Economist's View

"Embedded vs. Non-Embedded Inflation"

Paul Krugman explains why the Fed focuses on core rather than headline inflation. I've made this argument a different way, but it's basically the same argument. Boiled down, the argument is that the problem prices are the sticky prices, not the prices like those on food and energy that are flexible, and you want an index (core inflation) that best highlights the problem, i.e. that includes only the problem prices and throws out the ones that can be left to adjust on their own  (I prefer measures that trim out the most volatile prices or use other mechanisms to extract the slowly adjusting prices rather than simply tossing out food and energy, but that's a technical point).

Here's how Krugman explains the intuition (the exact story is model dependent, but the intuition almost always comes down to indexing the problem prices so that they stand out, and leaving the other prices to take care of themselves, and expectations of inflation are a key part of the story). But more important than the explanation for why the Fed focuses on core inflation is the conclusion Krugman comes to, that the Fed shouldn't let worries about inflation interfere with stabilization of the financial sector and the broader economy:

Embedded vs. non-embedded inflation, by Paul Krugman: The big economic debate of the moment is whether the Fed and its peers have made a terrible mistake by focusing on staving off financial crisis while more or less ignoring the rise of inflation. “Inflation is rising and it seems the world’s central banks have critically misjudged the situation,” says Wolfgang Munchau in the FT. I’ve heard even more apocalyptic views from some serious people in the last couple of weeks. As it happens, I don’t agree. And I thought it’s worth spelling out why — especially because many if not most of the participants in this debate don’t explain their premises very clearly. So: when is it appropriate to get very concerned about inflation, and when is it OK to assume that a rise in prices is a temporary shock that will pass? The answer is that inflation becomes a big problem if it becomes “embedded” in the economy, which makes it hard to restore more or less stable prices. But how does inflation get embedded? [Here's how...]

So now you've read Krugman and you are confused. I've talked about core measures of price inflation, yet Krugman is worried about wages adjusting sluggishly. How can the two views be reconciled? There is a larger theory that says to include any price that adjusts slowly, whether it's an input price or an output price, in Fed's monetary policy rule. Here's Michael Woodford:

The theory also provides important insights into the question of which price index or indexes it is more important to stabilize. Again, the answer depends on the nature of the nominal rigidities. If prices are adjusted more frequently in some sectors of the economy than in others, then the welfare-theoretic loss function puts more weight on variations in prices in the sectors where prices are stickier... This provides a theoretical basis for seeking to stabilize an appropriately defined measure of "core" inflation rather than an equally weighted price index. .... Similarly, if wages are sticky as are goods prices, as implied by many empirical ... models, then instability in the rate of growth of a broad index of nominal wages results in distortions similar to those created by variations in goods price inflation. If [adjustments in] wages are staggered ..., then the welfare-theoretic loss function includes a term proportional to the squared rate of goods price inflation and another term proportional to the squared rate of wage inflation each period. In this case, optimal policy involves a tradeoff between inflation stabilization, nominal wage growth stabilization, and output-gap stabilization...

I should also add that, under some theoretical formulations, asset prices should also be part of the Fed's monetary policy decision rule. However, for the most part, asset prices exhibit a high degree of flexibility so little is lost from leaving those prices out. However, as I've argued before, an exception is housing prices - they can exhibit downward rigidity - and this is a reason to consider including housing prices in decisions about the direction of monetary policy, something that would cause the Fed to lean against housing price bubbles as they are inflating.

One final note. Some people will disagree that the Fed should worry about wage inflation, i.e. they will say that the Fed moves to suppress wages whenever workers begin to realize gains and hence works against their interests. But I think that wage inflation that exceeds productivity growth hurts workers in the long-run. Thus, it's something to avoided.

Greg Mankiw: The Problem With the Corporate Tax

Greg Mankiw wants a cut in the corporate income tax:

The Problem With the Corporate Tax, by N. Gregory Mankiw, Economic Scene, NY Times: At this point in the presidential campaign, Senator John McCain is the candidate of ideas on issues of tax policy. Too many ideas, in fact. While some of his ideas are great, others are almost laughable. The one that has received the most attention recently — a gas-tax holiday — falls in the second category. ...

Lost in this hubbub, however, is a bigger idea that Mr. McCain and his economic team have put forward: a cut in the corporate tax rate, to 25 percent from 35 percent. It is perhaps the best simple recipe for promoting long-run growth in American living standards. ...

A cut in the corporate tax as Mr. McCain proposes would initially give a boost to after-tax profits and stock prices, but the results would not end there. A stronger stock market would lead to more capital investment. More investment would lead to greater productivity. Greater productivity would lead to higher wages for workers and lower prices for customers. Populist critics deride this train of logic as “trickle-down economics.” But it is more accurate to call it textbook economics. ...

Compared with other ways of funding the government, the corporate tax is particularly hard on economic growth. A C.B.O. report in 2005 concluded that the “distortions that the corporate income tax induces are large compared with the revenues that the tax generates.” Reducing these distortions would lead to better-paying jobs.

Of course, a corporate tax cut would affect the federal budget. ... Cutting the rate to 25 percent would seem to cost the Treasury about $100 billion a year.

Part of that revenue loss, however, would be recouped through other taxes. To the extent that shareholders would benefit, they would pay higher taxes on dividends, capital gains and withdrawals from their retirement accounts. To the extent that workers would benefit, they would pay higher payroll and income taxes. Increased economic growth would tend to raise tax revenue from all sources.

Some economists think that these effects are strong enough to make a corporate rate cut self-financing. A recent study by Alex Brill and Kevin A. Hassett of the American Enterprise Institute, looking at countries in the Organization for Economic Cooperation and Development, supports exactly that conclusion. But even if that turns out to be too optimistic, both theory and evidence make it reasonable to expect a significant discount from the sticker price. In the end, the net budgetary cost of the tax cut might be, say, $50 billion a year.

Senator McCain wants to fill that hole in the budget by restraining spending. If he can stop bloated legislation like the recent $300 billion farm bill from becoming law, more power to him.

But in case that quest proves quixotic, I have a back-up plan for him: increase the gasoline tax..., a gas-tax increase of about 40 cents a gallon could fund a corporate rate cut, fostering economic growth and reducing a variety of driving-related problems.

Indeed, if we increased the tax on gasoline to the level that many experts consider optimal, we could raise enough revenue to eliminate the corporate income tax. And the price at the pump would still be far lower in the United States than in much of Europe.

Don’t laugh. I’m serious.

I think a 50% recovery rate on tax revenues is far too optimistic, and I'm disappointed that Greg would even hint that the tax cut would be self-financing.

[He also discusses the distribution of the tax burden, but the 70% figure he cites as the amount of corporate taxes paid by labor relies upon an assumption of perfect capital mobility (and other assumptions), and he doesn't include how the burden of paying for the corporate tax cut would be distributed, i.e. how the gas tax or any other means of paying for the tax cut would be distributed across households. So the analysis of the tax burden is a bit incomplete and relies upon some fairly optimistic assumptions. I'm not opposed to either change, but the distributional consequences need more consideration. Predictions about the distributional consequences of policies that rely upon trickle down arguments have not been accurate in the past, and we should be wary when they are used to justify further cuts in taxes.]

From comments:

Corporate Tax Declines and U.S. Inequality, By John Irons, April 9, 2008: Over the last 60 years, the U.S. tax code has dramatically shifted away from corporate taxes and toward taxes on individuals, especially through the payroll tax, the financing backbone of Social Security and Medicare. In the 1950s, the corporate income tax brought in, on average, one of every four dollars in federal tax revenues. By the 2000s, however, it raised just one of every 10 tax dollars.

The shrinking share of corporate taxes was made up by an increase in payroll taxes to fund social insurance and retirement programs. Excise and other taxes—such as fuel taxes, phone taxes, etc.—shrank as well over the last 60 years, while the individual federal income tax rose slightly, from an average of 43% of total federal revenue in the 1950s to 46% in the 2000s.

This shift is important because of who pays these different taxes. The corporate income tax is significantly more progressive than other taxes. Those with incomes in the top 20% of the income distribution (those making more than about $86,000 a year in 2007) pay four times the average tax rate on corporate income than the middle 20% (those making between $27,000 and $48,000); while, for the payroll tax, those in the top 20% actually pay less than those in the middle as a share of their income.

This shift has been one of the factors leading to the drop in average federal tax rates for the very highest earners. Between 1960 and 2004, the average tax rate has fallen by about 14 percentage points (from 44.4% to 30.4%) for the top 1% of earners (those making more than $435,000 in 2007), while it has increased slightly (from 15.9% to 16.1%) for those in the middle 20%. 

Without offsets, further erosion of corporate tax revenues—either through lower statutory tax rates or through special preferences—would expand the already wide and growing income inequality in the United States.

Stephen Gordon makes the point that the countries with larger social insurance programs generally have lower corporate taxes than the U.S., but they also do much more redistribution after taxes are collected so that the net tax burden is fairly progressive even when they rely on fairly flat tax collection mechanisms such as a value-added tax. These redistribution programs are an important part of those systems.

Update: Brad DeLong comments on the article here.

Obama Should Agree to Go to Iraq with McCain

McCain keeps asking Obama to go to Iraq with him. Even though the people responsible for security have said they would not allow them to go to Iraq together, and Obama has declined, I think it's a good idea. It would be a great opportunity for Obama to straighten out McCain on all the things he has wrong about Iraq. In the past, McCain has had Joe Lieberman around to whisper in his ear when he makes great big mistakes. But Lieberman has his own problems and his own misperceptions, and he can't always be there, and Barack is a much better choice if the goal is to gain a clearer understanding of the political, economic, social, military, and other issues that make Iraq and the greater area such a complicated and difficult problem to solve.

Let's start with an easy one. If the two of them were there today, Obama could point to troops and say see those people in uniform? There's 155,000 of them - more than the pre surge levels. I know you have trouble with technical stuff, economics, that sort of thing, but this is easy John - 155,000 is a bigger number than 130,000 so we are not back down to pre surge levels like you have claimed. And if the numbers have changed by the time they get there, it will still be worthwhile for Obama to explain why it's important for someone wanting to be the Commander in Chief to keep track of how many soldiers we have deployed.

He could point to Mosul and say, I know you said that things are quiet there, but on a day when there were three suicide bombings, it's probably best to describe it some other way.

He could, and this is important for McCain to learn because he's made this mistake more than once, set up meetings with Sunnis and Shi'as. Then, - very slowly because as, as just noted, McCain has trouble on this one - explain how they differ and why it's important to understand the difference.

And as a follow up to the previous point, once McCain does finally get this distinction, Obama could point out that understanding this will help him to avoid saying it's common knowledge that Iran is training Al Qaida when it's not true (though this is one case where, when he said this, the ear whispering Lieberman did cause him to correct his obvious lack of knowledge).

Speaking of Iran, though they wouldn't actually be in Iran, it's bound to come up, and when it does it would be a great opportunity to explain to McCain how Iran's government is structured. McCain has been confused about who leads Iran, so once again, Barack could help McCain with this. And he could, yet again, also explain why it's important to get this right.

If they are walking through a market under very heavy military guard, if there's no other way to enter the area other than with armed escorts, Barack could explain how it's probably not quite correct to say the market is safe.

And, while they are strolling through the streets of Iraq protected by hordes of military personnel who could be doing more important things than setting up TV shots for campaigns, maybe Obama can talk about other things too, educate McCain on the economy, explain that tax cuts don't increase revenue, that sort of thing. It's a bit unrelated, but not completely given how poorly the Bush administration has handled economic development issues in Iraq.

So I can see why John McCain wants Barack Obama to come along to Iraq with him, he needs somebody with him who actually understands how the politics, economics, relations with nearby countries, military presence, and so on affects Iraq, he needs to hear from someone who had Iraq policy right from day one.

Why should Barack help McCain? Aren't they political opponents? Yes, but McCain, along with the noise machine that supports whatever he says no matter how daffy or gaffey, has been confusing the public about these issues. There are considerable misperceptions as a result of McCain's confusion and lack of knowledge. When Obama does win the presidency this fall, that confusion will make it much, much harder to do what needs to be done to get things back on the right track, so whatever he can do now to help to overcome those misperceptions will help to pave a smoother road to the future.

So go ahead, agree to accompany McCain to Iraq, he really needs you there. McCain has been there several times already, and his lack of knowledge shows he really needed to take those trips, but it hasn't been enough, he still gets key things wrong. You'd think he'd have figured it all out by now, if he could, that he would have had someone explain it again and again until he gets it, but maybe you can help him, and yourself, and all of us, by going along.

links for 2008-05-31

• Lessons From the Housing Bubble - Capital - WSJ.com
• Former Bush donors now giving to Obama - McClatchy
• Credit Card Debt Absent the Mortgage Bubble - Credit Slips
• The economics of Scrabble - The Bayesian Heresy
• Troubled Oceans - Editorial - NYTimes.com
• Farewell, Fair Weather - Op-Ed - NYTimes.com
• Commodity Policies Set for Revision - NYTimes.com
• Bush Administration Improves Nixon Playbook - Capital Gains and Games
• Are smoking bans “contagious”? - Richard Baldwin

"Who Gentrifies Low-Income Neighborhoods?"

This examines the distributional impacts of gentrification. The results may not be what you expect:

Who Gentrifies Low-Income Neighborhoods?, by Terra McKinnish, Randall Walsh, and Kirk White NBER Working Paper No. 14036 May 2008 JEL No. J15,J60,R23 [Open Link]: Abstract This paper uses confidential Census data, specifically the 1990 and 2000 Census Long Form data, to study the demographic processes underlying the gentrification of low-income urban neighborhoods during the 1990's. In contrast to previous studies, the analysis is conducted at the more refined census-tract level with a narrower definition of gentrification and more closely matched comparison neighborhoods. The analysis is also richly disaggregated by demographic characteristic, uncovering differential patterns by race, education, age and family structure that would not have emerged in the more aggregate analysis in previous studies. The results provide no evidence of displacement of low-income non-white households in gentrifying neighborhoods. The bulk of the increase in average family income in gentrifying neighborhoods is attributed to black high school graduates and white college graduates. The disproportionate retention and income gains of the former and the disproportionate in-migration of the latter are distinguishing characteristics of gentrifying U.S. urban neighborhoods in the 1990's.

I. Introduction

"Concern, and anger, over gentrification has grown in communities across the country as housing rental and sales prices have soared .… there are numerous reports of resident displacement from neighborhoods long ignored that now attract higher-income households."¹ -2006 Urban Institute Report

Over the past several decades, there has been substantial gentrification of low-income neighborhoods in many U.S. urban areas. These neighborhoods typically experience large increases in household income and housing prices. Some laud the revitalization of decayed neighborhoods and others criticize the displacement of low-income, often minority, households.

The distribution of benefits from neighborhood change is a crucial policy issue. Since 1974 the U.S. Department of Housing and Urban Development (HUD) has allocated nearly $120 Billion in Community Development Block Grants.² These grants, that are intended to benefit low and moderate-income individuals by eliminating slums or blight and addressing urgent community development needs, have been allocated to more than 1000 U.S. cities. While public investment in neighborhood revitalization is ubiquitous, the consequences of neighborhood gentrification for low-income and minority individuals remain an open question.

Ending the Soft Ride for Mendacious Politicians

Paul Krugman, "a self-described pussycat":

Maverick loads gun for new round of shots, by Ben Naparstek, Business Day: Today, Paul Krugman doesn't seem like a maverick. A CNN poll in April found George Bush to be the least popular American president in modern history... But in the run-up to the Iraq invasion, Krugman was one of the few pundits in the mainstream media to unflinchingly attack Bush. Since beginning his twice-weekly column in The New York Times in January 2000, Krugman has relentlessly accused Bush of lying — about the motives behind cutting taxes for the rich and attempting to roll back social security, for example, and about weapons of mass destruction in Iraq.

After the September 11, 2001, attacks, newspapers and magazines of the liberal centre ricocheted to the right. As the Times, The Washington Post, New Yorker and New Republic fell obediently in line with the Bush Administration, Krugman's heretical columns made him a poster boy for the anti-war left and a hate figure to neocons. "I was largely alone on the major op-ed pages," says the mild-mannered 55-year-old Princeton economics professor. "We look back now at 2002 and say, 'Nothing really bad happened to people. We did not have a new era of McCarthyism'. But that was very far from clear at the time. It was pretty frightening." ...

In the fevered climate of post-9/11 America, his outspokenness attracted death threats. But Krugman, a self-described pussycat, ... never set out to fight political battles. "It has been a much less easy life than I expected to be leading at this point. I should be sitting around in well-stuffed armchairs reflecting upon my life's research work."

When The New York Times approached Krugman to write a column in 1999, he wrongly presumed it wouldn't be too time-consuming. The main burden would be financial — the newspaper's conflict of interest rules prohibited him from giving corporate talks, for which he commanded up to $50,000. With the American political scene calm and the economy booming, Krugman expected to write about business deals, the internet, and developing world financial crises. But the 2000 presidential election politicised him. "A funny thing was happening. The candidate of one major party was being blatantly dishonest in what he said — at that point about economics — and no one was calling him on it." Krugman argues that the media give a soft ride to mendacious politicians because journalists are trained to consider two sides of any issue.

"If Bush said that the world was flat, the headline on the news analysis would read 'Shape of Earth: Views Differ'," he said in 2000. In "The Great Unravelling..., Krugman explains why many people failed to grasp the radicalism of the Bush agenda: "People who have been accustomed to stability can't bring themselves to believe what is happening when faced with a revolutionary power, and are therefore ineffective in opposing it."

He understands why journalists feared speaking up. "There really has been, for the most part, no reward for having gotten in front of the story and reporting what was going on. On the contrary, people who got it right have been fired and there's no cost to having gotten it wrong. Most news outlets are owned by large corporations. The journalists may be mostly highly educated people from the north-east who tend to be liberal, but the ultimate decisions on the coverage are made by people who are, on the whole, Republicans."

Whereas most Times columnists are career reporters, Krugman's academic background means he was never socialised to follow the dominant media line. ... Krugman maintains his independence by leading the relatively secluded life of a university professor in New Jersey. ...

Even Krugman's admirers sometimes flinch at his savagery. "He steps over the top," says Stiglitz, a Nobel Prize-winning economist and close acquaintance of Krugman. [...read more...]

If the Democrats win this presidency this fall, it will be interesting to see how people react when he is writing about Democrats rather than Republicans (it already has been interesting). My view is that Krugman has been right when most everyone else was wrong, and, agree or disagree, he's earned the right to be heard.

Update: Free Exchange seems to have stumbled across the same article (it's from an Australian business publication) and comments here.

Update: Stephen Moore of the WSJ says:

A few weeks ago, I gave a talk about tax policy to a group of elderly people ... I reminded the audience that the estate tax is scheduled to fall from 45% today to zero in 2010, but then rise all the way up to 55% in 2011. I joked that what we have here is the "Throw Mama From the Train Tax."

Then:

Democrats are starting to wake up to the death-tax calamity

I'm afraid he has this wrong, he seems to just be waking up to this, but Krugman was all over this years ago - in 2001 - even using the same joke:

Reckonings; Bad Heir Day, by Paul Krugman, Commentary, NY Times, May 30, 2001: ...The Bush tax plan was always peculiar: in order to hide the true budget impact, its authors delayed many of the biggest tax cuts until late into the 10-year planning period; repeal of the estate tax, in particular, was put off to 2010. But even that left the books insufficiently cooked, so last week the conferees added a "sunset" clause, officially causing the whole bill to expire, and tax rates to bounce back to 2000 levels, at the beginning of 2011.

So in the law as now written, heirs to great wealth face the following situation: If your ailing mother passes away on Dec. 30, 2010, you inherit her estate tax-free. But if she makes it to Jan. 1, 2011, half the estate will be taxed away. That creates some interesting incentives. Maybe they should have called it the Throw Momma From the Train Act of 2001.

That's by no means the only weird element in the tax bill. ...

Moore tries to blame it on Democrats, then says:

the obvious solution to a death-tax nightmare scenario in 2010 is to make the estate-tax repeal permanent.

Krugman predicted this:

In short, the tax bill is a joke. But if the administration has its way, the joke is on us. For the bill is absurd by design. The administration, knowing that its tax cut wouldn't fit into any responsible budget, pushed through a bill that contains the things it wanted most -- big tax cuts for the very, very rich -- and used whatever accounting gimmicks it could find to make the overall budget impact seem smaller than it is. The idea is that when the absurdities become apparent -- when mobs of angry junior vice presidents from New Jersey start demonstrating against the A.M.T., or when elderly multimillionaires develop a suspiciously high rate of fatal accidents -- Congress will always respond with further tax cuts. ...

Someday, responsible politicians — or is that an oxymoron? — will have to untangle this mess. ... But for now, it's a defensive game. The administration, having successfully rammed through a ridiculous tax bill, will try to bamboozle us on other matters. ...

Aid to Poor Countries: "Cruel Joke" Week

Is the opening paragraph serious?:

Bread and Bush-bashing, by Chris Patten, Project Syndicate: I feel a little sorry for President Bush. Whatever his other many failings, he has a pretty good record on aid to poor countries, particularly in healthcare. True to form, he recently announced a big increase in US food aid -- good for the hungry poor and good for American farmers. ...

What made me feel a little sorry for Bush was the reaction to his announcement. Bush referred to the reasons for shortages and price hikes. He did not dwell on the diversion of American corn from food to heavily subsidized bio-fuels. Nor did climate change feature prominently in his argument, although many experts suggest that this may be the cause of the droughts and floods that have ruined wheat harvests in Australia and vegetable oil production in Indonesia and Malaysia.

Bush pointed his finger primarily elsewhere. Food prices had responded to growing demand. In Asia, economic growth had stimulated food consumption. The Chinese and Indians were eating more and eating better. ...

What Bush said is of course true. ...

But many Indians are still wretchedly poor. Too many. They have a miserable diet -- not least when compared with Bush’s Texan neighbors. Grain consumption per head in India has remained static, and is less than one-fifth the figure for the US, where it has been rising. I do not imagine you will find too many vegetarians in Crawford, Texas, and the meat consumed by the average American is way ahead of the figure for any other country. Think of all those T-bone steaks.

Bush’s partial explanation of the world food crisis, accurate as far as it went, brought the anger of India’s media and of many politicians... According to India’s Defense Minister, A.K. Anthony, presumably an expert on butter as well as guns, Bush’s statement was “a cruel joke.”...

Later in the “cruel joke” week, Bush’s White House compounded the sin. According to Bush’s press spokesman, the growth in world demand for oil -- in Asia, for example -- was one of the causes of the high price of filling the tanks of gas-guzzling sports utility vehicles ... at America’s pumps.

Meanwhile, the US government papered over the fact that Americans, who make up less than 4 percent of the world’s population, own and drive 250 million of the world’s 520 million cars. More outrage around the world at American double standards.

Now, all this is more than the knock-about of international politics. One day soon, Bush and Cheney will be out of office. But we will still be left with the most difficult global issue we have ever faced: as more of us prosper, how do we deal fairly with some of the economic and environmental consequences?

What do we do about the bottom billion in the world who remain in grinding poverty while the rest of us live better and longer lives? How do we deal with equity on a global scale when we cannot even deal with it country by country?

This conundrum will lie at the heart of the diplomacy next year to find a successor to the Kyoto agreement. Can we prevent a calamitous increase in global warming in a way that is fair,... and that does not thwart legitimate hopes for a better life everywhere? We have never faced a more difficult political task.

Meanwhile, there is a food crisis to solve. We have already seen many examples of how not to deal with it. Stopping food exports is stupid. If we restrict market forces, there will be less food and higher prices. We should also avoid the cheap political trick of holding down what we pay to poor farmers in order to benefit poor city dwellers.

Why do governments do this? The answer is obvious: city dwellers riot; in the countryside, people just starve. The best way to deal with the problem is to subsidize food for the poor; we should not cut the price we pay farmers for growing it. ...

Here's the reason I asked. This is Africa, not India, but I don't suppose the story is any different:

Food Relief For Africa 'Insufficient,' GAO Says, by Anthony Faiola, Washington Post: Efforts by the United States and multilateral agencies including the World Bank to reduce hunger in sub-Saharan Africa have been "insufficient," with foreign aid to the region failing to flow into agricultural development projects vital to the ability of poor countries to feed themselves, according to a report to be released this morning by the U.S. Government Accountability Office. ...

The report, a draft copy of which was obtained by The Washington Post, additionally describes U.S. aid efforts in sub-Saharan Africa as fragmented and misdirected. It says, for instance, that a Bush administration initiative to "end hunger in Africa" launched in 2002 effectively amounted to a repackaging of existing programs and came with no new funding. ...

The report comes on the heels of another released by the GAO last year sharply criticizing U.S. food aid programs. That report called them "inherently inefficient" because they rely on the sale of American-grown food that is costly to transport overseas, as opposed to food purchased closer to the troubled regions themselves. ...

links for 2008-05-30

• Are gas prices becoming more volatile? - Tim Haab
• Mr. Lessig Goes to Washington - Chris Hayes
• Introducing ... Treasury Secretary Phil Gramm? - Andrew Leonard
• Wasps Reveal Clues about the Evolution of Intelligence - Scientific American
• Behavioral Economics in D.C.: We Don't Have to Wait for Obama - Zubin Jelveh
• Fedspeak Highlights: Kohn on Central Bank Lending - Real Time Economics
• U.S. Regulators Push to Strengthen Oversight of Energy Markets - NYTimes.com
• Agency Sounds an Alarm on Banks’ Shaky Outlooks - NYTimes.com
• Sources of growth in projected health care costs - CBO Director’s Blog
• McClellan on McClellan - Kinsley - washingtonpost.com
• Double, double, oil and trouble - Economist.com
• Probe of Crude Oil Trading Disclosed - washingtonpost.com
• Neuroscientists Take Important Step toward Mind Reading - Scientific American
• The Doha dilemma - Economist.com
• Foreclosure Phil - Mother Jones

Universal Health Care and Military Retention

Worries that universal health care will hurt military recruiting:

Health’s Gain May Be Army’s Loss, by Floyd Norris, Commentary, NY Times: Call it the law of unintended consequences. When you fix one thing, it messes up other things.

If the Democrats win the election this year, and are able to enact a health care plan that extends adequate coverage to all Americans, the loser could be the Army. Getting enough people to enlist could become a major problem for the next president. ...

Government polls show that the proportion of young people who think they might enlist is roughly half what it was in the late 1980s. The military has responded with more recruiters and higher cash enlistment bonuses, and has met its goals. A significant factor for many recruits, it turns out, is the military’s generous health benefits for dependants.

Michael Massing, writing in the April 3 issue of The New York Review of Books, tells the story of one part-time college student from Brooklyn, who was holding down two jobs but still going into debt. “Meanwhile, he got married, his wife got pregnant, and he had no health care. From a brother in the military, he had learned of the Army’s many benefits, and, visiting a recruiter, he heard about Tricare, the military’s generous health plan.” He enlisted. ... All that could change if the push for some kind of national health insurance program were to be successful. ...

[I]f such a program were adopted, it seems likely that the military, and particularly the Army, would feel the immediate effect. To expand the Army, as all the candidates say they want to do, would require some other incentive for enlistment... In the near term, it is possible that a recession will improve the military’s recruiting success. ...

One partial solution to the negative effect on enlistment of a health care plan for all could be a new G.I. education benefit. Both the House and Senate have approved such a plan... President Bush is opposed to the legislation, which its sponsors say would cost $50 billion over 10 years, and it is far from clear it will be enacted. ...

Senator Jim Webb, a freshman Democrat and Vietnam veteran, is the principal Senate sponsor of the legislation. He argued — with something less than precise data — that passage of the bill would increase enlistment by 16 percent...

Senator McCain has proposed a less costly alternative that would provide better benefits to those who stay in the military longer. He may have a point. Last year about three-quarters of Army volunteers who completed their first term of enlistment, and nearly as many marines, chose not to re-enlist. ...

If we get a real health care plan for all Americans, it might require something like the Webb bill — or a very unpopular revival of the draft — just to keep fighting in Iraq and Afghanistan. The backers of health care legislation do not want to hurt the Army, but that is what could happen.

Continuing a discussion of this topic from not too long ago, the right way to do this is to state the the goals we are trying to reach, then build incentives into the polices that direct people toward those goals with as few negative consequences as possible.

One possible goal is retention. If you want people to stay longer, deferred compensation schemes are a way to accomplish that goal. We need to decide how many people we want to stay for additional terms, and then set the compensation incentives accordingly (these can be tweaked as needed, e.g. you can have incentives for reenlistment at each decision point, or you can discourage reenlistment after some number of terms if there is some reason to do so). Yes, it may require that the government pay people serving in the military more, at least those who stay longer, but that is simply what it will cost to reach the goal, that's the price to command these resources. People who applaud the ability of markets to value resources should understand that. If it costs too much to induce sufficient reenlistment, i.e. if the costs of producing higher retention rates are greater than the benefits, then it's not a very good policy anyway.

But if the goals are different, e.g. if the goal is to provide educational benefits to make up for lost opportunities in the private sector due to service in the military, the the policy will, of course, be different as well. When evaluating a proposed policy to, for example, increase educational benefits all of the consequences, including the effects on retention, should be examined. But this is part of a cost benefit calculation. If the educational benefit - the goal of the policy - exceeds the retention cost, then it's still worthwhile.

And it may not be necessary to give up on the retention goal just because you offer educational benefits, one does not have to be traded against the other. It's possible - if you are willing to pay the cost - to offer both higher education benefits and higher deferred compensation so that both goals are attained. More help for education is available for those who choose to leave when their term ends, but since deferred compensation is higher for those who reenlist, just as many stay as before. Whether it's worth it to do this is  matter of comparing the costs and benefits, but increasing education benefits does not have to lower retention rates.

If national health care is enacted and that lowers the incentive to enlist, or to reenlist, then the compensation levels will have to be adjusted to compensate, but it doesn't have to change retention rates or the ability to provide education benefits after people leave the military if we are willing to pay what's needed to induce the desired behavior.

"Crude Awakening: Behind the Surge in Oil Prices"

Stephen P. A. Brown, Raghav Virmani, and Richard Alm of the Dallas Fed look at why oil prices are so high, and whether the high prices are likely to continue. It's a more optimistic view than many. Their bottom line is "Absent supply disruptions, it will be difficult to sustain oil prices above $100 (in 2008 dollars) over the next 10 years" (comments at Real Time Economics and The Big Picture):

Crude Awakening: Behind the Surge in Oil Prices, by Stephen P. A. Brown, Raghav Virmani and Richard Alm, Economic Letter, Vol. 3, No. 5, May 2008, Federal Reserve Bank of Dallas: The first few months of 2008 saw crude oil prices breach one barrier after another. They topped $100 a barrel for the first time on Feb. 19, then rose past $103.76 about two weeks later, surpassing the previous inflation-adjusted peak, established in 1980. In April and early May, oil prices pushed past $110 and then $120 a barrel and beyond.[1]

These milestones reflect a new era in oil markets. After the tumult of the early 1980s, prices remained relatively tame for two decades—in both real and nominal terms (Chart 1). This long stretch of stability ended in 2004, when oil topped $40 a barrel for the first time, then embarked on a steep climb that continued into this year.

Two from Jeff Frankel: Whether We are Currently in a Recession and the Impact of Monetary Policy on Commodity Prices

There are two different topics to choose from, so let's start with the latest news on GDP. Today, GDP growth for the first quarter was revised upward from .6% to .9%. How does this affect the odds that we are currently in a recession? Jeff Frankel is a member of the NBER's Business Cycle Dating Committee:

Despite Positive First Quarter, Odds of 2008 Recession Are Still Above 50%, by Jeff Frankel: The Commerce Department this morning revised upward its estimate of first quarter growth in real GDP to 0.9% (precisely in line with the expectations of economic forecasters).

As a member of the Business Cycle Dating Committee of the NBER, I am asked frequently if the country is entering a recession, or if we have already done so. I cannot speak for the Committee, and I am not a professional forecaster. But I can give my views, for what they are worth.

It is hard to say that we entered a recession in the first quarter, without a single negative growth quarter, let alone two of them. Even so, three minor qualifications to that 0.9% remain: 1) The number will be revised again, and could move in either direction. 2) A bit of the measured growth consisted of an increased rate of inventory investment, which was almost certainly not desired by firms and is likely to reverse in the 2nd quarter 3) As Martin Feldstein has pointed out, the QI growth number is defined as the change for the quarter as a whole relative to QIV of 2007; within QI, the information currently available suggests that GDP fell from January to February to March.

The reason why many suspected a QI turning point in the first place is employment, which is virtually as important an indicator to the NBER BCDC as is GDP. Jobs have been lost each month since January. Total hours worked is my personal favorite, because in addition to employment it captures the length of the workweek, which firms tend to cut before they lay off workers. This indicator too has been falling.

And of course there are the longer run indicators that have been very worrisome for almost a year: depressed household balance sheets, mortgage defaults, high oil prices, low consumer confidence, etc.

The economy is a four-engine airplane flying at stall speed, skimming along the top of the waves without yet going down. ... The big question mark is the consumption engine. Is the long-spending American household taking a hard look at its diminished net worth and taking steps to raise its saving rate above the very low levels of recent years?

We are already clearly in a “growth recession.” All in all, I put the odds of an outright recession sometime this year at greater than 50%. That number is meant to add together: (1) the odds that it will turn out that we have already entered reached the turning point and (2) the odds that the sharp recent expansions in monetary and fiscal policy will succeed in postponing the recession, but only until later in the year. Come the fall, if demand starts to slow, I can’t see either the Fed delivering a second big dose of interest rate cuts (as they were able to in the 2001 recession, when the dollar was strong and inflation under control), nor the government delivering a second big dose of tax cuts (as they could in the 2001 recession, when the budget outlook was strong and debt under control).

Next, a different topic. Jeff Frankel defends his argument that high commodity prices are the result of easy monetary policy:

Monetary policy and commodity prices, by Jeffrey Frankel, Vox EU: In a speech delivered last week, Federal Reserve Vice Chairman Donald L. Kohn addressed a theory to which I am partial: the theory that low real interest rates have contributed to the continued rise in prices of agricultural and mineral commodities, including oil, over the last year. He said:

“Some observers have questioned whether the news on fundamentals affecting supply and demand in commodities markets has been sufficient to justify the sharp price increases in recent months. Some of these commentators have cited the actions of the Federal Reserve in reducing interest rates as an important consideration boosting commodity prices. To be sure, commodity prices did rise as interest rates fell. However, for many commodities, inventories have fallen to all-time lows, a development that casts doubt on the premise that speculative demand boosted by low interest rates has pushed prices above levels that would be consistent with the fundamentals of supply and demand. As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies, hence raising the amount demanded by people using those currencies. But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one.”
(Speech at the National Conference on Public Employee Retirement Systems, New Orleans, Louisiana, May 20, 2008).

As real interest rates have come down over the last year, real commodity prices have accelerated upward despite declining economic growth, as shown in Figure 1, where the commodity price has been inverted so that one can see the correlation visually.

Coming Up Short

People in other countries used to look up to Americans, but that is changing:

Economist traces height trends, by Tom Hundley, Chicago Tribune: When John Komlos wants to take the measure of a nation's economic well-being, he doesn't check its gross domestic product or consumer price index. He ignores ... unemployment figures. Instead, Komlos takes a look at how tall its people have grown.

"Height is a very good overall indicator of how well the human organism thrives in its socioeconomic environment," he explained.

Komlos, a professor in the economics department at the University of Munich, Germany, has dedicated his professional life to the study of anthropometric history—his own coinage for the academic field that studies the links between a population's height and general well-being.

What Komlos has learned is that Americans, despite their nation's prosperity, abundance of food and cutting-edge medical technology, stopped getting taller in the 1950s and have now been passed by their European cousins.

"Americans were head and shoulders above Europeans in the 18th Century, and it stayed that way for two centuries," he said. "Now it's the other way around."

This, according to Komlos, suggests that Europeans eat better, have better access to health care and enjoy a more equitable distribution of national wealth. They will almost certainly live longer than their American counterparts. ...

Genetics determines an individual's height—whether a person is shorter or taller than the national norm—but external factors determine a population's height.

While the media quickly latched onto the height rankings, Komlos and other economists were more interested in the external factors that were causing the startling disparity between American and European growth rates.

In the 2004 paper, Komlos fingered two likely suspects: the growing gap between rich and poor in the U.S., and its lack of universal health care.

Although the U.S. has been the dominant economic power since the end of World War II, its wealth has not been very evenly distributed. According to standard measures, countries such as the Netherlands and the Scandinavian nations are at the top of the list; the U.S. ranks near the bottom, tied with Ghana and Turkmenistan, according to UN figures.

When income is distributed more evenly, it follows that access to health care also is evenly and equitably distributed, Komlos said.

He noted that a high number of Americans are without health insurance (a U.S. Census Bureau report put the figure at 47 million for 2006), meaning that millions of American children do not get top-notch medical care during the critical growth years. Meanwhile, the "tall" countries of the world have been providing their citizens with cradle-to-grave health care for generations.

Komlos does not claim that his research has established a causal link between a nation's height and its health care delivery system, only that "height is a pretty good indicator of how well a society treats its children and young people."

Komlos is struck by two things when he visits the U.S.: the alarming proportion of the population that is overweight, and the shortfall in height—especially among females.

Could America's diminished stature have something to do with its expanding girth?

Very likely, Komlos said. "The tremendous amount of fast food consumed by Americans ... has to have an impact," he said. ...

The latest national height data contains some good news and some bad, Komlos said.

The good news is that there are indications that Americans may have started to grow again. The bad news is that this growth trend appears to be bypassing black females. "This is an uncomfortable finding, especially at a time when Europeans and other developed countries are not only catching up but exceeding us," Komlos said.

Here's Paul Krugman on the same topic. He says:

We seem to be left with two main possible explanations... One is that America really has turned into 'Fast Food Nation.'

A broader explanation would be that contemporary America ... doesn’t take very good care of its children. ... Whatever the full explanation..., our relative shortness, like our low life expectancy, suggests that something is amiss with our way of life. A critical European might say that America is a land of harried parents and neglected children, of expensive health care that misses those who need it most, a society that for all its wealth somehow manages to be nasty, brutish — and short.

Update: Eric at Edge of the American West has a brief follow-up on whether this is due to immigration (it's not). Free Exchange weighs in here.

Taylor: Fed Partly to Blame for Global Inflation

John Taylor thinks the Fed needs to tighten policy to reduce the pressure on global inflation:

Easy policy behind global inflation: Taylor, Reuters: Inflation is rising globally because of an easy monetary policy, ... John Taylor said... To tackle rising inflation, Taylor urged the world's policy-makers to talk about adopting a global inflation target.

The creator of the so-called "Taylor rule" of monetary policy, which stipulates that interest rates should rise by more than the increase in inflation..., said U.S. interest rates are now below appropriate levels indicated by the rule.

"During the past year, as global inflation has risen, global short term interest rate targets set by central banks have not increased on average by as much as inflation," Taylor said in a conference on monetary policy hosted by the Bank of Japan.

The average targets have in fact declined since the credit market crisis started in the middle of last year, largely due to sharp rate cuts by the Federal Reserve, said Taylor, now an economics professor at Stanford University.

When interest rates are declining ... in the United States, other central banks have tended to be reluctant to raise rates because that could lead to a sharp appreciation of their own currency, he said.

"Because of concerns about exchange rates and the impact on the exports sector, on the economy in general, central banks are not following the principles that they come to think of as important," Taylor said.

That leads to higher commodity prices, driving inflation all around the globe, he said.

"There is strong evidence that at least part of the increase in energy and commodity prices is related to the global inflationary pressures and thereby, in part, to the policy response to the financial crisis in the United States," he said.

The global dimension of current inflation means a global response is necessary.

"A good place to start is with discussions about some kind of global inflation target," he said, adding that such a target does not need to be a strict numerical target.

I'd like to hear more about what he has in mind for the mechanics of global inflation targeting, i.e. how it would be coordinated across central banks. Credibility of the promises of other members of the coalition in such an arrangement would seem to be one difficult hurdle to overcome (though not the only one), so there would have to be strong penalties for deviating from the global inflation targeting rule. But that would discourage nations from joining in the first place unless they were convinced that the extra restrictions they'd have to follow as part of the coalition would bring them benefits (such as reducing exchange rate changes brought about by a trading partner pursuing a high inflation policy) they couldn't get on their own by strict adherence to a domestic inflation target. [One minor technical point. The article says that the "'Taylor rule' of monetary policy ... stipulates that interest rates should rise by more than the increase in inflation...," but this is usually called the Taylor principle, not the Taylor rule.]

Drinking and Driving

When I was in high school, most of my budget went to two items, gas and beer. At that time, the price of gas was 25 cents a gallon, and beer was $1.25 a six-pack if I remember correctly (and I may not). So the relative price was 5 to 1, i.e. to get five gallons of gas, you had to give up a six pack of beer.

Today, the tradeoff is a bit different. A gallon of gas is around $4.00 and beer is over $5.00 a six-pack. I'm not sure on the price today, but say let's say it's $5.50. So now, roughly, the relative price is 5.5 to 4, or 5 to 3.63 rather than 5 to 1 as before. Gas costs a lot more beer these days, to get five gallons today you have to give up 3.63 six packs, where before it was only one.

If someone had an allowance of $5 per week back then and purchased two six-packs and 10 gallons of gas, then they would need $51 to purchase the same basket of goods (or bads) today. Since this was 36 years ago, that works out to inflation of 6.7% per year. Not quite as bad as I imagined, but still pretty high, certainly higher than the increases in the minimum wage over that time period. Kids who didn't drink at all, say they put all of their allowance into gas, would need $80 today to buy the 20 gallons of gas they could get for $5 at a quarter per gallon. That's an inflation rate of 8.0%. But an all beer kid, one who spent all $5 on beer and didn't drive at all, would only need $22 today to get the same amount of beer. That's an inflation rate of 4.1%.

Given the shift in relative prices, kids today should be tempted to drink more, and drive less.

links for 2008-05-29

• European economic integration: Undoing 1914-1945 - Vox EU
• Fed's Stern Frets About Inflation - Real Time Economics
• Mishkin Resigns: A Look Back - Real Time Economics
• Mishkin to Leave Fed in August, Return to Columbia - Bloomberg
• How fairness is wired in the brain - EurekAlert
• William Sharpe casts a sharp eye on Social Security - InvestmentNews
• As Portland Changes, Blacks and Whites Talk It Over - NYTimes.com
• Barack Obama’s Spring Flaws Won’t Matter in the Fall - Op-Ed - NYT
• Lessons from the North Atlantic Financial Crisis - Willem Buiter

"A Time of Unexampled Prosperity"

Dallas Fed president Richard Fisher reminds us that bubbles are nothing new (suggested by email):

Listening to Washington Irving, by Richard Fisher, Dallas Fed: There is nothing “unprecedented” about the situation we find ourselves in. To illustrate the point, I want to read a passage from Washington Irving’s 1819 essay on the Mississippi Bubble. For those of you who think the recent housing bubble and the ensuing financial imbroglio are “unprecedented,” listen to these words penned almost 200 years ago:

Every now and then the world is visited by one of these delusive seasons, when the ‘credit system’…expands to full luxuriance: everybody trusts everybody; a bad debt is a thing unheard of; the broad way to certain and sudden wealth lies plain and open…. Banks…become so many mints to coin words into cash; and as the supply of words is inexhaustible, it may readily be supposed what a vast amount of promissory capital is soon in circulation…. Nothing is heard but gigantic operations in trade; great purchases and sales of real property, and immense sums made at every transfer. All, to be sure, as yet exists in promise; but the believer in promises calculates the aggregate as solid capital….

Now is the time for speculative and dreaming or designing men. They relate their dreams and projects to the ignorant and credulous, [and] dazzle them with golden visions…. The example of one stimulates another; speculation rises on speculation; bubble rises on bubble…. No ‘operation’ is thought worthy of attention, that does not double or treble the investment…. Could this delusion always last, the life of a merchant would indeed be a golden dream; but it is as short as it is brilliant.

And to think, Washington Irving had never met a subprime mortgage, or a CDO, a CLO, an SIV or a credit default swap...

Here's the entire essay, "The Great Mississippi Bubble" from The Crayon Papers (it's a bit longer than usual):

The Crayon Papers, The Great Mississippi Bubble, by Washington Irving:

"A TIME OF UNEXAMPLED PROSPERITY"

In the course of a voyage from England, I once fell in with a convoy of merchant ships bound for the West Indies. The weather was uncommonly bland; and the ships vied with each other in spreading sail to catch a light, favoring breeze, until their hulls were almost hidden beneath a cloud of canvas. The breeze went down with the sun, and his last yellow rays shone upon a thousand sails, idly flapping against the masts.

I exulted in the beauty of the scene, and augured a prosperous voyage; but the veteran master of the ship shook his head, and pronounced this halcyon calm a "weather-breeder." And so it proved. A storm burst forth in the night; the sea roared and raged; and when the day broke, I beheld the late gallant convoy scattered in every direction; some dismasted, others scudding under bare poles, and many firing signals of distress.

I have since been occasionally reminded of this scene, by those calm, sunny seasons in the commercial world, which are known by the name of "times of unexampled prosperity." They are the sure weather-breeders of traffic. Every now and then the world is visited by one of these delusive seasons, when "the credit system," as it is called, expands to full luxuriance, everybody trusts everybody; a bad debt is a thing unheard of; the broad way to certain and sudden wealth lies plain and open; and men are tempted to dash forward boldly, from the facility of borrowing.

Promissory notes, interchanged between scheming individuals, are liberally discounted at the banks, which become so many mints to coin words into cash; and as the supply of words is inexhaustible, it may readily be supposed what a vast amount of promissory capital is soon in circulation. Every one now talks in thousands; nothing is heard but gigantic operations in trade; great purchases and sales of real property, and immense sums made at every transfer. All, to be sure, as yet exists in promise; but the believer in promises calculates the aggregate as solid capital, and falls back in amazement at the amount of public wealth, the "unexampled state of public prosperity."

Now is the time for speculative and dreaming or designing men. They relate their dreams and projects to the ignorant and credulous, dazzle them with golden visions, and set them madding after shadows. The example of one stimulates another; speculation rises on speculation; bubble rises on bubble; every one helps with his breath to swell the windy superstructure, and admires and wonders at the magnitude of the inflation he has contributed to produce.

Speculation is the romance of trade, and casts contempt upon all its sober realities. It renders the stock-jobber a magician, and the exchange a region of enchantment. It elevates the merchant into a kind of knight-errant, or rather a commercial Quixote. The slow but sure gains of snug percentage become despicable in his eyes; no "operation" is thought worthy of attention that does not double or treble the investment. No business is worth following that does not promise an immediate fortune. As he sits musing over his ledger, with pen behind his ear, he is like La Mancha's hero in his study, dreaming over his books of chivalry. His dusty counting-house fades before his eyes, or changes into a Spanish mine; he gropes after diamonds, or dives after pearls. The subterranean garden of Aladdin is nothing to the realms of wealth that break upon his imagination. Could this delusion always last, the life of a merchant would indeed be a golden dream; but it is as short as it is brilliant. Let but a doubt enter, and the "season of unexampled prosperity" is at end. The coinage of words is suddenly curtailed; the promissory capital begins to vanish into smoke; a panic succeeds, and the whole superstructure, built upon credit and reared by speculation, crumbles to the ground, leaving scarce a wreck behind:

"It is such stuff as dreams are made of."

When a man of business, therefore, hears on every side rumors of fortunes suddenly acquired; when he finds banks liberal, and brokers busy; when he sees adventurers flush of paper capital, and full of scheme and enterprise; when he perceives a greater disposition to buy than to sell; when trade overflows its accustomed channels and deluges the country; when he hears of new regions of commercial adventure; of distant marts and distant mines, swallowing merchandise and disgorging gold; when he finds joint-stock companies of all kinds forming; railroads, canals, and locomotive engines, springing up on every side; when idlers suddenly become men of business, and dash into the game of commerce as they would into the hazards of the faro table; when he beholds the streets glittering with new equipages, palaces conjured up by the magic of speculation; tradesmen flushed with sudden success, and vying with each other in ostentatious expense; in a word, when he hears the whole community joining in the theme of "unexampled prosperity," let him look upon the whole as a "weather-breeder," and prepare for the impending storm.

The foregoing remarks are intended merely as a prelude to a narrative I am about to lay before the public, of one of the most memorable instances of the infatuation of gain to be found in the whole history of commerce. I allude to the famous Mississippi Bubble. It is a matter that has passed into a proverb, and become a phrase in every one's mouth, yet of which not one merchant in ten has probably a distinct idea. I have therefore thought that an authentic account of it would be interesting and salutary, at the present moment, when we are suffering under the effects of a severe access of the credit system, and just recovering from one of its ruinous delusions.

Income Volatility

There's a lot being written about free trade today, e.g. see this discussion from Greg Mankiw (some of the discussion is about technological change rather than free trade, but it has the same characteristics in terms of displacing labor, Free Exchange explains how trade and technology are related here). Given these discussions, perhaps it's a good time to recall that it's not just the level and distribution of income that matters, it's also the volatility, and according to the latest estimates from Jacob Hacker and Elizabeth Jacobs, family income volatility has been rising in recent decades:

Income volatility: Another source of growing economic insecurity, by Jacob Hacker and Elisabeth Jacobs: There are many dimensions to the economic insecurity facing American families today. Mid-level incomes have stagnated in real terms over the past few years, and most recently, higher gas and food prices are taking a larger bite out of paychecks. But one dimension of economic insecurity gets less attention: the increase in family income volatility, or how much families' incomes fluctuate up and down over time.

Recent analysis shows that families are facing much greater income swings than they did a generation ago. The Chart plots the increase in average family income volatility, showing various peaks and valleys around an upward trend since the mid-1970s. Over the last three decades, volatility by this measure has doubled.

Most Americans have little in the way of easily tapped wealth to tide them over when their incomes drop. It is on the downward trips of the economic roller coaster that jobs, houses, savings, and other things gained on the way up get lost. No wonder Americans are worried about their economic security.

"The Rich Get Hungrier"

Amartya Sen analyzes the food crisis:

The Rich Get Hungrier, by Amartya Sen, Commentary, NY Times: Will the food crisis that is menacing the lives of millions ease up — or grow worse over time? The answer may be both. The recent rise in food prices has largely been caused by temporary problems like drought in Australia, Ukraine and elsewhere. Though the need for huge rescue operations is urgent, the present acute crisis will eventually end. But underlying it is a basic problem that will only intensify unless we recognize it and try to remedy it.

It is a tale of two peoples. In one version of the story, a country with a lot of poor people suddenly experiences fast economic expansion, but only half of the people share in the new prosperity. The favored ones spend a lot of their new income on food, and unless supply expands very quickly, prices shoot up. The rest of the poor now face higher food prices but no greater income, and begin to starve. Tragedies like this happen repeatedly in the world. ...

There is also a high-tech version of the tale of two peoples. Agricultural crops like corn and soybeans can be used for making ethanol for motor fuel. So the stomachs of the hungry must also compete with fuel tanks.

Misdirected government policy plays a part here... In 2005, the United States Congress began to require widespread use of ethanol in motor fuels. ... Ethanol use does little to prevent global warming and environmental deterioration, and clear-headed policy reforms could be urgently carried out, if American politics would permit it. ...

The global food problem is not being caused by a falling trend in world production, or for that matter in food output per person (this is often asserted without much evidence). It is the result of accelerating demand. However, a demand-induced problem also calls for rapid expansion in food production, which can be done through more global cooperation. ...

What is most challenging is to find effective policies to deal with the consequences of extremely asymmetric expansion of the global economy. Domestic economic reforms are badly needed in many slow-growth countries, but there is also a big need for more global cooperation and assistance. The first task is to understand the nature of the problem.

Insuring against Insurance Risk

Robert Shiller says we need to move to long-term home owners' insurance:

Insuring Against Insurance, by Robert J. Shiller, Project Syndicate: ...Almost universally in the world today, homeowners’ insurance is short term. Typically, it is renewed annually, which means that it does not cover the risk that insurance companies will raise rates at any future renewal date.

Yet we have seen major changes recently in homeowners’ insurance rates. For example, the average homeowner premium in Florida soared from $723 at the start of 2002 to $1,465 in the first quarter of 2007. Such rapid increases represent a risk that is on the same order of magnitude as many of the damage risks that the policies are supposed to address.

In a study..., the economists Dwight Jaffee, Howard Kunreuther, and Erwann Michel-Kerjan called for a fundamental change in policy aimed at developing true long-term insurance (LTI) that set insurance premiums for many years. Unless we do that, homeowners are unsure from year to year whether their insurance policies will be canceled or that their premiums will skyrocket unexpectedly as they have ... where there is hurricane and flood risk. As the authors point out, for insurers to even consider a long term policy they must have the freedom to charge premiums that reflects risk.

links for 2008-05-28

• Fed in Tug-of-War Between Pessimists, Optimists - John M. Berry
• Can central banks talk too much? - Vox EU
• Credit, Housing, Commodities, and the Economy - Janet Yellen
• Yellen: Fed Won't Allow Stagflation - Real Time Economics
• Time to Buy? The Conversion of a Committed Renter - NYTimes.com
• We Need Free Trade in Health Care - WSJ.com
• With Bold Steps, Fed Chief Quiets Some Criticism - NYTimes.com
• Kathy G. Mucks Up Interpreting Samuelson’s Paper on Trade - EconTech
• McCain's "Cap-and-Trade" Won't Work as Well as Obama's - Robert Reich
• Climate Report Sees Big Changes in Water Supplies and Agriculture - NYT
• Musings Inspired By a Quagga - Olivia Judson
• The link between tariff reform, poverty, and educational attainment - Vox EU
• Gramm Advised McCain while Registered as Lobbyist - Obsidian Wings
• 7,389 Returns With Incomes of $200,000 Paid No U.S. Income Tax In 2005 - Capital Gains and Games

"The Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too"

This is a review of Jamie Galbraith's The Predator State from a forthcoming edition of the Journal of Economic Issues:

Review of the Predator State: How Conservatives Abandoned the Free Market and Why Liberals Should Too, by James K. Galbraith. New York, London, Toronto, Sydney: Free Press, 2008. (Note: review is based on Advance Uncorrected Proofs.):

This is political economy at its best, in the tradition of Veblen’s Theory of the Leisure Class, or J.K. Galbraith’s The New Industrial State. The comparators are chosen carefully, for not only is The Predator State an update, it is equally as deserving of status as a classic. The issues are carefully examined, the prose is delightful, the arguments appear unassailable, and the choir—including this reviewer and presumably most of the readers of this journal—shouts “Amen!”. But will the book be read? Can any book today capture the attention accorded to Veblen a century ago, or to Galbraith, senior, nearly fifty years ago? Still, one must applaud Jamie for trying. This is an amazing effort...

The general theses can be simply stated. First, while conservatives toyed with laissez-faire, they quickly abandoned it in all important areas of policy-making. For them, it now serves as nothing more than an enabling myth, used to hide the true nature of our world. Ironically, only the progressive still takes the call for “market solutions” seriously, and this is the major barrier to formulating sensible policy. Second, the “industrial state” has been replaced by a predator state, a coalition of relentless opponents of the very idea of a “public interest”, whose purpose is to master the state structure in order to empower a high plutocracy with nothing more than vile and rapacious goals. Finally, the “corporate republic” created by the likes of Dick Cheney is highly unstable, a formula for national failure. Progressives must wrest control from the reactionaries before it is too late for restoration of America as the world’s financial anchor, technological leader, and promoter of collective security.

Jamie thus resurrects both the extreme pessimism of Veblen’s notion of predation (by the conspicuously consuming leisure class in Veblen’s day, but by the corporate elite and Cheney’s imperial court today) as well as his only partially defined but optimistic vision of a world dominated by the engineers. As Jamie argues, his father admired Veblen but was most influenced by the New Deal, the mobilization during WWII, and the rise of the modern corporation that cooperated with government and labor to create the planned economy of the postwar period. Hence, Veblen’s opposition of the business enterprise versus the public interest was replaced by countervailing powers that compromised a largely acceptable truce. Jamie insists that his father’s analysis was correct, however, it was already becoming outdated by the early 1970s as the Bretton Woods system fell apart.

The free market reactionaries promised that some combination of monetarism, supply side economics, balanced budgets, and free trade was the solution to America’s woes. The mantra “free markets” provided an easy antidote to “planning” that was said to constrain recovery and growth. As each conservative policy was tried, however, it resulted in obvious and even spectacular failure. In truth, all economies are always and everywhere planned—for the simple reason that planning is the use of today’s resources to meet tomorrow’s needs, something that all societies must do if they are going to survive—so the only question is who is going to do the planning, and to whom are the benefits going to flow? There are still a few true believers (principled conservatives that Jamie compares to noble savages in the political wilderness), but most conservatives realized that there is no conflict between “big government” and “the market” as they abandoned the myth but usurped the “free market” label. All we are left with is the liberal who embraces the myth out of fear of being exposed as a heretic, a socialist, or a fool. Thus, the liberal pines to “make the market work better”, never challenging the view (abandoned by all but the most foolish conservatives) that government is the problem.

Economic freedom is reduced to the freedom to shop, including the freedom to buy elections, and anything that interferes is a threat. “Market” means nothing more than “nonstate”, a negation of use of policy in the public interest. Jamie provides a careful analysis of the frontline battles on many of the most important issues--Social Security, health care, inequality, immigration, security after 9-11, trade and outsourcing, and global warming—showing how “market solutions” are designed to enrich a favored oligarchy through a spoils system administered through the state’s structure. The policy “mistakes” in Iraq or New Orleans or at Bear-Stearns do not result from incompetence—indeed they only appear to be failures because we apply inappropriate measures of success. There is no common good, no public purpose, no shareholder’s interest; we are the prey and governments as well as corporations are run by and for predators. The “failures” enrich the proper beneficiaries even as they “prove” government is no solution.

There is a way out, but it is not easy. Historically, regulation and standards have required acceptance by progressive business—those firms that recognized they would lose in races to the bottom. Today, corporate and public policy alike are run by the most reactionary elements, well-paid rogues that suck capacity. Wherever one finds a sector that still operates reasonably well, one finds remnants of New Deal institutions that support, guarantee, regulate, and leverage private activities, in spheres as diverse as higher education, housing, pensions, healthcare, the military-industrial complex (and the prison-industrial complex). Naturally, even these sectors are endangered as they represent potential riches (witness subprimes, a privatization mess that Wall Street would love to repeat with Social Security). Still, Jamie is hopeful. The ideology of free markets is bankrupt, but the US is not. The path is clear: re-regulation, planning, standards (including wage controls), and coming to grips with the nation’s global responsibilities.

L. Randall Wray University of Missouri—Kansas City The reviewer is Professor of Economics, and Senior Scholar at the Levy Economics Institute.

Socially Unacceptable Externalities

David Beckworth:

Which Externalities Should Be Internalized?, by David Beckworth: Robert Frank's NY Times column on using Pigovian taxes as an "efficient" way to deal with the negative externalities of gas consumption ... points to an important question that has been bugging me for some time. But first ... Gabriel Mihalache ... points out an important assumption in Frank's analysis:

...A Pareto improvement [from imposing a Pigovian tax on gas consumption] means that afterwards, everyone is at least as well off (subjectively) as before and some are better off. ...

The implicit, unstated, assumption of Frank’s article is that we could compensate the losers from the new energy policy from the gains of others.., there exist potential transfers to compensate the losers and still leave the winners better off.

When supporters of free trade point out that the net losers from the full opening of borders could be compensated with transfers from the net winners, the common criticism is that those transfers are both politically and institutionally unfeasible. There’s no mechanism we can trust that would identify the correct transfers (from whom, to whom, how much?) and make it in a way that’s politically acceptable.

I will unashamedly yield the same critique against Frank. He wants to seduce us with Pareto improvements but he only tells us half the story, less that half really… he mentions introducing the carbon tax but he remains strangely silent on the ways he’d use to compensate the losers.

Gabriel suggests we avoid resorting to the Pareto efficiency argument and say up front there may be net losers. Josh Hendrickson, meanwhile, also questions the usefulness of invoking Pareto efficiency and goes on to stress that the proper use of a Pigouvian tax requires a Herculean ability to properly assess social costs:

The problem inherent in any such analysis is the view of societal benefit and societal loss that is assumed to be easily calculated and dealt with through Pigouvian taxation. The ability to identify the social cost of a particular action is extremely difficult as each individual has his or her own subjective valuation. The problem is communicating each of these preferences in aggregate form to some central authority. This is a distinct problem in terms of both Hayekian knowledge and a neoclassical framework (Arrow’s Impossibility Theorem). In the absence of this ability, setting the tax rate is extremely difficult.

In short, both of these commentators suggest we should be more humble about our ability to (1) rigorously justify and (2) precisely implement a carbon tax. As noted above, Frank's column also points to another important question that I have been wrestling with for some time: exactly which externalities should be internalized? There are so many negative externalities in society so why stop at those created by gas consumption? Frank alludes to this in his article:

Gasoline is one of a host of goods whose production or consumption generates costs that fall on outsiders. Noisy goods, like leaf blowers, for example, can jolt whole neighborhoods from calm. And goods that don’t biodegrade readily, like many plastic bags, can generate costly waste streams. The list goes on.

Okay, then, why not tax noisy leaf blowers (noise pollution) or billboards along the highway (sight pollution) or rancorous, smelly, ugly people (noise, sight, and smell pollution)? Conversely, should we subsidize quiet neighbors, firms that do not advertise on highway billboards, and beautiful, well-kept people?

Now I am not advocating we tax or subsidize the above items. However, this list does illustrate the fact that society does choose to correct only certain externalities. So what is the decision criteria used in this process? Presumably it involves equating some margins; I am just not sure which one they are though. Any thoughts?

In closing, let me refer you to Peter Klein who, in the context of applying a Pigouvian tax to negative externalities, makes the following statement:

But my main beef with today’s Pigouvians is that they cherry-pick a case here and there — taxes on gasoline, primarily — without fully pursuing the implications of the analysis. If increasing gasoline taxes is efficient, why stop there? What other market failures should the state be empowered to remedy? Here’s my question, specifically:

Please name the activities you believe deserve Pigouvian subsidies. For each activity provide the efficient subsidy amount, explain how this was calculated, and say how the revenues should be raised.

Maybe someone has thought about this more than I have, and your comments are welcome and encouraged, but a couple of quick reactions. It seems to me that one way societies solve this problem is to define which externalities are actionable and which are not through the political process, and then prohibit them by decree rather than through incentive mechanisms such as taxes. Whether you care about the noise from leaf blowers or not, loud music, etc., so long as it's before 10 p.m., you are stuck no matter how much it bugs you - nothing can be done. But after 10 p.m., there are exact restrictions in terms of decibels on how loud music, etc. can be. If someone violates that rule, police will enforce it if asked to do so. For barking dogs, the rule is equally explicit, if it barks continuously for more than a half hour (you are supposed to record it), it is actionable - you can call and have animal control do something about it. Many externalities are like this, the community decides what is and isn't acceptable, whether you like it or not. Some externalities can be stopped, others you are stuck with (though you can still negotiate on an individual level, but the response "there's no law against it" is always available to the person being asked to be more considerate). This isn't the most efficient solution, but it is practical (and given how hard it would be to do individual calculations, it may be the best solution available) - it defines community preferences through the political process and forces adherence to them. This notion works at the local level - e.g. neighborhoods that enforce how houses are painted for example - but I'm having a harder time fitting it into national issues such as global warming, and to issues where taxes are used to discourage behavior rather than issuing blanket prohibitions. But I guess it's the same. If all nations but one decide that polluting the atmosphere with greenhouse gases is just fine, little can be done, it does not violate community standards. If one country really cares about the issue but others don't, it can turn down its music voluntarily at 10 pm to be courteous, i.e. try to fight the problem on its own, but it's only when the majority of nations agree that it is a problem that effective enforcement can begin. Anyway, I've pushed this far enough - thoughts?

McCain: Why Americans Think America is on the Wrong Track

I was surprised this statement by John McCain showing how out of touch he is with people who have to work for a living didn't get more notice in the media:

McCain: Out of Touch on Trade, by Seth Michaels, AFL-CIO Blog: At a speech in Florida yesterday, Sen. John McCain made a baffling pronouncement: The rising discontent in our country is not due to job losses, home foreclosures or the health care crisis, but rather the fact that we aren’t passing a bad trade deal with Colombia.

Here’s what McCain had to say at yesterday’s event:

We have made progress toward this vision by expanding the benefits of free commerce, through ... our free trade agreements... But the progress has stalled; our longstanding bipartisan commitment to hemispheric prosperity is crumbling. We see this most vividly in Barack Obama’s and Hillary Clinton’s opposition to the free trade agreement with Colombia. The failure of Congress to take up and approve this agreement is a reminder why 80 percent of Americans think we are on the wrong track.

What country is he living in?

If Obama had made the same statement, his "elitist views" would have been highlighted all over the airwaves and internet, we would have heard repeatedly about how out of touch Mr. Arugula is with the working class. But McCain says it and there's hardly a stir. Why?

If I were running Obama's campaign, I would be tempted to pull a Bill Clinton and let it slip out that he sometimes sneaks out for fast food, has a secret passion for big time wrestling, dreams of driving around the track at Indie, something like that. Some foible that betrays his "true" identity.

Shaking Hands after the Game

[If you don't like sports analogies about the election, you'll want to skip this.]

links for 2008-05-27

• Give my stimulus check to the rich - Los Angeles Times
• Horse Several Miles from the Barn ……Let’s Lock the Door - Across the Curve
• The Global Effects of U.S. Fiscal Policy - Worthwhile Canadian Initiative
• As Credit Tightens, the Auto Industry Feels the Pain - NYTimes.com
• Soaring Fuel Prices Take a Withering Toll on Truckers - NYTimes.com
• How Bush Sold the War - WSJ.com
• Fed Keeps Watch on Wall St. -- From the Inside - washingtonpost.com
• Trade theory and inequality - Kathy G

"Sweden: Image and Reality"

Lane Kenworthy has "surprises for the left" and "surprises for the right" about Sweden:

Sweden: Image and Reality

Women’s Rights: What’s in it for Men?

I'd be interested in hearing other theories as to why power relationships between men and women change as economies develop. Here's one argument:

Women’s rights: What’s in it for men?, by Matthias Doepke and Michèle Tertilt, Project Syndicate: Improving women’s rights is one of the main goals of development policy; the United Nations names “promoting gender equality and empowering women” as one of the eight Millennium Development Goals. As Figure 1 shows, today most rich countries are close to the ideal of gender equality, while in the poorest countries women have only limited rights and face widespread discrimination. What, if anything, can development policy do to close the gap in gender equality between rich and poor countries?

"The US Dollar Hits an Oil Slick"

Martin Feldstein says to expect more rapid dollar depreciation in coming years:

The US dollar hits an oil slick, by Martin Feldstein, Project Syndicate [alt]: The rapid rise in the price of oil and the sharp depreciation of the dollar are two of the most noteworthy developments of the past year. ... To many observers, the combination of a falling dollar and a rise in oil prices appears to be more than a coincidence.

But what is the link between the two? Would the price of oil have increased less if oil were priced in euros instead of dollars? Did the dollars fall cause the price of oil to rise? And how did the rise in the price of oil affect the dollars movement? ...

Paul Krugman: Divided They Stand

Will Democrats reunite for the election in November, or will "lingering bitterness" cost them the election?:

Divided They Stand, by Paul Krugman, Commentary, NY Times: It is, in a way, almost appropriate that the final days of the struggle for the Democratic nomination have been marked by yet another fake Clinton scandal — the latest in a long line that goes all the way back to Whitewater.

This one, in case you missed it, involved an interview Hillary Clinton gave ... in which she tried to make a case for her continuing campaign by pointing out that nomination fights have often gone on into the summer. As one of her illustrations, she mentioned that Bobby Kennedy was assassinated in June.

It wasn’t the best example.., but it’s absurd to suggest, as some Obama supporters immediately did, that Mrs. Clinton was making some kind of dark hint about Barack Obama’s future.

But then, it was equally absurd to portray Mrs. Clinton’s assertion that it took L.B.J.’s political skills to turn Martin Luther King’s vision into legislation as an example of politicizing race. Yet the claim that Mrs. Clinton was playing the race card, which was promoted by some Obama supporters as well as in a memo by a member of Mr. Obama’s staff, achieved wide currency.

Why does all this matter? Not for the nomination: Mr. Obama will be the Democratic nominee. But ... many grass-roots Clinton supporters feel that she has received unfair, even grotesque treatment. And the lingering bitterness ... could cost Mr. Obama the White House.

To the extent that the general election is about the issues, Mr. Obama should have no trouble winning over former Clinton supporters... But elections always involve emotions as well as issues, and there are some ominous signs in the polling data.

In Florida, in particular,... Pollster.com shows Mr. McCain running substantially ahead of Mr. Obama, even as he runs significantly behind Mrs. Clinton. Ohio also looks problematic, and Pennsylvania looks closer than it should. ...

So what should Mr. Obama and his supporters do?

Most immediately, they should realize that the continuing demonization of Mrs. Clinton serves nobody except Mr. McCain. One more trumped-up scandal won’t persuade the millions of voters who stuck with Mrs. Clinton ... that she really was evil all along. But it might incline a few more of them to stay home in November.

Nor should Obama supporters dismiss Mrs. Clinton’s strength as a purely Appalachian phenomenon, with the implication that Clinton voters are just a bunch of hicks.

So what comes next?

Mrs. Clinton needs to do her part: she needs to be careful not to act as a spoiler... But mainly it’s up to Mr. Obama to deliver the unity he has always promised — starting with his own party.

One thing to do would be to make a gesture of respect for Democrats who voted in good faith by recognizing Florida’s primary votes — which at this point wouldn’t change the outcome of the nomination fight.

The only reason I can see for Obama supporters to oppose seating Florida is that it might let Mrs. Clinton claim that she received a majority of the popular vote. But which is more important — denying Mrs. Clinton bragging rights, or possibly forfeiting the general election?

What about offering Mrs. Clinton the vice presidency? ... I’d do it. Adding Mrs. Clinton to the ticket — or at least making the offer — might help heal the wounds of an ugly primary fight.

Here’s the point: the nightmare Mr. Obama and his supporters should fear is that in an election year in which everything favors the Democrats, he will nonetheless manage to lose. He needs to do everything he can to make sure that doesn’t happen.

links for 2008-05-26

• How Effective Will Monetary Easing Be? - Econbrowser
• Help for the Burmese people - Vox EU
• Another Rodrik review - The Bayesian Heresy
• McCain: Out of Touch on Trade - AFL-CIO Blog
• Hillary: Why I continue to run - NY Daily News
• Claims That Tax on Millionaires Would Damage Economy are Wrong - CBPP
• But there won't be any transfers! - Economic Investigations
• The Free Trade Benefits Everyone Canard Again - pgl
• Open-Source Upstart Challenges the Big Web Browsers - NYTimes.com
• NASA - Phoenix
• Patching up the parties - Los Angeles Times

Chaoplexity and Complexitarians

On non-traditional approaches to economics:

• A Brave Army of Heretics, David Warsh, Economics Principles
• John Horgan on "Can Chaoplexology Save Economics?", by Barkley Rosser
• Can Chaoplexity Save Economics?, by John Horgan

"Flat-Out Anti-Immigrant Fearmongering"

Joe Klein is unhappy with CNN:

Lou Demagogue, by Joe Klein: ...I've got to wonder why [CNN] allows Lou Dobbs to continue spewing false, inflammatory nonsense under the guise of objective journalism. Here is his latest confrontation with Paul Waldman of Media Matters about the fictional NAFTA superhighway. Indeed, the Washington Post's Fact Checker gave the NAFTA Superhighway myth four Pinocchios. Now, I know that Dobbs brings in some serious ratings. And he is certainly entitled to his own opinion. But he is not entitled to his own facts--especially not on a network that makes a real effort to separate truth from falsehood and represent all sides of the political debate. Shouldn't someone be editing this swill? Doesn't CNN have a responsibility to tell its viewers that, in this case, one of their presenters is engaged in flat-out anti-immigrant fearmongering? Perhaps the network could employ a simple superimposed title--THIS IS NOT TRUE...or LOU HAS JUMPED THE SHARK ON THIS ONE--whenever Dobbs pretends that there is such a thing as the NAFTA Superhighway. This sort of thing diminishes the credibility and hard work of the other journalists on the network. (And no, I do not count the execrable Glenn Beck as a journalist.)

I don't mean to include every individual in a sweeping statement, but Joe Klein's baseline opinion of CNN appears to be higher than mine. I agree, though, that Lou Dobbs is a downward drag from whatever starting point is assumed.

Markets find a way to work no matter how hard governments work to stop them (see drugs), and with the difference in opportunity as large as it is between the US and Mexico, illegal immigration will continue to be a problem. Sure, we can get tough and reduce the flow of illegal workers, crack down on employers, put illegal workers in jail, but for those who are still engaged in the activity it will become more brutal, more violent, and those who make it here to work will be subjected to much worse working conditions than they already are as people work as hard as they can to conceal their activity. The bigger the penalties if they are caught, the more they will be willing to do to prevent discovery and it will be the workers trying to escape poverty who will bear the brunt of the effort to keep things underground. I'm not saying we shouldn't enforce immigration law, but we need to recognize the consequences of intensified enforcement, and do our best to make the punishment fit the crime of trying to escape from difficult conditions at home.

The only long-term solution is for opportunity to increase in Mexico, for Mexico to develop economically. That's the only thing that, ultimately, will substantially reduce the flow of illegal workers without draconian measures. That means, in part, accepting that some companies will need to move to Mexico, it means building highways between the US and Mexico, etc. The politics of such a policy aren't easy, but we have to do more to help Mexico develop economically if we want to solve this problem - it's in the long-run interest of both countries that we do so. Thus, this needs to be on our political agenda - what will we do to help Mexico to develop? How can we help them to help themselves? Instead of spending money building fences, why not spend it helping to create opportunity for Mexicans in Mexico? Instead of working so hard to keep people out, why not focus more of our efforts on giving them an economic incentive to stay home? We'll all be better off if we do that.

"The Bush Administration's Teapot Dome"

Stan Collender says it's "hard to come to any conclusion other than that the spending of taxpayer funds in Iraq bordered on, or actually was, simple and straightforward corruption," and wonders if anyone will be prosecuted for their actions:

The Bush Administration's Teapot Dome, by Stan Collender: Discussions about the federal budget ... here at CG&G, typically focus on "formulation," that is, on the process and politics of putting the budget together and getting it enacted. That's the part we all generally agree is broken, not working properly, overly politicized, and...well...you get the picture.

But this story from Friday's Washington Post, which talks about $15 billion in spending on Iraq that can't be accounted for properly, or in some cases at all, shows that the other stage of federal budgeting -- implementation -- is similarly broken, not working properly, and...well...you certainly get this picture as well.

In fact, it appears as if virtually every procedure and law designed to prevent just this type of malfeasance was circumvented.

This spending was done in the midst of a national emergency and some of the usual safeguards couldn't be followed in the interest of national security and getting the job done quickly, right?

Nonsense. The Pentagon's own inspector general confirmed that this lack of concern for procedural safeguards was blatant and commonplace. That makes it hard to come to any conclusion other than that they were ignored rather than expedited or poorly executed.

It's also hard to come to any conclusion other than that the spending of taxpayer funds in Iraq bordered on, or actually was, simple and straightforward corruption.

Given the magnitude of the spending involved, Iraq may be the Bush administration's contribution to the biggest public corruption scandals of all time like Boss Tweed in New York, James Michael Curley in Boston, and Teapot Dome.

My question is whether any one, that is, any individual, will be prosecuted for their actions. ... [L]aws and spending rules were broken by individuals and there are three reasons why they should be criminally prosecuted.

First, we need to know whether they were ordered to ignore the laws and regulations. If they were ordered to break the law, we need to know who was pulling the strings. ...

Second, these individuals almost certainly broke a variety of laws. At least one of these, the Antideficiency Act, actually calls for civil penalties and jail time...

Third, not prosecuting the individuals and instead allowing this situation to be nothing more than a political scandal will encourage others to do this again, or keep doing it...

There would have been widespread outrage and anger if this were a domestic department or agency. The fact that this was the Pentagon and the spending was related to activities in Iraq doesn't make this more acceptable.

Update: Pete Davis follows-up.

links for 2008-05-25

• In defence of central bank independence - Vox EU
• Redesigning the EU trade strategy towards China - Vox EU
• Who Owns Transaction Information? - Discourse.net
• Real Archaeologists Don't Wear Fedoras - washingtonpost.com
• Could Someone Explain Stolper-Samuelson to James Surowiecki? - pgl
• Brazil Rainforest Analysis Sets Off Political Debate - NYTimes.com
• Global Dreams for a Wireless Web - NYTimes.com
• Tibet, quake and the Chinese media - Project Syndicate

"The Invisible Hand Is Shaking"

I recently talked about relative prices as signaling mechanisms in the economy, and how distortions in these signals relate to Fed policy (see False Signals). Part of the discussion noted that "Market failure can also cause distorted prices, but ... this is outside the Fed's purview, so ... that's for another discussion." Conveniently, Robert Frank takes up this issue:

The Invisible Hand Is Shaking, by Robert Frank, Economic Scene, NY Times: Adam Smith's modern disciples are far more enthusiastic about his celebrated invisible-hand idea than he ever was. ...

If you believe, with Smith’s modern disciples, that unfettered pursuit of self-interest always promotes society’s interests, you probably view all taxes as a regrettable evil — necessary to pay for roads and national security, but also an unwelcome drag on economic efficiency. The problem, according to this view, is that taxes distort the price signals through which the invisible hand guides resources to their best destinations.

Smith’s more nuanced position supports a different view of taxes. When market prices convey accurate signals of cost and value, the invisible hand promotes the common good. But prices often diverge from cost and value and, in those cases, taxes can actually help steer resources toward more highly valued uses. ...

The production and consumption of many ... goods ... generate costs or benefits that fall on people besides buyers and sellers. Producing an extra gallon of gasoline, for example, generates not just additional costs to producers, but also pollution costs that fall on others. ...[M]arket forces cause production to expand until the seller’s direct cost for the last unit sold is exactly the value of that unit to the buyer. But because each gallon of gasoline also generates external pollution costs, the total cost of that last gallon produced is higher than its value to consumers.

The upshot is that gasoline consumption is inefficiently high ...[, a] classic breakdown in the invisible hand when a product’s market price doesn’t reflect all its relevant social costs and benefits. In such cases, the simplest solution is to discourage consumption by taxing it.

Doing so would not only raise revenue to pay for public services; it would also make the allocation of society’s resources more efficient...

Efficiency is important because any policy that enlarges the economic pie necessarily lets everyone have a bigger slice than before. Economists opposed suspending the gas tax because doing so would make the economic pie smaller.

Of course, when millions of voters feel the pinch of rapidly rising prices, politicians find it hard to stand idly by. But as the late economist Abba Lerner once remarked, the main problem confronting the poor is that they have too little money. The best solution is not to reduce the prices they pay, but rather to bolster their incomes — for example, by selectively reducing the payroll tax for low-income workers or increasing the Earned Income Tax Credit. Suspending the gas tax would encourage rich and poor alike to do more ... driving. It would also promote sales of fuel-intensive vehicles. Because the gas tax reduces waste, it actually makes more resources available to help low-income families.

Gasoline is one of a host of goods whose production or consumption generates costs that fall on outsiders. ... That the invisible hand often breaks down is actually good news. After all, we need to tax something to pay for public services. By taxing forms of consumption that generate negative side effects, we could not only generate enough revenue to eliminate budget deficits, but also help steer resources toward their most highly valued uses.

Because such taxes make the economy more efficient, it makes no sense to object that they impose hardships on low-income families. Again, an efficient policy is one that maximizes the size of the economic pie. And with a bigger pie, it’s always possible for everyone to get a bigger slice.

With regard to the size of the pie and who gets what, this is not the only basis for arguing for income redistribution, but I think you can base redistributive policy on a market failure argument, i.e. that distribution mechanisms have failed to reward factors of production according to their contributions to the production process. Some have received too much and others too little, and more could be done to counteract this so that we have a better chance to realize the possibility of everyone getting "a bigger slice."

Illegal Immigrants Sent to Prison

The administration takes immigration enforcement to a new level:

270 Illegal Immigrants Sent to Prison in Federal Push, by Julia Preston, NY Times: In temporary courtrooms at a fairgrounds here, 270 illegal immigrants were sentenced this week to five months in prison for working at a meatpacking plant with false documents.

The prosecutions, which ended Friday, signal a sharp escalation in the Bush administration’s crackdown on illegal workers, with prosecutors bringing tough federal criminal charges against most of the immigrants arrested... Until now, unauthorized workers have generally been detained by immigration officials for civil violations and rapidly deported. ...

The unusually swift proceedings, in which 297 immigrants pleaded guilty and were sentenced in four days, were criticized by criminal defense lawyers, who warned of violations of due process. ...

The illegal immigrants, most from Guatemala, filed into the courtrooms in groups of 10, their hands and feet shackled. One by one, they entered guilty pleas through a Spanish interpreter... Moments later, they moved to another courtroom for sentencing. ... Most immigrants agreed to immediate deportation after they serve five months in prison.

The hearings took place on the grounds of the National Cattle Congress in Waterloo, in mobile trailers and in a dance hall modified with black curtains, beginning at 8 a.m. and continuing several nights until 10. On Wednesday alone, 94 immigrants pleaded guilty and were sentenced...

The large number of criminal cases was remarkable because immigration violations generally fall under civil statutes. Until now, relatively few immigrants caught in raids have been charged with federal crimes like identity theft or document fraud.

“To my knowledge, the magnitude of these indictments is completely unprecedented,” said Juliet Stumpf, an immigration law professor... “It’s the reliance on criminal process here as part of an immigration enforcement action that takes this out of the ordinary, a startling intensification of the criminalization of immigration law.” ...

Kathleen Campbell Walker, president of the American Immigration Lawyers Association, said that intricate issues could arise in some cases, for example where immigrants had children and spouses who were legal residents or United States citizens. Those issues “could not be even cursorily addressed in the time frame being forced upon these individuals and their overburdened counsel.”

Linda R. Reade, the chief judge who approved the emergency court setup, said she was confident there had been no rush to justice. In an interview, Judge Reade said prosecutors had organized the immigrants’ detention to make it easy for their lawyers to meet with them. The prosecutors, she said, “have tried to be fair in their charging.”

The immigration lawyers, Judge Reade said, “do not understand the federal criminal process as it relates to immigration charges.”

That last part confuses me. How was the process fair if immigration lawyers don't understand it? The Judge seems to be arguing that the process was fair because prosecutors adjusted their charges to compensate for the fact that immigration lawyers don't understand federal procedures. If so, I don't get that argument.

But the main question is, as George Borjas notes, why did the administration choose to pursue this now? They haven't hesitated to politicize the Justice Department to suit their needs, so does this help Bush's reputation or McCain's chances of winning the election?

Update: I probably should have included this part - these issues have come up in comments:

No charges have been brought against managers or owners at Agriprocessors, but there were indications that prosecutors were also preparing a case against the company. In pleading guilty, immigrants had to agree to cooperate with any investigation.

Chaim Abrahams, a representative of Agriprocessors, said in a statement that he could not comment about specific accusations but that the company was cooperating with the government.

Aaron Rubashkin, the owner of Agriprocessors, announced Friday that he had begun a search to replace his son Sholom as the chief executive of the company. Agriprocessors is the country’s largest producer of kosher meat, sold under brands like Aaron’s Best. ... Normally it employs about 800 workers, and in recent years the majority of them have come from rural Guatemala.

Since 2004, the plant has faced repeated sanctions for environmental and worker safety violations. It was the focus of a 2006 exposé in The Jewish Daily Forward and a commission of inquiry that year by Conservative Jewish leaders.

links for 2008-05-24

• More on the Opportunity Cost of Religion - Macro and Other Market Musings
• Some simple measures would alleviate the global food crisis - Jeff Sachs
• Is the EU budget a product of benevolent principles or selfish politics? - Vox EU
• Public schools as good as private schools in raising math scores - EurekAlert
• The Conventinonal Wisdom on Deflation - Macro and Other Market Musings
• What Would It Cost to Save Nature? - Spiegel
• America's Other Housing Crisis - washingtonpost.com
• The Great Depression - Crooked Timber
• The era of big government was over - The Edge of the American West
• Hiding Chameleons and Martian Hot Springs - The New York Times

"The Effect of Minimum Wages on Immigrants’ Employment and Earnings"

Here's more on the effects of the minimum wage:

The Effect of Minimum Wages on Immigrants’ Employment and Earnings, by Pia M. Orrenius and Madeline Zavodny, FRB Dallas: Abstract This study examines how minimum wage laws affect the employment and earnings of low-skilled immigrants and natives in the U.S. Minimum wage increases might have larger effects among low-skilled immigrants than among natives because, on average, immigrants earn less than natives due to lower levels of education, limited English skills, and less social capital. Results based on data from the Current Population Survey for the years 1994-2005 do not indicate that minimum wages have adverse employment effects among adult immigrants or natives who did not complete high school. However, low-skilled immigrants may have been discouraged from settling in states that set wage floors substantially above the federal minimum.

The Lincoln Cent

Greg Mankiw has been pushing to eliminate the penny, so he's pleased that Barack Obama might consider it:

Barack's Best Idea Yet, by Greg Mankiw: Reported by USA Today:

Barack Obama, the presidential candidate of "change," told a town hall meeting recently that he'd "seriously consider" eliminating the penny if Lincoln's face could be placed on another coin.

I kind of embarrassed to admit that in all my discussions of this topic, the social significance of removing Lincoln's image from coins in circulation never occurred to me. I only thought about the economics (I've been a bit more resistant to the idea than a lot of people, but I leave them in the trays at the counter too).

False Signals

In a money economy, each good has a price expressed in terms of dollars. But what's important is not the price itself, what's important is relative prices, the price of one good in terms of another. If milk has a price of $4 and gasoline has the same price, $4, then we know that buying one gallon of gasoline means giving up one gallon of milk. If purchasing milk is the highest valued alternative to purchasing gasoline, then this measures the cost of the purchase. Thus, the cost of a good is what you give up to get it, and this is measured as a relative price.

Relative prices provide important signals to both producers and consumers. They give consumers a means of deciding how to optimally allocate their purchases, and they direct the flow of resources to their most profitable locations. Because of this, it's important that price signals be as accurate as possible.

When there are sluggishly adjusting prices in an economy, accurate signaling becomes a problem since some relative prices will slip out of alignment with their optimal values, and this causes a misdirection of resources across sectors. The wrong mix of goods is produced and consumed, and the outcome is suboptimal.

Inflation can make this worse because it accelerates the rate at which relative prices fall out of line with optimal values. If all prices are perfectly flexible and adjust instantaneously in response to any shock, then inflation isn't a problem since relative prices will always be maintained at their proper values. But if prices aren't perfectly flexible, or there are other rigidities, then the Fed has to worry about keeping inflation from distorting relative prices and causing problems.

So one job of the Fed is to make sure that the price signals in the economy are as pure as possible, and that is the point behind inflation targeting. It's a way of trying to maximize the information content of relative prices so that resources are directed, as much as possible, to where they would go under ideal circumstances.

But think about commodity prices, oil perhaps. Is the run up in prices a true signal of scarcity? Is the price increase accurately reflecting underlying conditions? If so, then this is not the kind of a change in prices that the Fed should try to mute even if there is a temporary increase in the inflation rate because of it. It's signaling to substitute away, to bring more supply to market, to innovate, to drive less, etc. It's a change in relative prices that is providing an important signal to consumers and producers.

But if the increase is due to speculation, that's a different matter. In that case, the increase in price is providing a false signal to market participants and that distorts resource flows. Here the Fed would, if it could, want to try to temper the increase in prices and institute other changes as needed to allow fundamentals to take over once again.

The intense debate right now about whether the increase in oil prices and commodity prices more generally is due to fundamentals or due to speculation that is driving prices away from fundamentals - i.e. whether or not there's a bubble - shows how hard it is for the Fed to identify and do something about bubbles as they are inflating. Do we have a bubble in commodity markets or not? Is it the Fed's fault? Are prices going up partly from fundamentals and partly from speculation? Then how much of each? (I think some people use the word speculation when what they really mean is that oil producers have excessive market power that allows them to increase prices almost at will. Market failure can also cause distorted prices, but except for financial market regulation, this is outside the Fed's purview, so, while it's important to maintain competitive markets, that's for another discussion.)

We can't always have zero (economic) profit in every market at every point in time. In order for resources to be attracted to their best uses in a dynamic economy, there have to be profits - there has to be a pie to fight over - and sometimes that pie will be huge if there has been a large shock to a particular market and there will be lots of money to be made. That's not a bubble, that's the market doing what it's supposed to do and we don't want to get in the way of the market's ability to move resources where they are needed the most (though there may be reasons to slow the adjustment down at times, but that's another discussion as well). It will look a lot like a bubble when there is a large amount of excess supply or demand, but popping it would be a mistake.

Thus, while I certainly think would certainly be desirable for the Fed to pop speculative bubbles, practically it will be hard to do and mistakes can be costly. If, somehow, they are relatively certain that a bubble exists, action is warranted, but this is likely to be a rare event.

Will Tax Credits for Renewables be Renewed?

Tax credits for investment in renewable energy projects are in danger:

Tax credits for renewables, Editorial, LA Times: You don't have to be an environmentalist, or even a believer in global warming, to support tax credits for renewable energy ... at a time when prices for fossil fuels are soaring. Yet congressional Republicans and the Bush administration are willing to let existing credits expire because they don't want to close a tax loophole for multimillionaire hedge-fund managers. ...

The House on Wednesday passed a $54-billion package of tax breaks, of which incentives for clean energy account for a little under $20 billion. Because generating solar, wind or geothermal power involves steep upfront expenses, the tax credits are vital. ... Yet even though the incentives enjoy wide bipartisan support, efforts to extend them have repeatedly failed because members of Congress can't agree on how to pay for them.

The House bill passed 263 to 160, but that's not enough to overcome a threatened veto from President Bush. The bill's fate in the Senate, meanwhile, is highly uncertain given opposition from Republican leaders.

Many Republicans object to the credits because they would be offset by postponing an obscure tax break for corporations with foreign operations that was supposed to take effect next year, and by cracking down on hedge-fund managers, who would no longer be able to avoid billions of dollars in taxes by diverting money to offshore havens. Thus, while middle-class Americans are struggling with skyrocketing energy costs, these lawmakers are standing in the way of alternative energy sources in order to defend an unfair tax loophole for the mega-rich. ...

The trouble with the House bill isn't that it proposes unreasonable new taxes, it's that it doesn't go far enough -- it extends the tax credit for wind power for just one year, far too short-term a guarantee to make investors comfortable. Still, it's a good next step until President McCain or Obama or Clinton brings a savvier approach to the White House.

links for 2008-05-23

• The persistence of sovereign defaults - Vox EU
• Gaps in the popular presentations of scientific theories - Andrew Gelman
• Fed Seeing World as It Is - Real Time Economics
• Economics: Which Way for Obama? - The New York Review of Books
• An Inquiry Into Interbank Loan Rate - NYTimes.com
• U.S. in Difficult Position Over Japan’s Rice Plan - NYTimes.com
• 'Wheel Of Fortune' Contestants Hit Hard As Vowel Prices Skyrocket - The Onion
• Inflation in emerging economies - Economist.com
• A run on central banks? - Interfluidity

"The Church versus the Mall"

What happens when the opportunity cost of church attendance goes up? Just what you'd expect:

The cost of repealing blue laws, by Sarah H. Wright, News Office: Blue laws, or Sunday closing laws, refer to statutes that restrict certain activities on the Christian Sabbath. By the end of the 19th century, nearly every state had at least some law prohibiting certain activities on Sunday. The 1960s saw the beginning of push to repeal these laws in favor of commerce, although a few still remain on the books.

In their study, which appears in the May 2008 edition of The Quarterly Journal of Economics, Gruber and Hungerman show what happens when religious services must compete with shopping, hobbies and other activities.

To measure that competition, they studied the large number of states that repealed their blue laws over the past 50 years. ...

The economists used data from the General Social Survey on religious attendance and from the Consumer Expenditure Survey to show a very strong reduction in religious attendance and a decline in religious contributions once the blue laws were repealed. They found no change in other charitable activity, Gruber notes.

To confirm their findings and to complete the economic portrait, the authors also analyzed budget data for four major Christian denominations over the past 40 years. Church expenditures declined significantly since the repeal of the blue laws, they found.

Gruber and Hungerman did more than track how individuals chose to allocate their resources on Sunday once the malls were opened...

They considered the negative consequences for individuals or society from loosening secular constraints and they found those consequences in behaviors associated more with Saturday night than Sunday morning.

Using data from the National Longitudinal Survey of Youth (NLSY) on consumption of alcohol and illegal drugs, the economists found that repealing the blue laws did lead to an increase in drinking and drug use.

What's more, they found that individuals who had attended church and stopped after the blue laws were repealed showed the greatest increase in substance abuse, Gruber notes.

Those effects have significant economic and social implications, the authors say.

The study, "The Church vs. the Mall: What Happens When Religion Faces Increased Secular Competition?" can be accessed online here.

Menu Costs and Phillips Curves: The CalvoPlus Model and Intermediate Inputs

Awhile back, I posted a summary of a paper by Golosov and Lucas. The paper is important because it raises questions about the ability of New Keynesian models to explain fluctuations in real output. As I stated at the time:

A lot of you don't believe in a Phillips curve, but I've argued that there is a short-run inflation-output tradeoff and I've cited New Keynesian models along with supporting empirical evidence to reinforce that position. But when I make that argument, you should cite this paper by Golosov and Lucas to argue against the existence of a significant inflation-output tradeoff. The paper argues that if there is a Phillips curve, the inflation-output tradeoff is pretty steep, steep enough so that nominal shocks are "nearly neutral":

And since we believe nominal shocks matter for real GDP - there is empirical evidence in support of that claim - the fact that nominal shocks (think monetary policy) aren't able to explain much of the movement in output in the class of theoretical macroeconomic models used to assess policy and learn about the economy is a problem.

As a review, here's part of the introduction and conclusion from the Golosov and Lucas paper:

Menu Costs and Phillips Curves, by Mikhail Golosov and Robert E. Lucas Jr., Journal of Political Economy, 2007, vol. 115, no. 2 [open link]: I. Introduction This paper develops a model of a monetary economy in which firms must pay a fixed cost—a "menu cost"—in order to change nominal prices. Menu costs are interesting to macroeconomists because they are often cited as a microeconomic foundation for a form of "price stickiness" assumed in many New Keynesian models. Without sticky prices these models would not exhibit the real effects of monetary shocks—Phillips curves—that they are designed to analyze.

Under menu costs, any individual price will be constant most of the time and then occasionally jump to a new level. Thus the center of the model will be the firm's pricing decision to reprice or not to do so. Many New Keynesian models do not examine this decision but instead rely on a simplifying assumption proposed by Calvo (1983) that the waiting time between repricing dates is selected at random from an exponential distribution: Firms choose the size of price changes but not their timing.

As many others are, we are skeptical that the Calvo model provides a serviceable approximation to behavior under menu costs.[1] One reason is that the assumption of a constant repricing rate cannot fit the fact that repricing is more frequent in high-inflation environments. But a second, more important, reason was discovered by Caplin and Spulber (1987), who constructed a theoretical example of an economy with menu costs in which only a small fraction of firms reprice yet changes in money growth are neutral. In their example, there is a stationary distribution of firms' relative prices, and as a monetary expansion proceeds, the firms at the low end of this distribution reprice to the high end. The repricing rate is very low—prices are very "sticky"—but no price stickiness can be seen at the aggregate level. The key to the example is that the firms that change price are not selected at random but are rather those firms whose prices are most out of line.

The Caplin and Spulber example is well designed to exhibit this selection effect, but it is unrealistic in too many respects to be implemented quantitatively. In this paper we capture the selection effect in a new model of menu cost pricing, designed so that it can be realistically calibrated...

Our main finding is that even though monetary shocks have almost no impact on the rate at which firms change prices, the shocks' real effects are dramatically less persistent than in an otherwise comparable economy with time-dependent price adjustment. Simulations of the model's responses to a one-time impulse of inflation show small and transient effects on real output and employment..., in contrast to much larger and more persistent responses of the same model with Calvo pricing. ... In the menu cost model, a positive aggregate shock induces the lowest-priced firms to increase prices. At the same time, it offsets negative idiosyncratic shocks, and some firms that would otherwise have decreased prices choose to wait. As a result, the lowest-priced firms do most of the adjusting, their adjustments are large and positive, and the economywide price level increases quickly to reflect the aggregate shock. In the Calvo setting, in contrast, firms get the opportunity to reprice randomly, many firms reprice even though they were already close to their desired price, and the average response of prices to the shock is much smaller. It takes longer for the monetary shock to be reflected in prices, and impulse responses become more persistent. ...

VII.      Conclusions ... In summary, the model we proposed and calibrated to microeconomic evidence on U.S. pricing behavior ... does not appear to be consistent with large real effects of monetary instability. These results seem to us another confirmation of the insight provided by the much simpler example of Caplin and Spulber (1987) that even when most prices remain unchanged from one day to the next, nominal shocks can be nearly neutral...

But not so fast. The paper below develops a multi-sector "CalvoPlus Model" that maintains the mathematical simplicity of the Calvo approach, but allows state dependent pricing. In particular, in the standard Calvo model of price rigidity, firms are allowed to change prices with probability a, and prices remain fixed with probability 1-a (with the parameter a chosen based upon empirical results on the average frequency of price changes). Essentially, with probability a the cost of changing the price in a given period is zero, and with probability 1-a, the cost to change price is infinite. The CalvoPlus model changes this so that with probability a, the cost of changing a price is very low, and with probability 1-a the cost is high, but not infinite (the high-low costs vary across sectors). This introduces an element of state dependency because if a price is far enough away from its optimal value, it may be worthwhile to pay the high cost to change it since the benefit of changing the price would be even larger than the cost. It introduces heterogeneity due to the multi-sector set up (the degree of non-neutrality goes up as the number of sectors is increased, and the model is calibrated so that around 75% of price changes occur in the low cost states).

However, allowing heterogeneity across sectors in the frequency and size of price changes by itself is not enough to allow the model to generate non-neutralities large enough to be consistent with actual fluctuations in real GDP. Thus, the model also adds a second change, the introduction of intermediate inputs. As the authors note, "Intuitively, in the model with intermediate inputs, firms that change their price soon after a shock to nominal aggregate demand choose to adjust less than they otherwise would because the prices of many of their inputs have not yet responded to the shock." In the model, the price of these inputs depends directly upon the price of other goods in the economy (they are "strategic complements"). Because intermediate input prices adjust sluggishly, an increase in aggregate demand of 1%  increases input costs by less than 1%, and prices do not rise by as much as they would if intermediate inputs were not present (i.e. if input costs were completely flexible). This extra price sluggishness results in larger real effects and doubles the degree of non-neutrality in the model (i.e. the output movements attributable to CalvoPlus pricing and to the presence of intermediate inputs are about equal, and total around 25% of the total variation).

Here's part of the introduction to the paper (it's been keeping me occupied today):

Monetary Non-Neutrality in a Multi-Sector Menu Cost Model, by Emi Nakamura and Jon Steinsson, NBER WP 14001, May 2008: [Open Link] 1 Introduction Much applied work in monetary economics relies on models in which nominal rigidities are the key friction that generates monetary non-neutrality. The workhorse models in this literature - e.g., the Calvo (1983) model and the Taylor (1980) model - make the simplifying assumption that the timing of price changes is independent of firms' incentives to change prices. It has been recognized at least since Caplin and Spulber (1987) that models based on this assumption can yield very different conclusions about monetary non-neutrality than models in which nominal rigidities arise due to a fixed cost of changing prices (see...). Golosov and Lucas (2007) calibrate a menu cost model based on newly available micro-data on the frequency and size of price changes and conclude that nominal rigidities due to menu costs yield monetary non-neutrality that is "small and transient".

Given the importance of nominal rigidities as a source of monetary non-neutrality in most models that analyze the transmission of monetary policy, this conclusion poses a serious challenge for monetary economics. If realistically modeled nominal rigidity yields monetary non-neutrality that is small and transient, much of our understanding of the transmission of monetary policy is called into question. It is therefore of great importance for monetary economics to assess whether the implications of highly stylized menu cost models hold up in a richer, more realistic setting. ...

In this paper, we ... extend a simple benchmark menu cost model to include two features for which there exists particularly clear empirical evidence: 1) Heterogeneity across sectors in the frequency and size of price changes; 2) Intermediate inputs. We show that when we subject our model to calibrated nominal shocks it generates fluctuations in real output that can account for 26% of the U.S. business cycle.[1] This result of our model accords well with empirical evidence on the importance of nominal shocks for business cycle fluctuations.

Shapiro and Watson (1988) attribute 28% of the variation in output at short horizons to nominal shocks. In contrast, the Golosov and Lucas model generates fluctuations of real output that can account for only roughly 2% of the U.S. business cycle. Roughly half of the difference in monetary non-neutrality in our model relative to the model of Golosov and Lucas (2007) is due to the introduction of heterogeneity in the frequency of price change; the remaining half is due to the introduction of intermediate inputs. ...

The Distribution of Price Changes

It's interesting that there has been such a large increase in the number of prices that are currently falling, from 16% last month to 28% this month. Is this the Phillips curve at work?:

Digging deeper into the components that comprise the CPI, we can see that nearly 50 percent of the market basket rose at rates exceeding 3.0 percent in April, down slightly from 55 percent last month, but in line with price changes over the past 12 months. Also, 28 percent of the CPI components posted a decrease in price during the month, compared to 16 percent in March and an average of 20 percent over the past 12 months.

More on inflation (first link) and the Phillips curve (second two links):

Hmmmmm, by Bill Gross

Explaining Apparent Changes in the Phillips Curve: The Great Moderation and Monetary Policy, Charles T. Carlstrom and Timothy S. Fuerst, Economic Commentary, Federal Reserve Bank of Cleveland

Explaining Apparent Changes in the Phillips Curve: Trend Inflation Isn't Constant, Charles T. Carlstrom and Timothy S. Fuerst, Economic Commentary, Federal Reserve Bank of Cleveland

The G.I. Bill and Retention

John McCain opposes the Webb and Hagel bill to update the G.I bill:

Does McCain Have a Vets Problem?, by Jay Newton-Small, Time: Of all the voting groups John McCain will target this fall, none would seem like more of a sure thing than this country's war veterans. So why is the celebrated Vietnam War hero and POW bracing for a potentially bad week with so many men and women who have served in uniform?

The point of contention between the two seemingly natural allies is a piece of legislation the Senate is expected to vote on this week to update the 1944 G.I. Bill to provide expanded education assistance and opportunities to the armed forces. The bill ... would effectively provide full tuition and housing costs at a four-year public university for veterans who have served at least three years of active duty. ... McCain, concerned about the estimated $4 billion annual price tag and the incentive he worries it might give people to leave an already strapped military, has sponsored his own competing proposal. It increases the existing monthly education benefit from around $1,100 to $1,500 a month while adding more generous benefits for those who've served more than 12 years.

McCain's concerns, however, don't seem to impress the vast majority of veterans' organizations. They are feverishly lobbying him to support the Webb and Hagel bill...

Even with the current dustup, it's hard to imagine John McCain not winning the majority of the veterans vote in November. But the nation's 26 million veterans are by no means a monolithic voting bloc, and any level of disappointment with McCain could sway some undecideds. ...

Supporters of Webb and Hagel's bill dismiss McCain's concerns about the retention issue. While the Congressional Budget Office estimates that the bill would cause a 16% drop in re-enlistment rates across all four branches of the military, the same study also predicts a 16% uptick in new recruits attracted by the benefit. The bill has 58 co-sponsors, including none other than Obama — just two shy of a veto-proof majority. It was passed last week by the House with a comfortable veto-proof majority...

Suppose you run a firm and, subject to minimum qualifications, you will hire anyone willing to accept the wage and retirement plan that you offer. Assume you currently have some number of employees, and suddenly you announce that you are going to double retirement benefits. What would happen to the number of employees? A lot of people at or above the retirement age who are still working would likely decide to retire, but you would also get a lot more people showing up at the door wanting to work for you. It seems to me that after full adjustment, it's likely employment would rise. This problem is just like the military changing education benefits and though the CBO says the bill would not change the number of people in the military, the new recruits would just equal those leaving, I think the number might actually go up here as well. But whatever the case, there's certainly a large offset from new recruits, and reduces any retention concerns. The other concern is the price tag, but the price tag of 4 billion is pretty modest - what did top hedge fund managers make last year? - so that part doesn't concern me much.

Going back to retention, I recently heard a talk where the speaker noted in passing that firms use deferred compensation schemes to create the incentive for their employees to retire at a certain date, the date they want employees to retire. That is, suppose the law says you can't force someone to retire. You can still make it economically unattractive to work past a particular date by altering the size of the deferred compensation (retirement) package. The larger it is, the more likely it is that people will leave rather than working past the retirement date.

But the decision about when to retire is also affected by what you are currently earning, and the more you earn, the longer you are likely to work before retiring (I'm assuming the income effect doesn't dominate the substitution effect). This means that if retention turns out to be a problem for the military, i.e. if people are retiring as soon as they can (at the three year minimum) rather than re-enlisting, a solution would be to provide a positive incentive to stay by promising higher wages for those who re-enlist or make it past a particular benchmark (e.g. McCain's twelve years). This would increase the price tag further, I don't know by how much, but I think the military is underpaid as it is, so again, that doesn't bother me. [And if McCain is so worried about paying for it, couldn't he just cut a few more earmarks? He seems to think that works just fine for tax cuts costing far, far more than this bill.]

So a response to McCain's concerns about retention is to say that, according to the CBO and others, it's unlikely he's correct about numbers falling, but just to be sure maybe we should adopt his proposal about increasing the compensation for people who choose to stay past some number of years. We still do the Webb and Hagel bill, but we add the additional incentive of higher future compensation for those who choose to re-enlist. With this change, it's hard to see how the number of people in the military would fall as a result of the bill.

links for 2008-05-22

• Oil price fundamentals - Econbrowser
• The Science of Irrationality - Scientific American
• Fed Modesty Regarding Its Role in High Commodity Prices - Jeff Frankel
• Fed Calls Latest Rate Cut a 'Close Call' - washingtonpost.com
• Does Time Run Backward in Other Universes? - Scientific American
• Giant Carnivorous Mice! - The Debatable Land
• Fedspeak Highlights: Warsh on Rates, Inflation - Real Time Economics
• Are online gamers normal economic agents? - The Undercover Economist
• Enter the Cybrids - Olivia Judson
• More on Inequality and Prices - Lane Kenworthy
• OPEC Should Get Smart and Start Pumping More Oil - John M. Berry

"The State of Long-Term Expectation"

This is something I want to have in the archives - it's part of Chapter 12 of Keynes' General Theory - but you might enjoy reading his comments about speculation, bubbles, and other factors that impact the price of a an asset by changing the "state of confidence" (the beauty contest problem and animal spirits are part of the discussion):

John Maynard Keynes The General Theory of Employment, Interest and Money Chapter 12. The State of Long-Term Expectation: ...In this chapter we shall consider in more detail some of the factors which determine the prospective yield of an asset. ...

The state of confidence, as they term it, is a matter to which practical men always pay the closest and most anxious attention. But economists have not analysed it carefully and have been content, as a rule, to discuss it in general terms. ...

There is ... not much to be said about the state of confidence a priori. Our conclusions must mainly depend upon the actual observation of markets and business psychology. This is the reason why the ensuing digression is on a different level of abstraction from most of this book.

For convenience of exposition we shall assume in the following discussion of the state of confidence that there are no changes in the rate of interest; and we shall write, throughout the following sections, as if changes in the values of investments were solely due to changes in the expectation of their prospective yields and not at all to changes in the rate of interest at which these prospective yields are capitalised. The effect of changes in the rate of interest is, however, easily superimposed on the effect of changes in the state of confidence.

The outstanding fact is the extreme precariousness of the basis of knowledge on which our estimates of prospective yield have to be made. Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible. If we speak frankly, we have to admit that our basis of knowledge for estimating the yield ten years hence ... amounts to little and sometimes to nothing; or even five years hence. In fact, those who seriously attempt to make any such estimate are often so much in the minority that their behaviour does not govern the market. ...

Some of the factors which accentuate this precariousness may be briefly mentioned. ...

Do You Care?

How much should the well-being of people in other countries matter for domestic policy?:

China’s Class Divide, by Daniel A. Bell, Commentary, NY Times: ...Tsinghua is one of China’s most prestigious universities and it is known for its politically conservative orientation. President Hu Jintao is an alumnus, and most of my colleagues are Communist Party members, as are many of my students.

Yet the atmosphere is anything but conservative. The most popular lecturers tend to be the ones who openly criticize contemporary China. In private, students are quick to express frustration at Internet censorship and official propaganda. In class, student questions are often critical to the point that I need to introduce some “pro-government” views for balance.

Shortly after the uprisings in Tibet in March, I happened to lecture on Locke’s idea of constitutional democracy. A student asked if the “right to rebel” would justify the use of violence by Tibetans fighting for independence. In the interest of class time, I had to shut off the discussion. The next week we discussed Isaiah Berlin’s concept of freedom... Once again, I was forced into the strange position of cutting off debate before it got out of hand.

After the Sichuan earthquake, ..., I was due to lecture on John Rawls’s theory of justice. ... I tried hard to think of an example that the students could grapple with.

Finally I came up with a good one (or so I thought). According to Rawls, the state should give first consideration to the worst-off members of the community. But which “community” matters? Do the state’s obligations extend outside national boundaries? For example, the cyclone in Burma caused more deaths than the Chinese earthquake. Should China help the victims of the Burmese cyclone, even if it means less aid for the rescue mission in China?

When I finished, the class went unexpectedly silent, to the point that I could feel a certain amount of hostility. Finally a student said that of course the Chinese government should help the Chinese first. But why, I said? Another student said, it’s obvious, the victims are Chinese. “But why, why?” I asked, somewhat impatiently. Give me some reasons.

Some students spoke up. There is no global institution that could distribute aid in accordance with Rawls’s principles of justice. The Chinese people pay taxes to the Chinese state, so the state has special obligations to them. The Chinese state couldn’t do much for the Burmese people even if it wanted to.

I responded that the Burmese government is truly awful, blocking aid to its own people, and that the Chinese government could have some influence on it. ...[T]he bell rang. In the past, the ever-polite students would clap in appreciation before leaving. This time, there was no applause.

When I got home, I realized that I had trodden on sensitive territory. Chinese TV has been filled with scenes of death and devastation, of Chinese soldiers wading through mud and gore to help the victims. Every conversation is prefaced with concern about the victims. I sent an e-mail message to the class apologizing for the “wrong-headed” example...

A student wrote back saying, “It is not a wrong-headed example; we just have clear and strong identification.” That seems to go to the heart of what went wrong. It’s perfectly natural to care about people closer to home, especially in times of disaster. ...

I've wondered about this - how much to care about people inside the US versus people in the rest of the world - when it comes to monetary and fiscal policy. Say, for example, the US is about to go into a recession and it can save itself, but in doing so it will make life much more difficult for developing countries. Should policymakers do what's best for the US even if it impacts other countries negatively, or do monetary and fiscal authorities have an obligation to consider the interests of other people in the world when they are making policy decisions? Shouldn't policymakers always do what's best for the US?

Yes, but policymakers are supposed to represent our interests, and if we care, on average, a lot about how our actions impact other people in the world, then policymakers should reflect that in their policy choices - that's what's best for us. Conversely, if we mostly care about ourselves, and the rest of the world matters little, then policymakers should reflect those preferences too and show little regard for the potential negative impact of domestic economic policy on other people in the world (except to the extent there are negative feedbacks effects).

But I'm less comfortable with that position. What's the argument against it, i.e. what's the argument for internalizing the negative economic externalities that hit other countries because of our policy choices even if we don't care very much about those countries?

Output Growth and Economic Security

I don't think there is much new here, but it's nice to see Robert Samuelson is catching on to the consequences of decreased economic security:

Cause of Middle-Class Anxiety, by Robert Samuelson, Washington Post: We middle-class Americans are in a funk. "The overarching economic narrative of the 2008 campaign is the idea that life for the middle class has grown more difficult," Paul Taylor of the Pew Research Center ... writes. ... By its survey, more than half of Americans believe they either have not moved ahead in the past five years (25%) or have fallen behind (31%). Pew pronounces this "the most downbeat short-term assessment of personal progress in nearly half a century."

It's not that Americans have lost their optimism. About two-thirds say they have higher living standards than their parents..., and by a 2-1 margin they expect their children to live better than they do. But there's an underlying disenchantment that seems to predate today's higher oil prices, falling home values and declining employment.

"When my college-educated, gainfully employed thirty-something friends and I get together, we talk about money," Nan Mooney writes in her new book... "We talk about our inadequate health insurance and whether we can afford it, about how to juggle credit card payments and crushing student loans. ... This wasn't the life I'd expected."

Part of the deceptive sense of falling behind reflects the elastic nature of being middle class. According to Pew, 70% of households now have two or more cars, and a similar share has satellite or cable TV; 66% have high-speed Internet; 42% already have flat-panel TVs. ... More students ... have debt. Health care is expensive... One in 10 households now has a vacation home.

"Progress" keeps draining our pocketbooks. ... But today's middle-class anxieties transcend the well-advertised "squeeze" on incomes. The deeper source of disquiet, I think, lies elsewhere. Middle-class families value predictability, order, and security, and these reassuring qualities have eroded. People worry about rising living expenses; but what really upsets them is the possibility that their incomes or fringe benefits — pensions, health, and disability insurance — might vanish.

Paradoxically, "the lives of individual Americans have grown simultaneously more prosperous and more precarious," Peter Gosselin writes... The share of families suffering a 50% loss of income with a spell of unemployment rose to almost 26% from 17%. Fear of these setbacks has also climbed up the social ladder: not just factory workers and low-paid service employees but also managers and engineers.

Companies downsize. Older workers exit in buyouts. Companies raise health-insurance premiums. The reliable "defined benefit" pension ... has given way to the riskier 401(k)... Corporate protections have weakened...

One result is that bad economic news packs greater psychological punch than it once did, because more people identify with the victims. Change isn't just something that happens to them; it could happen to us. People worry even if they hold well-paying jobs.

We are losing our sense of entitlement. Under the implied social contract, people who "played by the rules" — to use a phrase popularized by Bill Clinton — deserved modest middle-class guarantees: a steady job, rising income, and protection against random misfortune such as sickness, disability, job loss, and accidents. There was a belief that diligence and responsibility were their own rewards. ...

But the prevalence of middle-class ambitions and values creates a vexing contradiction: The advances in living standards that Americans expect require a flexible and competitive economy that weakens the security and stability that Americans also expect.

But the question is how severe the tradeoff is between economic security and economic growth, and I'm not convinced that it's as severe as implied. After the Great Depression, and also after World War II, we had significant changes in the level of economic security (and there were more changes in the 1960s with the Great Society programs), but we didn't seem to sacrifice anything in terms of economic growth, at least not as measured against other countries in the world. Now that security has eroded over the last several decades, it's hard to see how returning to previous levels will somehow destroy our flexibility and competitiveness, and it's not at all clear that modest steps beyond previous levels of security would have any significant impact either, particularly steps like universal health care (which could help businesses as well as their employees). So maybe the contradiction isn't so vexing after all.