A debt-free stimulus?

Economies may need to be stimulated sometimes, through tax reductions or public expenditures. The problem is that this costs. Opposition to such stimulus programs is typically grounded on the unavoidable debt run-up, which implies that at some point in the future taxes will need to be raised at a level that is higher than before the stimulus. Would there be a way to pacify this opposition?

According to Laurence Seidman there is. It involves the Federal Reserve, or the corresponding central bank, making a loan to the government treasury for the amount engaged in the stimulus, and then the Fed conveniently forgiving this debt. That is a different way of putting what Seidman proposes: the Fed makes simply a transfer to the Treasury that satisfies the dual mandate of the Fed, full employment and stable prices. Despite what Seidman claims, this is monetizing the debt. Even if no debt is explicitly created, the government is still financing its stimulus by (virtually) printing money, and with the same effect on inflation which guarantees that the dual mandate will not be satisfied for stable prices, and one can have doubts about full employment, too. Seidman argues that there would be no inflation if aggregate demand gets back to the "normal" level with the stimulus. But you still have increased the money supply for the same quantity of goods. The price level needs to increase accordingly. The only way to avoid the inflation is if the Treasury returns the transfer to the Fed. The transfer is thus again a debt.

I find it really strange that a chaired professor at the University of Delaware would write this. The only way I can rationalize his writing is that he confuses real and nominal quantities. He also seems to reason in partial equilibrium, not thinking that prices adjust to such large changes in macroeconomic aggregates, especially in the medium run. We are used to seeing this from crackpots with little economics education, but not with apparently well-educated economists.

Capitalism's rapture

Economics is based on a small set of very powerful axioms that a the foundation of utility theory, general equilibrium theory, and more. Experiments have contradicted every one of these axioms one way or the other. We still keep them because they seem to apply most of the time, and the occasional violation does not invalidate the general picture. But it is good to keep an eye on their validity and think about alternative scenarios, especially if they bring us better theories.

Egmont Kakarot-Handtke decides to start afresh with a completely new set of axioms. And instead of choosing some that have some subjectivity, he takes some that are as objective as any axiom could be: four accounting identities and definitions. Yes, you read that right. 1) definition of national product (income approach); 2) a linear production function in labor; 3) definition of nominal consumption as the product of real consumption times a price; and 4) the values of all economic variables this year are last year's variables times one plus their respective growth rate plus an independent and random component for each. Easy. From this Kakarot-Handtke builds an elaborate theory that demonstrates with a mathematical proof (it is in the title, so it must be true) that capitalism is on the verge of collapsing. To me it looks more like his readers could collapse from hyperventilating over this amazing pile of rubbish.

This bizarre scientist has trademarked his models. I am afraid I cannot go into more details about this work without violating some law (Trademark law? Law of sanity?). So I leave it at this.

The best justification for IS-LM?

IS-LM models have always left me puzzled. To me, they are the equivalent to a reduced-form regression with omitted variables and endogeneity issues. Through a lot of hand-waving, you can have any model fit the data. But what I find the most bizarre is this strange obsession with justifying the IS-LM models from micro-foundations. Somehow, IS-LM is taken as an ultimate truth, and one needs to reverse-engineer it to find what can explain it. The ultimate truth is the data, not the model.

Pascal Michaillat and Emmanuel Saez bring us yet another paper that tries to explain the IS-LM model from some set of micro-foundations. The main ones this time are money-in-the-utility-function and wealth-in-the-utility function (and matching frictions on the labor market, which are not objectionable). I find it very hard to believe that by now anybody would consider this a valid starting point. Rarely does anybody enjoy simply having money, the reason why people like having money is that they can buy things with it, things that are already in the utility function, or that money facilitates transactions, something that you can easily model. The same applies to wealth. True, some people may be obsessed with getting richer just for being rich, but for the remainder of the citizen, they like wealth for what it brings in future consumption for themselves and their heirs, and for the security it brings in the face of future shocks. All this easily modelled in standard models.

It seems to me this paper is a serious step back. Macroeconomists try to understand why there are frictions on markets, so that one better determine the impact of policy on such markets. Simply sweeping everything in the utility function, where in addition one has a lot of freedom in choosing its properties, does not help us in any way. And it is wrong, because it is again some sort of reduced form that is not immune to policy changes. Suppose the economic environment becomes more uncertain. Are we now supposed to say that suddenly households like wealth more? They could also like wealth more because of changes in estate taxation or because of longer lifetimes, and these imply very different policy responses in better flushed-out models.

I just do not get it. Maybe some IS-LM fanboys can enlighten me.

Ageing and deflation in Japan

Inflation rates across industrialized economies have been remarkably low in the past decades, and at the same time these economies have been subject to considerable demographic ageing. Nowhere has this been more true than in Japan. What are the government's or the central bank's incentives to set policy that triggers lower inflation if the population gets older? I do not see where monetary policy would matter, but the fiscal theory of inflation may tell us something.

Hideki Konishi and Kozo Ueda study the latter in an overlapping generation model where the fiscal authority has a shorter lifespan than residents, but takes into account the impact of its actions on future governments. The fiscal theory of the price level tells us that inflation goes up when more debt is accumulated, and that is certainly the case when the population gets older and requires more retirement benefits. But the authors point out that this does not necessarily hold once you take into account the endogenous responses of income tax rates and public expenses. Then, because of the policy response it matters why the ageing is happening: lower mortality or lower fertility. Deflation is more likely in the former case. Now we just need someone to bring this to the data...

Tax refunds and myopia

From anecdotal evidence, it appears that many Americans like to use the refund from their yearly tax filing for various home improvement projects. That seems like a strange habit, but could be explained by its timing (Spring season) and the unexpected nature of this windfall that is large enough to allow some major purchase that would not happen during the rest of the year. For perennially cash-constrained households, being forced to put a little aside for a one-time cash-out is the only way to do some capital purchase. Does this theory make any sense? It does in developing countries where ROSCAs are popular for this reason.

It looks like the same holds for US households. Brian Baugh, Itzhak Ben-David and Hoonsuk Park look at purchase patterns when the tax forms are filed and when the tax refund check arrives. The first finding is that consumption does not move at the filing, even though uncertainty about the refund resolves. In other words, a change in the permanent income here does not matter, presumably because there is some constraint. When the refund check is cashed, though, consumption jumps up and returns to the previous levels within weeks. It looks like households are cash-constrained. But the composition of the purchases indicates that there is a substantial amount of non-durables in the basket, showing also they are rather impatient. In fact very little remains for savings. I would have expected that at least credit card debt would be drawn down. One can thus conclude that their myopia dominates the cash constraint. Sad.

Exchange rate commitment always beats capital controls

The recent financial crisis has scared a lot of countries into adopting so called macro-prudential policies that introduce frictions into capital market that can be best summarized as capital controls. The idea is that you want to make sure that market participants are constrained in a way that makes them consider the consequences of their actions onto others. The IMF has encouraged a lot of countries to adopt such policies, in stark contrast to previous stances. And this is backed up by a recent literature that shows these policies are welfare-enhancing.

Gianluca Benigno, Huigang Cheng, Christopher Otrok, Alessandro Rebucci and Eric Young show this is right but suffers from the absence of other policy options. Specifically, once you add a policy to the mix that would be to stabilize the real exchange rate of the local currency in times of crisis, then macro-prudential policies are dominated. I suppose one could then even imagine better policies or policy combinations. But the point is that you need to expand the set of policy options. Why is this exchange rate commitment better? Capital controls act like Pigovian taxation that applies always and leads to a constraint-efficient outcome. A commitment to a real exchange rate applies only at particular times and leads to a conditionally-efficient outcome. That flexibility is key.

Why firms do not like cutting wages

Nominal wage downward rigidity is a feature of many macro-models that help justify positive optimal inflation rates. In fact, that is pretty much the only way to get a monetary monetary model not to conclude that the Friedman Rule and its deflation is optimal. This rigidity is always assumed on the presumption that somehow employers and employees do not like to reduce nominal wages. Are they subject to a nominal fata morgana or is there more to it? Instead of pontificating from theory and limited data, maybe asking market participants could help.

Philip Du Caju, Theodora Kosma, Martina Lawless, Julian Messina and Tairi Rõõm conducted a survey of firms across 14 European countries. They conclude that issues with unions contracts or collective bargaining were of secondary importance to worker morale and staff retention. This means that including renegotiation costs seems misguided. This does, however, not explain why this is so important to staff morale. After all, what really matters is the real wage. What is this psychological factor that makes us think foremost in nominal terms? Or is it that managers only have the impression that this matters? What we need here is some experimental data where some employees are hit with a nominal wage decrease and others not, and see whether it makes a difference. Good luck finding a manager willing to do that, though. And I wonder whether the surveys results would be different in economies where the social mission of employers is less developed.

Taxing banks does not tame them

During the last financial crisis, it was quite obvious that at least some banks were taking excessive risks. What do economists usually advocate when it comes to discouraging particular behaviors? Taxes. And that is popular as the foolishness of banks has imposed costs on the taxpayers. Thus, some countries such as Germany, the UK and the Netherlands have imposed taxes on banks. Did that work?

Not really, tell us Michael Devereux, Niels Johannesen and John Vella. They look back at the experience in various European countries and conclude that while this taxation on borrowed funds indeed reduced borrowed funds, and therefore loans, it turns out that it also increased the riskiness of the funding. These are two bads. First, loans actually encourage the economy. Second the risk has increased is of course counter-productive. Even worse, it is the safest banks that reduced most borrowing the the unsafest ones that took on additional risk. How could this happen? As there were fewer borrowed funds, and hence relatively more own assets, regulations allowed banks to modify their risk-weighted portfolio. In other words, regulation that was invariant to the introduction of the taxes made things worse.

Consumption taxation is not that regressive

It is a fact of life that governments need revenue. How to get this revenue without hurting the economy too much has been the topic of much research. Quite obviously, you first want to tax activities that are optimally discouraged, such as smoking and polluting. But that is not sufficient. You do not want to depress the labor supply and thus you want to avoid taking labor income. The alternative is taxing consumption, which you indeed want to discourage in favor of investment, but a consumption tax is deemed regressive and unfair: it hurts proportionally more the poor than the rich.

Nico Pestel and Eric Sommer claim that this perception may only hold in the short-term. Indeed, they find the standard result that a revenue-neutral switching from labor income tax to value-added tax is regressive in the short run. This seems to reverse itself in the longer run, though, thanks to a shift in the labor supply. Using a model estimated on German data, they highlight that the ones responding the most to the reduction in the wage taxation are indeed the poorest, and their response overcomes the progressivity of the income tax. The key here is also reducing payroll taxes which seem to be very discouraging for low income workers.

Uncertain times and price setting

Much has been written, including here, about how policy uncertainty is bad for business. Firms do not want to invest much when it is not clear what lies ahead in terms of fiscal policy, for example. This is particularly bad in countries where such uncertainty is chronic. If fiscal authorities or the government cannot get their act together, maybe the central bank can.

Isaac Baley and Julio Blanco show that if firms face uncertainty, monetary policy has less bite. The reason lies in the endogenous price formation (no Calvo fairy here). Specifically, firms are modeled to forecast their nominal costs, but the learning process is obviously imperfect. As the forecast variance increases, for example due to uncertainty about after tax returns, firms become more sensitive to new information and adjust prices more frequently, paying a menu cost. This effect is stronger than their urge to wait-and-see in the face of uncertainty. All this accelerates the transmission of information about the monetary policy, further dampening its impact. In other words, an ineffective government renders the central bank less effective as well.

Economic Logic, Too is posting

The companion blog, Economic Logic, Too that was created last December has started posting. This blog features similar posts to Economic Logic, but submitted by guest bloggers. Two posts are up, one is in the works, and I hope more will be coming. If you are reading this through an RSS feed, consider subscribing also to EL2 (RSS). And if you are interesting in posting, shoot me an email (submission rules).

Are NBA coaches behavioral or neoclassical?

Snnk cost do not matter once spent. Yet, we just cannot help thinking that if we already paid so much for something, we should rather use it, even if it is inferior to something less expensive. With this reasoning, we deviate from neoclassical theory into behaviorial theory. Such attitudes are not well documented, and it is not quite evident how one would put together a dataset to study attitudes towards sunk costs.

Daniel Leeds, Michael Leeds and Akira Motomura found a way, and it is in front of everyone. Professional sports teams sometimes invest or commit considerable resources to recruit players, and a substantial amount can be considered sunk, as it is in the form of a signing bonus, guaranteed pay, or by using an early draft pick for new players. A neoclassical theorist would say that this sunk cost only allows the coach to expand his decision set, but who actually plays on the team should only depend on the players' current performance. This study shows that at least NBA coaches do follow this neoclassical thinking and are not more likely to let under-performing young player stay on the team if they were drafted in the early rounds. Indeed, the data focuses on players in the first five NBA seasons when they all have a uniform contract, thus only draft order should matter. However, there could have been a perfectly neoclassical justification for a bias on the part of the coaches: some players were drafter early because they have potential, and that potential is going to develop with playing time. If there is a puzzle it is thus rather why early draftees get so little playing time.

No need to ban incandescent lightbulbs

It is sometimes difficult for a shopper to understand all the consequences of purchasing choices. Take lightbulbs, for example. The variety in price is large, and so is the variety in expected life or energy consumption. When more efficient lightbulbs came on the market, they were massively more expensive than existing bulbs, yet in the long run worth it thanks to much lower energy consumption. Consumers did not seem to understand that, along with what this entails for pollution, hence the old bulbs were banned. Was this really necessary?

Hunt Allcott and Dmitry Taubinsky exploit two randomized experiments to look into this. The first is computer based and gives participants a budget and different information about lightbulbs. The second is a field experiment at a home improvement retailer where shoppers where given different information and discount coupons. They find that people do not undervalue energy costs that much, meaning that only minor, if any, subsidies were necessary to win them for next-generation lightbulbs. Once more, it looks like a ban is outdone by the nudging that the price mechanism can do with appropriate subsidies or taxes. They also find that there is a large fraction of shoppers that wants to stick with incandescent lightbulbs, indicating a substantial welfare loss from a ban that is similar to standard rationing. One more piece of evidence that bans need to be banned.

All that financial innovation has not lead to more transparency

What is the purpose of financial innovation? I would say it is to find new ways to insure against risk, to finance projects and to allocate funds optimally. We are taught that generally the price mechanism is the best way to do the latter, as long as it is contains all the available information. Thus, a good way to measure whether financial innovation has improved things is to measure whether prices have become more transparent.

Jennie Bai, Thomas Philippon and Alexi Savov take the idea that stock and bond prices should contain information about future earnings. Thus if you regress future earnings on current valuation (and some controls), errors should become smaller over time, because information costs have decreased and we have become more efficient at allocating financial resources. But over the last 50 years, no progress is to report. No matter how you decompose the errors, there is nothing to write home about. That is quite disappointing after all the increased financial sophistication of the financial industry. Or did this sophistication lead to more obfuscation?

Did home ownership made things worse in the Great Recession?

I have complained several times already that house ownership should not be encouraged by public authorities, mainly because it prevents diversification of risk by households and because there is slim evidence at best that home owners are happier and better contributors to society. It also quite obvious that high ownership rates have contributed to make the last recession worse in the United States. A recent trio of papers studies this last point.

Silvio Rendon and Núria Quella show that higher homeownership rates fed by easy financing lead to higher unemployment rates. This is because homeowners have higher reservation wages through a wealth effect. They find that in the US this has increased the unemployment rate by an incredible 6 percentage points. You may also want to add to this that homeowners are less willing to move for a new job, further increasing the unemployment rate, something the model does not capture.

Ahmet Ali Taṣkin and Firat Yaman look at unemployment duration in the US and find that renter stay unemployed the shortest and homeowners the longest, especially those who do not carry mortgages. Following this result, facilitating home financing would lengthen a little unemployment spells and increase the unemployment rate, under the hypothesis that job losing rates are unaffected.

Stijn Baert, Freddy Heylen and Daan Isebaert show that the unemployment spell length depends on the housing tenure situation in Belgium. The homeowners with mortgages exit the fastest, those without mortgages the slowest and renters lie in between. Easier home financing would thus reduce the unemployment rate here, again assuming it does not affect the rate at which people lose jobs. Keep in mind that Belgium is unique in that unemployment insurance benefits can last forever.

Do MRSPs (manufacturer suggested retail prices) have an impact on prices?

In some countries, manufacturers are allowed to suggest to retailers how to price their goods. What does this do to prices? It may increase them if it reduces competition and the MRSP is set high. It could also increase competition if set low, as retailers may find it difficult to sell at a higher price than printed on the packaging.

Babur de los Santos, In Kyung Kim and Dmitry Lubensky report on a natural experiment in South Korea where MRSPs were banned and then allowed within a one-year span. The ban increased prices on average by 2.3%, the reintroduction reduced them by 2.6%, from which you can conclude that MRSPs increase competition. Prices were significantly below MRSPs, so it is not likely MRSPs acted as price ceilings. Rather, the authors conjecture that MRSPs help consumers in forming expectations of prices at other retailers once they see the mark-down at the current retailer. Absent the MRSP, the consumer faces higher search costs, and the retailers takes advantage by increasing the price. To be convinced of this argument, I would have liked to see some estimates by product category. Different mark-downs must have had different implications for price changes, and those should help us distinguish theories better than aggregate results.

Early marijuana use and educational outcomes

Marijuana use is getting more and more accepted by the public and lawmakers. Indeed, many studies have shown that its effects are no worse that allowed addictive goods such as tobacco and alcohol, that it may in some cases even have a positive impact (foremost example: tolerating consequences of various deceases), and it is not even clear that it is addictive. However, there has been little study about the consequences of using marijuana early, that is, by children or teenagers who are still growing up. It is known for a variety of goods that consuming too early can have sometimes dramatic results.

Deborah Cobb-Clark, Sonja Kassenboehmer, Trinh Le, Duncan McVicar and Rong Zhang look at early adopters of marijuana and their educational outcomes. Studying this is not straightforward, as those who smoke early are clearly not a random draw from the population. They likely share characteristics that have an impact of educational outcomes. The study focuses on those 14 years or younger in Australia and how they complete high school and obtain university entrance scores. Marijuana use is obtained by survey, which may introduce additional difficulties, and is linked to an administrative data set on welfare use by their parents. The authors find strong penalties in high school completion from early marijuana uses, and stronger ones for intensive use and for those coming from a disadvantaged background. The impact on university entrance scores is milder, and this applies of course only to those who managed to complete high school. The penalty for welfare-recipient families is, however, dramatically higher in that case. In other words, even if marijuana gets legalized, it needs to be treated like alcohol and tobacco and early use needs to be strongly discouraged with campaigns that can be efficiently targeted toward welfare-recipients.

Update: An email correspondent tells me I am over-eager to reach policy conclusions given the large endogeneity issue which the authors also acknowledge. I think I was indeed too eager. But I would still pursue this policy. The potential risk appears too large for me.

When countries manipulate economic data

Conspiracy theorists have a field day whenever official statistics look conveniently better just before elections. Whether statistics are really manipulated for political gain is hopefully less frequent than what they assume. We know it is currently done in Argentina, was done by the Soviets and their allies, and used to be done by some countries to qualify as poor in the United Nations' eyes. Those cases were rather obvious, but how could you recognize the more subtle ones?

Tomasz Michalski and Gilles Stoltz use Benford's Law, the distribution of first digits in economic figures, to determine the likelihood of manipulation across a large set of countries. While this does not catch a country red-handed, it gives probabilities, and one can analyze this against a set of indicators to determine what would drive them to cheat. Michalski and Stoltz find that higher likelihood of cheating is associated with fixed exchange rates, high negative assets, negative current accounts or subject to capital flow reversals. So it seems that this kind of cheating is not for internal consumption, but rather to deceive international financial markets. The authors did the analysis on balance of payments data, though, so the picture may be quite different when looking at unemployment, GDP or inflation data.

Reported returns on investment for artwork are too high

Art is something one may like to have for the enjoyment of it, but it is also often touted as an investment vehicle. Quite obviously, you would need to diversify heavily. "Experts" claim that art gets a good return on average and that it is viable investment option.

Arthur Korteweg, Roman Kräussl and Patrick Verwijmeren say it is not. The issue is that all the indexes out there are based on transactions, and art items that have higher returns tend to have a higher turnover. The resulting selection bias is not negligible: 7% instead of 11%. Given that high amount of risk, it thus does not look like art is a good investment, unless you enjoy it, of course.

Prospects of tariff increases and manufacturing employment

US manufacturing is on the decline, and the obvious reason is pressure from globalization. This is not necessarily bad as it means a better use of resources, except for some potentially large transition costs. Globalization has been encouraged by decreases in tariffs, thus one should find a strong correlation between tariff reductions and declines in US manufacturing. That does not seem to be the case, though, and a sharper decline in manufacturing since 2001 cannot be traced to any major change in tariffs.

Justin Pierce and Peter Schott find that it is not the actual tariffs that matter, but the potential for tariff increases. Indeed, there was a change in 2001 that removed potential increases especially for sectors in competition with China, and once these sectors lost this potential tool for protection, they withered. There was no such change in Europe, where no sharper decline in manufacturing occurred.

Political polarization and the business cycle

It is difficult for politicians to have much of an impact on economic outcomes when policy is set by consensus. Any fluctuation in power changes a policy a little, and the economy is in a rather flat portion around the optimum. In a polarized government where any power shift implies dramatic policy changes, not only are they never close to the optimum policy, they yank the economy around significantly. There are two losses here: first the average is substantially lower in the second case due to the concavity of outcomes, second there are significant fluctuations for the same reason.

This is essentially the explanation of Marina Azzimonti and Matthew Talbert why emergent economies have such wild business cycles, and I suspect this is even more so for developing economies. All they need to do to obtain such results is to take an off-the-shelf real-business-cycle model and add uncertainty to the returns of private investments. Let this be a lesson for more developed economies that are showing tendencies for political polarization.