself as being happy, if so asked.  Even if this accurately captures one notion of happiness, it is not the only relevant notion. 

For instance a wealthier economy probably gives us more “fleeting” happiness experiences, or at least greater chances to trade-off long and short-term sources of happiness.  Recent research (Kahneman, et.al. 2004) looks at the allocation of time during the day and classifies events according to how much (temporary) happiness they produce.  It turns out that intimate relations, time spent with friends, and television, all appear to make people happier in this sense.  Working and commuting make people less happy.  A wealthier economy will offer greater options for structuring these choices, again noting that there may be trade-offs between long- and short-term happiness.  Wealthier economies, on average, are associated with higher levels of leisure time, although they accommodate workaholic preferences as well.

Often context effects matter for temporary happiness.  An individual will admit to being happier if he has recently found a dime, or if his soccer team won rather than lost (Schwarz and Strack 1999).  These sources of happiness will likely be systematically larger over time in the wealthier society.  A diverse commercial economy offers more sources of temporary stimulations and more short-term turns of good fortune.

Most generally, we must ask which institutional structures give people the greatest opportunities to structure their lives to achieve their preferred forms of happiness or well-being.  Some persons may seek temporary stimulations, others may want to feel fulfilled at the end of their lives, and others may seek to maximize the quality of their modal day.  Some will seek happiness through out-competing their peers for status, while others will look inward.  Again, greater opportunities and freedoms will likely favor the wealthier society in these regards.  Well-being is not a single variable to be maximized; rather individuals prefer to structure the kinds of well-being or happiness they can achieve.

Finally, even if we accept the “flat-line” empirical result as valid, the questions are posed to individuals in normal life circumstances.  The answers will not pick up the ability of wealthier economies to postpone or mitigate extreme tragedies, whether in the wealthier or poorer parts of our world.  For instance the happiness measures, by their nature, do not pick up the benefits of greater life expectancy.  The dead and incapacitated cannot complain about their situation, at least not in questionnaire form.  If an immigrant, or a child of immigrants, fills out the form, there is no comparison with a pre-immigration state of affairs.  By its very nature, happiness research draws upon a fixed pool of people in relatively normal circumstances.  This will limit its ability to measure some of the largest welfare changes brought by economic growth.  Happiness research, whatever its positive uses, is poorly suited to underpin a welfare economics of tragedy.

The happiness literature at most shows that many more changes are irrelevant than we had previously thought.  This result would not, however, eliminate the major benefits of economic growth, as experienced over longer periods of time.  It might turn out that (if we believe the happiness literature) many “small” changes are irrelevant or nearly irrelevant for happiness.  Yet sufficiently large changes still can boost or harm our welfare by significant amounts.  If the small changes do not much matter, that is all the more reason to focus on the large changes and thus reason to elevate the importance of infra-marginal welfare economics.

To give a few examples of how large changes matter, most life catastrophes create significant misery.  Very sick individuals have less autonomy, experience more pain, and face the stress of dealing with their condition.  The death of a child or close family member has a strongly detrimental affect on happiness for most individuals, often persisting for many years.  Torture, extreme stress, rape and severe physical pain also produce depression, trauma, and persisting unhappiness.  Individuals who have been through wars, revolutions, and collapses of civil order typically experience recurring flashbacks, nightmares, irritability, depression, alcoholism, troubled relationships, and inability to concentrate.  Well-functioning capitalist democracies tend to minimize these problems.

It is sometimes questioned whether even extreme catastrophes make people less happy.  Individuals who experience severe disabilities or physical handicaps do to some extent adjust their expectations.  Often these victims compare themselves to individuals who are even worse off than they are, or they lower their aspirations in life.  The loss in happiness is not as great as a naïve perspective might expect.  Nonetheless victims of catastrophe still report lower levels of happiness than do comparable healthy individuals.  The happiness difference is most distinct, the greater the extent of the disability.  At the very least, a significant percentage of victims experience an ongoing "core of distress" for many years.

People cope least successfully when the catastrophe or malady is ongoing and involves an ongoing deterioration of condition.  Most of the counterintuitive results come when the bad event has a “once and for all” nature, such as a one-time physical handicap.  In these cases many people recover their initial level of self-reported happiness.  But individuals remain subjectively badly off when they suffer from progressive or degenerative problems.  So to the extent that a poorer society brings an ongoing worsening of conditions for many individuals, the associated human suffering will be greater.  Once again, we are led back to significant benefits from ongoing economic growth."

Read also Will Wilkinson on the topic.  And if the above remarks appear to differ from my previous remarks on these topics, it is because I am still changing my mind.

Harvey Rosen has been promoted to chairman of the Council of Economic Advisors.  Rosen is a respected professor of public finance and expert on tax policy from Princeton.  Speaking personally, I find his work accomplished but boring.  He can, however, surprise at times.  I like this paper quite a bit, especially the title (fortunately CEA chairman need not pass through a Congressional gauntlet 🙂 ).

The Self-Employed are Less Likely to Have Health Insurance Than Wage Earners. So What?

David Altig and I are featured in this week’s WSJ Econoblog on the topic of the "savings crisis," with sidetrips into behavioral economics, preference sovereignty, weight loss, and more!

Here are some lengthy excerpts from today’s WSJ article on the economics profession.  Did you know that 15% of the Harvard undergraduate class is majoring in economics?  And Nobel Prize winners can earn $300,000 or more?

David Bradford, the Princeton public finance economist, passed away last night.  David was a leading scholar of public finance and was active in the world of economic policy; this included stints at Treasury and the CEA.  Bruce Bartlett directs my attention to David’s seminal tax reform document, which continues to influence tax thinking to this day.

[a] woman thinks she has found a niche by turning canine fur into
fashion, spinning hairballs into accessories that can cost $200.

Read more here, noting that the most "sumptuous hair" is from the underbelly. And did you know that other yarns are made of wire, paper, and possum hair?  For the pointer I thank Ennis of the Indian-flavored www.sepiamutiny.com, one of my favorite blogs.

Readers of this blog will be familiar with Tyler’s insistent question, what’s your P?  As in what probability do you put on this event or belief?  (Examples here, here and my favorite here).

Unfortunately this type of thinking is all Greek (I am tempted to say all Arabic, but that would be cruel) to our intelligence services.  Writing in the Washington Post Michael Schrage argues:

It’s time to require national security analysts to assign numerical
probabilities to their professional estimates and assessments as both a
matter of rigor and of record. Policymakers can’t weigh the risks
associated with their decisions if they can’t see how confident
analysts are in the evidence and conclusions used to justify those
decisions….

[T]he CIA, Defense Intelligence
Agency, FBI and the federal government’s other analytic agencies have
shied away from simple mathematical tools that would let them better
weigh conflicting evidence and data. That bureaucratic shortsightedness
undermines our ability to even see the dots, let alone connect them.

Consider the National Intelligence Estimates, the
Presidential Daily Briefings or many of the critical classified and
unclassified analyses flowing through Washington’s national security
establishment. Key estimates and analytic insights rarely come with
explicit probabilities attached. The nation’s most knowledgeable
experts on the Middle East, counterterrorism, nuclear proliferation,
etc., are seldom asked to quantify, in writing, precisely how much
confidence they have in their evidence or their conclusions.

Your
personal financial planner does a better job, on average, of
quantitative risk assessment for your investments than the typical
intelligence analyst does for our national security.

All true.  I would add only that one virtue of information markets, like the short-lived Policy Analysis Market, is precisely that they produce such probabilities as a matter of course.

Students at a high school in Austin, Texas gave their teachers a lesson in the economics of prohibition.

When Austin High School administrators removed candy from campus vending
machines last year, the move was hailed as a step toward fighting
obesity. What happened next shows how hard it can be for schools to
control what students eat on campus.

The candy removal plan, according to students at Austin High, was
thwarted by classmates who created an underground candy market, turning
the hallways of the high school into Willy-Wonka-meets-Casablanca….

"It’s all about supply and demand," said Austin junior Scott Roudebush.
"We’ve got some entrepreneurs around here."

Thanks to Sean Brown, a student at another Austin high school, for the pointer.

Robert Shiller writes:

According to a study by the Insurance Information Institute, expenditures on non-life insurance in 2003 amounted to only 0.83% of GDP in Indonesia, 1.19% of GDP in Thailand, and 0.62% of GDP in India, compared with 5.23% of GDP in the United States.

And his bottom line?

Foreign aid is no substitute for insurance. Charity inspires, reassuring us of our humanity, but it is often capricious. You wouldn’t want to rely on it. Indeed, when deciding how much disaster aid to offer, countries often seem to be influenced mainly by their leaders’ concerns about how others will view them. Charity responds to attention-grabbing events, often neglecting less sensational disasters.  Insurance, on the other hand, is a reliable and venerable institution, its modern form dating back to the seventeenth century.

Could the micro-credit revolution be followed by a micro-insurance revolution?  Shiller argues valiantly but I am not convinced.  Economists miss one of the biggest problems with insurance.  We are blinkered by adverse selection models, which imply that the dangerous prospects most want to buy insurance.  The opposite is more often true.  If you are an irresponsible driver, you are likely to be irresponsible in other spheres as well and not buy auto insurance.  On the whole many insurance markets show positive rather than adverse selection.  In a development context, this means that the people who most need insurance will be the least likely to buy it.

Rachel Soloveichik writes:

I completely agree [with my earlier post] that parents aren’t perfectly altruistic toward their children, and parents are happier when their children are better behaved rather than happy.  But if society shifts toward giving more power to children parents are much less likely to have children.  The small effect on children’s utility from more toys may be hugely outweighed by fewer children being born.  That’s probably part of the reason religious parents have more children, because they have a set of norms that justifying pushing their children to good behavior rather than being happy.

My question is where the limits lie, once we make this a moral question.  Say you could cut a deal with a fetus or would-be fetus.  You agree to raise a child, under the condition that it remain your slave for life. You also make sure that the life of that slave remains better than no life at all, although just barely.  Should we, as believers in the Pareto principle, approve of such deals?  I’ll say no, which is one reason why I don’t put much stock in Nozickian libertarian rights.  But I find this view difficult to defend.  After all, everyone is better off (forget about secondary consequences, if you wish to make the hypothetical example airtight).  Should we allow parents, or corporations, for that matter, to make such deals?  And would we need actual consent from the child-to-be, or is it enough to recognize that in expected value terms the child-to-be would likely prefer to be born, despite the onerous terms of the deal?

I suspect that yes, it is better for the deal to be made.  More happy people is a good thing, all other things equal.  But it is also better for the deal to be broken, ex post.  Some ways of treating people are just wrong, even if they were agreed to ex ante.

Oddly, perhaps libertarians should welcome this conclusion.  Arguably their ancestors consented to rule by the U.S. government when they moved to this country.  Or perhaps you offer a kind of implicit consent from your consumption of public goods or from your dealings with broader society, nearly all of which favors the idea of government power.  But libertarians still can object to their current treatment, no matter what explicit or implicit agreements were made in the past.

What if parents agreed to have kids, but only on the grounds that those kids would not freeze their social security benefits?

The blogosphere has been involved in a huge debate over the Baker-Krugman position that high stock returns are inconsistent with a low growth rate of the economy (thus either social security privatization won’t work or, if economic growth is high, it’s unnecessary).

Brad DeLong offers a useful summary laying out the possible scenarios.  I think, however, that he and everyone else have missed one scenario which may be important  (see also Tom Maguire and Andrew Samwick).

Everyone has assumed that economic growth and social security privatization are independent variables but suppose that social security privatization raises economic growth then one can consistently assume that economic growth will be low under the current system but stock market returns will be high if we privatize.

Can social security privatization raise economic growth? Certainly the answer is yes.  It’s a big reform which (done right) can significantly increase savings and reduce labor market distortions.

Can the increase in economic growth be enough to solve the Baker-Krugman problem?  I think not in the long run but I am not so sure about short-run dynamics, even a small increase in growth rates can increase prices significantly.  I turn this one over to better macro-economists than I.

Last week I examined the ethics of gradually indexing social security benefits to prices rather than wages.  It has never been obvious to me that the elderly are the deserving recipients of greater largesse.  Don’t we have better ways of spending the money, such as on biomedical research, immigrants, or foreign aid abroad?  Why might you think that the elderly deserve a greater share of resources in society?  Here are some options:

1. We should be egalitarians, and evaluate individual well-being in a "time-slice" rather than lifetime sense.  Yes the elderly have lived a long time, but right now they are the ones closest to death and often poor as well.  We should transfer resources to those who are not so well off.

2. The relevant political alternative is lower marginal tax rates for the well-to-do.  Transfer resources to anyone but them, whenever you can.

3. True, the relatively wealthy American elderly are not our highest priority, all things considered.  But in political equilibrium taking care of the elderly is unlikely to prove a substitute for other forms of charity.  By cementing our self-images as being caring people, it renders other forms of charity more likely, not less likely.

I suspect that some version of #2 is what motivates most liberals.  But consider a few points.  First, is this the relevant political trade-off today?  Can we not imagine a Republican-led Congress, for better or worse, determined to make the Bush tax changes permanent?  Alternatively, you might think the tax changes are headed for repeal in any case, bringing us back to no trade-off.  Might the real policy trade-offs involve Medicaid, immigration reform, and discretionary spending, not to mention the looming fiscal disaster known as Medicare? 

Second, marginal tax rates for the wealthy cannot be the relevant political trade-off forever.  It would be quite simple to favor repealing the Bush tax changes, and also wanting to price index social security benefits.  Note that price or wage indexing is supposed to continue for the indefinite future.  So we could arrive at your ideal tax policy — whatever that is and whenever that happens — and still face the social security issue.

I actually find #3 to be the stronger argument.  Note that the welfare-exorbitant Scandinavian states also spend relatively high amounts on foreign aid per capita.  #3, however, does suggest that the cost of helping the truly deserving is much higher than we had thought.  Not only do we have to spend the money, but we must invest significant resources in bringing around our social consciences.

Addendum: Here is more from Alex.

I find most of the installments in this series sad:

…the 3 tablespoons of water said to have been touched by The King at a 1977 concert…recently sold on eBay for $455. Then, someone else paid thousands for a "guest appearance" by the cup that held the water from which Elvis sipped nearly 30 years ago.

In recent years, someone paid nearly $1,500 for a billiard ball from Elvis’ pool table. A hanging macramé plant holder from Graceland, complete with a plastic fern, went for $633. And someone else paid $748 for a tree limb that "mysteriously" broke off and fell to the ground during Presley’s funeral at Graceland in 1977.

We all know that Elvis’ fans can be wacky, and Elvis himself has pride of place in the dead-celebrities pantheon. But does that explain the excitement surrounding the Feb. 15-17 tag sale of ordinary household items that belonged to the late Jacqueline Kennedy Onassis? (Related story: Nothing too icky to sell)

Sotheby’s expects to raise at least $1 million auctioning such things as her glass jars, wicker baskets, duck decoys and dirty oven mitts. And some experts think that estimate is way low – that many items will go for 10 times the estimates. Spending big bucks on an authentic antique that once belonged to the Kennedys is one thing, but spending hundreds of dollars for a couple of Jackie’s Mason jars?

"There are a lot of bored and lonely people out there, and this would be their one little thing they can say was once part of a Kennedy estate," says Lynn Dralle, author of The 100 Best Things I’ve Sold on eBay.

Here is the story.  And how about this one?

Justin Timberlake…made an appearance on a New York radio station and failed to finish the French toast he was served. The partially eaten toast sold on eBay for more than $3,100.