Doing Calvo all wrong

On a number of instances, I have hyperventilated here about the misuse of the Calvo pricing hypothesis, which is an analytically convenient but empirically wrong hypothesis that a only fixed proportion of firms can change prices in any given period, and that price changes are not history or state dependent. There is a very limited set of circumstances where this is a reasonable assumption, and the following paper is by far not in that set.

Willem Van Zandweghe and Alexander Wolman study monetary policy in a Calvo world. The only thing that is endogenous is the money supply. This implies in particular that the share of firms adjusting prices is constant no matter what the money supply or its growth rate are. One would have thought that firms, when faced with a larger money growth rate and thus inflation, would increase the frequency at which they adapt prices. Also, money velocity is assumed to be constant, while we know very well that it is not.

The worse is that the paper is trying to determine what the optimal monetary policy is, and even worse, it is trying to give quantitative answers. There is no way any of the results can be credible.

Earth magnetism and the crisis

I sometimes come across papers, in general from India, that describe how the world could be saved by humanity becoming aware of some philosophical aspect of life, by printing money, or by having a new economic system. Rarely are the writers economists, and rarely do they have functional notions of Economics. But for once, I found a paper that is way off the broken path, yet written by economist and is based on actual science.

Ligia Melo makes the observation that economic outcomes are based on human behavior, and that the latter can be influence by external circumstances. Think about working in extreme climates, where priorities (consumption, comfort, saving) are different from temperate climates. Also, we start to learn from neuroscience, and in particular neuroeconomics, how decision are taken in the brain, and how they may be influenced by external factors.

Melo observes that the magnetic activity of the Earth has markedly decreased, by about 10% in close to two centuries, and the movement of the magnetic poles has increased, currently 41km a year. This is leading to speculations that the magnetic poles could reverse in the foreseeable future. Why would this matter for economic behavior? Magnetic activity has been linked to suicide, mental illness and depression rates. Also, studying human history, people have observed that there has become stronger awareness of individuals (vs. collectivity) in times of low magnetic activity.

Why could this be important? Because most of our decisions are based on expectations, and there is plenty of evidence of self-fulfilling expectations, that is, people for no particular reason expect something to happen, and then it happens. Bubbles, for example. Also, risk-taking behavior is influenced by health, in particular mental health. Melo shows that there is a positive relationship between a country' magnetic field intensity and its GDP. One would want to control with climate factors, but it is intriguing as distance from the equator has consistently been shown as an important factor in growth regressions, even including climate variables.

You are more trustworthy if you are drunk

One advice I give to job market candidates is to make sure they do not drink to much at dinner, or they may say stupid things. It turns out I may be wrong on that one.

Jan Heufer makes the point that being drunk or under the influence of a drug is a very good commitment device if you are trying to show truth telling. He finds that this is a possibly good argument for the legalization of some drug that is not addictive if consumed in moderate quantitites. There is a loss of efficiency because people are sometimes under the influence, but there is a gain because better contracts are written.

Olympic Games have no long-term impact on employment

Is it worth holding mega-event like Olympic Games? Repeatedly, they turn into a financial fiasco, yet new organizers keep believing they can pull it off. Usually, they manage to obtain some public guarantees or even financing on the grounds that such an event and the infrastructure will kick-start an economy and encourage tourism beyond the event.

Arne Feddersen and Wolfgang Maennig show that these beliefs are wrong, at least for the 1996 Olympic Games in Atlanta. They concentrate on the impact of these games on employment, and using monthly data they cannot find any impact in any sector, except for the sectors directly affected by the event, and only for the duration of the Games: retail trade, accommodation and food services, arts, entertainment, and recreation. How disappointing. I can only reiterate that such events should find a permanent home.

Physics envy?

As any academic economist who has done consulting fr government or the private sector can testify, it is very difficult to convey the uncertainty about your results and contract givers expect precise numbers with no standard errors. It is particularly ironic that the financial industry, which lives from uncertainty, cannot cope with advice that has qualifications and caveats.

This interpretations does not appear to be shared by Andrew Lo and Mark Mueller, who claim that economists suffer from Physics envy in the sense that they want precise results like in a Physics laboratory. They see part of the reason for the current crisis in the large reliance on quants in the finance industry, and that those quants have neglected that market participants do not behave like electrons, they have feelings and can be unpredictable.

I share with the authors the belief that this crisis is not a failure of Economics and economists, but rather that the expectations of the customers of those economists were way too high. And when those customers were disappointed, they blamed the profession. This rather long paper tries to educate those customers how it really works in Economics, and shows that even Physics is not immune from this unpredictability.

The point of not overdoing entrepreneurship favoritism

Often, economic policies are set to encourage entrepreneurship, with the idea that entrepreneurs are the ones that drive economic growth. But not everyone is a good entrepreneur, and encouraging this too much leads some people to become entrepreneurs while they would have been more productive as employees. In other words, there is an optimal number of entrepreneurs, and it is not 100%.

André van Stel and Mirjam van Praag are set out to find this optimal number using cross-national data. They see one of their contribution in adding a little bit of microeconomic reasoning in macroeconomics. I quote: "We think it is important, per sé [sic], to inspire a macroeconomic study on insights from microeconomics, thereby providing a link between macro and microeconomics that is often missing, but may provide valuable insights." Really? What has macroeconomics done for the last thirty years? Only run cross-country regressions?

Anyway, they estimate a Cobb-Douglas production function with the following factors: labor, physical capital, knowledge capital, and the number of business owners. That is not how I would have imagined a microfoundation. It would have included a model where entrepreneurs hire workers, something along the lines of what Vincenzo Quadrini has published. But no, van Stel and van Praag prefer the good old reduced form way. Maybe that will at least inform us about some features of the data. The problem is that they measure knowledge capital, a stock, with R&D expenditures, a flow. To obtain an optimal business ownership rate, a squared rate is added to the regression. Is there a microeconomic justification for this? Is there evidence that the elasticity of substitution between the business ownership rate and the other factors is different form one and variable? You cannot just throw something into a regression because it then yields a maximum.

Too bad this is so poorly implemented, it was an interesting question.

Forecasting with CGE models

Computable General Equilibrium (CGE) models are highly disaggregate models that encompass many goods, sectors and household types that are used to understand the consequences of various policies on the structure of an economy. Typical applications have been international trade reform and fiscal reform, with also recent applications to environmental issues. They are used extensively for "what if" scenarios, but how well they fare is little studied. The only retrospective I am aware of, on the predictions about the introduction of NAFTA by Timothy Kehoe has shown that CGE models did not predict at all what would happen.

Peter Dixon and Maureen Rimmer try to push the envelope even further with a CGE model and explore how good it is at plain forecasting. They take the USAGE model for the United States and claim that it removes about 40% of the forecasting error that plain extrapolations of trends from 1992 to 1998 into 1998 to 2005 would have given. That sounds great but it would still mean, for example, that a forecast 15.8% forecasted increase in consumption turned out to be 26%, no small difference. Or that exports would increase by 57%, while it was 24%. But the real comparison should be with other forecasting models, in particular dynamic ones.

Bounded rationality or limited information?

On multiple occasions on this blog, I have presented research that rationalizes some observation that at first sight appeared irrational, or at least bounded-rational. Maybe it is because of this obsession that economists have with rationality (and psychologists with irrationality).

Ran Spiegler claims these exercises can be very misleading. Such rationalization typically leans on three modifications of the standard model: some change in the information set, or in preferences, or there is a larger model where behavior is rational. Spiegler claims that this kind of rationalizing can be problematic. 1) It implies an actual change in the environment agents face. For some case studies at least, this is not appropriate. 2) It introduces new parameters, which need to be properly calibrated. 3) The rational equilibrium may have multiple equilibria. Which one should be selected? 4) The rationalized extension may not make sense. 5) Natural extensions may not make sense either. In other words, we should be really careful with rationalizations.

Why less educated mothers have children from different fathers

By casual empiricism, I noticed that uneducated mothers tend to have children from several fathers. I tended to blame this on their ignorance and shortsightedness, but apparently there is a very rational reason for this. Risk diversification.

Jinyoung Kim makes an evolutionary argument about mothers being ex-ante uncertain about the human capital of their children. In particular when the mother is less educated, she was to diversify the human capital risk of her children by having several fathers. In other words, monogamy is only a good idea if you are reasonably sure the children will all have good characteristics and are thus worth investing human capital into.This hypothesis is validated with data from the National Survey of Family Growth: a women with less education is more likely to have a different father for her next child. The same holds true for women with higher income, which is consistent with the theory because the cost of human capital investment is higher if the mother diversifies.

Consequently, if you do not like that some women have multiple fathers, which is completely rational behavior, one should provide them with the proper incentives to stick to one. This theory would tell us that this can be achieved by making sure that children get a proper education no matter what.

Optimizing patent law design is hard, why not drop it

Patents are supposed to rewards those successful at developing new technologies by granting them a temporary monopoly on their innovation. We know monopolies are bad for social welfare, in this case because it leads to underprovision of the innovation, and thus the length of the monopoly protection needs to be determined according to all sorts of factors. But patent law provides a uniform length for patents. Is this really bad?

From my reading of the latest paper by Angus Chu, yes. While it seems quite obvious that optimal patent length should depend on the level of competition in a sector, or that latter's market size, what really matters is how much patent length differ, and what a uniform patent length implies in terms of welfare losses. Chu performs in this regard an interesting numerical exercise. In a two-sector model, welfare costs of uniform patent length can reach 34% of consumption if the arrival rate of innovation is five times higher in one sector, and both sectors have the same market share. One could reasonably ask whether it is even worth have patent protection, considering all the other problems they generate (1, 2, 3).

What is legal tender

The term is "legal tender" is liberally used in monetary economics, so it is a good idea to read a legal scholar explain what legal tender really means using contract law. And legal tender does not means that you have to accept currency for payment, except in some totalitarian regimes.

Dror Goldberg brings us a nice note on the topic, complete with a "FAQ." For brevity, I quote here one of those frequently asked questions:

How can the legal status of money in the U.S. be summarized in one paragraph?
Taking into account other relevant laws, I suggest the following: First, all Federal Reserve notes and U.S. coins are legal tender for all dollar-denominated obligations. This means that contractual creditors who do not specify another medium of payment in their contracts, as well as all tax authorities and courts (federal, state and local), cannot reject a payment made using these objects. In addition, many banks (national banks and members of the Federal Reserve System) must accept Federal Reserve notes in all transactions. Anyone else can reject these notes and coins. Practically nothing else is legal tender, and thus anything else can be rejected by anyone in any transaction. These notes and coins are redeemable by their issuers only for other notes and coins, possibly of different denominations

Still, if the contract specifies payment in anything other than dollars, this other good becomes the legal medium of payment for this contract. For example, if there is a note next to a cash register that specifies payments are to be made in euros, then payment in dollars can be refused, even if this is happening in the US. This is because the note determines the contractual medium of payment. No business has the obligation to accept dollars by default, except federal authorities and banks.

This implies that claiming cash-in-advance is a representation of legal tender is wrong. In particular, one cannot force someone to use money, at least at the contract writing stage.

How could price risk hedging be bad for producers?

When one faces fluctuations in income, it seems quite natural to find some way to insure yourself. For farmers, price fluctuations can be a serious problem, especially with non-diversified crops. In developing economics, this insurance was provided by commodity marketing boards. But as their margins kept increasing, fueling incredible corruption, they have been abandoned virtually everywhere. Instead, the World Bank has been advocating commodity futures, where farmers can hedge their risk. In principle this looks like the perfect thing to do.

But there are some pitfalls, as Sasha C. Breger Bush argues. First, farmers may face margin calls, and given the wide fluctuations in the underlying prices, this can be devastating if you have little assets to meet those calls. The weakest thus go bankrupt, facing essentially something like a gambler's ruin. Second, hedging provides the wrong incentives if farmers do not understand that current low prices mean that their supply should be reduced and they should diversify. Clearly, it is not obvious to find a mechanism that allows farmers to whether price fluctuations while still letting the price influence demand and supply the way it should.

About the persistence of gender roles

We live in a society where traditionally the role of the wife was to take care of the house and the children. Now that we have schools, daycare and better domestic technologies, wifes do not need to spend that much time at home and can participate in the labor market. By the principle of substitutability, when women work more on the market, men should participate more in household work, especially if the woman is the bread winner.

Sayyid Salman Rizavi and Catherine Sofer look at time use data in France. And while male household work responds to the female labor supply, it is nearly not enough to overcome century old persistence in gender roles. And yet, I would have thought that France would be, with Scandinavia, the first place where this would happen. Indeed, female labor market participation is especially high, French women are notoriously independent and yet they still manage to have more children than other Europeans. Somehow, they are really efficient, yet they still get burdened with most of the household work. There is no hope if even French women cannot make it.

Why do daughters have a more positive impact on parents than sons?

Ads for educational institutions or for life insurance, if they feature a child, almost always show a girl. Is it that girls would lead you to take wiser decisions regarding the future? It turns out that having a daughter does indeed make you less risk taking, for example in terms of smoking, drinking, and drug-taking.

Nattavudh Powdthavee, Stephen Wu and Andrew Oswald use British and American data to come to this conclusion. It is well known that females are more risk averse, and risky behavior is at least partly inherited from the parents or taught by them. This study shows that it also goes the other way: the gender of the child influences risky behavior by the parents. Why would this happen? The authors conjecture that boys, especially at a very young age, are more stressful than girls. British data does indeed show that parents of boys are more stressed. Thus they resort to "self-medication" with alcohol, smoking and drugs.

The disadvantage of being incumbent

It is conventional wisdom that it is a large advantage to be an incumbent in an election. The evidence is certainly there, as incumbents are much more likely to be elected than challengers. Incumbents have the advantage of name recognition and easier access to resources to improve on this name recognition. This is particularly important when the electorate is rather ignorant about what its representatives actually do, say the United States. They also have access to pork barrel and redistricting. What about a country where people follow more closely their politicians and where they need to take clear positions like, say, Spain?

Enriqueta Aragonès and Santiago Sánchez-Pagés claim that incumbents may then have a disadvantage, as they have to take stands, while challengers have no need to compromise. If fact, the challenger has the further advantage to act after the incumbent voted. Using a three period model, Aragonès and Sánchez-Pagés show that despite this, the incumbent can always find an optimal strategy to get reelected, but it may not be his best choice. Indeed, he may prefer not to compromise, knowing a defeat is looming and reap whatever rewards may come thereafter.