New insights on optimal unemployment insurance

Insurance is useful because it allows to prevent (at a price) the consequences of adverse, unpredictable events. However, the viability of insurance systems can be undone by asymmetric information, adverse selection and moral hazard. In the case of unemployment insurance, the insurer cannot reliably observe the search effort and in particular whether a job offer was turned down. The empirical evidence, starting with Robert Moffitt, shows that larger unemployment insurance benefits lead to longer unemployment spells, thus highlighting an apparent moral hazard issue.

Since Steven Shavell and Laurence Weiss, we know benefits should decrease with the length of the unemployment spell, and since Hugo Hopenhayn and Juan Pablo Nicolini we know that one should even get a wage subsidy during the first periods of a new employment spell, a subsidy that depends on the length of the preceding unemployment spell. The basic idea behind these schemes is that unemployed workers need to be encouraged to search and accept the first job opportunity.

Raj Chetty asks whether the patterns observed in the data by Moffitt and others are not a sign of moral hazard, but rather a sign of lack of liquidity. Households with little cash on hand need to accept any job when unemployment insurance benefits are low. With higher benefits, they can afford to look for a better matches, which lengthen the unemployment spells but leads to better outcomes, as previously argued by Daron Acemoglu and Robert Shimer. The key here is to allow households to accumulate assets, but not all can gather sufficient precautionary savings, as in the model pioneered by Gary Hansen and Ayse Imrohoroglu.

The novelty in Chetty's work is that he found a way to test this empirically and finds indeed that this liquidity effect is very important: 60% of the marginal effect of unemployment insurance benefits on unemployment duration. For example, severance payments lengthen unemployment duration, and cross-state variations of benefits indicate that this duration does increase with benefits for liquidity constrained households, but very little for others. The big consequence is high benefits in the range of 50% are now easier to justify, even if there potential for moral hazard issues, something Stéphane Pallage and Christian Zimmermann had already highlighted, but in the context of a political equilibrium.

Transfers: cash or in-kind?

Should government transfers be provided in cash or in-kind? Simple economics clearly states cash is better for welfare. Just think about how cash raises the budget constraint leading to higher indifference curves. With an in-kind transfer, however, you (potentially) impose a constraint on the basket of goods, thus (potentially) reducing utility compared to he cash case. This argument is reminiscent of the deadweight loss of Christmas, discussed a year ago on this blog.

Janet Currie and Firouz Gahvani have a nice survey of reasons to provide transfers in-kind, and the circumstances where they apply. The parternalistic argument is the most obvious and applies when the government wants the recipient to consume specific goods. This would be called for when one wants to make sure children are adequately fed or are followed by health professionals. This violates consumer sovereignty, but it the whole point in this case.

But there are other reasons beyond paternalism. Social programs are often targeted, and in the presence of imperfect information for recipient identification, offering in-kind transfers leads to self-selection. for example, only needy people will show up at a soup kitchen or health clinic providing free services. Also, offering social housing in small apartments offers better selection among recipients than cash allowances. Of course, some needy people may be erroneously screened out. Note, however, that targeting does not necessarily imply overprovision of in-kind goods like paternalism does.

Cash transfers do not encourage poor people to do something about their future, as future cash payment depend on them being poor. Providing in-kind transfers takes care of this problem by forcing them into consuming goods that will help them out (education, health screening, etc.).

Finally, another circumstance where in-kind transfers make sense is when the target recipient is a member of the household that has no decision taking power. Children are such an example in most societies, and women in many as well.

I am appalled

I am appalled by the policy decisions currently taken in Washington. There should not have been a recession if these politicians had not started talking, and implementing, these bailouts. Let us first think about the origin: people realized that their mortgage backed securities may not be worth their market price. Some institutions may thus not be liquid or solvent. There are standard procedures for this, which do not involve climbing on roofs and shouting that the world will go under if huge amounts of money are spent bailing out these institutions. Essentially, Bernanke and Paulson have panicked, and showed it. The media and the market then believed them and started panicking as well. This dramatically increased the cost of the problem.

Now that the government seems to be in the mood of giving money left and right, with the blessing of the incoming administration, what is the reaction of banks? Wait until they see how much funds will come their way. Of course, they are not going to commit to anything until it is clear what they get. Even, they do not want to show that business as usual is possible, or they get nothing. With respect to banks, the bailout has achieved exactly the contrary of what it was supposed to trigger, get banks to lend again after the initial panic.

And why stop at banks? Now that the car industry is getting money, a provision that was not even in the bailout bill, any industry that somehow suffers will line up for more. And the US car industry should not get the money in the first place: it is structurally unsound. We are not talking about an emergency loan to a company that usually flourishes put goes through a temporary liquidity problem, we are talking about an industry that has had repeatedly losses even in good times, that never bothered to reform because of a "too big to fail" mentality and counted on its influence in Washington to postpone any adjustment.

And the current deal is money just thrown away: it gives a loan to the Big Three for three months, and by then it should have reformed. The car industry is incapable of doing so for several reasons: 1) it never did before, 2) part of the necessary adjustment is cost reform, and this money takes away any negotiating power against unions, 3) everyone is realizing that this throw-away money will be reflected in higher taxes, saves accordingly, and does not buy cars (and other things), 4) everybody realizes that this is just postponing the eventual bankruptcy, and you do not want to buy a car from a manufacturer who is soon incapable of honoring its warranty. If anything, the government should have imposed a transition form the Big Three to, say, a Mid-Sized One, and now, not after pushing this task onto the next administration at great cost.

This recession was completely unnecessary. By its declarations and its actions, the government talked the US into it. And unfortunately, no one, in the current or the future administration, seems to realize the impact of such short-sighted policy moves whose costs will linger for a long time.

What if one could buy votes?

Until secret votes were imposed throughout democracies, outright vote buying was not uncommon. Even today, there are suspicions that some elections or referendums are influenced by vote buying. In fact, delivering campaign promises to particular segments of the polity is a particular form of vote buying that is openly practiced today. So what if vote buying were generalized and accepted?

Eddie Dekel, Matthew Jackson and Asher Wolinsky at this question under two scenarios: outright vote auctioning and campaign promises, both compared to a status quo scenario where the electorate honestly votes according to its preferences. Campaign promises can only be delivered upon successful election, whereas vote buying implies payment is contingent only on (observable) votes. Two parties compete in a sequential and alternating bidding process.

The two scenarios lead to dramatically different distributions of favors: with campaign promises, only the electors close to the median voter matter, and those get substantial promises. Vote buying is substantially cheaper for the winning party and is not influenced by voter preferences. This implies that vote buying is inefficient: the richer party wins no matter what.

The impact of leader assassinations on institutions

Zimbabwe is a mess and voices are growing louder that only a violent overthrow of Robert Mugabe can solve the humanitarian, political and economic crisis of the country. While the leader is clearly a problem, would his disappearance really change institutions?

Benjamin Jones and Benjamin Olken ask this question in a broader framework: does assassinating a leader matter? In the case of autocratic leaders, it increases the probability to democracy if the assassination attempt is successful, but decreases it if not. In ex-ante expectation, attempts only increase the likelihood of democracy by 2-3%. Democracries, however, seem to be robust to this kind of violence.

The empirics exploit the randomness of the success of an attempt. But is this randomness truly random? For example, is the leader really ripe for an attempt and/or is not protected. Thus the optimal control group should be leaders who die in office, at least among autocrats. This may make the slim positive anticipated effect on autocracies vanish.

So, all in all, it does not appear to be appropriate to call for the assassination of Mugabe. But once his reign is over, here is how to fix hyperinflation.

Economic Logic is one year old!

I have already been posting for a year, and it has been fun doing so. While I started by commenting on the world around me from the perspective of an economist, I soon started discussing research. I guess it is just in my blood.

For those interested in blogging: it is quite a commitment to write on a regular basis, but it is rewarding in the sense that putting thoughts on "paper" allows one to put them in order, and sufficiently well for them to sustain the criticism of others. It is, however, somewhat time consuming. If I continue at this rhythm, it will cost me a paper a year, but I still think it is worth it.

While there are fewer comments than I anticipated, and while the readership is still rather confidential (although being featured on Econ Academics gave it a bump), I still hope I make some impact and get people interested in the topics I approach. Some posts had indeed some impact, here is a list:

The most viewed posts: Who will win the Olympics?, Why do people vote?, 2008=1929?

The most commented: Gas taxes are much too low, Illegal immigrants have rights that need to be defended, What is wrong with today's undergraduates?,

The most linked to: What is the FDIC thinking?, Blanchard's sad state of macroeconomics, I am upset.

In the comments section, I encourage you to state what you liked or disliked about the blog so far. It may or may not influence what I post in the future. But one thing is for sure: I will continue posting about research.

Optimal bureaucratic hassle

This week-end I had a conversation with a person complaining about the seemingly useless bureaucracy and hold times to obtain social assistance, and in that particular case unemployment insurance. He then went on railing against those inefficient bureaucrats. But what if they did that on purpose?

I am not saying that those civil servants have a manic pleasure at seeing all those applicants despair in their impatience. They rather follow rules within a system that purposely makes people wait and spend time applying for privileges. The bureaucratic hassle is essentially a discrimination tool. Indeed, those who really need help are those that have plenty of time on their hands (think unemployed) and can afford, even if they do not like it, to go through this hassle. But those, for example, who already have a job and try to defraud the unemployment insurance system will not want to go through the hassle, or at least they will be discouraged to do so.

Monitoring who can and who cannot obtain government services that are destined to the needy is difficult. Part of the bureaucracy is about monitoring, but it also has this added side effect that it allows people to self-select. Those who do not need help will not bother.

Why do Europeans work so little?

Over the last fifty years, the labor market of the major European countries went through a remarkable transformation: while Europeans worked 15% more than Americans in 1956, as measured by total hours of work per capita (15-64 years old), they now work 30% less. Richard Rogerson looks at this evidence, details it further and offers some explanations.

Looking more closely at the data by sector, he observes that while the service sector saw no change in relative hours between both regions, the good producing sector saw large shifts in Europe. Thus understanding the structural reallocation of labor across sectors during this period is crucial.

In early stages of development, an economy devotes more hours to good producing and less to services. As it catches up, like Europe did in the post-war period, it shifts labor from the goods sector to the service sector. By 2000, output per hour is similar in both regions, yet the European service sector is 35% smaller. Why?

Richard Rogerson ties this to the development process and taxation. Using a calibrated model with a home service sector (production of services at home as an alternative to buying them on the market), he shows that while technological progress allows a greater allocation of labor into the service sector, the increasing taxes drive this additional labor into the home service sector instead of the market service sector.

Is this good? Before arguing that "Europeans have a better quality of life," consider this: who is more efficient at producing goods and services, an autarky or a specialized economy with trade? At least since Adam Smith we know that specialization is better. So, unless the provision of home services entails particular enjoyments compared to buying those services on the market, the American situation is better.

Cost of default on sovereign debt

Now that various governments seem committed to increasing their debt drastically, it may become appropriate to investigate whether it could be optimal for them to default on this debt. What would this entail? Eduardo Borensztein and Ugo Panizza discuss this and identify four costs to default. This is based on an empirical exercise using 200 years of default data.

They find that reputation costs, as measured by credit ratings and rate spreads are significant, but short-lived. Indeed, consider how many times Argentina has defaulted yet managed to get decent credit conditions. International trade also is negatively affected, and this beyond what can be explained by a reduction in trade credit. The impact on GDP is also significant, especially when the cause for default was not very compelling. The impact on the economic activity is, however, short-lived. Finally, defaults may cause banking crises, but not vice-versa. And absent a banking crisis, the financial industry is not more affected than the rest of the economy.

Reading this, it does not seem that defaulting is that bad. In fact, it seems better than a personal bankruptcy, even US style, where establishing decent credit conditions is a long and hard battle. So, who is going to be the first to default? Not so quick, because it seems that some people suffer greatly from sovereign debt default: governments, and especially their finance ministers.

Sexism and university administrators

If you are currently in one of the few university departments that are hiring, you are probably getting frustrated by all the hoops you need to jump through to prove that you are not discriminating against various populations. These exercises imposed by the university administrations are sometimes silly, like asking you to figure out whether job candidates have certain characteristics, while you are supposed to take decisions while being blind to these characteristics.

Now, it is then a good question how the practices of the administrators are. Information on hiring practices of administrators is hard to come by, but it is easier to figure out how much they are paid. This is what Alison Booth and Jeff Frank set out to do with British university administrators, looking and gender differentials as well as the influence of sexual orientation or marital status. It turns out academics exhibit no bias in wages, but male administrators are significantly more paid than females. Hmmm. Do as I say (not as I do).

The cost of corruption

Today is anti-corruption day, and today is also when Daniel Kaufman gives his farewell speech at the World Bank. He is leaving the World Bank Institute for the Brookings Institute frustrated about the lack of progress in recent years in the fight against corruption. This obviously begs the question: is corruption really that bad?

The classic paper in this regard is that of Paolo Mauro, which documented in cross-country regressions how corruption was significantly and negatively affecting GDP and investment. Such an exercise is, however, subject to concerns of endogeneity that this paper does not address properly, as documented by Philip Shaw, Marina-Selini Katsaiti and Marius Jurgilas. The latter find that with a statistically adequate instrument, corruption has no effect on investment or GDP. Zvika Neeman, Daniele Paserman and Avi Simhon also show a no impact result, this time limited to financially closed economies, while corruption is bad in financially open economies. Toke Aidt, Jayasri Dutta and Vania Sena show that corruption does not matter if institutions are of low quality to start with.

Costas Azariadis and Amartya Lahiri argue that the causality runs the other way: rich countries elect good and honest governments. Cesar Calderon and Alberto Chong make a similar argument. Jac Heckelman and Benjamin Powell claim that corruption is in fact growth enhancing when economic freedom is limited.

Obviously, this survey is heavily tilted to demonstrate that corruption is not bad. There is also good evidence that shows the opposite. My point is, do not take for granted that corruption is necessarily bad.

What are unemployed people doing with their time?

When we model unemployment, we like to think that unemployed workers enjoy more leisure, but still spend a significant time searching for jobs. This modeling choice has important implications as it means that it is normal for the start of an unemployment spell to lead to lower consumption, as market consumption is substituted for home consumption and leisure. Do these choices by theorists make sense?

This is one question that Alan Krueger and Andreas Mueller can answer in a pair of papers that use the American Time Use Survey (which still needs saving) and other surveys. Overall, unemployed people behave in expected ways: they sleep more, they spend more time in home production, including care of children, and have more leisure, in particular TV watching. They also spend more time shopping and, of course, looking for a job.

This is where it becomes interesting. On a weekday, an American spends 40 minutes looking for a job. While this is surprisingly low, consider that Scandinavians bring it down to 5 minutes. These numbers hide considerable within country variation as, for example, only about 20% unemployed Americans actually spend time looking for a job. For those that actively search, the time spent is determined by the "urgency" of the job search: being married or female leads to less job search time. Educated people search more. But again, this is conditional on searching at all.

Unemployment insurance benefits do not seem to explain the cross-country variation in time spent searching, except maybe the change in benefits as the unemployment spell last over six months. However, in the US, cross-state variation can be explained by UI benefits. And for those eligible, search time increases as the end of eligibility approaches.

All in all, it looks like unemployed workers are behaving as theorists would expect. Except that the length of time spent looking for a job is an order of magnitude shorter that what is generally assumed.

Looking for Giffen

Everyone has heard of Giffen goods in their first Economics class: goods whose demand increases with their price. But do they exist? Marshall, who introduce the concept had the example of bread for poor families, but no such case was found in reality. Samuelson popularize the idea that potatoes in the Great Irish famine were Giffen goods, but again, there is no evidence. So, do Giffen goods exists at all?

Robert Jensen and Nolan Miller claim to finally have found a Giffen good, or rather Giffen behavior, as the good has a regular demand in normal circumstances. After running some field experiments in China by subsidizing some goods, they find that if 1) households are very poor and face subsistence nutrition concerns, 2) households consume a very simple diet of a staple good and a fancy good, 3) the staple good provide cheap calories, comprises a large part of the budget and has no substitute, 4) households are not so poor they only consume the staple good, then one can observe Giffen behavior. In the particular case in Hunan, household eat mostly rice with supplements of meat. When the price of rice increase, households seek to maintain caloric intake by eating less meat (which is even more expensive) and more rice.

We are impatient because our brains are schizophrenic

There is ample evidence that humans are impatient. The traditional assumption in Economics has been to assume that we have preferences that exogenously feature a discount factor. Isabelle Brocas and Juan Castillo claim to explain endogenously impatience by thinking about how the brain functions.

Essentially, the brain is composed of competing entities. Say that there is a principal maximizing undiscounted intertemporal utility on a finite horizon. Then, there are distinct agents in each periods, all myopic in the sense that only contemporaneous utility matters. The principal can impose choices on agents, but the latter have private information on marginal utilities. The problem is closed with an intertemporal budget constraint with a strictly positive interest rate.

Impatience emerges as a result of this asymmetric information. Each agent has independent valuation, so there is no information to be gained from one agent that would be useful on the others. However, the principal can elicit some valuation revelation by granting more immediate utility to the agent. Thus, impatience is the result of asymmetric information between the principal and the independent agents.

In the particular implementation of this problem, the only intertemporal binding is the interest rate. This is the reason why the principal wants some savings. In the model, this positive interest rate is exogenously imposed. If it is zero, there is no impatience. Then, why would the interest rate be positive in the first place? Isn't it to reward patience among impatients? Aren't we going in circles here?

The case against student evaluations

It is time again for student evaluations and the biannual ritual where students are given the authority to judge how well they were treated in their classes. While I agree that it is useful to have some indicators about the quality of teaching, I do not think students are the best people to ask about this.

As Walter Bossert argues, the facts that students are obviously no experts in the taught material, that they perform the evaluation anonymously without having to justify their marks and they have no guidelines on what the marks are worth makes this a highly dubious effort. Imagine if teachers were evaluating students this way!

From my own experience and from pouring through others' evaluations (a sad exercise), students reward those who make it easy on them. Just look how students discuss their teachers on Professor Performance or Rate My Professors. A committed teacher who wants her students to really learn and pushes them to work hard is doomed.

Then, how should teachers be evaluated? By their peers, and by students who have graduated. These are the people that can best evaluate how the teacher masters the material and how it has an impact.

Talking up recessions

The NBER has now decided, the US is in a recession. It is, however, my impression that this recession is totally unnecessary and has been mostly talked up. Indeed, banks have all the necessary liquidity, they just look each at other and wait for the first one to move. To make things worse, now that this bailout plan has been decided, they are waiting for money to flow before doing anything. Think of it is terms of living on anticipated profits. Without the bailout, they would have given loans by now as they cannot afford to sit idle on cash.

But when I say this recession has been talked up (much like the Gulf War recession), that does mean that economist should continue telling things like they are, instead of feeding the fear mongering of the media. And if things are truly fundamentally bad, they should not hesitate to say so, as in most countries they will not face the consequences they would face in Latvia...

Undersaving governments

A lot of governments are now expecting to face severe revenue shortfalls, especially for US states. They should have had some rainy day funds, but the conventional wisdom is that they find it very difficult to build up in good times, because of both the pressure from the electorate to reduce taxes and the temptation to extract political rents beyond lower taxes. These problems led to many states to impose limited borrowing rules on themselves, but it still seems that rainy day funds are vastly insufficient, just look at the current emergency slashing of public spending left and right.

Ricardo Caballero and Pierre Yared argue that this should not be so in an economy with substantial fluctuations, where a rent-seeking government over-saves compared to a benevolent government. The idea is that if economic uncertainty is more important than political uncertainty, politicians over-save in order to make sure to get reelected and exploit rents in the future. For example, if the economy is low, the government keeps taxes low to guarantee reelection, in the anticipation that when the economy is better, the taxes will be increased and more rents can be extracted. This will also prevent future politicians to extract anything significant.

How can one then force the government to act more benevolently? Cap deficits again, but for different reasons than usually, as politicians tend to behave the opposite way of other situations. They still want to run deficits, just at different times. This contrasts, however, with my earlier post showing that soft budget constraints may be optimal. the case then was that there could be substantial moral hazard in completing investment projects if spending needs to be curtailed.

Marry our daughter

Arranged marriages are alive and well, and the Internet allows apparently even this institution to flourish. Witness Marry our Daughter where underage daughter are proposed for marriage. This site features bride prices based on biblical justifications. But there can also be perfectly rational, economic justifications for a bride price.

The bride price is based on the idea that a family looses child-bearing services when it gives a daughter away. The argument is very similar to the one used to justify the high pay of prostitutes, especially young ones.

In this context, it may be puzzling that one can also have dowry, that is, a gift that a woman brings into marriage, typically from her parents. The usual justification is that she will not be able to use the services of her old family, in particular bequests (Maristella Botticini and Aloysius Siow). One can therefore understand dowry as an anticipated bequest. In fact, bride price and dowry can coexist, see Ted Bergstrom.

The value of undergraduate education in public universities

High school seniors in the United States are now sending their applications to universities and they will soon face the problem of choosing between public and private colleges. This year seems to be different from others, as student loans were apparently among the first ones to suffer from the current financial crisis, despite being in many cases guaranteed by the government.

As private universities have typically suffered heavy losses in their endowments and are thus not expected to offer the level of tuition support of past years, students are expected to be more likely to accept offers from public universities. In fact, the latter already report much larger admission submissions than previous years.

At the undergraduate level, there is not much difference between public and private universities in terms of value added. Having taught in both, the variance of students is high in both, and I saw no notable difference in motivation. Teachers are better in elite universities, whether private or public, as teaching and research qualities are positively correlated.

Is it worth going private if one did not get into a public school? I would say no. Lower ranked private universities are not worth the price and the student debt. If a student could not make it to public university, he should not go to college at all, as I have argued before.

The quality of students in public schools may actually significantly increase for next year "thanks" to this crisis. And universities may want to accomodate this with increased enrollments. It would not be a good time for state governments to cut support to their universities.

Are democracies good for peace?

While I argued a few days ago that war was good in Malthusian economies, there is little doubt that war is bad in modern economies, except possibly for winners. Thus on average wars generate welfare losses. Then why do we still have wars? One key aspect here is that wars could be instigated by leaders who disrespect the welfare of their underlings. The logic conclusion of this argument is that democracies should be much less at war as, following Kant, democracies need to be accountable.

Paola Conconi, Nicolas Sahuguet and Maurizio Zanardi test this hypothesis by exploiting the fact that in some democracies presidents face term limits and are thus not accountable in the last term. The idea is that there is a repeated prisoner's dilemma game, where the horizon of the policy maker does not necessarily coincide with the country. Policy makers are semi-benevolent, care about rents from reelection and election success is endogenous. There is a short-term electoral boost of war, following Gregory Hess and Athanasios Orphanides, but there is more importantly a long-term cost to the country.

Conconi, Sahuguet and Zanardi construct a dataset of term limits from 1816-2001 for many countries and find that presidents in a legally binding last term behave as aggressively as autocrats. Thus, democracy is not sufficient to bring peace, you need to avoid term limits as well. However, what to think of the electorate, as voting for a lame duck seems to have negative consequences? Are people stupid, or are they manipulated? Also, the paper does not explore the implications a lame duck to continue presiding through his party (exhibit A: Vladimir Putin). But even without these consideration, the empirical evidence should us to explore ways to make war more difficult for lame ducks, as they have war mongering inclinations.

Tribute to David Cass

Today, David Cass is celebrated at the University of Pennsylvania. He was not only a supreme theorist, but also a driving force in the department, both with graduate students and with CARESS, a research center he founded to help researchers disseminate their work.

His work on general equilibrium theory is probably the best known. For example, he modified the Ramsey model to take into account discounting, and the model is nowadays often refered to as the Ramsey-Cass-Koopmans model. David Cass has also developed crucial analysis of the overlapping generations model and sunspot equilibria. He also advised numerous graduate students.

For people outside these circles, he will however be best remembered for his fight against the UPenn administration that tried to remove him from administrative responsibilities because he happened to be in a relationship with a (willing) graduate student. In reaction, he gave a memorable speech on women (pdf) that is a very good showcase of this free thinker.

National flag colors and well-being

While is it apparently known that wearing red apparel improves performance in sports (and this has nothing to do with the earlier post on red-shirting), what about the colors of national flags and the World Bank's Human Development Index (HDI)? Voxi Heinrich Amavilah tackles this all important issue.

And the result is that flag colors do not really matter. While one may have some serious doubts at the theorizing in this paper, it is reassuring that the empirics turn out the expected result. An example of what counts as theory here: the dominant colors of a flag are reduced to a number by the sum of numbers arbitrarily assigned to base colors. To quote the paper, "Afghani dominant flag colors are Black and Green set on White. Therefore, the dummy variable for the Afghani flag colors = White + Green + Black = White + (Yellow x Blue) + Black = 5 + 8 + 1 = 5 + (2 x 4) + 1 = 13." And so on. One can only hope no journal will accept such work.

Meanwhile, I take from this exercise that we can continue to stick to the fundamentals of the economy.

Fair marriages are impossible

Getting the right people married to each other is a very complex undertaking. Preferences are heterogeneous and information issues are important in marriage markets. Economists have been interested in finding ways to get Pareto equilibria in such markets, algorithms that can also be applied in other matching markets, says for medical school seats, medical residents, electricity markets and so on. The standard approach is the Gale and Shapley algorithm, wherein everybody ranks his/her best mate, and successive rounds of matches from the top down allow a Pareto optimum.

This algorithm has been challenged on various grounds, in particular because it does not deal with envy. One could imagine that introducing side payments may introduce fairness: if you lucked out on a potential mate, you are compensated by the lucky one. However, Bettina Klaus offers an explanation why side payments are not sufficient to gain fairness. The big stumbling block in the indivisibility of the matched objects. In other words, one cannot randomize or diversify.

Thus, even in the best of the worlds, marriages are unfair.

War was good

Today, many countries celebrate the armistice, contemplating the contributions of their veterans and the losses and gains imposed by war. I want to reflect here on how internal wars may have contributed to the rise of Europe over the past millenum.

I have already reported how the steady competition among European powers forced them to keep taxes low and guarantee property rights in order to prevent emigration and how this helped Europe to grow faster than the Asian hegemonic empires. Nico Voigtländer and Joachim Voth have a different angle on this point. They claim that the competition among European states lead to sufficiently many wars to keep population from growing. In a Malthusian economy this is a particularly important point: With lower population and decreasing returns to labor, people are living above subsistence levels, which means longer lives, added incentives to save, and the ability to think beyond subsistence and innovate.

In those days, wars were horrible as they are today, but they may have left the foundations of today's wealth. Who knew then?

The advantage of being tall

It is well known that tall people have more success on the labor market, see for example T. Paul Schultz. The big question is whether this is due to discimination, say, because tall people are considered more beautiful, or because being tall is a signal of other positive characteristics. Schultz, for example, has highlighted that being tall is a sign of health.

The articles of Anne Case and Christina Paxson in the Journal of Political Economy and the American Economic Review detail how tall people have actually more cognitive abilities. It is not because the air is better higher up, it has to do, they demonstrate, with the fact that children that are taller at age 3, before school had any influence, already show better cognitive skills. Jere Behrman and Mark Rosenzweig also demonstrated that higher birth weights lead to better school attainment. This just reinforces the point that James Heckman has been pushing so hard, that schooling and labor market outcomes are to a large extend determined even before children are going to school.

In economies where nutrition is more important for developmental issues, Carl-Johan Dalgaard and Holger Strulik show with an intriguing biologically micro-founded model that tall people have distinct labor market advantages: They have higher wages and are less unemployed. It is, however, not clear whether this can translate to an economy with little food security issues.

What prompted me to write about this? Reading about tall people being upset at so-called discrimination in some airlines. Indeed, some of the latter are charging a fee for the priviledge of sitting in the front row or on an exit row where the legroom is larger. Tall people view this as a tax against them. In fact, one should tax them, as shown by Tomer Blumkin, Yoram Margalioth and Efraim Sadka, and as such tax does not exist, they should count themselves lucky. And by the way, if tall people need those seats so badly, why would they not pay for them? And if they are more expensive, they are less likely to be taken by short people.

Cheap talk matters

Chatting and cheap talk in the office may have a impact of the social cohesion of the group, but does it matter amongst strangers? Stefano Demichelis and Jorgen Weibull take the example of the following game popularized by Aumann:

	c	d
c	9,9	0,8
d	8,0	7,7

This is reminiscent of the prisoner's dilemma. If players can coordinate, c,c is the optimal outcome.But as both have the incentive to deviate, d,d is the Nash equilibrium. In other words, both say c but secretly think d. However, if they can send some message that has some meaning c,c can become a stable equilibrium.

This is different from a repeated game. There, if the same players keep interacting, they can build a reputation and c,c becomes, as experimental evidence shows, easily the equilibrium. The Demichelis and Weibull paper shows that small costs of lying can destabilize the d,d equilibrium as well. This may seem trivial, as adding such costs is equivalent to reducing the outcomes of strategy d. In the present context, however, the point is that pre-game messages ("cheap talk") are part
of the information set of actions. These messages may be complex, such as detailing what action one player takes in response to the other. But this cheap talk, even if cheap, may be effective in getting the better, cooperative outcome.

Beeronomics

Some economists like studying their hobby, witness the large number of papers written on Sports Economics, and there are some quirky associations out there. Exhibit one, the American Association of Wine-Economists, where wine tastings are surely part of the agenda and studying the Economics of wine is a good excuse.

There are also the Vineyard Data Quantification Society and the Society for Quantitative Gastronomy, not surprisingly both based in France.

And now there is Beeronomics, at this point just a conference in Belgium about the Economics of beer, but I am sure the participants will find good reasons to meet on a regular basis.

Change I can believe in

Now that elections are over, here are a few things the new president could take to his heart and change for the better:

• Introduce direct democracy. In particular, have a referendum on abortion and close the issue.
  
• Deal with Social Security and Medicare reforms.
  
• Promote annuities to soothe the consequences of inevitable social security cutbacks.
  
• Remove incentives for legal corruption.
  
• Auction carbon credits, do not give them away.
  
• Tax fossil fuels, do not subsidize renewable energy.
  
• Do not rely on self-regulation.
  
• Drop tax deductibility of mortgage interest.
  
• Scrap agricultural subsidies.
  
• No more tax rebate stimulus package.
  
• Get retailers to include taxes in their prices.
  
• Get rid of pennies.
  
• Replace the dollar bills by dollar coins.
  
• Go metric. Only Myanmar and Liberia are sticking with the United States.
  

Show leadership!

Taxes, charges and hidden prices

For a market to be efficient, it needs to be clear what the prices of the goods are. As I am traveling, I am noticing that who prices are advertised differs notably from country to country, and I wonder what this implies for efficiency.

Take for example sales tax or VAT, depending on country. In some places, such a tax is included in the price, while in others, it only gets revealed once the transaction is concluded. It hurts the transparency of the price. We all know the example of airline tickets, where all sorts of surcharges and taxes can in some cases multiply the price. I am especially irked by this "fuel surcharge," where the ticket price could easily reflect it. In the case of hotel reservations, guests often do not know the final price until check-out. For the sale tax, it is usually guessable what the final price is, but it is annoying, and it never ends up with a round number thus needing extra change.

Why would sellers not state the real final price? Because it gives the impression it is cheaper and the potential buyer does not have the guts to cancel the transaction after realizing what the true price is? Because it makes people more aware what share of the price is attributable to taxes? (I once saw a receipt in Canada attributing the federal and provincial sales taxes to the respective prime-ministers who introduced them). Because the first mover in including taxes would face a disadvantage with respect to the competition?

Clearly, we are a situation with a Pareto dominated equilibrium. This calls for government intervention, imposing on retailers to include taxes, charges and fees in their price.

Tribute to economist and eminent explorer Jacques Piccard

Jacques Piccard, the second generation in an ongoing line of explorers died on November 1, 2008. Trained as an economist, he joined his father's operations and dived in 1960 11,000 meters (seven miles) into the ocean. This record still holds and cannot be beaten, as this was the deepest place on earth. Surprisingly, he and his diving partner found life at such depths in the forms of shrimp and fish.

In 1969, he dove with seven partners in the Gulf of Mexico and let his capsule drift with the currents to reemerge four weeks later on the coast of Maine. His father Auguste was remarkable as well, as he was the first man reaching the stratosphere, and thus technically the first man in space, using a balloon. Auguste was the inspiration for Captain Jean-Luc Picard of Star Trek and Professor Calculus in the Tintin comics. Jacques' son, Bertrand, was the first man to circumnavigate the earth in a balloon without stopping and is currently working on achieving the same with a solar powered airplane.

The minimum wage lowers wages

We have all heard about the controversy whether minimum wages increase or decrease low-wage employment. But what is its effect on wages? Presumably, the idea of the minimum wage is to raise the lowest wages to a level that makes them living wages. What about the other wages?

Natalya Shelkova suggests that the workers with productivities not much higher that the minimum wages get their wage depressed to the minimum wage. The reason is that the minimum wage acts like a coordination device for employers who thus implicitly collude to offer lower wages. Empirically, she shows that this happens more in states that follow the federal minimum wage, as well as at times where the minimum wages has not been changed for a long time. This implies that introducing a minimum wage reduces wages, at least for those who had wages reasonably close to this new minimum. However, increasing an existing minimum wage raises wages.

The reasoning is similar to that of Christopher Knittel and Victor Stango for credit card interest rates. Once maximum rates were defined by state laws, financial institutions quickly converged to those rates which then not only were maximum rates, but also median rates. It shows that sometimes good intentions can backfire.

NB: I will traveling next week, so I may not be able to post every day, if any.

Social security and immigration policy cycles

At least since the work of Kjetil Storesletten, we know that it is possible to find an immigration policy that can make social security sustainable. But is such a policy politically feasible, taking xenophobia aside?

Edith Sand and Assaf Razin address this question with a very simple overlapping-generations model. Obviously, old people prefer having lots of (young) immigrants as well as high tax rates that will both sustain their pensions (we are talking about a pay-as-you-go plan). Young people clearly prefer low tax rates on their income, but it is unclear what they prefer in terms of immigration policy. They like high immigration quotas because it implies that there will be more when they are old, as immigrants have higher fertility rates. But they also like lower rates for the following reason: immigrants once old have the right to vote, as their descendants. Due to their fertility, this may shift the median voter from the old to the young and thus reduce future pensions. To top all this, immigrants depress wages (what the young do like) but increase the return of capital (what the old like).

All this implies that there can be immigration policy cycles. If the country is primarily populated by old people, it will let in a lot of immigrants. But once the young are in majority, borders are closed, until the old get sufficiently numerous. Guess where we are headed.

Victoria, Sex and the City and why women get married

Marriage is an implicit contract that is very difficult (and costly) to renege on. But it is an institution that has been around for a very long time, so it must be satisfying some need from both parties. There must be some Economics involved, right?

Gilles Saint-Paul offers an explanation: it is all about the children. Just from biology, women know which children are theirs. But to convince men they are the legitimate fathers, women need to offer a marriage contract and thereby forgo potentially better opportunities for other men. Men are fine with this contract, despite the fact that they could have mated with other women, because they are assured of the legitimacy of their children, and that it is worthwhile investing in them. For this contract to be credible, women must be able to commit to the marriage and thus accept penalties in case of adultery. Men do not need to, though, because it works against their interest to recognize their children.

What does this entail for investment in human capital? Assume human capital is at least partly inherited. Clearly, men will provide more effort if they can recognize their children. But it matters also what kind of marriage matches happen. By committing to a man, a woman passes on future better opportunities. But, unlike some other contracts, she is unable to transfer utility if she marries a male of lesser quality. This means that the marginal utility of consumption is lower for a women of higher human capital and she will require a much larger transfer from the male for forgoing future opportunities. For men, the more human capital they have, the lower the marginal utility and the more they are willing to invest in their kids.

It turns there are two possible equilibria here: A so-called Victorian one, where there is positive assortative matching with women marrying men with the same human capital. But there can also be a so-called Sex and the City one, where men marry women with lower human capital, and there are high human capital ones that are not satisfied with the remaining low human capital men. The latter is more likely if the distribution of human capital becomes more unequal, as some women (dumb blondes?) can underbid more intelligent ones. In aggregate terms, this means also that there is less talent in the next generation.

Blanchard's sad state of macroeconomics

I finally came around to read Olivier Blanchard's State of Macro paper that was discussed in other blogs when it came out. I am not sure I have the same reading about the state of macro that he has.

While I agree there has been convergence, the real convergence, and it is phenomenal, is between microeconomics and macroeconomics. I consider macro now to be a subfield of micro, so much is the use of microfoundations pervasive. Nowadays, macroeconomists can actually be understood by people outside their field, and vice-versa. The only difference is in the kind of questions they ask.

I do not understand his aversion to reverse-engineering a model. When you observe the data, you try to find a model that fits the data. You may take a general class of models and then narrow it down to the one(s) that correspond best to the data. Heck, isn't exactly what structural estimation is doing, reverse-engineering a model?

Olivier Blanchard is an unabated neo-keynesian. He is still trying to find some way in micro-foundations to justify the Phillips curve, or even IS-LM. He uses Calvo pricing and pretends this is general equilibrium. With Calvo pricing, he also assumes from the start that rigidities matter, while empirical evidence about this is mixed. He insists on analytical solutions so that a model can be reduced to a few equations. As far as I understand it, macro has evolved since those days where you were limited by tractability. With computers, you can solve more realistic models that may actually highlight complex relationships. You can find numerical answers to questions that remain ambiguous in an analytical setting. But this is now old neo-keynesianism.

In fact, V. V. Chari, Patrick Kehoe and Ellen McGrattan seem to have written a response to the Blanchard piece, essentially claiming that the shortcuts that neo-keynesians take do not render their models useful for policy. This trio of authors has written a series of controversial papers, but the current one is one I can agree with the most readily. The new generation of neo-keynesian models are bloated, tend to deviate from microeconomic principles and add lots of free parameters in order to fit the data better. In that vein, one can do better with neural networks where basically anything goes as long as it fits. But you gain no understanding of the economy.

The greatest advance in macroeconomics since Lucas, Sargent and Prescott has been the use of solidly founded theory. Neo-keynesians have consistently fought against this once they realized their favorite equations could not be justified. Blanchard is still fighting this battle, and although he made concessions, he lost that war. The new battleground is on getting these models usable for policy. Neo-keynesians are ahead in policy circles, but only because they have again renounced on the very principle of modern macro, the consistent use of theory and microfoundations.

Generalized fraud on Wall Street

If you still think that people are honest on Wall Street, you need to read the article on forensic finance in the latest issue of the Journal of Economic Perspectives. Jay Ritter documents several frauds that were so widespread that they were discovered by looking at aggregate data, thus instigating investigations.

Ritter documents four examples. The first the so-called late trading of mutual funds. Their price is set at the end of the trading day, but predictable market movements, say due to major announcements made while the market is closed, implies that their value continues changing. Yet some sold shares at old prices, because either they were in exchange allowed to invest in vehicles that were generating high fees, or employees where plainly enriching themselves.

The second example pertains to employee stock options backdating, whereby options where given with an exercise price set at the market price of the share, as required by law, but at the lowest price in recent trading. In other words, firms where pretending their filing was late, while it was really on time with an old price. Just from looking at abnormal stock returns around stock option grants, it became obvious that those returns where more than 3% lower on aggregate for firms that do not have a fixed stock option granting calendar. A major scandal ensued, and it uncovered that firms that were backdating lost 7% on the stock market. All this for allowing executives to gain on average half a million dollars annually per firm.

The third example is the so-called spinning of IPOs, that is, offering underpriced new shares to privileged people. As IPOs were generally oversubscribed (and could thus have been priced higher), bookrunners could choose whom to sell them. Of course, they chose those who could provide them with other favors, either separate deals or in the case of executives, loyalty. And said executives were fine with the underpricing that cost their firms.

The final example pertains to something that looked like fraud, but ended up being "just" incompetence. The Thomson Financial I/B/E/S database of analyst recommendations had at some times about 30% of the recommendations altered after the fact, putting them more in line with actual outcomes. While this looked like rewriting history to highlight the competence of these analysts, it turns out the coding and data entry policies were horrendous. Yet plenty of investors relied on this data. Such incompetence seem also present in rating agencies and elsewhere.

Some have called the increased government involvement in financial markets a step back. But looking as these generalized frauds or examples of incompetence, it seems regulation and consistent disclosure requirements that are also verified are necessary.

What I look for in a president

Now that the presidential campaign in the United States is finally entering its last stretch, let me expose my thinking about what I look for in a president, whether it is this year or other years.

• The president should be an exceptional person. It is an exceptional job and it requires exceptional abilities. The interact with world leaders that are also exceptional people.
  
• The president should be surrounded by competent people. Competent, but not with vested interests. For example, the Secretary for Agricultural should not be a farmer, but should still be competent, and himself be surrounded by competent people.
  
• The president should listen. He cannot know everything, and gut feelings are sometimes wrong. Also, environments change and decisions need to be revised.
  
• The president should understand that there is something between white and black. Learn about the pros and the cons, and take both into account. Incorporate side effects into decisions. Listen to minorities.
  
• The president should be a leader. Once decisions are reached, he should be able to rally the administration and especially federal staff towards implementing them.
  
• The president should be an explainer. Sometimes, unpopular decisions need to be taken. The president should be able to convince people that this is the right choice.
  
• The president should be open to challenge. He should welcome challenging questions from the press. He should answer question in Congress.
  

Note that I did not mention any opinion on policy. The two candidates are very close in this regard, and at this point policies are secondary to my points above. And besides, there is always a gap between election promises and actual outcomes once reality sets in.

Red-shirting the first grade, a good idea?

It is becoming increasingly popular to delay the entrance of children into first grade, or red-shirting them to use a term for university sports. The idea of parents is to give their offspring a competitive edge throughout their academic career as they would be more mature. While this should clearly work in the early grades, does this work for educational outcomes?

David Deming and Susan Dynarski claim it does not work, in fact there is even evidence that it is counterproductive. They show that red-shirted children make a slower progression through grades, going even as far as demonstrating that most of the slowdown in grade attainment over the past 30 years is due to the delay in school entrance. There is also a significant effect for the attainment of an undergraduate degree. Finally, delayed school entry also entails a shorter time spent thereafter in the labor force.

Why would parents still want to red-shirt their kids? They would clearly have advantages in non-academic areas: less subject to bullying, better at sports. In fact, I have heard the latter argument from other parents. While there is clearly an overemphasis on competitive sports in America schools (witness parents calling for less homeworks so the kids can train more), some argue that sports scholarships are the only way to finance a college education. School officials are also tempted by this practice, because it allows to have better students in a particular grade, and the school looks better in assessments.

While red-shirting does not seem to carry advantages for the children, it is a clear disadvantage for kids who enter school on time. They are typically of lower socio-economic status and face an even higher gap in the classroom. In this respect, this may also lead parents to red-shirt their children in order to avoid these disadvantages. This lead to competitive delays and a clearly negative outcome for society.

Is skill-biased technological change driving education improvements?

Soon after yesterday's post about the surprising increase in US adult literacy between ages 16-17 and 26-30, I stumble in the latest NEP dispatch on a working paper that seems relevant. Diego Restuccia and Guillaume Vandenbroucke point out that educational attainment as increased constantly from 1940 to 2000 and try to find a reason for it. They conclude that the skill premium in wages is the main motivator for people to get more educated. So far so good.

But they also show that all this is driven by skill-biased technological change. This is where the results do not seem to square with the paper discussed yesterday. If US students catch up late on adult literacy, it is because they are getting general education in college. In Europe, however, college is specialized from the start. If this is an equilibrium outcome, I would have expected technological change to be skilled-biased in Europe and be more general in the US. This is confirmed by the low mobility of the European labor force (and the ensuing high unemployment rate) that has a hard time changing sectors or occupations if necessary, at least compared to the United States.

What am I missing?

On adult literacy in the United States

Browsing through the latest issue of the Journal of Economic Perspectives, I stumbled on puzzling numbers on education in the article by Elizabeth Cascio, Damon Clark and Nora Gordon: while the United States is severely lagging in literacy for 16-17 year olds among countries with similar income levels, it is in the middle of the pack for ages 26-30. This is based on the International Adult Literacy Survey, which tests how well respondents answer to questions after reading a text.

That the performance of school students in the US is poor should surprise no one. What I find surprising is how well they catch up on the other countries later on. It is true that university graduation rates used to be higher than anywhere else, but this has changed now. Also, I am not convinced that a diploma in the US is worth the same as in other countries. However, the first two years in US colleges are typically spent furthering general education which has already been acquired in high school elsewhere. Can this explain the catching up? At least part of it. But I cannot believe that US college students learn that much to pass the Italian, Swiss or Danish ones.

Candidate attention in 2008

Following up on my earlier post on candidate attention, David Strömberg emails me about an interesting update to his article.

He uses his model to figure out out where presidential candidates should spend most of their time. Again, Florida comes on top, followed by Ohio, Pennsylvania, Michigan, Virginia and Colorado, which are the so-called battleground states. I am somewhat puzzled that California is next on the list: while loaded with electoral votes, it is a near certain Obama state.

Do candidates actually optimize? Obama does very well, with a correlation on 0.9. This is rather surprising given earlier promises to campaign in all states. But it is not surprising that McCain does not optimize well, with a correlation of 0.8. In particular, he spends a lot of time in New York, which he has a 0.3% chance of winning.

Why are stocks dropping so fast?

How is it possible that stocks could be dropping this fast all over the world while the current crisis is mostly limited to the US financial sector? Stock prices are supposed to represent the discounted present value of the expectations of future dividends, and possibly the liquidation value of the firms. What in that equation would lead to such price drops?

Lower expectations for dividends? Possibly, as people must by now realize that someone will have to pay for this horrible bailout package, and firms are likely to be the first ones on the hook in an election period. But that would not explain why stocks drop in the rest of the world, and it probably does not explain the amplitude of the drop in the US.

Changes in discounting? With the recent reduction in interest rates by the Federal Reserve Bank, we should in fact see increases in stock prices? So what is left? Irrational panic? While one cannot rule this out, there may be a perfectly rational explanation, and the lead article in the last American Economic Review gives one.

Ana Fostel and John Geanakoplos show how perfectly rational agents can generate something that looks like a panic. The premise is an economy populated with liquidity constrained individuals (no borrowing and short sales) who are heterogeneous in terms of optimism. They show that even a small group of agents heavily invested in a small sector of the economy can lead the economy into a so-called anxious state, where bad news is contagious for assets to which the news is orthogonal.

The crucial aspect is heterogeneity of agents combined with incomplete markets. The key is that some bad news increases volatility, because of the latter this does not necessarily increase the information. The result is more disparity in opinions. Some sell because of increased pessimism, others have to because of the liquidity constraint. It snowballs from there and looks like a panic, but everyone is acting in a rational manner.

Does this pertain to the current situation in the United States? The authors have emerging markets in mind, where indeed markets are much more incomplete than in the US. But the current US situation is one where it is very difficult to borrow and most agents never contemplate short sales, and some of those who do have just been forbidden to do so. And given that the model economy just needs few people in such a situation, I think the model applies.

But the model has good news. We'll get over it.

US still a leader on the policy front, unfortunately

Now that the US has passed this unfortunate bailout package, other governments around the world are eager to pursue similar policies. This is quite silly, as we seem to create a gigantic moral hazard problem at great cost.

Iceland reached heights in silliness by taking over much of its banking sector. Icelandic banks had been very aggressive on European financial markets, in particular pursuing depositors with high interests rates. This means the banking sector is much larger than the country in that a majority of its customers are abroad. Why would the government then step in to save foreign customers? This is especially questionable as the Icelandic government is now itself in a situation of default as a consequence and is begging for money in Russia, of all places.

The only explanation I can think of for this decision is that Iceland just imitated US policy action without thinking too much. And other European governments are following suit as well, except for Switzerland. The latter is an interesting case, as UBS has been particularly bad hit by the subprime-mortgage situation. But knowing the government would not help, it recapitalized several months ago with funding from Asia, and it seems to be in relatively good shape now. The other big Swiss bank, Credit Suisse, is fundamentally healthy and has announced plans to hire 1000 investment bankers in anticipation of a rush of new customers. So much for preventing moral hazard problems: not intervening leads to a healthier financial sector.

What faculty spend their time on

A popular complaint by faculty is that they do not have enough time for research and spend too much time on teaching and administrativa. A common complaint of the general public is that faculty do not spend enough time teaching. While it is difficult to say what the optimal time allocations are, one can study what they currently are.

Albert Link, Christopher Swann and Barry Bozeman do this for science and engineering faculty using a survey a US research universities. The survey has a drawback that it uses recall, asking how much time the surveyed faculty member spent on various tasks over a typical week of the last term. There is plenty of evidence that such questions elicit inaccurate and, especially, biased responses, which is why I will not report on the number of hours.

Rather, I want to discuss on how the time allocation evolves over an academic career. First, the number of hours per week is remarkably stable over a career. The allocation varies significantly, though. Take teaching (including preparation time and student advising), which starts very high for the two first years. Given that new faculty typically have a lower teaching load, it is surprising to see how it still does not compensate for the additional prepping for new classes. Teaching time then steadily declines, presumably because prepping time decreases with experience, but then increases for associate professors who where not promoted to full professors. As they did not make it to higher level in terms of research, they are presumably asked to take more teaching responsibilities. Or they lie about the time spend on prepping. Or they are simply less efficient.

For time devoted to research, again there is a peak in the two first years, then an almost steady decline for those staying on as associate professors. Full professors, however, maintain research time steady from the point of promotion. Grant writing time, important in the sciences and engineering, does not fluctuate much over the career. However, time dedicated to "service" (committees, consulting) increases steadily, without much difference between titles. Other remarkable findings: non-tenured faculty works 2.5 more hours a week, women 1.2 more.

Would these results pertain to Economics faculty? I can only relate to my anecdotal evidence (and that of a few others I called about this). It seems that the research hours actually decline over their career. They get plenty of opportunities in consulting, especially for full professors, or they just stop doing research, especially long-term associate professors. For the latter, I have not noticed any additional time devoted to teaching, so I conclude their total hours must be declining. Readers may correct me if my observations are truly anecdotal.

PS: Thanks to the Geary Behaviour Centre blog for alerting me about this article.

Why is prostitution so well paid?

The oldest trade usually pays well, even where it is legal. Why so? Prostitution is low-skilled, labor intensive and female, all attributes that are usually associated with low pay. Lena Edlund and Evelyn Korn have proposed that the high pay can be justified by that fact that prostitute give up their fertility. This is based on the taboos that prevent the marriage of prostitutes. But this is theory.

Raj Arunachalam and Manisha Shah provide an empirical test of this theory. They use sex worker data from Ecuador and Mexico. Prostitutes are indeed better paid, especially when young, when they are also more likely to be married. Even worse for the theory, the premium is higher for male sex workers.

The authors hypothesize that the true explanation for the higher pay is risk. Sex workers face much higher risks of catching sexually transmitted diseases. Some proof of this is that sex workers earn less when using a condom, as shown by Paul Gertler, Manisha Shah and Stefano Bertozzi. But in the Ecuador sample studied here, this can only explain a quarter of the 30% premium.

Predicting the Nobel Prize

There are plenty of blogs trying to predict who is going to win the next Nobel Prize. Let's introduce some objectivity in this by using the RePEc rankings. Below, I look at various criteria and the three top papers or economists who have not yet won a prize.

• Most cited articles: Manuel Arellano and Stephen Bond, Greg Mankiw, David Romer and David Weil, Paul Romer.
  
• Same, with citations weighted by simple impact factors: Lars Hansen, John Taylor, Avinash Dixit.
  
• Same, with citations weighted by recursive impact factors: Lars Hansen, Rajnish Mehra, Robert Barro.
  
• Authors, overall ranking: Andrei Shleifer, Robert Barro, Peter C. B. Phillips.
  
• Authors, most citations: Andrei Shleifer, Robert Barro, Mark Gertler.
  
• Same, weighted by simple impact factors: Andrei Shleifer, Robert Barro, Mark Gertler.
  
• Same, weighted by recursive impact factors: Andrei Shleifer, Robert Barro, Lawrence Summers.
  
• h-index: Andrei Shleifer, Robert Barro, Jean Tirole.
  
• Wu-index: Andrei Shleifer, Robert Barro, Ben Bernanke.
  
• Number of citing authors: Robert Barro, Andrei Shleifer, Olivier Blanchard.
  

Note that I have not used any criteria that puts more weight on recent citations, as I do not believe the prize committee thinks this way. There are a lot of macroeconomists above, probably a reflection of the fact that it is a wider field and thus people get more cited. But then, they should also get a proportional share of Nobel Prizes. Now, applying rigid rules is never a good way to perform forecasts, so let us through some subjectivity in there.

From the list above, Andrei Shleifer emerges as a favorite. His chances are, however, severely hampered by the Harvard-Russia scandal. That would leave Robert Barro, but I have a hard time imagining him getting the prize alone. With Thomas Sargent? The latter is one of those who have been extremely influential without being cited that much. In the same category are the often mentioned Eugene Fama and Kenneth French, who have the drawback of pioneering work in finance, and awarding the prize during the current financial crisis would reduce the credibility of the prize. This could also discount the chances of Lars Hansen, but his work on empirical asset pricing has had implication way beyond finance. Another personal favorite is Jean Tirole, who should have received it with Jean-Jacques Laffont before the latter died of cancer. Finally, let us not forget Paul Romer, who is fourth for several of the criteria above, including the very first one.

In conclusion: Robert Barro (with Thomas Sargent?), with Fama-French, Jean Tirole, Lars Hansen and Paul Romer as dark horses.

Depressed

No post today. Too depressed by what is happening in Washington. They will never learn.

Update: my condition is upgraded to "in sarcastic mood" after seeing this.

I am upset

We have just witnessed another example why the political process is broken in the United States. There is complete disregard of policy advice from people who understand the issues, staggering amounts of money is thrown at problems with policies that are ill-conceived from the start, are amended to make them worse, and then hastily packaged with other poor policies to "sweeten the deal".

In a nutshell, here is what is wrong: If the government buys the toxic assets, it will face a very serious adverse selection and buyer's remorse problem: it will only get the worst ones, and at a price well above the market. The idea to have a reverse auction on a good that is not homogeneous is also ludicrous. If the government can recoup 20 cents on the dollar for those toxic assets, it will be lucky. Remember that those assets will be pushed from people with little competence (banks) to incompetent ones (government).

There are other solutions. My favorite one is the Swedish one: have the government take equity positions, thus recapitalizing, force write-offs of bad assets, dilute shareholder value (shareholders are supposed to carry risk, remember), and then sell the stake once things are back to normal. This keeps incentives in the proper place, as banks continue to service the loans. The cost to tax payers was relatively minor when a similar situation happened in Sweden in 1992. Americans may not like this idea of partial nationalization, though. Alternatively, let those who are sitting on plenty of cash recapitalize, like in the Middle East or in Asia. UBS did this earlier in the year twice, as it was not expecting a bailout.

Another one is to get all problematic institutions through bankruptcy court. No tax payer money is involved (well, a little, to pay the courts) and it force the bad assets to be written off, and all can start afresh.

But stop scaremongering and claiming something needs to be done immediately and hastily. We have seen with the Iraq war and the Patriot Act how this can go wrong.

What is the FDIC thinking?

I have been trying on this blog to focus on other things than the current financial situation that everybody else is covering, but it is getting really difficult. The government is trying to find ways to get lending institutions to lend again, and guess what the FDIC is doing?

Preventing them from lending. That's right. The FDIC is going through the banks, looking at their balance sheets, readjusting the risk measures of the loans (I am fine with that), downgrading to junk anything that is related to real estate. That is problem number one: Not every real estate loan is poorly performing. In fact, most are still paying their mortgage every month, and will be until maturity. Forcing bank to basically write off every real estate loan is poor risk management. The consequence for most banks is that their rating with the FDIC is tanking, they must pay higher premiums to the FDIC and must recapitalize.

But it gets worse. The FDIC forces bank not to make loans, unless they are backed by cash. Banks are even asked to call back loans of well capitalized borrowers that were performing just fine. The FDIC is taking a wholesale approach killing all real estate loans, severing long-standing business relationships and basically negating all government efforts to get lending going again.

The FDIC has a mission, ensuring depositors can get to their money if needed. But it should not act in isolation of the other agencies, and it should not kill performing, sane business relationships. We definitely need to reduce the alphabet soup and merge the regulating agencies so that they can cooperate.

What is a CEO worth?

Now that Congress seems due to pass this horrible bailout bill, let us reflect a little on one provision that seems to have sweetened the deal: limits to executive compensation. CEO pay has been controversial for a while now, so it is natural to ask whether they are worth it.

This is what Marko Terviö does using an assignment model and data from 1000 publicly traded US firms. First about the assignment model: its idea is to match firms and CEOs with different characteristics. Outcomes depend on the distribution of those characteristics, and as they are in fixed supply, the price of ability does not necessarily reflect marginal productivity.

The market value of a firm is pivotal here, as it is not only dependent on its current characteristics (and CEO), but future ones as well. Also, a firm contains capital that can be transferred to others. The current surplus of a firm is the product of CEO ability, firm size, a growth factor and capital. This may seem oversimplifying, but you needs to keep managerial ability observable by deduction.

Matching this model with Compustat data, the top 1000 CEOs appear to contribute between US$21 and 25 billion in 2004 (about 0.15% of market capitalization), and they have been paid $7.1 billion for it, including option packages. CEOs seem to be of little impact, but still a bargain. But what if all CEOs were replaced with the best one? The surplus gain would be $3.2-3.4 billion, rather modest. The reason is that the best are already matched with the largest firms.

Polls are useless

We are getting poll results every day on the presidential election. Even at other times, polls are used on a regular basis to elicit which way the public leans on policy matters. Is it a good idea to do so?

John Morgan and Phillip Stocken would probably say polls are of very limited use. There are several issues at hand. First, there is the sample size, with many polls aggregating the opinions of 1000 people or less, the statistical significance of the result may be very low, especially for close outcomes. With small samples, polls work reliably only when the population is relatively homogeneous. But then you do not need polls.

Second, there is strategic behavior, especially in larger polls, where responses tend to follow ideology instead of truth-telling. Inferring outcomes from polls without taking into account strategic behavior can be very misleading. Luckily the authors provide estimators that correct for such biases. But this raises the question: If the polity knows such estimators are used, would it not adjust its strategy accordingly?

Third, poll results differ from referendum or election results. The problem is that in a limited sample poll, it is impossible for voters to convey credible information in equilibrium. We need referendums, as I called for the other day.

The critical point here is that the polled ones have information that the pollster does not have, and that it is costless to convey information in a poll. As an example, the article takes the case of Oregon, where it was contemplated whether to lower the minimum wage for tipped workers. To gain information about the economic effects of such a policy change, restaurant owners were polled. It is clear that it was in their best interest to act strategically instead of revealing what they really know about the industry. They faced no negative consequences if lying, and they knew they could influence policy their way by lying.

Voting with your feet

Much of public economics relies on the assumption that people vote with their feet, following the idea of Charles Tiebout (Yes, there is link on IDEAS). Yet there not been a good test of it. While there has been empirical work, the problem lies with the scale of moving. Moving is costly, especially if it implies building new social networks, finding a new job and adapting to a new culture. Few people moves because Bush got elected. More people move locally when local amenities such as schools change in quality. Typical test where at the county of census tract level, which could be too coarse.

Spencer Banzhaf and Randall Walsh manage to test Tiebout's suggestion by using California data on neighborhoods defined as sets of half-mile diameter circles. They have demographic data (useful for controls) as well as data from the Toxic Release Inventory. This allows to study the response of households as air quality changes.

And yes, households move away when the air quality deteriorates. Public economics is saved.

Income and Democracy

There is an obvious correlation between GDP and democracy. Just think about OECD countries, all democratic, which are much richer that Third World economies, which are often not democratic. This correlation has often been a motivation for imposing democracy on some unsuspecting country, arguing it would improve its economy. But correlation is not causation. And even if there is causation, it could go the other way.

Daron Acemoglu, Simon Johnson, James Robinson and Pierre Yared use two strategies to try and find causality: First introducing country fixed-effects in a panel regression, which are supposed to take into account country-specific effect impacting jointly income and democracy. Second, use an instrumental variable approach, which gives sources of exogenous variation useful for estimating causation. In the first case, the correlation disappears, and in the second, no causal effect is found from income to democracy.

In the latter case, one can discuss forever whether the instruments are adequate, especially as their strength is not reported. Also, causation could actually go the other way (as advocates of imposing democracy onto other countries like to argue). Still it remains a puzzle why rich countries are democratic. The authors advance a few vague ideas (political and historical accidents, long term effects not identifiable in the short sample), but clearly much remains to be done here.

The electoral college and candidate attention

US kids are taught a myth in civics classes, that every vote counts. In presidential election this is certainly not true. The fact that the winner takes all electors when winning a state and some states consistently vote for one party (and if not, it is a landslide) makes that many states become completely irrelevant in the campaign. It is all about the battleground states.

There are two ways in which campaigns realize that not every vote is equal: they allocate unevenly their resources, both in time (candidate visits) and money (TV ads). Do they do this in a manner that would be predicted by a model of electoral competition? How would these allocations change if the electoral college were replaced with another system? These answers are answered by David Strömberg. The critical thing here is to measure the uncertainty that a state would vote for either camp and determine how visits (and TV ads) influence this likelihood.

It turns out the proposed model works remarkably well to explain the actual campaign decision. Or put in another way, the campaigns seem indeed to optimize following such a model. Now that we have estimated the components of the model, one can look at alternative election scheme. This is where it becomes really interesting. If one lets electors be attributed proportionally to the number of voters in each state or even switches to a direct vote, the battleground state become significantly less interesting. Large states do not benefit much, however, due to the decreasing returns of visits. It is the small states that are big beneficiaries of this system, both because of the higher return of a visit, but also because they have disproportionately many electors to begin with.

It is time to make all states relevant. There have been previous attempts to reform the presidential election. One other aspect that a reform would bring, as demonstrated by Strömberg, is that the likelihood of razor thin victories would decrease 40-fold. Not good for the 24-hour news channel, but good for the country.

Guarding the guardians

The June 2008 issue of the American Economic Review has a nice set of articles in political economy that are an interesting read with the current presidential election in the backdrop. I will be writing about them over the next few days.

The three lead papers are dedicated to the Nobel Prize lectures and give a good overview of mechanism design. I found the one by Leonid Hurwicz, entitled But who will guard the guardians? particularly interesting giving the recent failures of the safeguards in the US government. It turned out that the US Constitution could not prevent abuse of power when the executive and the legislative (and some argue also the judiciary) are dominated by the same party. Hurwicz's point is that whenever somebody may misbehave, you need a guard, and also somebody guarding the guard, etc.

Luckily, in the political arena, there is an ultimate guard: the people. But one needs to put an institution in place that actually lets people guard their government. This is currently not the case in the United States, as it is very difficult to recall a president or congressman. Tell this to Connecticut who seems to regret very much electing Lieberman, for example, but is stuck with him for another four years.

And a recall is not necessary in fact, as long as the people have a way to overturn a decision the government has taken. In this respect, I am a big fan of direct democracy, where people can take the initiative and put measures on the ballot. This is currently the case in several US states, most prominently in California. The champion in direct democracy is Switzerland, where every decision taken by the government is fair game with a relatively low hurdle in terms of support before it goes to a ballot. This means that the government needs to be awfully careful in its decisions. In fact, the Swiss constitution specifies that some laws face mandatory referendums.

Now imagine direct democracy applied at the federal level in the United States. People would be much more involved in politics, as they now have the power to overrule the politicians. Politicians become much more careful in they policy making. Long standing issues, like gun control, abortion, gay marriage, immigrant rights, public health care, size of the military, and the role of government in general could be settled once for all. Everybody could then finally move on and leave these poisonous issues behind.

Building trust

A fundamental building block of a developed economy is trust. You need trust to make transactions happen, to enforce contracts, to create a banking system, to use money. So how can you create trust?

Ernesto Reuben, Paola Sapienza and Luigi Zingales address this question with an interesting experiment: person A has $50 and can send it to person B. If this happens, person B obtains $150 and can chose to send any amount back to person A. If A trusts B to send more that $50 back, A should send $50 to B. If not, no transaction happens. The twist in this classic game here is that people playing B play twice. Once without any information, and once knowing that A expects something in return.

They conclude that people behave in a more trustworthy manner when more is expected from them. This is an important result. It shows that people need to be constantly reminded what we expect from them. For example politicians, bankers, plumbers and teachers.

Spite and development

One of the big lessons Adam Smith has taught countless generations of economists is that homo oeconomicus is all its selfish glory can be quite useful to society. Of course, there are circumstances were selfishness is not the best outcome for society, for example when an activity exerts negative externalities onto others.

In a recent article, Ernst Fehr, Karla Hoff and Mayuresh Kshetramade give an example of a situation where society would be better off if people were selfish: spiteful preferences. This happens when somebody desires to reduce another's payoff only to increase one's relative payoff, and doing so hurts oneself. Society would be better off if this person would just be selfish and not commit such acts of spite.

Two points here: first, we need to define what selfishness is. If it maximizing private utility, then if it is relative outcome that are relevant to one's preferences, then this is what we ought to accept as utility. Where it become problematic for society is if such preferences are widespread and people enter into spite tournaments and mutually hurt each other. But even if there is only one spiteful person, his actions exert a negative externality onto others that needs to be redressed.

Second, how widespread is such behavior? The authors of the article argue it is more widespread than you may think. They conducted experiments in India with a game where cooperation is a Nash equilibrium. They find that between 61 and 73 percent of players punish cooperators, and this is more prevalent among higher castes.

I am saddened by such results, as this is obviously bad news for economic development. If people are so willing to hurt themselves to prevent others to become richer, everyone is going to stay poor.

The brain drain and the financial crisis

While almost every economic or financial blogger has given his opinion on the current financial troubles, I have resisted because I do not think the consequences of the crisis are a s large as the press suggests. Recent events seem to precipitate the financial crisis, which does not yet means this would lead to a recession. However, the current alarmist tone teases me to react.

First, at this point the economy is sound. The financial sector is a mess, but the rest of the economy is remarkably resilient to what is happening. This may not last as credit is the lifeblood of entrepreneurship, and if this situation lingers for another year or so, we may get into a Japan-like slump. But we are not there yet. And if there is a longer lasting credit crunch because the US banks cannot lend, there are plenty of others, in particular in the Middle-East, that are flush with cash.

Second, the problem is not a lack of oversight or regulation. The institutions that are in trouble are all regulated institutions. Those that are not regulated are doing fine, for example hedge funds. If there is a lack of something, it is that various federal agencies should be intervening, not the Federal Reserve.

Where I think I see a problem is in terms of misplaced human capital. There are bright people in the financial world, but also some not so bright ones. Among the latter are people who learned to work with recipes and pre-established rules and cannot adapt to new situations. The bright ones have gradually moved to where the money is: hedge funds. This leaves investment banks, banks and in particular regulators lacking. This explains the incredibly stupid decisions we have seen, like developing the sub-prime market, venturing into markets investors did not understand. For example, Lehman Brothers is currently not able to price some of securities it holds. It bought only because it could sell them further. Call that a bubble.

This crisis will thoroughly shake the financial industry. It is showing who is really competent. It is in times of war that the real leaders emerge. But clearly regulators are not emerging as leaders here. And one should not expect them to be. They do not have the resources to stay ahead of the financial institutions. The answer to the crisis is not to increase (poor and poorly enforced) regulation. Rather, give more liberties (with proper disclosures) to regulated institutions, thus letting them get better returns and attracting back talent that understands the business.