Are the Chinese capital controls optimal?

China is currently amassing large foreign reserves while imposing internally capital controls. Does this make sense? Wouldn't an economy that has the ability to create such surpluses want to participate more fully in world markets? One should not forget that these foreign reserves are accumulated thanks to a positive trade balance and a fixed exchange rate, not thanks to a particularly well functioning capital market in China. In fact, the financial sector in quite under-developed in China, and most households have access to nothing more than simple bank accounts.

Philippe Bacchetta, Kenza Benhima and Yannick Kalantzis build a model where the central bank has access to world market, but domestic households not. This enables the central bank to impose a different interest rate than the world interest rate, but it steady-state it is best to replicate an open economy: accumulate reserves and issue domestic debt at the world interest rate. If the economy grows rapidly, though, you want to have a higher interest rate domestically while imposing capital controls, that is, one needs to prevent arbitrage. But then, intertemporal substitution needs to happen through international reserves, as households cannot do it.

What is intriguing here is that we have a situation where open markets are welfare inferior to restricted ones with a reserve accumulation policy. Usually, we think that free markets would work best, especially as here there is no moral hazard, systemic risk, or other distortion. The reason is that borrowing constraints are binding as the economy converges towards steady state, and it cannot provide adequate intertemporal allocation in open markets. The central bank needs to help, and needs to differentiate interest rates to do so. That can only happen with capital controls.

Amy Finkelstein wins MIT Award

This was certainly a busy week for anyone following some of the ethics sagas in our profession. First, there was the non-renewal and temper tantrum of Bruno Frey, then there is the American Economic Association awarding the John Bates Clark Medal to Amy Finkelstein. Following my previous post on this award, this is hardly a surprise. For those keeping score, the last awards were given to:

2012: Amy Finkelstein, PhD MIT, Faculty at MIT
2011: Jonathan Levin, PhD MIT, Faculty at Stanford
2010: Esther Duflo, PhD MIT, Faculty at MIT
2009: Emmanuel Saez, PhD MIT, Faculty Harvard then Berkeley
2007: Susan Athey, PhD Stanford, Faculty at MIT then Stanford and Harvard
2005: Daron Acemoglu, PhD LSE, Faculty at MIT
2003: Steven Levitt, PhD MIT, Fellow at Harvard then faculty at Chicago
2001: Matthew Rabin, PhD MIT, Faculty at Berkeley
1999: Andrei Shleifer, PhD MIT, Faculty at Princeton, Chicago and Harvard

It is somewhat hard to swallow that MIT students and faculty are so much better than the rest, but one cannot discard the possibility that this could happen. What is more suspect is the composition of the committee: of the seven, three have an MIT PhD (Abel, Crawford and Hoxby), and one is faculty at MIT (Banerjee). What is the American Economic Association thinking? If you want to lend any credibility to this award, and you know who the prime candidates are, you put together a committee that does not look like it was constituted at the MIT ASSA cocktail party. It is true that in the past years, MIT PhDs were a majority on the committee, so there is progress, but the longer the streak goes, the more it looks dubious. It is especially annoying that Banerjee was put back in the committee two years after he gave the award to his colleague and lover (not a secret any more now that they have a baby).

The American Economic Association needs a serious overhaul of its committees. They are stacked with people from the same places, losing the representativity of the association. The proposed candidates for office are always coming from the same institutions, and a write-in campaigns cannot be successful. The AEA has already lost its credibility with its main award, and it needs to be very careful that its new journals do not go the same way, as they are again stacked with the usual suspects as editors. No surprise then that they have a really hard time taking off, despite all what people at the suspect institutions will tell you.

I hate quotas, but I think that in the current situation, the AEA needs to institute quotas in all its committees and editorial boards, if only to get out of a potential situation of self-fulfilling group thinking. No more than two PhDs or faculty from the same institution on the same committee or board. Have at least a "professional" economist and an economist from government or Fed on every committee. Same for non-PhD-granting colleges. Have true elections for president and vice-president with multiple candidates. And, why not, let the John Bates Clark medal be awarded by complete outsiders: academic economists not based in the US and not educated in the US (but not Ernst Fehr).

Bruno Frey: the story that keeps giving

A few weeks ago, I had a post entitled Bruno Frey, the epilogue, thinking that now that the University of Zurich made him a gigantic gift by manipulating the investigation into his behavior and keeping mum, Bruno Frey would have learned to finally shut up. But no, he has still not understood a thing a keeps going on, to the point that was getting daily updates in my email about the latest on him. Let me run a few highlights by you.

As was rumored for some time, the University of Zurich decided not to renew the two-year contract he was entitled to as an eminent retiree. There no official announcement, but it was reported by Olaf Storbeck, then by the Tages Anzeiger, a local newspaper. In the latter, Frey's wife, Margit Osterloh, defends his behavior and confirms that "he will continue working in Warwick", so he has indeed been told to leave the University of Zurich.

This firing then explains the bizarre behavior of Bruno Frey in the preceding days. Indeed, he appeared unusually incoherent in a television show, then wrote an outrageous piece in the same Tages Anzeiger newspaper calling for the defunding of his department (which actually got a major gift that was probably waiting for his departure). His reasoning is that the professors try too hard to publish their research, neglecting working with the media. He also mentions his research is essentially the only relevant one. Never mind that his employer tried very hard to protect him, gave a special status to his students who were exempt from exams, and now that was simply to possible to go on, the university did its best to let the situation quietly disappear to avoid embarrassing him. He answers with a slash-and-burn tactic.

That said, I also got a copy of the report commissioned by the University and looking into his self-plagiarism on the Titanic studies. As mentioned earlier, there is nothing about the many previous cases. View a pdf copy here.

So Bruno Frey will now continue his activities at the University of Warwick, which has a long tradition of hiring prominent retirees to boost its academic ranking. He joined in early 2011, that is right before the Titanic case came up, and early enough to qualify for the next research assessment exercise of the UK universities. But for the University of Warwick to keep any credibility, it ought now to take position on the Bruno Frey case, now that it is his sole employer.

Finally, as the story keep going on, I created a tag just for Bruno Frey.

Volunteers are happy

Why do people volunteer? Obviously it must be because they find some satisfaction in it. But they may be forced to do it (say, by peer pressure or because it improves one's CV), yet one can still argue they appreciate the volunteering because they find a benefit in it: without it, there would be adverse consequences. It thus seems unavoidable to find a positive relation between volunteering and happiness, unless one is able to tease out the circumstances of volunteering. Add to this the endogeneity issue that people may be volunteering because they want to spread their happiness, or because they enjoy good circumstances that allow them to work without pay.

Martin Binder and Andreas Freytag use the British Household Panel Survey to study whether volunteering makes happy. I am not sure their reduced-form estimates are able to capture the subtleties I mentioned in my first paragraph with propensity score matching. I find more promising their inclusion of personality traits to take care of selection bias in volunteering, although personality cannot completely be ruled as exogenous. Also, their quantiles regressions can potentially highlight some heterogeneity that can be useful for our understanding of the relationship. In the end, they find that volunteering makes people happy, no surprise here, and more so the longer they volunteer. The quantile regression, however, reveals that the happiest individuals do not derive happiness from volunteering, presumably they are happy for other reasons. The least happy ones do enjoy volunteering much more. I wonder whether this comes from some decreasing marginal utility of volunteering, and whether this ties in with the fact that the poor are more generous, as discussed before.

Econochemistry?

I have highlighted in the past some exceptionally bad examples of forays of physicists into Economics (search for "Econophysics"). Not all are that bad, but they generally have in common that they portray the economy just as exogenous stochastic processes where no economic agents take decisions. That can make sense in some contexts, but these are rare cases. Now it seems chemists are venturing into Economics, what good could that bring?

Yochanan Shachmurove and Reuel Shinnar are an economist and a chemist who managed to get a paper into the working paper series of the department of Economics at the University of Pennsylvania. So it must be a serious piece. Their point is that is Chemistry, they have to deal with chemical reactors that depend on many variables and are very difficult to predict. This is not unlike an economy, where a multitude of factors may matter in ways so complex with some randomness thrown in that forecasting is very difficult as well. The authors suggest to use partial control, which involves identifying a few crucial variables and monitor those for forecasting. That does not look like much of an innovation to economists, as we are used to abstract modeling, factor analysis, econometrics and simple rules like the Phillips Curve or the Taylor Rule.

The methodology of partial control they are trying to push, though, hits a few roadblocks when applied to Economics. The first is that it needs an objective, which is easy to set in a chemical plant (it is the choice of the plant manager) but not so easy for an economy as a whole. The second is that it needs to separate the problem into independent units. They suggest, for example, to treat the United States as independent from the rest of the world. That may work for some questions, but many it does not, especially when the point is to summarize complex interactions. Third, the procedure requires a hierarchy of reactions. Much of our understanding of general equilibrium would not be captured by such constraints. Fourth, the method relies a lot on the ability to manipulate controls. That is easy in a chemical plant, but an entirely different problem in an economy. The authors take the example of the Fed and interest rates. Well, the Fed has a target on one very special interest rate, all others are market driven.

While Shachmurove and Shinnar offer scattered examples of how to apply partial control, there is no sense of how a complete model would look like. I would wait to see a model in operation before calling this an interesting modeling strategy for Economics.

Rational expectations as an optimal approximation

The rational expectations hypothesis has somehow fallen into disrepute because it is viewed as somehow failing to predict or account for the recent crisis. This is of course because of a fundamental misunderstanding of the hypothesis, as it does not imply that markets are efficient, or in equilibrium, or that the equilibrium is unique, or that bubbles cannot happen. But it is a hypothesis, and as any hypothesis it could be rejected by the evidence, for example by experiments showing people are afraid of Knightian uncertainty and yet are optimistic. But the fact that there was a crisis is not empirical evidence in this regard.

Kenneth Kasa actually shows that the rational expectations hypothesis is also a result, up to a close approximation. Indeed, if one is uncertain about the economic environment ("does not know the model"), one adheres to robust rules in the sense that among all possible models, one picks the one with the worst possible outcome. Call this the 'evil' agent. Add to this the assumption that one likes being optimistic. Call this the 'angelic' agent. Now assume that the evil and the angelic agents negotiate what to do in a Nash sense. They will then choose to behave in a way that is very close to rational expectations. This means that optimal expectations are rational, even though the model is not known and one has the documented psychological biases. In other words, rational expectations can be a useful approximation even outside the usual core of assumptions.

Named matching donor are best to elicit more donations

US universities care a lot about donations, as much of their operations are financed by endowment revenue. Foundations also spend considerable resources trying to build this endowment. Hence, it is no surprise that there is a steady stream of research on how to best elicit donations, especially from private universities. One of the big issues they face is to generate the first dollar in donation (which costs several dollars), after that it is usually much easier to get more donations.

Dean Karlan and John List find through experimentation that matching donors are particularly effective in enticing other donations, especially where they are named and recognizable. The latter effect is even stronger for new donors. The challenge now is to find the matching donor. The experiment was performed with the Gates Foundation, I doubt many other potential matching donors can be found to have such high appeal. The experiment may have been too extreme to draw reliable conclusions.

How to best tax by gender and marital status

It is well known that income taxes are distorting in a way that is not welfare improving, as it discourages labor supply. But as we need government revenue to finance public goods and there is support for some redistribution, we have to live with income tax. Of course, one can discuss whether it would be better to crank up sin taxes to provide revenue and provide lump-sum subsidies (or taxes) to provide for redistribution, but let us suppose we have only labor income tax available. Then it is obvious that tax rates need to be differentiated by labor supply elasticity. That is difficult to elicit from individuals, but there are some individual characteristics that can help here.

Let us focus on gender and marital status. Women have a higher labor supply elasticity, especially when married. One has therefore to be careful not to tax them too much, or they drop out of the labor force. The same applies to a much lesser degree to married men. Gender is mostly unalterable, thus it should be easy to tax by gender, but politics get in the way. It is easier to differentiate taxes by marital status, but the latter is unfortunately endogenous. All this is probably why many countries tax differently by marital status, but not by gender.

Spencer Bastani studies the question using a model where, unfortunately, marriage is exogenous and characterized by perfect assortative matching: the most productive men marry the most productive women. When married, spouse bargain over each one's consumption and labor hours. Critical here is the exogenous bargaining power of the husband. Note that it is assumed that marriage always remains viable, there is no divorce, even though divorce is a threat point. In the end, men should be taxed more than women, unless the bargaining power of the husband is high (where lump-sum payments to women are likely to be higher, so they do not lose completely. And remember, this bargaining power is exogenous, and can be changed by law). If household production has a significant public good component, there should be redistribution from couples to singles. Welfare gains from such taxation are important, especially if wage gaps between genders are large. And this is the situation where it is the most feasible: women are then secondary earners, and one can tax secondary incomes differently without causing too much of a commotion.

Is pardoning prisoners the best way to keep jail costs low?

I mentioned yesterday that we do not know whether capital punishment is a deterrent or not. What about imprisonment sentences? That is much harder to establish without very precise coding of convictions in multiple jurisdictions with different sentences for the same crime. Finding or establishing such a dataset should be very difficult. But maybe we can find some partial answers in indirect ways.

Nadia Campaniello, Theodoros Diasakos and Giovanni Mastrobuoni use an interesting natural experiment in Italy. There, the parliament occasionally decides on mass pardons to reduce jail crowding. When such proposals are being discussed, suicide rates in Italian prisons drop. That means clearly that prisoners do not like ex-post being in prison, and sufficiently to make life depend on it. If this matters also ex-ante (before they head to jail and in particular before the decide to commit a crime), we should see a deterrence effect. But this may be a big if.

We do not know the deterrence effect of capital punishment

Whether to enforce or not capital punishment is one of those never-ending debates Europeans and Americans cannot grow tired of. In theory (and the classroom), we economists like to think that imposing a capital punishment on a specific action will make it disappear. Yet, people still do get the capital punishment, despite the fact that it is well know it is exists. Well, maybe the criminals were not quite sure of that, or they were wrongly convicted, or they were framed. But in any case, we should be seeing some evidence that capital offenses should be less prevalent in jurisdictions where capital punishment is enforced.

Steven N. Durlauf, Chao Fu and Salvador Navarro look at the literature and find that there is no consensus whether capital punishment has a deterrence effect. And quite far from it. These diverging results sometimes even come from the same datasets. This is an indication that the model specification matters a lot, and they demonstrate that indeed this matters. A linear specification always leads to a positive deterrence effects, while a non-linear one favors a negative deterrence effect. Of course, we have no idea which specification is the right one, thus we have no idea whether capital punishment is effective or not.

Market competition and product quality

There is common perception that more competition can lead to lower quality, as firms try to lower prices. Of course, this presupposes that buyers do not require quality, or that the trade-off between prices and quality is tilted towards giving up quality. Thus, a lowering of quality cannot be a general phenomenon, but must be limited to some good. One area where we would think that quality is important and would not be traded off is health care. Yet there is evidence that where competition increased, lower quality has been provided. How could that be?

Kurt R. Brekke, Luigi Siciliani and Odd Rune Straume provide a theory that can can explain this under particular circumstances: First, sellers need to be motivated in the sense that they care for quality. Second the marginal utility they get from profits is decreasing as they make higher profits, which implies risk-aversion. These assumption does not seem unreasonable, especially for health care provision (but not for the financial industry, for example, where the bonus payment is so important). The intuition of more competition yielding lower quality is rather twisted: increase competition, and prices fall. Profit margins are smaller, hence also profits. With a higher marginal utility of profit, sellers try harder to increase profits, and quality is a dimension that is available. How to counteract this? Make people care more about quality (how?), tax lower quality (how?). Not obvious.

Are rickshaw pullers myopic?

It is sometimes difficult to imagine why some people take decisions that make no economic sense. Take those that accept to receive payday loans at interest rates that defy any reason. Yet it can make economic sense, under some circumstances. In a similar vein is the observation that some people pay rent that seems to be far too high compared to the intrinsic value of the good.

Magnus Hatlebakk reports about one such example, rickshaw pullers in Nepal. They typically rent their rickshaws, and the rent cumulated over a year corresponds to the price of the rickshaw. It is particularly puzzling as microcredit is available, although at a different payment schedule: rent is 40 rupees a day, while servicing a loan would be 240 rupees a week. From a survey, Hatlebakk concludes that rickshaw pullers are not myopic, excessively impatient or financial completely illiterate: their income is simply so close to subsistence consumption that they cannot save up the 240 rupees for the loan service. At least this is what Hatlebakk argues, which I do not understand. If they do not pay rent, they could have save 40 rupees a day and be able to pay the weekly 240 rupees after six days. I suspect what is at play is more something like what makes ROSCAs so popular in many developing economies: people unable to keep significant amounts of cash, either because of the risk theft, misuse or, yes, myopia.

It would have helped the paper if it mentioned what the average lifespan of a rickshaw is, and whether rental provided some form of insurance, for example by providing a replacement in the event a rented rickshaw breaks. Indeed, the insurance aspect could also be important if there is substantial risk, or if the owner provides for repairs.

On the state of economic research blogging

If you are an economist and maintain a blog, the best way to get an audience is to get into fights with pundits and journalists, and you then easily become a pundit yourself, losing the impartiality you are supposed to have as a scientist. The most popular economist bloggers are either openly libertarian or quite far right, or in reaction resolutely on the left. Almost all engage in politicking and wars of words and have basically abandoned the principles of impartiality their scientific upbringing taught them. The impartial scientists are drowned.

EconAcademics.org tries to rectify that, aggregating blog posts that discuss research, or at least refer to research. The list of monitored blogs is impressively long, yet it saddens me to see that the "popular" blogs are nowhere to be seen near the top of those who have discussed the most research, despite their considerable volume of posts. While I could be proud to be (far) ahead on this last list, it saddens me again how little consistent discussion of research there is. Out in the blogosphere, are we really so few economists doing this? Why can't the top economics blogs relate more to the results of their field?

A positive externality of EconAcademics.org is that is compiles a list of all papers I discussed, including where the ultimately got published. I have put the link in the sidebar and will come back to discuss it sometime soon.

We need more tax inspectors

The question on how to best tax people according to some criterion is the fundamental question of much of public economics. But it is little explored how the willingness of people to pay their taxes matters in this, except for a small literature on the underground economy.

Philipp Doerrenberg, Clemens Fuest, Denvil Duncan and Andreas Peichl Study a model economy where households have heterogeneous tax morale. It should come to no surprised that under such circumstances and if the tax authority can discriminate in this regard, it will tax more heavily those that are more willing to pay. That seems to be the pay of least effort for the tax authority. But the model completely neglects that the government can do something about those with low tax morale: go after them. Of course, it costs some resources, but when the objective is to maximize revenue, it can be worth it.

In fact, I find it amazing how a government in a budget crunch often first reduces the budget of its fiscal authority, thereby amplifying the problem. That can be viewed as a smart political move, tax authorities are never popular, but I am not even convinced of that. Think precisely about those with high tax morale: seeing there getting off free may reduce their tax morale, making things even worse.

Why less secure jobs pay less

In financial markets, risk is generally rewarded with higher returns. On labor markets, this is much less obvious. While some public jobs like police officers, jail guards and firefighters are rewarded with early retirement packages, the private labor markets is ironically much less willing to reward risk. Just compare miners and white collars. It is even worse for those facing unemployment risk, especially within firms. How could such an equilibrium come about?

Roberto Pinheiro and Ludo Visschers can explain this with a labor search model where firms differ in job separation probabilities. In firms with short expected job tenures, the value of a job is low for both workers and firms. As workers can search for better opportunities while on the job, they are willing to accept low wages with the riskiest firms, who thus also remain competitive. But some workers also get scarred but getting stuck with such jobs. Of course, this logic is not valid for low risk firms. This leads to wage heterogeneity across firms and workers. Coincidentally, workers tends to move to safer jobs, thereby increasing the average job tenure as they age, a nice feature of the model.

Why the rich save more

It surprises no one that the rich save more. But they save even more than what could be accounted for the lower propensity to consume that one would get from any reasonably parametrized model. What could account for the difference?

Annamaria Lusardi, Pierre-Carl Michaud and Olivia Mitchell that survey evidence tends to indicate that the rich are financially more literate, whereby the direction of the causality is not clear. They build a life-cycle model where financial literacy is endogenous. The mechanism generating higher savings is interesting. As the rich get retirement benefits that are relatively small compared to their permanent income, they need to have more precautionary savings. To manage these savings, they get more financially literate. This allows them to get higher returns and get even richer, while those that are content with their public retirement package see no need to save more and learn how to get better returns. One more reason to improve economic literacy in the public.

On the difficulty of implementing right-to-work legislation

The chronically poor have a low labor-market attachment, to a large extend because of a lack of skills and experience. This is thus a vicious circle. One way to break this vicious circle is to offer them employment and hope this turns into a virtuous circle. This is what India implemented in 2005, a program that guarantees any rural adult 100 works days on public projects at minimum wage (thereby getting the richer people to self-select out). Does the theory work out in practice?

Puja Dutta, Rinku Murgai, Martin Ravallion and Dominique van de Walle report that it worked, sort of. The poorest families do indeed use the scheme most, but here remains unmet demand, thus the state was not able to fulfill its work guarantee. In fact, this rationing was most prevalent in the poorest Indian states, where the guarantee is the most needed, and where the resulting public works would also be of the highest benefit. And while the scheme seems to motivate more rural women to participate in the labor market, the rationing still privileges men. All in all, the program seems to roughly target the right people, although there is substantial scope for improvement. But we still need to wait for more data to see whether it works to alleviate chronic poverty.

Congestion charges in Stockholm: Did they work?

Proposals for city congestion charges continue to be put forward (even outside cities), both as a means to make the congestion disappear, reduce pollution, make city life more bearable and generate some revenue. The pioneer, London, has some mixed results according to a previous post, although I personally feel London is now much more bearable. In some cases, the benefits are much clearer, yet voters resist because of the unknown (other previous post).

Maria Börjesson, Jonas Eliasson, Muriel Hugosson and Karin Brundell-Freij update us on Stockholm, where people should be used to taxes and be easier to convince. Yet, it was not that easy to pass it by referendum, but the electorate warmed to the idea once it was in place. Also, it has reduced traffic and let to a significant (and visible, I must say) substitution to charge-exempt alternative-fuel vehicles. There seems to be a general agreement this is a success, and one needs to find a way to overcome initial resistance.

When is the US going to reach its fiscal limit?

Most western economies currently show large public deficits. Whether they are sustainable is subject to much debate, and if they are not there is also much debate when action should be taken, and how radical it should be. One important part of the debate is the measurement of public deficits and debt, which makes any discussion of possible scenarios difficult. And these scenarios have to make heroic assumptions about the future evolution of the economy, which may in fact be endogenous to policy. All this is very complicated, and pundits do not help at all in this.

Richard Evans, Laurence Kotlikoff and Kerk Phillips take a different approach. Take the current policies, assume they persist forever. Calculate the fiscal gap, that is, the tax rate required to balance the current debt plus the sum of discounted future non-interest liabilities less future taxes. Feed this into a DSGE model and see when it violates feasibility (when the current generation has incomes lower than the tax necessary to close the fiscal gap. In their simulations, it takes a century for the US economy to reach its fiscal limit, although there is a 35% chance this could happen within 30 years. This results fits well within Kotlikoff's decade-old message that every economy is on an unsustainable fiscal path, message he repeats on his platform as a candidate for the US presidency.

Getting back to the model at hand, I do not quite understand the result. To me, this implies that there is somewhere a dynamic inefficiency, or some transversality constraint is being violated. But I do not see where this would happen in the model economy. There is a lump sum transfer from the young to the old in each generation that corresponds to 32% of wage income. To it corresponds a promise for future transfers that may be more difficult to satisfy were the economy to be hit by adverse shocks. Thus, it seems difficulties arise accidentally when the economy is hit by a series of bad shocks and continues forging ahead without any adjustment. That seems unlikely to me.

Africa should finally industrialize

Africa is frustrating, as it seems to be regressing in many ways despite substantial development aid. Several have pointed out that the problem is with this aid, for example because it provides perverse incentives. But I think an important aspect is this obsession with improving agriculture on a continent where land is simply not good for agriculture. While the development stage in development in the rest of the world went first through a boost in agricultural productivity followed by industrialization, I see no reason why Africa cannot skip straight to industrialization. It has a lot of labor. There is the problem with poor transportation and low education, but they will improve if demand increases through industrialization, which little growth in agriculture cannot.

I am mentioning this after reading the report of John Page, who shows that, if anything, Africa is deindustrializing. While one can discuss whether the strategies he advocate can work, the fact is that the climate is not the best for investment into industry in almost all of Africa. Maybe charter cities could be the right trigger?

About taxing children for climate change

While some impact from global climate change can already be felt, it is believed the significant impact will be for future generations. As the current generation would only face a cost to alleviate what leads to this climate change, one can make the argument that the future generations should pay us. But they are not there yet to do so. However, their parents are and these care about their offspring. So parents should be taxed to take care of reducing pollution and redistributing funds to those hurt by reducing pollution from current levels. That is a rather twisted argument to argue for future generations to pay (homework: where is the error?).

A better argument can be made for parents to pay. It is by Henning Bohn and Charles Stuart, who observe that each additional person exerts a negative externality onto the others by generating more population, taking more spaces, etc. That externality is not internalized, thus it needs to be taxed. Thus, whatever the reasons are that we subsidize having children needs to be amended by this tax. And by the calculations of Bohn and Stuart, the child subsidy could very well turn into a child tax. Indeed, the child pollution tax is 21% of life-time parent income per child, which is needed to divide the population by four in the long-run. However, that tax can be reduced to 5% if there is a cap of pollution permits set at current levels.

Of course, one can have endless arguments about the calibration used in the study. In this particular case, it is assumed that it costs 3% of output to reduce pollution by 25%. Also important is the output and time cost of children, as well as preference parameters. You may think of other parametrizations, but it remains that the child pollution tax makes sense. Only its amount it up to debate.

How to design public block and matching grants

In most countries, there are three levels of government: national, regional and local. In Europe, there is even a fourth one, the European Union. In many instances, higher level authorities provide funds to lower levels, either through block grants (allocations for a general purpose) or matching grants (allocations that requires matching funds from the grantee). How this should occur is not well studied, especially when one considers that these funds can be used to build local public capital.

Heng-Fu Zou makes an attempt at this, with a cascading Stackelberg structure from national to regional and local governments. I do not want to mention the conclusions, though, because I think the paper is fundamentally flawed. The most interesting aspects of the problem are bypassed here: first, there is a strong redistributive aspect to block grants, hence taxation need to be part of the model, but it is only modeled as a fix lump sum payment here. Second, the very reason why there are block grant for specific purposes instead on general grants is that lower governments may be tempted to put it all in public consumption. That variable is absent from the model, everything flows into public capital.

Third, the utility function is assumed to be log-linear in all public capital and expenditures individually. This implies that all of them are essential (a government can for example not take over responsibilities from another) and in particular that private consumption or investment is completely useless. As a consequence, it is always good to increases taxes, no matter their current level. Other results also derive directly from this assumption about the utility function. Fourth, the matching grant is so poorly set up that it allows the author to claim in all seriousness that capital can go instantly to infinity if the higher authority matches at 100% the local investment. Fifth, capital does not depreciate, which matters immensely when you write about the long run. Etc.

Interesting question, horrible execution.

An economist's foray into econophysics

I have described here some of the outlandish forays of physicists into Economics, where they try to use concepts from their discipline with disastrous results (last post here). But economists themselves may borrow concepts from physics. One that stuck was sunspots, from some chance correlation between sunspot activity and stock market performance, and made popular by David Cass and Karl Shell. But there were very little physics in this.

Martin Evans ventures deeper, using the concept of dark matter to understand exchange rate movements. It is well known that it is very difficult to understand what moves exchange rates. Dark matter is something that we cannot observe, but we see its impact. In this case, Evans builds a model where dark matter has an impact on nominal exchange rates, and then on other variables. This is based on the empirical observation that something like dark matter has an impact on expectations on long-run exchange rates, but not on recent and future interest rate differentials. This is achieved in the model by introducing shocks to household risk aversion. Why? Well, it is dark matter (or animal spirits). But all that matters is that it explains a large share of exchange rate fluctuations, in a rather consistent way for the other variables. Physicists would be happy with that. Economists would want to understand why.