Tuesday, January 31, 2012

Efficiency in Markets

Scott Sumner calls in the EMH opposition

I think efficient market hypothesis (EMH) makes a whole lot of sense. Large financial markets with many participants should, and do, tend not to leave unexploited opportunities for gains, whether from new information or through arbitrage. The empirical evidence for efficient markets at the aggregate level, and over a longer time frame, is also simply overwhelming as well. (See here for a collection of literature.)

Yet there are limits. And Scott Sumner seems not to see them.

Paul Krugman, in one of his more "I-told-you-so" political screed pieces for The New York Times during the worst of the recession, wrote that behavioral economics goes along way to explaining why markets can misprice assets. I agree with Krugman's contention here, despite his bombast: irrational panic and exuberance exists in markets and is generally standard behavior when you examine any crowd in constant communication. You can get very accurate predictions of probability, because of the decentralized calculations all of the market participants are making (witness Intrade). But that group loses its decentralized nature when relevant information is added, particularly when it is contradictory and uncertain. The group begins to coordinate its decisions, as Keynes famously wrote in his characterization of stock picking as a "beauty contest," to avoid taking a loss, even if they knew they were right.

Looking at major repricing events in large markets, we can see that the evidence for some sort of crowd-behavior effect in markets in not easily dismissed, but that markets often reach efficiency sooner than later.

But here's another interesting question: since EMH assumes that the interests of market efficiency and those of the individual investor are always in perfect alignment, it must presume that the costs for investors to make decisions are zero. (Otherwise, investors wouldn't take action to address mispricings.) There are rather dry explanations for why costs are not zero: transaction costs for stock brockers, banks, etc.

These are fairly small, though--they won't explain the billion-dollar-bills that seem to lie in the street every now in then. So now we add in the crowd effect more formally into our model: assume that there is a cost for an individual investor to sound a contrary note. This may come in the form of being fired or questioned at work; I'm thinking about contrarian analysts, and how they get some frankly rough treatment. Also, if an investor runs against the grain, then they are probably expecting to take a short-term relative loss, which suggests that they must apply some sort of discount rate to future gains different from other investors. So to the extent that this discount rate makes contrarianism unprofitable, the market doesn't have to be instantaneously inefficient.

But wait, that's not all. If markets are perfectly efficient, and assets are priced properly given all available information, who's keeping the asset prices in perfect alignment? Certainly not investors, because arguably there is no opportunity for gain. A common criticism of EMH is that the market simply doesn't look at all as it would predict: messy, busy, volatile--not smooth, mechanical, or low-volume. I'm trying to take this EMH-is-not-everything a bit further, though: it feels to me like an undiluted assumption from the classical model...not like a respectable position in an era where we tend to make some Keynesian assumptions in macroeconomics.

So when we make prices stickier, and say that investors are human and must be compensated, in effect, by the market, for acting on new information and taking a risk, EMH now takes on a much more nuanced, New Keynesian tenor.

Monday, January 30, 2012

Are Politicians Rational?

Exploring public choice theory, a fascinating niche field in economics

I feel quite bad calling public choice theory a "niche" field of economics. It is not so much as a niche as a rigor-seeking monster that the economic discipline has unleashed on its less disciplined cousin, political science. But the truth is that it is often overlooked--so much so that some of the most elegant and important findings in all of economics are often ignored because they don't fit neatly into the single-discipline box.

What is public choice theory, exactly?
Public choice applies the theories and methods of economics to the analysis of political behavior...But public choice, like the economic model of rational behavior on which it rests, assumes that people are guided chiefly by their own self-interests and, more important, that the motivations of people in the political process are no different [than the economic man]...Public choice, in other words, simply transfers the rational actor model of economic theory to the realm of politics. [More from the Concise Encyclopedia of Economics here.]
Mark Pennington of Pileus has a wonderful post describing exactly what lessons the political right should draw from public choice theory. It's worth a full read, certainly, but here's my attempt at a summary:

  1. Public choice theory's understanding of power dynamics is more rigorous and insightful than Marxian analysis. Whereas the latter presumes a near-rigid split between "capital" and labor," public choice theory identifies the behavior and influence of interested parties through their concentration or diffusion. (For example, the domestic sugar industry wields disproportionate power not because of its command of capital, but because the number of firms is low and their interests are closely aligned. See the graph above, which looks at the effect of the United States' system of tariffs and quotas to protect domestic sugar producers. An extra 10 cents a pound or so might not sound like a lot, but it is when you consider that the average world price in the past decade is 13.50/pound, the mind boggles at the windfall gains that can be attained through skillful political organization even in our supposedly "limited government" system.)
  2. Public choice theory is damning to the modern Left, which would trust an increasing amount of discretionary authority to government. Pennington puts it brilliantly: "if the modern social democratic state is the major source of special interest power then by far the most effective way to reduce this power would be to dismantle the apparatus of anti-competitive intervention in markets...[this] requires a framework of limited government where inequalities which reflect superior performance and entrepreneurial ingenuity are welcomed but where those that reflect the power of crony capitalists, crony union bosses and public sector bureaucrats are reduced to a minimum."
HT: Mark Perry, who previously cited the USDA data.

Sunday, January 29, 2012

Petrified Labor Markets? Maybe.

Turnover in labor markets remains weak

One quick new reason to worry about lingering issues in labor markets: the total percentage of the labor force that is moving between jobs fell significantly during the recession. It has not recovered.

By "total percentage," I mean the percentage of the labor force that was hired, fired, quit, laid off, or otherwise took or left a job. This is interesting to me because it gives a sense of the underlying fluidity and flexibility of labor markets, something which is hidden in the net change in payroll employment numbers.

And while payroll employment has grown, although hardly robustly, for several quarters now, we haven't seen labor market flexibility recover. In a recession, we might expect total labor market flexibility to decline or maybe stay constant, as (1) fewer are hired, as firms freeze hiring (2) more are fired, as firms reduce labor costs (3) fewer quit, due to the uncertainty they can get another job, (4) more are laid off en masse, as firms close, (5) fewer are otherwise separated, per reason #3.

For the same reasons, all else equal, we would expect the labor market to revert to more or less normal operation after the recession ended, as firms gain confidence to hire, and then workers observe this confidence and make corresponding decisions to quit or seek to be rehired elsewhere. In other words, we would expect to see the second crude sketch below enfold in labor markets, where the green line is hiring, and red represents all job losses.

Instead, though, we've seen the scenario described in the first crude sketch unfold. Although on net changes in payroll employment are positive, the absolute number of hires and absolute number of separations remains sharply lower than pre-recession.

Two broad reasons to worry about this: (1) inefficient allocation of resources, namely labor, may result from less transition and turnover in employment, (2) this implies lower frictional unemployment, in turn suggesting that economists may be significantly underestimating the fraction of unemployment which is structural.

Update (2/12/12): The Economist's "Free Exchange" column has a new article about labor market "churn."

Saturday, January 28, 2012

Trading Thoughts

This weekend's project: theories of trade

2011 U.S.-India Economic and Financial Partnership
Following the president's protectionist State of the Union speech, and a lengthy discussion this blogger had with a friend who is an Andy Grove- or MIT Tech. Review-species of trade skeptic, I decided to do some reading into the foundational economic background on trade theory.

At some point a while ago, this sort of thing became my idea of fun. Well, my priors had always led me to make full-throated defenses of free trade, and my introductory micro textbook gave little time to "protectionism," except to dismiss the infant industry argument as a "more sophisticated argument" for it, implying obviously that it was specious and ultimately just as wrong.

After doing a lot of reading and mulling over, and I only link to here the best of my research finds, I remain, fundamentally a Ricardian--but not a fundamentalist Ricardian. Yes, I do think that, in general, the principle of comparative advantage and mutual gains from free trade do hold. And while I think that protectionism makes little sense--I'm thinking of Romney on currency manipulation, or Obama on trade dumping--I do see a place, albeit limited, for an American industrial policy in high-tech manufacturing.

It turns out, from my research, that there are two broad, and largely compatible, "schools of thought" on trade: classical (i.e. Ricardian) and New trade theories. The former emphasizes comparative advantage, the production possibilities frontier, and the plain-as-day conclusions of microeconomic social welfare analysis on tariffs and gains from trade. (If any of these terms are unfamiliar, as I imagine they are, they are only a Wikipedia search away.) Ricardian trade theory remains dominant to this day, but the New trade theory has added some very interesting insights, which have assimilated rather well.

What is "new" in New trade theory? First, it scraps a number of assumptions (perfect competition, zero transport costs, constant human capital). In their place, it assumes some nastier conditions -- and by "nastier," I mean less ideal in terms of mathematical theory, and more realistic: imperfect competition, non-negligible transport costs, "industrial commons" externalities on human capital and competitiveness. The conclusions are pretty interesting, as they imply that to the extent that the world behaves more closely to New trade assumptions rather than Ricardian ones, that industrial policy makes sense.

The way these theories are combined is by the fact that the rivaling assumptions are both true in certain senses, in certain industries, and at certain times. In other words, if high-tech electronics production fits more in with New trade economic models -- and it does so appear -- then an industrial policy may gain traction there, even as that same nation pursues a Ricardian strategy in services industries, where Ricardian assumptions seem more sturdy today than ever before. The world, by the way, is becoming increasingly Ricardian in reality, but there are important exceptions in industrial areas like Germany's Mittelstand, which is an economic ecosystem of small high-tech manufacturers which serve niche export markets.

Update (2/18/12): VoxEU has a new article which describes empirical success for an "industrial policy lite" in Britain, targeted at small firms which served national/international markets. Hmm. This seems to fit in very nicely with what I've discussed here.

Friday, January 27, 2012

NGDP Targeting, Circa 1974

F. A. Hayek's iconic "pretense of knowledge" lecture and a "prebuttal" to Scott Sumner

I was re-reading for no real good reason F. A. Hayek's 1974 Nobel Prize lecture, which came just in time for a backlash against Keynesian economics as the "stagflation" era began and inflation expectations rose.   (Now, we have more complicated models of the aggregate supply function, but that's another story.) The lecture is stern, certainly, in its condemnation of "scientism" in macroeconomics. Hayek extended that to the macroeconomic discipline as a whole, frankly missing the boat on that old Say's-Law-is-Wrong thing, insisting that the all recessions can be fully explained by adjustment processes to correct relative prices. (Of course, structural adjustments are non-negligible causes of recessions, some more than others, but they are not even close to the whole story.)

What struck me as even more interesting, though, was a warning -- a "prebuttal," perhaps? -- against what we would now call NGDP targeting:
The theory which has been guiding monetary and financial policy during the last thirty years, and which I contend is largely the product of such a mistaken conception of the proper scientific procedure, consists in the assertion that there exists a simple positive correlation between total employment and the size of the aggregate demand for goods and services; it leads to the belief that we can permanently assure full employment by maintaining total money expenditure at an appropriate level. Among the various theories advanced to account for extensive unemployment, this is probably the only one in support of which strong quantitative evidence can be adduced. I nevertheless regard it as fundamentally false, and to act upon it, as we now experience, as very harmful.
Scott Sumner, watch out...

Thursday, January 26, 2012


Disturbing and insincere undertones in Pres. Obama's 2012 SOTU

Watched the president's speech Tuesday night and found myself in agreement with him on a number of fronts, especially on immigration, but also on education to a certain degree and on state investment for public goods like pure scientific research...but I was really bothered, frankly, by his stated position on trade and industrial policy. Let's go to the transcript:
We can't bring back every job that's left our shores. But right now, it's getting more expensive to do business in places like China...So we have a huge opportunity, at this moment, to bring manufacturing back. But we have to seize it. Tonight, my message to business leaders is simple: Ask yourselves what you can do to bring jobs back to your country, and your country will do everything we can to help you succeed...It's time to stop rewarding businesses that ship jobs overseas, and start rewarding companies that create jobs right here in America...And I will not stand by when our competitors don't play by the rules. We've brought trade cases against China at nearly twice the rate as the last administration— and it's made a difference. Over a thousand Americans are working today because we stopped a surge in Chinese tires. But we need to do more...It's not fair when foreign manufacturers have a leg up on ours only because they're heavily subsidized. Tonight, I'm announcing the creation of a Trade Enforcement Unit that will be charged with investigating unfair trade practices in countries like China. There will be more inspections to prevent counterfeit or unsafe goods from crossing our borders. And this Congress should make sure that no foreign company has an advantage over American manufacturing...
I find it hard to believe that President Obama actually thinks this, and I bet that his economic team tried to get this populist, protectionist crud out of the address. (Romer? Goolsbee? Geither? Lew? Where are you?) Greg Mankiw thinks that it was an economic mess too.

These tax credits amount to relative tariffs on multinational corporations. And for what? Sure, China's subsidizing their industries and undervaluing their currency, but they do so at their expense to our benefit. They're selling us a dollar for fifty cents--of course America can't do that, but here's the key thing: nor should we. On net, basic social welfare analysis shows that tariffs create domestic losses in welfare--as does, for the record, China's policies in China.

But from a game-theoretic perspective, we should take as given China's decision, and not try to fool ourselves into thinking we have any meaningful degree of leverage over them. This is a deliberate development strategy on their part, albeit misguided. Our optimal response is to take the free fifty cents in goods, despite the resultant trade deficit and corresponding capital inflow.

Now that doesn't mean we hang Ohio, Indiana, and Detroit out to dry. We can provide retraining, unemployment insurance, etc., to ease the adjustment process. But let's not indulge an uneducated protectionist impulse. It sets a poor precedent, and the President and his team should know better.

Wednesday, January 25, 2012

Why 70% Makes No Sense

A response to Brad DeLong on the top marginal tax rate

In one of his own posts he deems "worth reading"--one is tempted to ask what he considers the remainder--UC Berkeley professor Brad DeLong discusses work by economists Peter Diamond and Emanuel Saez. The Diamond-Saez study purports to show that a 70 percent top marginal income tax rate would be optimal policy in the United States, and they derive this result from modeling utility with diminishing returns on marginal increases and income in combination with a "Laffer curve" model which posits that the maximum revenue on a tax occurs at a value 0 < t < 100, where t is the tax rate, because as t -> 100, the incentive for tax avoidance rises. 

The problem with their work is that they've worked from a model that is oversimplified, in that it leaves out important considerations--namely, as Scott Sumner points out, capital gains.

But allow me to add that the study is now out of date in terms of academic literature. It fails to include findings from Benjamin Lockwood and Matthew Weinzierl which demonstrate that, considering heterogenous preferences, a term which we will explain momentarily, the optimal top marginal income tax rate falls dramatically.

What are "heterogenous preferences"? In the Lockwood-Weinzierl model, it means that, in short, people placing different relative marginal values on increases in income versus increases in leisure.

They matter because in a conventional Mirrleesian model, which assumes total homogenous preferences, the only explanations for differences in income are luck and differences of ability. This explains the Diamond-Saez finding, as Lockwood and Weinzierl argued, that the United States' marginal income tax rate structure is insufficiently progressive and redistributive to maximize social welfare.

Enter preference heterogeneity, and the differences in income can be explained by differences in preferences as well as luck and differences of ability (i.e. the three factors can receive different weights as explanatory variables). Obviously, preference heterogeneity means that the utility calculations aren't as simple as before, but because we know now that the distribution is by some measure closer to optimal then a random question of luck and ability, the economic case for redistribution is meaningfully weakened.
The results from theory are clear: taking preferences into account lowers optimal redistribution for themost plausible specifcations of the model. We start by showing that, if preferences and ability are the same for all individuals with a given income (as in the standard model), attributing more of the variationin incomes across individuals to preferences rather than ability lowers the optimal linear tax rate. Then, we show that if preferences and ability vary conditional on income, preference heterogeneity is even more likely to reduce optimal redistribution relative to standard results.
There is so much more in this fascinating study, too. A gem.

Tuesday, January 24, 2012

Thinking about America

Lots of good writing recently about America, and the state of our union and its future--in advance, of course, of the President's speech to Congress this evening, to which I will react in due course.

1. Charles Murray, author of Losing Ground, writes a fascinating essay entitled "The New American Divide" in the WSJ about how a class split is emerging in white America on issues like marriage, employment, and child-rearing, where there once were broad cultural consensus behaviors.

2. Adam Davidson of NPR's "Planet Money" program writes about change in American manufacturing and how it is affecting the working class. (HT: Russ Roberts)

3. Daniel Drezner of Foreign Affairs argues that threats to American economic and military hegemony are overdone. (HT: Tyler Cowen)

4. Ryan Lizza, in The New Yorker, peeks into the changing political calculus of the Obama administration through memos--fascinating stuff.

Monday, January 23, 2012

Year of the Bear?

Demographic dividend, transition, and economics

I could very well retitle this post "Why I'm Suspicious about China" or maybe "China: Like Japan in '90, but Even Worse."

Let's get right to the charts. The UN maintains global population datasets, and one of the interesting measures, from an economic perspective, that their demographers produce is something called the "total dependency ratio." In short, it's the percentage of a nation's population which is working age. Due to laws of demography (#1: people get older, #2: fertility rates change slowly and predictably) they are able to forecast such numbers decades ahead, given certain assumptions about changes in fertility rate. (As a statistical note, I'm using the "medium variant" series, which is, as the name implies, neither an overly liberal nor overly conservative estimate.) The reason it's called "total" is because it's actually the sum of two related dependency measures: the child-dependency ratio and the elderly-dependency ratio. But for our purposes, the total dependency ratio best expresses very-long-term changes in the labor force.

In the first chart, I have graphed for your viewing pleasure the total dependency ratios of four nations--China, India, Japan, and the United States. In the second chart, I have graphed the annual change in the dependency ratio, calling it the "demographic dividend" for reasons which shall become clear soon enough.

We can see a whole lot just in the first chart: the post-war population boom in Japan followed by the well-publicized story of its aging population, beginning in the late 90s; the United States' "Baby Boom" entering the workforce in the early 70s and its echo boom; China's population boom, which continues up to the present as its workforce balloons.

In the second chart, we see the changes in dependency ratio, expressed as an annualized percentage (the UN's dataset uses a five-year interval). This is what we call the "demographic dividend," the contribution that, in the long-term, when we can assume full employment, growth in the labor force makes to economic growth. You should be able to see a few things here: first, Japan's rise was not fueled by labor force growth--it had to do with other factors, namely productivity--but its sharp reversal in economic fortunes had a whole lot to do with demography, which is costing it almost 3 percent in 2015. China, on the other hand, has netted a roughly 2 percent contribution to output growth from population alone. The U.S. has more or less broken even; India is gaining a stable percentage point or so.

Now let's look ahead. What do we see? In the U.S., the retirement of the "Baby Boomers" is going to produce an annualized cost to output growth of approximately 1.3 percent. In China, as the "One Child Policy" begins to bite in terms of the labor force, the costs are more severe, and more sudden, as the demographic dividend is sharply reversed in 2015. By 2035, the cost imposed by demography will be 3 percent.

I would produce a changes in demographic dividend chart, which I think is more important, but that would get confusing. The idea which I see coming out of this is that it is very hard to nations to adjust to long-term changes in output trend growth. Witness Japan. There is reason to think, too, that the economic dislocations are more severe with sharp changes in the annual demographic dividend, as governments often become accustomed to the "breathing room" that the dividend gives them, and they miscalculate. (If you're Japan, you get yourself stuck in the liquidity trap--I bet demography has played no small part in this event.) The culture of countries seems to evolve in tune with the dependency ratio, as countries with falling dependency ratios seem to develop pro-business political cultures to accomodate labor force growth, and political fragility and worries of déclinisme in periods of rising dependency ratios. The American political sphere is having a slow-motion panic about the future cost of entitlement programs--a symptom of its changing fortunes--but in comparison to China, these worries are small, which will end up building some form of social security, I imagine, to care for the aging.

I also worry about this because I bet that the demography has spillover effects, that is, it impacts the trajectory of economic growth beyond a simple addition/subtraction of the dividend. As an economy ages, it must retool rapidly to care for its elderly--but because of Baumol's cost disease, these industries (healthcare) have lower productivity growth rates and thus a lower long-run output growth rate.

Saturday, January 21, 2012

Death of the Salesmen?

On right and left, rising mistrust of capitalism

Giles and Adam
Is this beginning to scare anyone yet? From both the ostensibly conservative right--Newt Gingrich and Rick Perry--and the left, I see an increasing chorus of populist anti-capitalism.

Now Jon Stewart's point about private equity's "carried interest" exemption is well taken, and the case that the capital gains tax should be level with the top marginal income tax rate indeed makes economic sense. (Of course, one would want to tax only real, i.e. inflation-adjusted, capital gains, and one should also strip the income tax code of all deductions and reduce rates in a revenue-neutral and proportional manner.)

But I think he and his guest, New York Times columnist Joe Nocera, were off-base when they said that Bain Capital represented a capitalism which had "metastasized" into evil, and that the Right was exaggerating when they deemed any attack on private equity or Wall Street an affront against the capitalist system. The truth is, this aspect of their critique, although perhaps more nuanced, suffers from essentially the same flaws as Gingrich's rants against "rich people figuring out clever legal ways to loot a company" and Rick Perry's demonization of "vulture capitalists."

Stewart, Nocera, Gingrich, and Perry all ignore the fact that the only way to achieve sustainable per capita income growth, regardless of the economic system, is through productivity gains. Now there are ways to ensure that this income growth translates into true and not overly unequal gains in terms of quality of life--progressive taxation, a social safety net, state support for education, R&D, and other public goods--but productivity gains are essential. They, however, induce a clear long-run--short-run tradeoff: when workers  are more productive, you need fewer workers for that task. The result is structural unemployment as resources (labor and capital) are reallocated to more productive uses. Again, we can institute "market-legitimizing" institutions to ease the short-run pain, such as unemployment insurance or retraining. But the idea that we can somehow grow in the long run without the sort of economic dynamism that implies economic dislocation--that is a fallacy.

Private equity, as Wall Street Journal columnist Daniel Henninger argues, is one of the major engines of this process of "creative destruction," remaking companies to maximize profit. I don't doubt this means layoffs, restructuring, and occasional failure--but what mistake I see as increasingly common is a distrust of this process, one which is so central to capitalism itself. There are ways to fault Wall Street, and Stewart's argument against inequality is fair game, but I saw a shortsighted, anti-capitalist dislike of "creative destruction" come through in his critique of Bain Capital.

And then you have those who are unapologetically anti-capitalist, like Onion columnist Representative Dennis Kucinich, whose recent proposed legislation of a "Reasonable Profits Board" would be laughable if it didn't scare me about the rise of populism.
The Democrats, worried about higher gas prices, want to set up a board that would apply a "windfall profit tax" as high as 100 percent on the sale of oil and gas, according to their legislation. The bill provides no specific guidance for how the board would determine what constitutes a reasonable profit. 
The bill effectively empowers three federal appointees to set whatever level of profit they deem "reasonable" and confiscate the rest for green pet projects like a subsidy for fuel efficient cars and mass transit systems. If the company overshoots the profit cap, the Feds can take 50, 75, or even 100 cents from every marginal dollar of "unreasonable" profit. I can't even begin to contemplate how bad of an idea this is.

Friday, January 20, 2012

Going Postal

Government and creative destruction

The Postal Service is on its way out, ready or not, public or private. The debate over whether to continue Saturday delivery or not and about prepaying in retirement accounts obscures the fundamental question: does the U.S. need state provision of a postal service?

I grant that there was a compelling case for a postal service at the time of the founding--the Postmaster General was one of the original positions in the Cabinet--but I think that it's time to engage in a gradual winding-down of the state program, complemented by a broad and simultaneous privatization.

The case against this is extraordinarily weak, relying on demagogic rhetoric, non-sequiturs, and ignorance, and almost all of it comes from the public union interests of mail-carriers and other postal service employees, whose interest lies in protecting their jobs rather than taxpayer dollars or even the existence of a postal system, whether public or private. For the next five years, the federal government ought to take action as would a conservator appointed by a bankruptcy court.

Allow me to sketch out the way ahead:

  • Continue to reduce the Postal Service employment through attrition as far as increases in productivity will allow. Given that mail volumes are at 1986 levels and allowing for a reasonable rate of productivity gains, I think a target of 500,000 jobs is appropriate in the medium term. That's 112,000 less than the current level. With attrition currently eliminating roughly 2,500 jobs a month, this will be done in 45 months.
  • Correct payment of retirement accounts to private-sector standards. The union argument tries to paint prepayment programs as the root cause of the Postal Service's troubles and would like to effectively defund the accounts of future employees to buy itself a few more years of superficial fiscal rectitude. That is of course the wrong approach, but for the sake of this analysis, let's assume that the payment has been over-aggressive compared to private accounting standards. Let's say that a change to private standards cuts costs the Postal Service by $2 billion annually--that ought to buy them a few years to adjust their business and to dodge outright default.
  • Roll out a privatization/liberalization program to urban areas first in a deficit-neutral manner: offer a "do not mail" option to end the subsidy on direct mailers, auction off post offices, relocate some branches to malls and other retail areas instead of stand-alone buildings, end Saturday delivery, revoke the monopoly on first class mail to addresses in urban zip codes. Congress should repeal the law banning post office closure for economic reasons--31,000 offices is too many, and 80 percent of them are net losers. Let stamp and shipping prices be set by revenue-maximizing considerations. Congress should also remove any federal guarantee, explicit or implicit, of Postal Service debt obligations by legislation. It should preemptively ban any entry of the Postal Service into other businesses--this runs against the end-goal of a private system.
  • Gradually introduce the privatization/liberalization to suburban and rural areas. At this point, the Postal Service should be operating with no net losses, although with steadily shrinking revenue and costs. Use an auction system to rent out existing post offices to private carriers, under a contract which guarantees a level of service for 10 years in return for an auction-determined subsidy, capped at a percentage level. Those which cannot be auctioned off are closed, with business relocated to offices within malls or supermarkets.
  • Now that the Postal Service has been appropriately downsized, complete the liberalization by legislation which ends all government obligations other than the rural-office subsidy programs. Remove the restraints on entering other businesses, and allow it to expand, add services, or end rental agreements as it chooses.

Thursday, January 19, 2012

Are Capital Gains Taxes Too Low?

A Response to Paul Krugman

Paul Krugman argues here that capital gains taxes are historically low. Unfortunately, he's clipped the graph of historical capital gains tax rates misleadingly. Here is the full historical data set, graphed.

Given the way illusory gains due to inflation were taxed in the 80s, and the sound economic reasoning for low capital gains taxes -- there is a "lock-in" effect of high taxes which impedes capital mobility and thereby reduces the allocative efficiency of capital -- I don't see this as a bad thing. If inequality is the issue here, there are ways with less damaging secondary effects to correct it.

Wednesday, January 18, 2012

Wanted: Good Monetary Policy

The disproportionate consequences of untimely contraction

The graph above takes a pair of Treasury bonds, one inflation-indexed, the other not, for several different maturities and calculates their differences to determine a market expectation for average inflation during that time frame. What fascinates me here is the extraordinary volatility in long-term inflation expectations since the end of the recession in July 2009.

It may seem small: we're talking about swings of roughly 1 percent in inflation expectations in the 5-year time frame, and swings of 50 to 75 basis points in the 7-, 10-, 20-, and 30-year time frames. But this is extraordinary--historically anomalous, in fact. Prior to the recession, these breakeven rates were anchored at 2.5 percent, regardless of economic conditions and monetary policy action.

Why does that matter? First, stable inflation expectations are essential to long-run growth. Unpredictable inflation introduces unnecessary risks to lending and borrowing, impeding investment. Yet I'm about to make a case you might not have heard before: the Fed's conservatism is seriously endangering inflation expectations in the medium- and long-run. (Not growth expectations, or "full employment"--that's an easy argument to win. Inflation.)

We can see this in how the volatility of these breakeven inflation rates move with short-run Fed policy--namely, the quantitative easing programs and related asset purchases. Yet these are short-run policies; why are we seeing them impact long-run inflation expectations?

I see this as the clearest evidence I've ever seen of market concern that without continued accommodative monetary policy, we could be heading for a liquidity trap scenario of protracted periods of low growth, low inflation, and high output gaps. The only reason long-run inflation expectations would respond in this way, we can see, is that if the market expected Fed actions now would be highly determinative of the long-run. This is what an economy making an unsure exit from a liquidity trap looks like. It is highly suggestive that the Fed, moreover, remains disturbingly close to deflationary pressures and has significantly more leeway than I would have thought previously for expansions of QE before it has any negative impact on inflation expectations.

Tuesday, January 17, 2012


Political science and economic perspectives on new legislation

SOPA wikipedia
As I write, several sites--Wikipedia and Reddit, to name a conspicuous two--are gearing up to go dark tomorrow. Kaput. Off. Closed. 

Why? This is about SOPA, the Stop Online Piracy Act, which aims to curtail theft of traditional media works (read: music, movies, and text in books, magazines, and newspapers). In this pursuit, opponents say, the copyright protections threaten to cripple the dynamism and synthesis of the modern Internet.

David Carr of The New York Times gives us a good overview:
SOPA deals with technical digital issues that may seem to be a sideshow but could become crucial to American media and technology businesses and the people who consume their products. The legislation is the rare broadly bipartisan piece of apple pie. The House Judiciary Committee is expected to resume hearings on it this month and all indications are that it will approve the measure, setting up a vote in the full chamber. The Senate is also expected to vote on its own version of the bill when it returns from the holiday break.
Virtually every traditional media company in the United States loudly and enthusiastically supports SOPA, but that doesn’t mean it’s good for the rest of us. The open consumer Web has been a motor of American innovation and the attempt to curtail some of its excesses could throw sand in the works of a big machine on which we have all come to rely.
From an economics perspective, this appears to be a question of concentrated gains (for traditional media corporations) and diluted losses (for everyone else, but rather concentrated for Internet corporations), with what appears to be a net social welfare loss, although there appears to be a strong case that, given the network effects and chaotic growth of the Internet, the net loss could be highly significant.

I also see an interesting political science perspective. From my reading of history, political systems tend to handle cases of potential concentrated gains-diluted losses rather poorly, particularly those with weak checks on government power or on the ability for interested parties to gain influence. The Internet, as I see it, though, threatens to change that calculus, because the reason why the "diluted losses" group could never respond effectively is because the opportunity cost of protest would have exceeded the individual loss due to the legislation. The Internet has drastically reduced those opportunity costs, and thus facilitated protest when the interested parties are spread. This could indeed get interesting.

Monday, January 16, 2012

What the Left Gets Right

Examining the strengths and weaknesses of modern liberalism

Occupy Wall Street
Thomas Edsall of The New York Times wrote what I found to be an extraordinarily thoughtful examination of the philosophical strengths and weaknesses of conservatism, both in its economic and social aspects. Since I found, as Mr. Edsall did, the response of the Heritage Foundation rather lacking, if not outright disdainful, I will do my best to answer his call with five compliments to modern liberalism, albeit from my idiosyncratic Republican perspective.

Liberals are alert defenders of mobility between socioeconomic strata and of equality of opportunity.
Liberals are quick to expand definitions of equality and justice to disadvantaged or stigmatized, as they have for black, Hispanic, or gay Americans.
Liberals are more able to appreciate when government policy can act in the social and individual interest--that is, they are not blinded by ideological aversion, although sometimes their level of comfort misleads them.
Liberals are better at finding a balance when rights come into conflict, such as weighing the rights of the unborn child with the woman's right to personal sovereignty.
Liberals are rightfully more suspicious of law and military, that is, they question the justice of "criminal justice" and idea of "national interest."

Here are five areas where I feel modern liberalism is particularly weak as a political philosophy:

Liberals too often lose sight of negative rights.
Liberals conflate inequality and injustice.
Liberals are too trusting of government, especially when it acts in its institutional interest, and are too quick to assume government must remedy a social ill.
Liberals fail to appreciate the complexity of the economy and society and the capacity of capitalism to be inherently just, making them overconfident in paternalistic, top-down intervention.
Liberals sacrifice too readily the individual for the societal "common good."

Saturday, January 14, 2012

The Innovation Economy

Charting a course for American business

I'd like to think I'm getting a clearer mental picture of the composition of the American economy, or at least what I'd term the "growth vanguard": highly innovative, globally competitive, high technology, high value. Fast Company thinks so too.

Let's think about it in terms of competitive advantage. In the broad sweep of history, the United States enjoyed a significant advantage over the world in consumer and durable goods manufacturing from 1946 through the 60s--Western Europe, due to World War II and the Marshall Plan, was effectively a captive market--due to its well-developed firms and intact industrial infrastructure. Then came 70s stagflation in the developed world, complemented by increasing global competition, particularly from Asia. American economic performance rebounded after the 1980 recession for almost two straight decades, except for the early 90s recession. Much of the gains in employment during this period came from services, particularly professional and financial, driven by a shifting competitive advantage to related to relative variable costs, especially labor. With the millenium came an era of increasing globalization, outsourcing, and intensified competition for the manufacturing which the nation had to a decent degree retained in the 80s and 90s.

My expectation is that, as this decade goes ahead, the United States will see a sort of long-term payoff for globalization. This includes a "reshoring" of some manufacturing, largely high-tech and high-end (read: machinery, chemicals, semiconductors, transportation equipment), as rising labor costs in Asia reduce that region's allure.

Friday, January 13, 2012

Jazz and Links

My taste for jazz seems to be developing. I'd always loved pieces like Brubeck's "Take Five" and "Blue Rondo," also some stuff off Miles Davis' "Birth of Cool"--"Move," for one, is affecting. They, the jazz critics, say that Thelonius Monk is difficult to appreciate, but I haven't found him difficult at all. Excellent accompaniment to the writing I have to do for school.


  • Josh Hendrickson of Ole Miss summarizes a paper from St. Louis Fed president James Bullard which discusses changing views on the roles of, and relationships between, monetary and fiscal policy. (Via Scott Sumner)
  • How deep is this liquidity trap? Greg Mankiw says we're almost out; Paul Krugman begs to differ.
  • Tim Duy of the University of Oregon says that the Fed is acting on the inflation side of its mandate in the medium term at the expense of the "full employment" part. (Via Mark Thoma)
  • The WSJ's Holman Jenkins comes to the eloquent defense of Mitt Romney's tenure at Bain Capital. Look for the discussion of the Davis-Haitwanger findings.
  • In the case Fisher v. University of Texas at Austin (its request for cert is pending), three members of the US Comission on Civil Rights author an amicus brief which, summarizing a wide body of social science literature, finds that affirmative action is hurting its intended beneficiaries.

Wednesday, January 11, 2012

NH Primary

What they say about young voters is true

Voted for the first time in the New Hampshire Republican Primary. Here's the quote I gave to The Exonian, Phillips Exeter Academy's school newspaper, about my experience:
My personal, significant disagreements on social values and policies eliminated most of the candidates for me. So I was left with three real options: Ron Paul, Mitt Romney and Jon Huntsman. Between those three, Romney seemed to be the most experienced and the most prepared to take on the incumbent president.
A bit of personal history: although this is the first time I voted, it is not I've ever been to the polls, and by no means the first time I've been civically engaged. For the last few elections -- that is, since I've been old enough to read anything of meaningful complexity -- my mom invited me to do the research for her. That is, look into the backgrounds and the proposals of the candidates and make a thoughtful recommendation as to for whom she should vote.

Yet when I went to the polls this afternoon in Exeter, it seemed as though I was the only person in the local public school gymnasium, which was serving as the polling center, without grey hair. A good 30 percent must have had canes.

So if my own anecdotal experiences are worth anything, it's that the relative disengagement of the youth vote has a whole lot to do with the passive attitudes of their parents towards this sort of thing.

Also, a friend alerted me to this (apparently satirical) perennial candidate. I did see him on the Democratic ballot.

Monday, January 9, 2012

Labor Markets

Should we be worrying about hysteresis or not?

The chart above depicts that the decline of the unemployment rate from its 10 percent recessionary high hasn't been good news. The "improvement" is caused by declining labor force participation, not by people actually being hired, on net. This could very much be a dangerous phenomenon, as economists have worried that in an extended recession, those who become unemployed due to cyclical phenomena, after a significantly long duration of unemployment, may enter the ranks of the structurally unemployed. They refer to this as hysteresis.

This "hysteresis" story is quite easy to tell from the data above. Gloomy employment prospects--total private hires are now at 3.87 million a year, well below their pre-recession values in the neighborhood of 5 million a year--are causing the unemployed to give up their job search. Given that the Bureau of Labor Statistics defines the most common measure of "unemployment" as having searched (unsuccessfully) for a job in the last four weeks, these drop-outs vanish from unemployment numbers. Yet the employment-population ratio, so often invoked by Brad deLong, has not budged.

Economists care about labor force participation because the labor force is one of the most basic resources, and labor force participation growth is of key importance in long-run output. Low labor force participation, moreover, inflicts all sorts of social costs.

Yet a recent working paper from the San Francisco Fed suggests that we might be worrying about this just a little too much. They find that, because of flows from nonparticipation to unemployment, prolonged high levels of structural unemployment--"Amerisclerosis," as they call it--is unlikely.

Sunday, January 8, 2012

The Progressive Raison d'Être

Scarcity as the justification for political rationing of goods

Catherine M. Rooney, 6th grade teacher instructs her alert pupils on the way and how of War Ration Book Two George F. Will, the esteemed conservative Washington Post columnist, had a very interesting column, one I found to be unusual in the depth of its thought and about which I had intended to post earlier. Jonathan Chait of New York Magazine and The New Republic disagrees, but I think he misses the crux of Will's argument.
For the indefinite future, a specter is haunting progressivism, the specter of abundance. Because progressivism exists to justify a few people bossing around most people and because progressives believe that only government’s energy should flow unimpeded, they crave energy scarcities as an excuse for rationing — by them — that produces ever-more-minute government supervision of Americans’ behavior.
While I think he's off-base when it comes to the actual points of climate science, Will makes an essential point that progressivism treats the existence of scarcity as normative evidence for the necessity of political rationing, as if one follows from the other by logical syllogism or induction.

It is an essentially Hayekian point, in that conditions of extreme scarcity of a good often strengthen the hands of those who call for political allocation, as opposed to what is portrayed as capricious or wasteful management by market systems in an unstated value judgement of what is just. Relief from this scarcity, as increasing supplies of shale oil and natural gas in the United States, in turn weakens the political pressure to "take action," any action.
To undertake the direction of the economic life of people with widely divergent ideals and values is to assume responsibilities which commit one to the use of force; it is to assume a position where the best intentions cannot prevent one from being forced to act in a way which to some of those affected must appear highly immoral. This is true even if we assume the dominant power to be as idealistic and unselfish as we can possibly conceive. But how small is the likelihood that it will be unselfish, and how great are the temptations! 
A hat tip to Mark Perry, who has been blogging about our improving domestic energy situation for months and months now.

Saturday, January 7, 2012

Audit SSDI?

As the American workplace becomes safer, more workers are reporting disability.

The Social Security Disability Insurance (SSDI) program is being seriously abused, if new findings are to be believed. The percentage of individuals claiming SSDI benefits has skyrocketed since the programs establishment, from approximately 0.1% of the workforce in 1952 to over 4.5% percent in 2009. With expenditures on disability also climbing, the old-age component of Social Security is under financial threat, with disability's share of the pie nearly doubling (10% of expenditure in the 80s, 18% in 2008). All this while occupational injuries and fatalities continue on to drop according to historical trends, according to BLS.

Friday, January 6, 2012

How New Is the Normal?

Are financial recessions not special?

Run on East Side Bank, N.Y. 2/16/12 (LOC) Some new findings from the Board of Governors' research team suggest a banking and financial (B&F) crisis has little explanatory power for the way economies recover from recessions.
Focusing specifically on the performance of output after the recession trough, we find little or no difference in the pace of output growth across types of recessions.  In particular, banking and financial crisis do not affect the strength of the economic rebound, although these recessions are more severe, implying a sizable output loss. However, recovery does change with some characteristics of recession.  Recoveries tend to be faster following deeper recessions, especially in emerging markets, and tend to be slower following long recessions. 
This runs in some ways contrary to what had been considered authoritative findings from Reinhard and Rogoff which argued that a B&F crisis tends to lead to a prolonged, deep recession and a delayed, anemic recovery.
Broadly speaking, financial crises are protracted affairs. More often than not, the aftermath of severe financial crises share three characteristics.  First, asset market collapses are deep and prolonged.  Real housing price declines average 35 percent stretched out over six years, while equity price collapses average 55 percent over a downturn of about three and a half years. Second, the aftermath of banking crises is associated with profound declines in output and employment. The unemployment rate rises an average of 7 percentage points over the down phase of the cycle, which lasts on average over four years. Output falls (from peak to trough) an average of over 9 percent, although the duration of the downturn, averaging roughly two years, is considerably shorter than for unemployment.  Third, the real value of government debt tends to explode, rising an average of 86 percent in the major post–World War II episodes. Interestingly, the main cause of debt explosions is not the widely cited costs of bailing out and recapitalizing the banking system.  
That is certainly true -- but the new finding argues that this relationship is not causal, i.e., it is the deep and prolonged drop in output and incomes which determines the nature of the recovery.

For a more precise and math-oriented understanding, the new research took four metrics -- (1) the depth of the recession, (2) the duration of the recession, (3) the rate of pre-crisis growth, and (4) the presence or non-presence of a B&F crisis -- and used linear regression to determine the impact and significance of these four  items on recoveries one, two, and three years out. At all points, item four -- the B&F crisis -- was judged to have statistically insignificant impact on recoveries when one had factored in the unusual severity and length of the accompanying recession.

Wednesday, January 4, 2012

Long-Run Incentives Matter

The fall of European manufacturing edition

Attention remains fixed on Europe and its debt crisis. Some of the worries relate to short-term emergencies of solvency and liquidity, the ability of several nations -- Greece, Ireland, Portugal, Spain, and Italy in particular -- to avoid defaulting on loan obligations. Other worries are, in the economist's sense of the phrase, long-term, such as meeting further obligations several years down the road, or enacting the structural reforms required at both the national and E.U. levels.

Yet could there be longer-term historical forces at work? Robert Samuelson contends that European nations' unfavorable growth and demographic trends make their welfare states unsustainable, and that the current chaos is "ultimately a crisis of the welfare state." Paul Krugman disagrees, observing the lack of correlation between interest rates on 10-year debt and the level of government spending as a percentage of GDP.

I don't think I agree with either. Samuelson's claim is specious, as Krugman argues, because the data do not support a conclusion that investors regard European welfare states as inherently unsustainable. Yet I do not think that today's crisis can be entirely disentangled from the question of the economics of the welfare state, as Krugman seems to believe.
Adam Davidson of NPR's "Planet Money" wrote an article yesterday in The New York Times which agrees precisely:
Europe is undergoing not one but two simultaneous economic crises. The first is a rapid, obvious one — all about sovereign debt, a collapsing currency and austerity measures — that we hear about all the time. The second is insidious but more important. After decades of trying, Europe as a whole still can’t quite figure out how to be flexible enough to compete in the global economy.
There are trade-offs, in other words, to the welfare state, with which the very-long-run consequences of which Europe now grapples.

Robert Lucas' recent Milliman lecture, for one, suggests a balance between the long-run path of output growth and the size of government, a finding very much in line with an endogenous growth theory's model of the economy, which contends that very-long-run growth is best supported by uninhibited forces of "creative destruction," free competition, support for innovation and public distribution of knowledge, and open entry into markets. What Lucas concludes is that economies in welfare states have a lower growth level and flatter growth path than economies with less government involvement.

Our graph above is another example of the trade-off. The welfare state's social supports, depending on how you choose to see it, provide the average manufacturing worker with significantly more leisure time -- or seriously undermine the will to or possibility of harder work. We can see this in the consistent hours of the American worker, versus the hugely significant drop for the sample of European nations during the 60s and 70s, as the post-war welfare state crystallized.

Tuesday, January 3, 2012

Advice for the Taxman

How to boost revenue in an era of deficits

I can't think of a pair of graphs which are more important than the ones above. They depict the two paths to increasing revenues, barring a fundamental change in the nation's tax policy (by, say, adding a value-added tax).

One might characterize the former scatterplot as the "supply-side" economist's perspective, illustrating how the maximization of federal government revenues has been dependent on an extended period of high GDP growth. Indeed, one is able to easily spot the early 90s recession, the dot-com bust, and the current recession on a time-series graph of federal government revenues. They line up as perfectly as any two economic variables might, and while that would not be per se an illustration of causation, the causative mechanism is all but apparent: low taxes represent a lower fixed cost on firms and spur investment and consumption.

One might characterize the latter scatterplot as the "modern liberal" economist's perspective -- or rather, the illustration of the factual flaws in such a perspective. Unfortunately for the modern liberal, the argument that a higher top marginal tax revenues produces higher revenues is simply not supported by the data. Nor is the argument that lower top marginal tax revenues produce lower revenues. And this is a very important point, because it has become an article of faith among this group that the "Bush tax cuts for the rich" are responsible for lower federal revenues. As we see in the first scatterplot, though, the low federal revenues are entirely consistent with the supply-side understanding of weak revenues in a weak economy. Indeed, if the Bush tax cuts had been responsible, would we not have seen the outright collapse of federal revenues under John F. Kennedy* (top rate from 91 percent to 70 percent) and Ronald Reagan (top rate from 70 percent to 28 percent)? The magnitude of their tax cuts, frankly, puts those of George W. Bush (39.6 percent to 35 percent) to shame. Yet we saw no change in revenues not explained by economic performance.

The lesson here is simple, Mr. Taxman: you grow revenues by ensuring that the political environment best facilitates "the uniform, constant and uninterrupted effort of every man to better his condition," from which "the natural progress of things toward improvement" shall come on its own.

Monday, January 2, 2012

Where’d They All Go?

The disappearance of small banks in America

Graph is in logarithmic scale. Source: Federal Financial Institutions Examination Council via St. Louis Federal Reserve.

There are nearly 8,000 fewer small banks in the United States today than there were in 1988. Since then, roughly half of the nation's small banks closed, were acquired, merged with a competitor, or grew to the point where they had above $300 million in assets.

It has been war of attrition of sorts, with a steady annual loss of around 4.5 percent of small banks, for one reason or another, disappearing. Amid the recessionary panic over banks which were "too big to fail," the story of America's shrinking class of small banks has been too readily obscured.

But what, exactly, is going on?

A Federal Reserve Bank of St. Louis paper furnishes us an additional datapoint: in 1984, there were approximately 15,000 banks. Back-of-the-envelope calculations confirm that this adds four years to the consistent period of losses. Within the period of 1984 to 1993, the paper's authors David C. Wheelock and Paul W. Wilson said, 80 percent of the small-bank closures are the result of acquisitions, with the remaining 20 percent the result of explicit bank failure, counting the acquisition of an insolvent bank as a failure.

In short, the larger banks are gobbling up the nation's small banks. Profit maximization, it seems, is driving the trend, a report by banking-industry consulting firm Celent suggests.

"Running a bank requires a certain amount of scale, and that floor is rising due to increasing regulatory requirements, channel support, and product support."

There is certainly something to say about the community bank being a relic in an age where capital can flow around the world with little in terms of transaction fees and where even small and midsize businesses compete globally. Along with online banking, these are services wholly out of reach for that entire class of banks, which places them at a significant competitive advantage.

It also appears that the considerable regulatory burden on banks works against the smallest ones, which have a lesser ability to spread compliance costs over their pool of borrowers and depositors. "I must spend half my day making sure that we are in compliance with current regulations and the other half of my day trying to be prepared for the new regulatory changes to come. Somewhere in there, I need to take care of some customers," one small bank CEO said to D. Bianucci of BAI Banking Strategies, a publication of a financial services industry group.

For now, at least, the banking industry seems to still be working through this decades-long evolution in market structure, driven largely by a dramatic change in consumer preferences but also by hefty regulatory compliance costs.

It seems rather unlikely, however, that the small bank will be driven to extinction. Niche demand from small businesses, who may prefer dealing with a loan officer who will be more involved in their business development, seems likely to keep the small bank alive in the new market structure, albeit in a reduced capacity.

Sunday, January 1, 2012

New Year, New Blog

Dear Reader:

Over the course of the coming days, weeks, and months (years, even), I hope to offer through this blog insight into economics to a general-interest audience. That mission will take a variety of forms. First, I will mainly discuss economic news. Second, I will discuss in depth economic policy measures, both those in effect and those under consideration. Third, I will keep you up-to-date on developments in the academic side of economics, such as emerging debates and trail-breaking research. Lastly, from time to time, I will post non-economic items which are of personal interest. A particular note about the level of expertise required to understand the blog: economics seems to have a particular disposition towards dryness and jargon. The former will be dutifully avoided; the latter will be explained and introduced when helpful. I hope that my particular background in economics -- currently, I am a student at Phillips Exeter Academy who will attend Princeton University next year -- will guide me in this mission.

...And off we go! Expect the first post tomorrow at noon. Please note that this blog is still under construction, technologically speaking.

- Evan Soltas