Housing market boom-bust cycles and monetary policy

The preceding boom and current bust in the housing market have been blamed on the false expectations of market participants that house prices would always increase. While this expectation was historically correct (the Case-Shiller for the United States never decreased until now), this is obviously wrong for local markets. So, it cannot be true that everyone would buy the myth of ever increasing house prices. Can boom and bust then still happen?

Hajime Tomura shows that it is possible even when market participants have heterogeneous beliefs. And these fluctuations also impact the rest of the economy, just like we observe now. The model is rich enough to show that a monetary policy that is actively fighting inflation exacerbates these boom-bust cycles. So maybe it is a good idea that many central banks are putting aside inflation considerations for the moment.

Reproducing business cycle features: what for?

There is a tradition of trying to have models replicating statistical features of the business cycle, this is what the real business cycle theory is about: find a model that seems to mimic the data reasonably well, so that one can then use the model to study the impact of some policies. These models have had mixed results, in particular regarding the labor market, but this is somewhat understandable, as these models are obviously abstractions and they are not fitted to the data. But the point is that one has a structural model that can be applied for something useful.

So when I stumbled upon a recent paper by James Morely, Jeremy Piger and Pao-Lin Tien on reproducing business cycle facts, I was expecting something along the lines described above. Not so. This paper is about fitting VAR models and the like with non-linear effects to business cycle features. What would this be good for? These statistical model are good for short-term forecasting, and then you try to minimize some criterion like out-of-sample forecasting errors. Why would you try to have these models try to mimic business cycle features? They are not even good for any policy use, as they are reduced form models. Beats me.

What makes you happy? Expectations

What makes people happy? This is a central question in economics, as much of the theory is centered on utility maximization or social welfare maximization. Unfortunately, there is little data that actually measures happiness, and it is impossible to assess relative happiness across individuals. However, one can try and assess relative happiness of an individual across time.

Martin Binder and Alex Coad do this using a British panel data set and taking a self-assessed indicator of mental well-being as a measure of happiness. Using a VAR framework, the natural thing is then study of various life events, like changes in income, marriage and employment impact happiness. Surprisingly, the impact in negative. Well, that may not necessarily be a surprise to some for marriage, but why would an increase in income make you less happy?

But what about a change in timing? It turns out that increases in happiness are followed by improvements in income, employment, health and marriage. In other words, it looks like expectations have an impact on happiness that is stronger than actual realizations. The econometrician cannot observe expectations, but it is reasonable to think that the latter are positively correlated with subsequent realizations. Quite obviously, we need to rethink utility.

Did railroads induce or follow economic growth?

It is, at least in the general public and in the teaching of history in schools, a well accepted idea that the development of railways brought economic development to the West in the nineteenth century in the United States. But thinking about it, it is also entirely possible that the railways went were business was already established, after all the railways companies were seeking profit.

Jeremy Atack, Fred Bateman, Michael Haines and Robert Margo look at this chicken and egg question under a new light with new a new technology, GIS data. Using geographic data on population density, as a measure of economic development, as well as the fraction of urban households and the development of the railroad system. Using difference in difference estimation they find indeed that development preceded the railway. There certainly is anecdotal evidence for that, as the most advanced western state at the time, Ohio, did not rely on railways, but canals. And Michigan was the first to adopt railways. But this does not mean that railways did not transform the economic landscape, as they caused urbanization.

Why so much teenage sex?

Jeremy Greenwood in recent years has had a knack for analyzing societal topics under an economic angle. His latest, with Nezih Guner, is to try and understand why premarital sex has increased so much in a century. While presumably the enjoyment of sex has not changed, the cost of it has significantly decreased, they argue: contraception is more readily available and less expensive, error correction devices like abortions and recently say-after pills are less dangerous.

They also argue that the young are now better educated about sex, and make this part of a reduction in the cost of sex. I am not sure I quite follow this. Sex education is an information, not a cost issue. And it can cut both ways. One may now be better educated about contraception, which would raise the likelihood of premarital sex, but one also knows better about the consequences, and this should reduce this likelihood. We all have gone through this, and one tends to do stupid things in those years. In fact, one could argue that some form of hyperbolic discounting would be better indicated, at least until the twenties.

In any case, I still think that the argument about reduced cost Greenwood and Guner is a good one. I fail to see, however, why this needed 62 pages to be fleshed out. Any simple dynamic model would have been sufficient, no need for a complex matching model. And while their history of condoms starts with Casanova, they fail to mention that ancient Romans already used goat bladders for that purpose, and others later goat and sheep intestines.

Brain drain and brain backflow: nothing to do with economic factors

Many less developed countries complain about brain drain, as very talented nationals leave for countries with better opportunities. What are the factors that lead them to leave and, in some cases, to come back?

John Gibson and David McKenzie use the example of Tonga, Papua New Guinea and New Zealand, countries where the brain drain is the highest, and show that, surprisingly, economic factors are not the most important, in particular for the decision to return. Gibson and McKenzie determined over about 30 years who the top students were and tracked them and asked them what made them migrate (more than half of them) and come back (about 30% of migrants). Preferences seem to matter most, for example, topic studied at school, risk aversion and patience for migrants. For return migrants, family and lifestyle matter most. In both cases, economic factors are negligible.

What this suggests is that policies centered on making it economically interesting for the best to stay or come back are useless. Improving career opportunities and government quality is much more important.

Institutions do not affect the business cycle

There is now much talk about reforming market institutions in order to prevent crises. Whether those reforms will have an impact remains to be seen. But does institutional change have an impact on business cycles? An obvious natural experiment in this regard is Europe, where a common currency and monetary policy, the Maastricht Treaty as well as the free movement of goods and people.

Fabio Canova, Matteo Ciccarelli and Eva Ortega look at this using a panel VAR with countries in and outside the European Union. They find that there is a slow change in terms of synchronization and transmission of business cycles, but this seems unrelated to institutional change and rather part of the long process of convergence that started over 100 years ago. The timing of change is simply not right. Does this mean institutions are not important? Not necessarily, as this study looked at fluctuations, not levels.

Measuring centuries of numerical literacy

Measuring the evolution of human capital in previous centuries is tricky business. The most common measure, years of schooling, is fraught with major mismeasurement even in modern times, as it does not take into account the quality of education. A better measurement is to look at various cognitive tests, but those are not available for more than a few decades. Some measure of literacy are available for the 19th century, based on the ability for individuals to sign their names.

Brian A'Hearn, Jörg Baten and Dorothee Crayen use a very subtle idea to get a better grip on the evolution of numerical literacy. Accuracy in age awareness is thought to be a reflection of people that are "calculating" and using numbers in everyday life. Inaccuracies translate into age heaping, for example reporting age in multiples of five. For recent data, it is known that age heaping is inversely correlated with human capital, so why not use it as a measure of human capital for older periods, as demographic data is not that bad.

This is what A'hearn, Baten and Crayen do, and they use it to compare different regions. They find that numerical literacy started to increase in Europe in the sixteenth century after a millennium of stagnation, and Russia waited two centuries to start improving.

Encouraging early retirement does not increase youth employment

The goal of early retirement incentives is to shed expensive older employees for a younger workforce. This has two intended consequences: reduce the unemployment rate of the young, which is particularly high, and reduce the costs for the employer. I am not convinced about the latter in the case that the employer has to supply a pension, but what about the former?

Sorry to disappoint you, but that does not seem to work either, at least at the aggregate level. Adrian Kalwij, Arie Kapteyn and Klaas de Vos show using data from 22 OECD countries that the young and old labor forces are not substitutes, they may even be slight complements. Thus: scrap those silly early retirement incentives, and think seriously about allowing workers to work past 65, or even raise the retirement age. It will not affect youth employment.

Where most of tax avoidance happens: small business owners

It seems obvious that the higher the tax rates, the more people will try to find ways to evade them. Employees usually few means to evade, as the employer is obliged to furnish payroll data to tax authorities. But self-employed people have much more latitude. One could thus expect that their numbers and/or reported income to vary with the tax rate.

Åsa Hansson uses a tax reform in Sweden to look at this. And our intuition is confirmed: the taxable income of small business owners is twice as responsive as that of employees. The reason is that self-employed people can more easily shift their income into categories that are easy to shelter from taxes. Indeed, gross income of small business owners does not seem to be responsive to tax rates.

Regarding the propensity to become self-employed, Åsa Hansson produces another study that shows a negative relationship between self-employment and marginal or average tax rates. That is counter intuitive, but has been found occasionally in other studies (although not systematically). Would there be something special about Sweden? The particularity is that taxation in Sweden is neutral in that the source of income does not matter, and one cannot play with gains and losses to exploit differences in marginal rates. To me, that makes the results even more puzzling. One would then expect to see no shifting of income in Sweden (but, say, in the US) and no correlation between tax rates and self-employment (while it would be positive in the US). Unfortunately, Hansson offers no convincing explanation for the results.

Savings rates and public pensions in China

Chinese savings rates are very high and increasing, which have allowed the current paradoxical situation that an emerging economy is massively lending to industrialized economies, in particular to the most advanced, the United States. But why is this savings rate so high? While the popular opinion seems to be that Chinese households just cannot consume fast enough given the very high growth rates of their incomes, closer inspection of household level data reveals a very different picture.

Take for example Jin Feng, Lixin He and Hiroshi Sato, who find that changes in the pension system can explain all of the increase in the savings rate from 17% in 1995 to 23% in 2004. The pension system has been reformed to become less generous, prompting households to compensate with their own savings. Add to this that precautionary savings is not only motivated by retirement, but also by the fact that economic uncertainty has significantly increased with the liberalization of labor markets, you have the perfect storm for a massive increase of savings rates as household try to reach an acceptable buffer stock. Public appeals for them to consume more will do nothing.

Expected earnings do not matter for post-secondary studies

Do college students choose their field of study according to expected income? One would hope so, as the price mechanism would then lead to more efficient uses of human resources. This optimality criterion would only hold if there were particular distribution of abilities across fields prior to the start of studies. But leaving this aside, do prices matter?

Magali Beffy, Denis Fougère and Arnaud Maurel use French data and exploit the fact that the expected returns of study majors vary with the business cycle. As the cost of studies in negligible in France, tuition is not a factor, although the duration of studies varies a little by field and thus the opportunity cost of studying, but that is largely unaffected by the business cycle. They conclude that while expected earnings matter in a statistically significant way, it is not significant in economic terms. That means, students take expected earnings into account, but it influences them little. This means, there will always be a lack of nurses, accountants, and engineers, and always a surplus of humanists, whatever the market wage is (within reasonable bounds of course).

Poor macroeconomics of money market freezes

There are plenty of papers attempting to analyze the current crisis. For proper modeling, I would claim that a model would need the following ingredients, at least: some sort of shock (or we would remain in steady state), agents forming expectations (as the evaluation of future prospects impacts current decisions), intertemporal substitution (as savings and investment are crucial to the current problem), some market imperfection (or there would no problem to take care of), general equilibrium effects (to take into account the impact on prices). In other words, you need some proper dynamics so that a crisis can be generated and policies scenarios can be over the following periods.

Max Bruche and Javier Suarez build a model with no dynamics whatsoever. Sure, there are two periods, but households save in the first to consume in the second, and care only about the second period. So it is really a static model as households face no intertemporal decision. Same for firms, that just take a loan and then produce. What is the alternative? And what to do once a "bad equilibrium" happens? The economy is already over.

Bad papers happen, and they disappear in drawers. But this one is slated to appear in the Carnegie Rochester Conference Series, now part of the Journal of Monetary Economics. This used to be a prime outlet, where papers like the Lucas Critique or the Taylor Rule were published. What a disappointment.

The case for independent statistical agencies

It is by now well established and accepted that the judiciary, the press and central banks should be independent from the government. What about statistical agencies? They inform the public about the state of the economy, so why would the government want to fool the public in this regard? We all know about the bogus statistics that former Eastern Block countries were spewing out, but nobody was fooled by that as it was common knowledge they were uninformative.

Facundo Albornoz, Joan Esteban and Paolo Vanin give the example of a situation where the government would want to fool people. Suppose there are distorting income taxes. By revealing wrong information, the government may want to counter the distortion, i.e., add a new distortion. It can increase the labor supply by hiding information in recessions, thus potentially canceling the decrease in the labor supply due to the income tax distortion. That would be precisely the opposite of last Fall when Paulson and Bernanke where claiming everywhere we were on the verge of a Great Depression. This may still happen, but they can be blamed for making it happen, following this theory.

Regulation and the financial crisis

Various people have argued that the current crisis has been the result of a lock of regulatory oversight, that basically allowed banks to do silly things. I fail to be convinced about this argument for the simple fact that the only financial entities that have run into trouble were regulated ones, and the unregulated hedge funds, while obviously facing losses, are still in business without outside help. But it is still worthwhile thinking whether regulation is at an optimal level.

Joshua Aizenman provides a rather intuitive model of banking regulation: regulation reduces the risk of a crisis, but the perceived lower risk reduces support for regulation. Thus, one would always have under-regulation and even no regulation after sufficiently long, crisis free spell. This under-regulation is exacerbated by the fact that the public typically does not observe (or understand) the regulator's efforts. Of course, there is over-regulation immediately following a crisis, especially if it is very costly. Bayesian updating will do that to you. How to prevent these issues? Essentially the same way one prevents the inflation bias of a central bank: independence, transparency and predefined goals.

That said, and I mentioned it above, under-regulation may not necessarily be the trigger of the current crisis. What is sure, however, is that additional regulation is certainly not necessary now. All the activities that people have decried (under-priced sub-prime lending, over-leveraging, etc.) have disappeared without regulatory intervention. Such is the market...

When matching markets go crazy

A long standing problem in matching markets is that they tend to become highly inefficient as one side rushes to get the best applicants. The classic example is the market for medical interns, where the candidates thought to be the best were receiving offers from hospitals barely after the start of medical school. The inefficiency here stems not only from the obvious incomplete information about the quality of the future interns, but also from the adverse incentives of already matched students, who will not study as hard. One could also see some of that inefficiency on the academic market in Economics, where schools rush to make offers as early as possible, and now sometimes even before students officially go on the market. In medicine, the solution was to force all hospitals and students to participate in a matching mechanism at the end of studies. Both sides submit preference lists, and an algorithm makes proper assignments, make can be shown to be efficient under some conditions, and they are certainly more efficient that under the previous regime.

But when should one put such a mechanism in place? In other words, when is a matching market inefficient when left alone? Muriel Niederle, Alvin Roth and Utku Ünver study this question and conclude that the following are needed: a surplus of applicants and a shortage of good applicants. Then, "firms" will try to make early offer to the best workers, and they are willing to accept such offers. This is reminiscent of early admission strategies in college, discussed before on this blog. This raises thus the question whether it would be more efficient to impose a matching mechanism there as well. Some countries have already done so, for example Germany for medical students.

We need public and private research and development

Should the public sector engage in research and development (R&D) or should the private sector be left to take care of it? While all agree that R&D is necessary, who pays for it is obviously important. And whether public and private R&D are substitutes or complements is of critical importance here.

Sadraoui Tarek and Naceur Ben Zina look at this question using panel data over 23 countries using an endogenous growth model and come to the conclusion that they are complements. Also, R&D depends on the countries' human capital, which should surprise nobody.

The usual justification for public R&D is that fundamental research would not be carried out by the private sector as there is no profit to gain from it. Thus, the complementarity result could just emerge from this. However, non-fundamental R&D is much more important, and if public and private non-fundamental R&D were substitutes, this would most likely show in the aggregate. But it would be nice if the data could make this distinction.

So, governments, continue doing research, and make sure your workforce is well educated.

Again: tax, do not subsidize

I reported previously that if the goal is to improve the environment, one should tax polluters rather than subsidize non-polluters. The reason is that subsidizing increases the use of resources and necessitates taxing something else to generate the income.

David Kelly provides another argument. While a subsidy may improve the environment in the short run, it hurts it in the long run. This has to do with higher interest rates, which lead to over-accumulation of capital and an increase the opportunity cost of the environment. Subtle, and this shows that partial equilibrium analysis can lead you astray.

Ponzi and regulation

Ponzi scheme are much more frequent than one would think, although not as big the Madoff scheme. Ana Carvajal, Hunter Monroe, Brian Wynter and Catherine Pattillo report about a series of them in the Caribbean and in particular on how regulators intervened. For example in Jamaica, regulators alerted the public that the schemes were not licensed to accept deposits and to trade in what they advertised. The schemes were defended by other officials, seeing their effective sponsorships of events and parties. A legal battle ensued over the licensing, giving much publicity and leading, perversely, to further growth of the schemes and copycats. Looking at other instances, it appears that independence of the financial regulator is essential, as well as speedy courts. The regulator needs to have broad authority and be proactive.

Now, one may question why regulation is needed in the first place, as investors just need to draw the consequences of foolish acts. Well, first Ponzi scheme have a social cost, in the they unnecessarily reduce the confidence in the financial sectors, draw funds away from productive investments and can cause civil strife. The other is that if every investor needs to independently monitor, the cost of verification is much larger than if a regulation agency could do it. This could also be delegated to a private agency, but the latter does not have deep pockets if it screws up.

Student aid and duration and success of study

We know pretty well that increasing student aid increases the likelihood of attending college, little is know about its impact on study duration and success. Daniela Glocker uses German data and finds that the source of support matters. Institutional student aid leads to shorter study duration than, say, support by parents. The amount of aid has no impact on duration, but improves the probability of successful completion of studies.

I find these results surprising. One would think that parents would be able to put more pressure on finishing in time than a government may be able to. Also, having more funding reduces the opportunity cost of studying, thus giving more incentives to take it leisurely, especially in Germany where students have plenty of opportunities to delay graduation. So why are those results found? One would think that this has to do with students not getting aid having to work, but it appears working time has not impact on graduation time or success. Glocker thinks this has to do with the fact that how of the loan needs to be repaid is tied to graduation time. too bad this could not be controlled for, or the results would have been really interesting.

Microsoft, still the evil monopoly

Let me rant about another evil monopoly, Microsoft. Unfortunately, this is not the first time. The problem with monopolies is that they manage to get away with actions that would never be tolerated in a competitive marketplace. Here are some recent examples regarding Microsoft.

Microsoft automatic updates recently installed updates for the .NET suite that included a Firefox plug-in. Now why would Microsoft bother installing plug-ins for competing products? In this particular case, the plug-in allows websites to install software without the user's knowledge, that is, it creates for Firefox the vulnerabilities that plague Internet Explorer. Users are never prompted about this. Worse even, it does not appear to be possible to remove this plug-in without much trouble (such as downloading additional material from Microsoft). Details.

In view of Vista getting much traction, Windows has been encouraging users to download Windows 7 (release candidate version) for testing (and getting used to). It will stop functioning in June 2010. This will then force users to purchase Windows 7. The installation of any operating system, including a purchased copy of Windows 7 or a return to the previous one, will require wiping clean the hard drive. Thanks. Details (see IMPORTANT).

Microsoft continues to push Windows on manufacturers, making it difficult to buy computers with alternative operating systems, or none. Why would manufacturers go along? Windows is so bloated (along with the ever growing virus software) that it requires to upgrade hardware. And Windows installs typically have a Microsoft Office teaser install, prompting you to buy it after 60 days, while there are free products out there that do the same job (if not better), such as Open Office.

And my previous rants about forced and unnecessary upgrades, abusing patents

The worst bailout of all

Bailouts are difficult to justify in general, because of the adverse effect they have on anticipations and thus the moral hazard they induce. They can only be justified if this moral hazard risk can be outweighed by a strong positive welfare effect. Say, in the case of the bailout of the Big Three car manufacturers, that there is the threat that a new Great Depression would ensue, like Edward Lazear thought when he advocated intervention last September. We can discuss this assessment, and also whether it is a good idea to bail out the financial industry, the airline industry or whoever else is going to line up. But I have just been made aware of the least justifiable bailout of all: Belgium sinking a billion euros into the diamond industry.

Why? Because the diamond industry is a fraudulent operation to begin with. The world market for diamonds is overwhelmingly dominated by the De Beers diamond cartel that forces everyone to sell through it. This allows the cartel to dictate the price, essentially setting it at a multiple of what it would be under normal competition. This cartel was put in place in the late 1800s to preserve prices after major discoveries in South Africa that suddenly increased a lot the diamond supply. When the cartel found it difficult to hold prices in the 1930s, it created the diamond engagement ring, the most successful marketing campaign ever as it created a must have for every fiancée. The latest marketing scam is that "diamonds are forever." Well, actually this is true, as it is extremely difficult to resell a diamond at a price remotely close to its supposed value as diamond sellers have to comply with the cartel. So you are stuck with your diamond forever.

Diamonds, the worst investment ever, now supported by the Belgian government.