Forecasting the weather using the market

In public opinion, economic forecasting has as low regards as weather forecasting. To some extend this is coming from a firmly anchored stereotype, because forecasts for both are actually much better than a mean reverting random walk. And one should factor in that the weather or the economy are very complex animals with a lot of interacting forces (including silly politicians who take nonsensical decisions). But, in a horse race between meteorologists and economists, who would be better at forecasting?

Enter the economist, Matthias Ritter. He uses the price of weather derivatives traded at the Chicago Mercantile Exchange to determine what the market thinks is going to be the future temperature, more precisely the two-week ahead Heating Degree Days and Cooling Degree Days for 6 US cities. And the economic forecast is impressive, it manages to lower the meteorologists' root mean square error by about a quarter. And people say such speculative markets are useless.

Your turn, meteorologist.

Discounting for future generations: the consensus?

I have discussed a few times the difficulty of figuring out what the proper discount rate should be when evaluating the impact of environmental policy, and in particular how small changes in that rate can have a huge impact on outcomes. See posts I, II, III, IV. And if there is so much disagreement and this matters so much, why not convene all the arguers and get them to agree on a common document?

This is what the US Environmental Protection Agency did , and the resulting document is co-signed by Kenneth Arrow, Maureen Cropper, Christian Gollier, Ben Groom, Geoffrey Heal, Richard Newell, William Nordhaus, Robert Pindyck, William Pizer, Paul Portney, Thomas Sterner, Richard Tol and Martin Weitzman (no Nicholas Stern, I note). They agree that the proper tool to determine the discount rate is the Ramsey formula. No big surprise here. They agree that a crucial component of this formula is the expected future growth rate of the economy, and that this is very difficult to obtain. And this is as far as they got. No magic number, after all they are economists. I wonder whether biologists could now be convinced that we actually need a discount rate.

Time preference may vary across goods

When we model intertemporal choices, we usually go with a single consumption good, which means (up to some aggregation assumptions) that all goods have the same intertemporal elasticity of substitution and economic agents have the same risk aversion for each. Or that somehow any dispersion would not matter through aggregation. Is there any evidence of such dispersion?

According to Diego Ubfal, there is, and it is considerable. Using a quite large experimental survey of 2400 people in rural Uganda, he finds that the monthly discount rate goes from 110% (meat) to 66% (salt). And unlike this literature, this paper does not assume linear utility and goes through the trouble of estimating the curvature of the utility function as well (without reporting results, though). I wonder, however, how seasonality may play in this. For households that are that poor and who have to live from day to day, it is perfectly understandable that the rate may vary widely whether the good is in season or not, whether one is in a period of the year with relative slack on the budget or resource constraint, and add to this whether the size of the remuneration from the experiment may distort things. Still, this is an interesting and detailed study.

The slow recovery is even more man-made than the start of the recession

I have argued before that this past recession is to a large extend policy-maker made. While there did not seem to be any fundamental reason (in the real economy sense) for a contraction, the problems in the financial sector have been talked up and aggravated both in Washington (I, II) and Brussels/Frankfurt. And these self-fulfilling actions of the politicians have made things so bad that we may have ended up with large, permanent shock to the economy.

What does all imply for the ensuing recovery? For the US, Kathryn Dominguez and Matthew Shapiro use policy announcements and news reports to see how they have influenced forecasts of the inevitable recovery. And, surprise, it looks like all this politicking on both sides of the pond has slowed down the US recovery significantly in the US, and by extension in Europe as well I would say. In each of 2010, 2011, ans 2012, initial positive forecasts for the year had to be downgraded. That may be a bias towards optimism by the forecasters, as Reinhard and Rogoff have warned that the recovery will be slow. Or it is the politicians' fault. And we may have had a bad permanent shock.

The lack of sleep of American school children

Children need sufficient sleep to grow and learn well. But every parent knows how difficult it is to get the children to get that sleep, especially sending them to bed while mom and dad are still up. And once children are in their teens, this becomes even more difficult, even though they still need that sleep time. In the United States it is even worse, as school starts earlier for older children and they sometimes have long school bus trips before that. So it is not uncommon for children to wake up at 6. With 10 hours of required sleep, calculate when they should have gone to bed...

Jay Stewart uses the American Time Use Survey to determine the factors of sleep time for children. First, when school is in session, and when it is a school day, they go to bed 38 minutes later and wake up 72 minutes earlier. This lost half hour accumulates quickly through the week and leads to sleepy heads by Friday. Second, while child development often depends on the mother, in this case sleep patterns during school are not influenced by maternal labor supply.

Then, who is to blame? It is certainly not school homework, of which American school children get little. Is it TV? For sure, it is difficult to drag the children away from the monkey box when the parents are glued to it. Is it over-emphasis on school sports? For many children and parents, sports have priority over academics (even in college). Maybe cutting down on those many hours of daily football training would do the children some good (and besides, there are still more academic scholarships for college that sports ones).

On the causality between the labor income share and the size of governments

One puzzling feature of national account data in recent years has been a decline in the labor income share across most economies. This is not limited to the last recession but has been happening by and large since the 1970s. Why this is occurring is an important research question, and what the consequences are as well.

François Facchini, Mickael Melki and Andrew Pickering claim that this decrease has lead to a reduction in the size of the government. For this, they build a small two-sector model from which they obtain this positive relationship. Then they run some linear regressions to confirm this. But have they really? With the same model, I can obtain a reverse causation or even both variables being jointly function of others. It all depends on what I am assuming to be exogenous. Invert the regression equation, and you cannot reject the reverse causality either (I suppose, I have not done it). So all they have shown is that there is a correlation, nothing more. Claiming causation here is misleading. And if anything, I would have assumed that the causality runs from government size (which is set by political processes and policy) to the labor income share (which responds to market forces and policy).

Most US students do not care about the academic quality of their college

The attitude of students towards college choice is starkly contrasted across continents. While I certainly tend to over-generalize in the following lines, let me highlight a few differences. In Asia, students are very aware of the ranking of universities and strive hard to pass entrance exams to the highest ranked institutions. After that, students do not work much towards learning. All that matters is the signal that you got in. In Europe, students typically go to the local university and are left to fend for themselves. Attrition rates are high, the surviving students are quite good, and there is limited variance in student quality across institutions. In the United States, students are willing to travel far to study, and the selection of the institution depends on reputation, cost and amenities. Having a nice campus, quality dormitories, extra-curricular activities and especially college sports is deemed very important, aspects that do not matter at all in Asia and Europe. Why?

Brian Jacob, Brian McCall and Kevin M. Stange try to offer an hint of an answer by looking at the demand side for colleges. They use detailed data from high school classes in 1992 and 2004, match this with college characteristics and estimate a discrete choice model. The results are more damning than my ramblings above. Except for the top students, high school graduates do not care about academics at all. All they want is excellent "college consumption amenities." And this likely explains why they learn so little while in college. Their focus is on the university as a consumption good, not an investment good. And colleges have responded by devoting to amenities half the resources they devote to academics, producing a generation of well-entertained know-nothings.

Poverty exacerbates self-control issues

Conservative pundits tend to blame the poors' behavioral issues for their fate. Liberals tend to claim that the poor do not have a fighting chance to make it from the day they were born. And of course neither is completely right, the truth is somewhere in between. It is the economists' task to find where that is.

Douglas Bernheim, Debraj Ray and Sevin Yeltekin bring an interesting piece to this question by integrating self-control issues into a standard model of savings. They are careful to limit the time-inconsistency to eliminate extreme cases where someone would never save (which belong to state assistance anyway) or would never use assets. Then it turns out that self-control issues are amplified by initial poverty. The reason that this poverty trap emerges is that if you have few prospects of assets in the future, there is little to lose from deviating from optimal, time-consistent behavior. If you have more assets or you know you should have more in the future, there is a lot to lose from falling in the trap. This implies, as whenever there is a trap, that one can help these poor people by providing them with enough support to get above the threshold level, and then they can happily fend for themselves.

Banking for those unwilling to bank

While we worry about the unbanked population that faces significant costs for trivial transactions, there is also a not insignificant share of the population that is unwilling to have bank accounts for religious reasons. Islam and some strands of Christianity forbid the use of interest. Islamic banking has emerged in response and is offering deposit accounts that do not provide interest, but shares in the bank's profits. If this becomes more commonplace this could have important implications for how we think about banking, regulation and systemic risk in this sector.

Cagri Kumru and Saran Sarntisart show that if such a sizable population exists, then it is welfare improving to have an alternative banking system in place. It seems kind of obvious that it would be a loss to society not to capture these savings for growth-enhancing loans. The paper also shows that this alternative banking sector would emerge endogenously. The market forces are thus doing the right thing. What we need to be careful about is how to adjust the regulatory framework to not mess things up unnecessarily. And I see no reason why we should resist the emergence of such a banking sector.

And what if the Fed were to make a loss?

Whether you think the Fed's actions have been successful or not in pulling the US out of a deeper recession, you have to admit that the gigantic increase in its balance sheet has been hugely profitable. US$88,900,000,000.00 last year. US$79,300,000,000.00 the year before. Despite what conspiracy theorists want to believe, this money is not going into the pockets of private bankers, but to the US Treasury, which is coming to rely on it in these trying budgetary times.

But these profits are not going to last forever. When the economy is going to do better, interest rates will have to be brought to saner, normal levels. And this is going to happen by selling the assets the Fed has accumulated, and this is going to happen at a loss, a substantial loss. Who is going to pay for it. Indeed, the Fed is not provisioning for losses, first because it never made a loss, second possibly because the law may prevent it from doing so. So if it makes a loss, what is going to happen? I could just print money to cover it, but that would run counter the very policy it is trying to implement. Or the US Treasury could cover the losses. I am not quite sure that it stands ready to do so. And in such a circumstance, conspiracy theorists would have a field day.

I have not seen anybody mention anything about the exit strategy of the Fed. So this is all personal conjecture. Am I missing something? The only positive aspect I see in this is that this seems to be an interesting revenue smoothing mechanism for the government. Or, once more, the Fed doing fiscal policy instead on the government.

Value of gold: is this time really different?

Why is gold valued? is year in year out one of the most visited posts on this blog. For some reason that I still cannot fathom people care a lot about the value of gold. The fact that is does not have much fundamental value except for what people believe it is worth makes it almost as much a fiat currency as the money doom sayers want it to replace. Another repeated myth about gold is that its value is stable or can only go up, despite the fact that there have been some spectacular drops. Like now, where people claim that this time it is different, gold is the best refuge in the face of a major meltdown of various currencies. Or at least as a hedge against pending inflation.

Claude Erb and Campbell Harvey explore the role of gold as a hedge against inflation. It turns out gold is a very poor hedge, and if it were, it should be at half its current price. I guess this over-reaction can be attributed to herd-behavior, which nowhere as common as for gold. And with the real price of gold at twice the long term average, and the fact that mean reversion invariably kicks in, sooner or later the price is going to go significantly down. Always has, always will. This time is no different.

If gold has a useful property, it is a very good hedge against inflation in the very long run. We are talking centuries here. Erb and Harvey compare the pay of Roman and US soldiers in gold and find that they are remarkably similar. But this means also that gold does not have returns that are in any way comparable to equity. We are taking here about returns that are a small fraction of a percent. Hardly a good investment. Also, gold is no good currency hedge either, as its fluctuations are so big that they drown out the fluctuations in exchange rates. Etc. Erb and Harvey go through a series of other arguments why gold should be held, and none seems to hold water. But gold is shiny.

The minimum wage under deflation

Whether the minimum wage is a good tool for poverty alleviation remains controversial. Still, it has proven politically impossible to reduce the minimum wage, which means that the only way to reduce its bite is to wait for inflation to eat the real minimum wage away, if this is you want. A minimum wage that is deemed to be too high then gradually gets back to an appropriate level. Of course, this assumes that there is positive inflation. What if there is deflation?

Ryo Kambayashi, Daiji Kawaguchi, and Ken Yamada look at Japan that has been characterized by some prolonged deflationary episodes. They look at the period from 1994 to 2003, where the cumulative inflation reached a whooping -0.5% (CPI) or 3-5% (median wages), a bit unfortunate that the sample for which wage data was available just happens to have little deflation to show. But the nominal minimum wage, which is set regionally, looks from the graphs to increase by about 12%, thus there is still a change in relative wages, like what could be seen in some other countries. The authors then find that the lower tail of wages is compressed, especially for women where half of this effect is attributable to job loss. This is not inconsistent with other studies.

Small countries are more right wing

Over the past decade or so, there has been a trend for European countries to drift toward the right on the political spectrum. Even nominally leftist governments have positive views of lean governments and austerity talk. Why this? I doubt this is because suddenly the United States has become a shining example. There is something more fundamental at work.

Franto Ricka thinks it has all to do with increased tax competition. This became more prominent with the expansion from EU-15 to EU-25 around 2004, where a series of relatively small countries joined the union. Smaller countries have an interest of playing tough in tax competition, especially for capital tax rates, as they can increase revenue by lowering taxes. And this puts pressure on the larger ones. Thus, even though political preferences have not changed, political outcomes have become more right wing as Europe expanded, and voters elected as well more politicians from the right.

How econophysics describes the income distribution

It has been a while since I last discussed a paper from econophysics, where it appears there is a substantial literature trying to describe the distribution of income. It turns out to be quite difficult, because the goal is to do this with a single equation. What one would want to do with that equation is not clear to me, but anyway.

Maciej Jagielski and Ryszard Kutner claim success with this endeavor by essentially dividing up the distribution in three parts, fitting each to a different distribution function, and then rejoining them into a single equation. But what income are they taking about, you may ask? They look at European income in 2006 and 2008, and take the data from the SILC EU project. That still does not determine what income they are considering, as the dataset allows multiple different ways to define income. It is not even clear whether this is income before or after taxes and whether it includes capital gains.

One problem the authors realized is that they need oversampling for to incomes. To take care of this, they look at the European billionaires on the Forbes list of the richest people over several years, conclude that changes in wealth must be "income" and take that, dropping all negative incomes along the way. Then they notice a large discontinuity from merging the two dataset and decide to divide the top incomes by 100 to make the joint distribution continuous. Oh boy. And this is the dataset they used for their study, believe it or not.

When kids are impatient: subsidize their savings

I do not have scientific evidence for that, but my observation is that children are very impatient, and they become more patient with age. That is rather paradoxical, as children have all their life to do things, while older people have a shorter horizon. Maybe patience is acquired, and the environment you live in conditions you to learn about patience. Some may call this learning to control deep instincts.

Nicola Pavoni and Hakki Yazici assumes that people have self-control issues regarding impatience, and that these issues vanish with age. Then how can one get the efficient allocation of savings through the life cycle? It should be no surprise that this comes with subsidies for savings, and those decrease with age. I would add that if savings is learned from experience, then the subsidy would be even higher very early on. And this is already happening, with banks offering to children savings accounts with particularly high interest rates.

Gender discrimination on the labor market in China

China is a country of contradictions. While its communist ideals dictate that all people are equal, genders are quite obviously treated differently. The country's leadership is more male-based than most (23 of 25 in the politburo) and parents routinely practice gender selection for their children, which leads to the ticking bomb of a large male population surplus (more here). Is such discrimination also practiced on the labor market in China?

Xiangyi Zhou, Jie Zhang and Xuetao Song went through the trouble of sending about 20,000 fake employment applications on various major Internet bulletin boards and analyzed the responses they got. The results are damning. There is signification discrimination, but in surprising ways. State-owned enterprises tend to prefer males. Foreign and private firms go the other way and tend to prefer females. The public sector is rigid and follows rules, so it seems deeply ingrained to privilege men despite all the rhetoric. The private sector is more flexible and, I suppose, takes opportunities where they are, and hiring discriminated women seems to be the way to go. On more lesson on how free markets can be powerful adjusters.