Saturday, July 31, 2010

A Sin and a Shame

New York Times editorial "A Sin and a Shame" (July 30th, 2010) offers another installation of Bob Herbert painfully writing about concepts he does not understand, and quoting figures that do not support his point.
The recession officially started in December 2007. From the fourth quarter of 2007 to the fourth quarter of 2009, real aggregate output in the U.S., as measured by the gross domestic product, fell by about 2.5 percent. But employers cut their payrolls by 6 percent.
Herbert then suggests that these figures mean that "cruel, irresponsible, shortsighted policy" has taken hold in American corporations. However, using a simple bread-and-butter real business cycle model involving investment-specific technological change, solved with Matlab program Dynare (this is a DSGE model, or Dynamic Stochastic General Equilibrium Model), we can show the relative movements can the result of far-sighted optimizing behavior, rather than the result of capital in the hands of individuals destined for the Fourth Circle of Dante's Inferno for their avarice, as Herbert perpetually suggests in various columns.

Below, we plot the impulse-response functions of one such model, in which firms maximize profits from a Cobb-Douglas production function, households have log-preferences, capital depreciates, produced goods are either invested or consumed, and both technology and quality of investment good are independent stochastic first-order autoregressive processes. (For the interested, this flavor of model is prototypically described in "The Role of Investment-Specific Technological Change in the Business Cycle", published in the European Economic Review (2001) by Greenwood, Hercowitz and Krusell). We examine what happens when we have a negative investment quality shock. The impulse-response functions to a are plotted below (click to enlarge):
How should we interpret these figures? First, for those unfamiliar, impulse-response functions plot the response of all other related variables to an exogenous shock over time. Here, we plot the reactions of all other variables in percentage points of their own standard deviations to a one-standard deviation negative shock to investment good quality. The "direction" of reaction can be seen by comparing the black line, which is the reaction of a variable to our shock, to the red line, which is a "baseline." We forgo concern about the size of the shocks and focus on the qualitative reactions of each variable.

Specifically, we see that when investment in durable goods this period gives less (lower quality investment goods), we see a decline in both production and labor (increasing back to steady state (or stable growth path) over time), while seeing an increase in productivity, precisely the sort of reaction Herbert pretends is irrational. This is a product not of shortsighted policy, but of perfect foresight (though not perfect information).

Indeed, one doesn't need to examine even simple real business cycle models to explain why we should see productivity rise, labor fall, and production fall by less than labor in the short run. In the United States, labor can be treated as a consumable good. Labor is more flexible than durable goods. In a simple analysis, we can hold capital as fixed and labor is flexible in the short run, while in the long run, both are flexible.

We might imagine our aggregate production function is Cobb-Douglas, using labor and capital, depicted graphically below (click to enlarge). We also denote a dark black line, indicating a schedule for production given fixed capital. Therefore, we might consider any point on this graph viable combinations for inputs and corresponding output in the long run, while considering only the dark black line viable in the short run (were we to have that specific level of capital, .5 in this case).
We could simply graph the dark black line in two dimensions (click to enlarge). This represents production along a fixed capital stock, as we would see in the short run:

On this graph, we can see our whole story: output, labor supply, and productivity. Marginal labor productivity, which may be defined as $$\Delta$$output/$$\Delta$$labor, is the slope of any point on this line. Average productivity is simply the ratio of output to labor. We can see that any time we shift downward along the supply schedule, labor will, on average, be more productive. Note that this is not true in the long run, because capital will shift as well (this Cobb-Douglas is constant returns to scale in the long run, decreasing returns to scale in the short run). We can display this on the same graph, also writing out productivity below two sample points (click to enlarge):

All this is to say that if we make less, our average productivity increases when we are in a regime with decreasing marginal returns to scale. It appears Bob Herbert's real complaint is about decreasing marginal returns, or his ignorance of economics, rather than "corporate greed" or "shortsightedness."

As a last point, Crypto-Marxists like Herbert appear to adopt the poor understanding of capital and labor that Marx shared with Malthus. The belief that capital (land, in Malthus's case) is fixed, and labor is elastic (people have more children and "soak up" any wage higher than subsistence living).
Productivity tells the story. Increases in the productivity of American workers are supposed to go hand in hand with improvements in their standard of living. That’s how capitalism is supposed to work. That’s how the economic pie expands, and we’re all supposed to have a fair share of that expansion.

Corporations have now said the hell with that.
This is incorrect. If corporations could always just say "to hell with that" and not pay workers as much, they would have done so at some point in the past 150 years. Over the last 150 years, the return on invested capital has remained unchanged, while real wages have continued to rise. The mistake that Marx, Malthus and Herbert make is to believe that capital is fixed (inelastically supplied) while labor is flexible (elastic), and so capital gains all benefits from a shift in productivity.

To be clear, the mistaken idea is as follows. Society has a productivity gain. There is a large excess pool of labor that will compete away any higher wages, while capital remains fixed. Therefore, because labor competes all gains away, capital gets all the benefits of a productivity gain.

The reason this idea is mistaken is that there is a large excess pool of possible capital--its primary "input" is simply foregone consumption, and that can be supplied rather easily, if the real interest rate is high enough. Real wages have gone up over time, while real return on capital has not.

The opposite is true--capital is elastic, while labor is relatively inelastic, explaining why real wages have been the claimant on all increases in productivity over the last 150 years.

Friday, July 30, 2010

Don't scorn Germany and Japan; learn from them

Los Angeles Times article "Don't scorn Germany and Japan; learn from them" (July 29th, 2010) offers a truly unbelievable statement.

Japan's economy has been and remains successful. So is Germany's. They have reached an economic steady state in which they don't need roaring growth rates to provide for their people.

This is, perhaps, the most dense quote that Corrections has yet reiterated. Not only is it not true, but it throws to the wind the most important idea that economics has to teach us in the macroeconomic realm: only growth matters. Indeed, as Robert Lucas put it well:

Is there some action a government of India could take that would lead the Indian economy to grow like Indonesia’s or Egypt’s? If so, what, exactly? If not, what is it about the “nature of India” that makes it so? The consequences for human welfare involved in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else.

Why is economic growth so important? Yearly GDP growth rates seem to range, generally speaking, between 2% and 6%. Is there any real significance between one and the other? The answer is best introduced with a bar graph of compounded (not simple average, but compound-average) growth rates from a few selected countries from 1988-2008 (click to enlarge):

To understand why these differences are large, take Afghanistan in 1960. It had a GDP/capita that was 4.73% that of the United States's GDP/capita. How many years would it take Afghanistan then to catch up with the United States in 1960 using different growth rates? (To account for population growth, population growth would need to be subtracted from GDP growth, unnecessary to the point here). The number of years required using each country's growth rate is graphed below (click to enlarge).

Similarly, if we wanted to see how many years it would take for Afghanistan in 1960 to catch up to the United States GDP/capita in 2008, we can plot the same graph:

The difference between the author's lauded Japanese growth and a high-growth country like China, Ireland, or South Korea is the difference between Afghanisan transversing from what it was in 1960 to what the United States is today, in a generation, rather than as a long-term joke. The above figures make it obvious how important economic growth is, due to its exponential nature.

As an aside, the notion of Germany and Japan being at a "steady states" is simply first-tier ignorance, an article more worthy of Pravda in the 1960's than the Los Angeles Times today.

Thursday, July 29, 2010

In American politics, stupidity is the name of the game

Washington Post editorial "In American politics, stupidity is the name of the game" (July 29th, 2010) offers shrill ignorance when making a backhanded comment concerning economics.

That could never happen here because the fairy tale of supply-side economics insists that taxes are always too high, especially on the rich.

The author was referring to various tax solutions to the deficit, though the topic is not what concerns Corrections here. What we wish to deal with is the snide sciolism that E.J. Dionne Jr. displays in his dismissal of "supply-side" economics. Corrections offers just such a "fairy-tale" story here, reiterating Harald Uhlig's recent American Economic Review article "Some Fiscal Calculus" (May 2010) (Corrections previously spoke about a working paper version here).

In his concise paper, Uhlig undertakes to understand the "multipliers" of tax cuts and government spending. He does so in a typical, non-Keynesian model, though his result is stronger in a Keynsian model. We replicate his figures using his code. In our case, the most important portion of his paper is displaying the benefits of a tax cut and government spending (both are advocated as stimulus measures, the former Mr. Dionne is criticizing).

The first figure we display, Figure 2 in Uhlig's paper, is of the multipliers calculated for either government spending and a tax cut (click to enlarge). As we see, initially government spending has a high multiplier, while a tax cut has a low. However, because the spending must be paid for with higher taxes in the future, government spending's multiplier drops over time. Tax cuts, because they encourage growth and reduce distortionary taxes, have a positive multiplier.

Figure 4 of Uhlig's paper offers the dynamics of debt and the tax rate's increase for a government spending stimulus, displaying the reason why stimulus is worse in the long run (increased taxes) (click to enlarge).

Figure 5 displays the dynamics of government spending and output in the very long run, indicating the massive long-run tradeoff to output for a short-run boost to today (click to enlarge).

Uhlig concludes with the finding that with government spending stimulus, $3.40 of output is lost eventually when we discount it back to the present day, while cutting taxes generates $1.70 in extra output, discounted back to today.

The Washington Post, as is its wont, is in need of a permanent Correction to its deep-seated love of taxation.

Tuesday, July 27, 2010

Student1776 on "No Closing Time for Income Taxes" and Response

Corrections deeply appreciates the opportunity to engage in subjects on a more substantial level than newspapers often warrant. To this end, we enjoy commentary. In this case, a comment from Student1776 on "No Closing Time for Income Taxes" (June 15th, 2010) offers just such an opportunity.
Government, particularly for the Democrats, is all about expropriating wealth created by some in order to give it to their own constituents using whatever rationale they can fashion for the purpose. Like the continuation of bridge and causeway tolls long after the bridge or causeway is long since paid off and monies for its maintenance in perpetuity are put away the toll continues. Any route for the draining of economic blood from any population susceptible to the draining is kept open. Plan on it. Some things never change. Parasitism is one of them.

Corrections largely agrees. It was perhaps Rothbard who said it best. Paralleling Plato's note that a city was man writ large, Rothbard stated: "Government is a band of thieves writ large." However, while we agree that parasitism will always be present and proportional to government size, it does shift in degrees, and may have multiple equilibria.

Let us imagine, in the vein of Murphy, Schleifer, and Vishy's 1993 paper "Why is Rent-Seeking So Costly to Growth?" (that there are two types of individuals: predators, and producers. Predators might represent all individuals who are net recipients of government benefits beyond their marginal product. Producers are the opposite--individuals who are producing more than they consume. Further, for the sake of simplicity, let us imagine all individuals are equal (our results hold without this). They will become either Predators or Producers depending on which pays better (therefore, unless everyone is a Predator or Producer, both roles must pay the same amount). Then we might draw the following diagram, also found in David Romer's Advanced Macroeconomics textbook (click to enlarge):

However, and our main point in this article, is that there may be multiple equilbria.  While obviously Predator income must be zero when 100% of a society is Predators, and that both slopes must be negative, the functional form on both functions is unknown.  Below, we display a curve with two stable equilbria (denoted by circles with green centers) as well as an unstable equilibria (denoted by a circle with a red center) (click to enlarge).

With this sort of analysis in mind, we might note that Student1776 is correct: predation, most significantly in the form of government, is not a stable equilibrium.  However, we should further note that there are multiple stable equilbria--one with low predation and one with high.  Absent the destruction of Predators and predation, a society should strive to move to the most efficient equilibrium (low predation).   

Corrections might tangentially mention that it is with the idea of multiple equilibria in mind that we should think of economists like Paul Romer and his push for Charter Cities.  The idea is that self-selecting experimentation on a large scale may help societies change the rules under which individuals interact, just as charter schools allow us to discover best practices in education.  For example, Shenzen's special economic area helped provide the evidence to begin to economically liberate China--it is yet to be seen whether or not men like Milton Friedman or Francis Fukuyama are correct in their suggestions that liberty follows prosperity.   Charter Cities are one means to an end of moving from the high-predation, low-efficiency rules third world countries have now, to low-predation, efficient rules.  

Monday, July 26, 2010

wheninrome15 on "Can a Soda Tax Save Us From Ourselves?"

Corrections appreciates commentary. A comment by “wheninrome15” was left in response to our post “Can a Soda Tax Save Us From Ourselves?” (June 4th, 2010).   It was thoughtful enough to warrant its own post in response.

The post by wheninrome15 follows:
I'm going to have to side with Mankiw on this one, but his argument is not completely clear, so I can see why you would go in this direction with it. Maybe he is just aiming at a more general audience, but if we're going to do the real deal, we have to address the elephant in the room, namely dynamic inconsistency. Below are my notes from thinking the matter through, hope they will benefit you as well.
To frame this issue, let's first consider a 2-period model with discounting (with 2 periods it doesn't matter what sort of discounting is going on, geometric, hyperbolic or otherwise). The agent maximizes $$u_1(x_1)+du_2(x_2)$$ subject to some budget constraint (say, $$x1+x2=M$$) where d is the discount factor.
In solving this problem, we know that, starting from an allocation of $$u_1(x_1), du_2(x_2)$$, the agent moves an extra dollar to the second period precisely when the transfer causes $$du_2$$ to go up by more than $$u_1$$ goes down. If we are instead thinking of a “multiple agents” framework, then it must be that such bargaining occurs precisely when agent 2, with utility function $$du_2$$, gains more from an extra dollar than agent 1, with utility function u1, loses. So you could think of this as Coasian bargaining, but the 2nd period agent is _not_ someone with utility function $$u_2$$; rather, he has utility function $$du_2$$.
[Sidenote: By the way, in one sense it is an illusion that Coasian bargaining is occurring here. Why are the agents trading with utility functions $$u_1$$ and $$du_2$$ rather than $$u_1$$ and $$u_2$$? The problem is a total unilateral lack of property rights. Agent 1 can steal whatever he wants from agent 2 (provided he has free access to credit, he can even go into debt, which agent 2 will be forced to repay). Agent 2's share is completely determined by agent 1's altruism. If $$d=0$$, for example, then agent 2 is simply screwed, unless we really are thinking of him as an agent with utility function $$du_2=0$$. Another clue is that the outcome is completely independent of the initial assignment of property rights (i.e. period 1 and 2 endowments). But for the present purposes it is actually somewhat useful to continue to suppose Coasian bargaining is occurring, so let's keep it.]
So, when you say that Coasian bargaining will occur, let us be clear that you mean between agents with utility functions $$u_1$$ and $$du_2$$, not $$u_1$$ and $$u_2$$. When Mankiw uses the word “externality,” he does not mean that perfect bargaining isn't taking place, but rather that it is taking place at the exchange rate of 1 to d rather than 1 to 1. Coase does not say what the exchange rate should be, it simply says that, given the exchange rate, trade will occur.
To say that agent 1 imposes an externality on agent 2 is to say that agent 1 is not fully weighing the effect of his actions on agent 2's how much should he be weighing it? How much, really, should we care about agent 2? Here we are discounting his native utility function $$u_2$$ by a factor of d, but maybe that's just reality we might think discounting should be going on. Perhaps people are fine with the fact that they don't care about tomorrow as much as they care about today. It would be a poor social planner who made it his goal to eliminate discounting that people really wanted around. It's hard to construct a defensible argument that people shouldn't be geometrically discounting. In a multiperiod model, with discounting $$(1, d, d^2, d^3,...)$$, there is no job for a social planner. But on the other hand it's pretty easy to take issue with hyperbolic discounting and the like. Dynamic inconsistency is rotten, and there is value in helping people to eliminate it [see endnote, but don't read it till you finish this paragraph]. Once you have dynamic inconsistency, everything you're saying simply flies out the window. Coase does not answer the question of what the relative price should be; you have to decide that for yourself, you have to take a stand. In the world of dynamic inconsistency, “the” utility function is no longer well-defined, because it depends on the perspective in time that you choose! You may want a “t=minus infinity” perspective or a “t=10 periods ago” perspective or a “t=now” perspective...but once you pick it you're stuck, you have to evaluate everything from that perspective. It is no longer simply maxing utility, but rather maxing utility w.r.t. time t. Go ahead and treat the agent's weights of ($$1, bd, bd^2, bd^3$$,...) as gospel if you like (that's quasihyperbolic discounting from t=now. The b captures the notion that the agent discounts in the usual geometric way except that he discounts all future periods by an additional factor of $$b<1$$, i.e. he really cares about now), have that be your criterion for how resources ought to be allocated if you like...but all the agent's plans will just fly out the window next period, won't they? If agent 1 wants to stop agent 2 from gorging at agent 3's expense, Coase will not save him! Agent 1 wants the terms of trade to be $$bd$$ to $$bd^2$$ (i.e. 1 to d), but next period they will simply be 1 to $$bd$$. One solution is for agent 1 to precommit, and indeed in a world with perfect information and frictionless and complete commitment, there is no dynamic inconsistency problem. But in reality people are often naive or inert. Thus, the reasoning goes, people can potentially be helped by a soda tax that helps them to resist soda that isn't really maximizing their utility (w.r.t. the point in time that you have decided they really care about). In matters such as these, protecting people from themselves is always always always about dynamic inconsistency. So if your argument does not go there, then you can be sure that it's not getting to the heart of the matter. The point of this is not at all to convince you that soda taxes are a good thing on net; that will come down to Mankiw's last sentence. But that is Mankiw's point too, that it comes down to his last sentence. I do not think his argument stops short of that.
[Endnote: I said that with dynamically consistent discounting, it's hard to argue that a person should do something else. The reason is that, for any proposed alternative, you would be telling them to do something they'd never want to do, no matter what perspective in time they were looking at it from. But with dynamic inconsistency, their decision about what's best depends on their perspective in time, and so in fact you have to make a judgment call about what perspective to call best. And once you pick the perspective, you are forced to concede that the agent -- who does not stick with the perspective you picked (or any perspective, for that matter) -- is doing things that do not maximize his utility.]

In broad strokes, your argument as Corrections understands it can be summarized by the following points (in order of their argumentation):

  1. Mankiw did not address dynamic inconsistency but it is relevant.
  2. We can summarize the intertemporal problem as a problem of negotiation between two agents.
  3. That point (2) is an illusion because the first individual has full property rights.
  4. Mankiw's point suggests that perfect trade may be taking place, but at the wrong "exchange" rate.
  5. We can't make an argument against geometric discounting very well, but we can against hyperbolic discounting.
  6. Hyperbolic discounting leads to an "unnecessary" loss in utility.
  7. When evaluating utility loss, one must pick a period and discuss utility from that discounted period only.
  8. People are naive or intert, and because of this, they may be helped by a soda tax.

Our responses are organized as follows:

  • We agree that dynamic inconsistency is an elephant in the room, but not that it is important.
  • We argue that the primary vehicle for dynamic inconsistency, hyperbolic discounting, is not suitable because it cannot generate a significant loss in utility for individuals (which is why it is so often used in public policy analysis).
  • We argue that dynamic inconsistency generally, and hyperbolic discounting in particular is either 1) secretly hidden among individuals 2) have some semi-hyperbolic discounting along some of their income but not all 3) are constantly starving to death in secret.
  • We argue that most empirical time preference literature is not necessarily a product of inconsistency, following a line of argument established by Gary Becker and Casey Mulligan.
  • We note that irrationality itself is endogenous, using a paper by Gary Becker and Yona Rubinstein on terrorism and fear to make our main point.
  • We disagree that one cannot argue for hyperbolic-style discounting--we believe it makes a great deal of sense when we deal with the idea of tradeoffs-with-certainty and tradeoffs-without-uncertainty.
  • Finally we note that hyperbolic discounting may largely be an artifact of the laboratory.
  • We conclude with a rule of thumb.

First, we agree that Mankiw did not address dynamic inconsistency, so we did not speak to it. We spoke to a case in which an individual body is composed of many different individuals over time. We further noted that these individuals appeared to all have a degree of income, due to savings. We then suggested that given some sort of exchange between past-and-future individuals is occurring, the two should be on the Pareto Frontier. If they are not, because a future-self smokes, then he would do better to save less, and smoke more, in the "Coaseian" bargain that we suggested. We suggest that this argument remains untouched, and maintain our point that Mankiw is wrong in the point he made, in our reading.

We see your point as related-in-conclusion but actually quite different from Mankiw's current-self future-self terminology. Yours is about a single, specific individual attempting to maximize their total utility.

First, we address hyperbolic discounting. For the uninitiated, economists generally model time preferences as exponential discounting. This suggests that people are as impatient between today and tomorrow as they are between tomorrow and the next day. Hyperbolic discounting suggests something special about today, and that people value the difference between today and tomorrow differently from tomorrow and the next day (less). The difference between the two systems in discrete time is displayed graphically below (click to enlarge; the graphic is deliberately very large in the enhancement). Hyperbolic discounting offers a "now-oriented" bent to discounting.

To understand why hyperbolic discounting might be of concern to economists, we can examine how two individuals who have ten time periods to consume 100 units of a good might behave. We give one exponential discounting with $$\beta=.95$$. This indicates that he would be indifferent between consuming 1 unit of good today or .95 units tomorrow. Similarly, we give another with quasi-hyperbolic discounting .95203 and the .96, deliberately calibrating it for comparability with our exponential discounting--they choose to consume the same amount on the first day. However, because in each period, the hyperbolic discounter is newly-impatient upon arrival at a new period, and initially they consume more than they planned in the first period. Using log-preferences, this is displayed graphically below (click to enlarge).

We might notice a few things. First, that the red line, the hyperbolic plan, is different than the green line, what actually happens. The second is how, with reasonable parameters (log-preferences and the aforementioned discount rates) and over a long span (ten periods, or years as calibrated), the deviation from optimal plan is not very large. Indeed, if we were to calculate how much our hyperbolic discounter should pay to stay on his optimal plan, it would be .0322 units, of his 100 units. That is, in this reasonable example calibrated for a ten-year horizon, individuals lose 0.03% of their initial income due to hyperbolic discounting. The sheer smallness of this number suggests that economists concerning themselves with this loss in public policy without first examining the much larger government waste must have ulterior motives.

But let us forego our concerns about the minute nature of hyperbolic discounting and instead note that even were it not small, any person without hyperbolic discounting should be hunting for these individuals with as much passion as the harpies who hunted an Aeschylean Orestes in The Eumenides. Why should we hunt these people with great passion?

Say they have a $$\beta$$ of .95 and a $$\delta$$ of .975. Therefore, in exchange for 1.026 units of period three, I buy one unit of period two consumption from you. Time passes one period, and I can now sell you the one unit of period two consumption for 1.08 units of period three, netting myself a profit of .05 in the third period without sacrificing any consumption.

Of course, this does not have to be done with only one unit--it can be done with your entire fortune. Because the relative prices between future periods are changing for hyperbolic discounters, any arbitrager may come along and, over the course of two periods, consensually exchange all of a hyperbolic discounter's fortune away from him--a hyperbolic discounter and his money are soon parted.

This leads us to conclude that either a) hyperbolic discounters do not exist b) they are well hidden within the population (and thus safe from such traders or c) they have starved in the streets, silently, bereft of the money that was once theirs.

We might further note that time preferences are endogenously determined, as Gary Becker and Casey Mulligan do in their 1997 Quarterly Journal of Economics paper "The Endogenous Determination of Time Preference." They note that by endogenizing discount rates, "it appears possible to explain with a model of rational behavior many assertions in the literature that are claimed to imply irrational choices." Their list includes the fact that people are not equally patient, that income is associated with higher consumption growth, and the relationship between schooling and consumption growth, relationships previously identified as irrational.

Finally, and in light of our previous point, we should note that any lingering inefficiencies will be small. It is difficult to see any market failure preventing individuals from investing in their own time preferences, in individuals requiring the government to provide that good, especially given information asymmetry going the wrong way. At any place where there should be great inefficiencies due to "irrationalities", we should also see great individual effort to overcome the irrationalities.

This is seen, for example, in the paper "Fear and Response to Terrorism: An Economic Analysis" by Gary Becker and Yona Rubinstein, who identify the role of fear in economic behavior, finding that individuals overcome their terror (they study suicide bombers and the use of buses by Israelis) more when they have incentives to do so. So too, do we expect individuals who lose the most because they are irrational to invest the most in changing their own behavior. We might add that subsidizing "irrationality" though a series of government nudges and shoves encourages the opposite type of meta-behavior.

Let us forego the ideas that hyperbolic discounting cannot generate large losses in utility with reasonable parameters, or that they provide arbitrage opportunities, or that individuals will optimally invest in controlling their irrationality and that there appear to be no market failures. Instead, let us note that even without these, hyperbolic discounting might have a real economic rationale. Specifically, there is a reason that today and tomorrow and tomorrow and the next day are different. The decisions we make are assured between today and tomorrow, where we have no such assurances in the next day.

Corrections only sees hyperbolic discounting literature applied in the literature on public choice, perhaps because only public choice examines long enough time periods for hyperbolic discounting to become important (for example, discussing global warming). In this case, there is an obvious reason why individuals should be today-focused. Specifically, because tomorrow has a degree of uncertainty that is not present today, but is present in all future periods. Let us imagine, for the sake of argument, that who is in power politically is an i.i.d. process. Then in making decisions about what legislation to pass, and what to have it depend on, whoever is passing the law should "trust" themselves more than future generations of lawmakers, because they have a smaller chance at being in power in all future periods (and due to our i.i.d. nature, the same, nonunity chance of being in power in all periods). This is a case in which hyperbolic discounting is "rational," though inefficient due to public choice incentives, rather than having anything to do with discounting.

Finally, we note, as Glenn Harrison and Morten Igel Lau do in "Is the Evidence for Hyperbolic Discounting in Humans Just An Experimental Artefact?," that while individuals participating in laboratory experiments appear to prefer to be paid in the present rather than the future, this may be a function of rational payment uncertainty rather than any discounting. Indeed, in this case, hyperbolic discounting in the lab in this situation is actually optimal behavior.

A number of the points we make hold for any form of dynamic inconsistency. We chose hyperbolic discounting because it was both mentioned in the post and is the most common form of dynamic inconsistency.

In light of these arguments, Corrections recalls a the opening of George Stigler's "The Intellectual and the Market Place"

The Intellectual has never felt kindly toward the market place; to him it has always been a place of vulgar men and of base motives. Whether this intellectual was an ancient Greek philosopher, who viewed economic life as an unpleasant necessity which should never be allowed to become obtrusive or dominant, or whether this intellectual is modern man, who focuses his scorn on gadgets and Madison Avenue, the basic similarity of view has been pronounced.
Corrections sees the relationship between the intellectual and individual freedom to be similar. Whether it is Rousseau's belief that individuals must be "forced to be free" (end of Section 7), or Plato's belief in a static, unchanging society where popular music, theatre, and poetry are banned, and the right to raise one's own children is eliminated (in The Republic), or Isaiah Berlin's corruption of the phrase "liberty" in Two Concepts of Liberty to argue a perverted liberty that required an obligation from one's fellow men beyond non-interference, intellectuals have rarely been friends of liberty.

It is in the light of a would-be tyrant that all paternalists should be seen, Corrections notes. As we have noted before, paternalists are would-be slavemasters with a smile.  History, economic and otherwise, as well as the economic theory of public choice, help us see this relationship. Individuals are very good at running their own lives, and are miserable, if not genocidal, when running the lives of others.  The ambivalence of intellectuals to a soda tax is simply a symptom of the hostility of intellectuals to the market place, and to liberty.

Thursday, July 22, 2010

California Blacks Split Over Marijuana Measure

New York Times article "California Blacks Split Over Marijuana Measure" (July 19th, 2010) provides a very incorrect conclusion about alleged discrimination against African Americans in marijuana arrests:

Rob MacCoun, a professor of law and public policy at the University of California, Berkeley, who has studied marijuana use in America, said there was little doubt that blacks — particularly black men — bore the brunt of arrests for marijuana.

“The arrest statistics are disproportionate with respect to African-Americans and disproportionate with respect to use,” said Mr. MacCoun. “And that’s very hard to justify in any way.”

On the contrary, it's easy to justify. For example, if African-Americans who smoke marijuana are conspicuous in their dress, while caucasians who smoke are not. In this case, even if 40% of both African-Americans and 40% of caucasians smoked marijuana, we would expect African-Americans to be stopped more often on suspicion of possession. Why? Because African-Americans arise suspicion at a higher rate than caucasians due to (continuing with the example) their dress code. So conditional on suspecting marijuana use, a police officer will be correct more often with African Americans. Certainly the police arrest those who arise the highest suspicion first--otherwise they would be wasting more of their time on innocent people, and so with sufficient constraints on how many people they can arrest, we would expect police to arrest a higher proportion of African-Americans than caucasians.

Tuesday, July 20, 2010

What happened to all that anger over CEO pay?

Christian Science Monitor article "What happened to all that anger over CEO pay?" (July 12th, 2010) claims that CEO pay is too high:
In 2008, the CEOs of major US firms were paid more than 300 times the wage of the average American worker. Last year, they were paid just under 300 times average pay, according to new research by Mr. Pizzigati. Now that most of those firms have paid back the government, they're setting their own compensation levels again.

Those levels would astonish the bosses of top corporations in the late 1960s. Those CEOs got about 30 times the average wage of US workers.

Are today's bosses 10 times more capable? Is there a shortage of able managers? Nope and nope, says Pizzigati. "There is more management talent today than ever before."
This argument is riddled with flaws. First, no economic model could possibly imply that CEO pay is set by looking at the ratio of their wages to those of their employees. LeBron James is paid significantly more than his towel boy, so what? They perform completely different tasks, requiring completely different skills, in completely different environments. The question is not "are CEO's 300 times better that their employees at stocking shelves?" Rather, the question is "is the market for CEOs competitive?". The article itself suggests that there are plenty of qualified CEOs to choose from when starting a company.

Quarterly Journal of Economics article "Why has CEO pay increased so much?", by Xavier Gabaix and Augustin Landier model CEO pay. They match the best CEOs with the largest firms, and note that even when CEO talent is not very disparate across CEOs, small differences in talent can lead to very large difference in pay because of firm size. For example, the top CEO (in terms of talent) can increase the value of his company by only 0.016% relative to the 250th talented CEO, but this translates to paying the top CEO 500% more than the 250th CEO because of firm size. In particular, the authors find that
The six-fold increase in CEO pay between 1980 and 2003 can be attributed to the six-fold increase in market capitalization of large U.S. companies during that period. When stock market valuations increase by 500%, under constant returns to scale, CEO “productivity” increases by 500%, and equilibrium CEO pay increases by 500%.
In this light, high CEO pay makes sense. When a company's value increases greatly, the decisions of a CEO require him to handle more and more money. While the value of the company increases, his productivity increases. Meanwhile, individual workers on the factory floor do not handle more and more responsibility or produce more output as the firm grows, and should not be paid as though they do.

Saturday, July 17, 2010

Larry Hagman of 'Dallas' fame becomes the new face of SolarWorld

The Oregonian article "Larry Hagman of 'Dallas' fame becomes the new face of SolarWorld" (July 13th, 2010) makes no effort to correct an utterly ludicrous statement by a solar energy spokesman:
"When affordable oil gives out, we're in real trouble -- I mean the collapse of civilization, within 15 to 20 years."
If oil companies thought that the price of oil would skyrocket in the next couple of decades, then they would hold on to this storable asset and sell only when the price skyrocketed, causing supply to decrease and current price to rise. This continues until oil companies are indifferent to selling now or later. What does this imply about an oil "shortage" in the coming years? It implies that quantity will fall predictably, based on the shape of the demand curve.  As price rises, quantity demanded falls.  When it becomes optimal, we will substitute into new energy sources.

In the figures below, the red dotted lines represent a theoretical "renewable energy only" world, while the solid red line represents the observed portion of renewable energy use in a world when both renewable energy and nonrenewable energy is available. The solid blue line represents observed nonrenewable energy prices and use in a world in which both renewable and nonrenewable energy are available, while the dotted line represents price and use in a theoretical "nonrenewable energy only" world (click here to enlarge).

We see that the price of energy should go up, in our simple model, at the interest rate, while we use oil. Consumers will buy renewables when they become cheaper than energy (the red-line price in the top figure).  Energy use falls gradually to a stable level (click here to enlarge).

In this model, there are no sudden shocks to oil consumption and no unexpected price increases. Rather, oil prices increase predictably, and the amount of energy we consume falls gradually and predictably. To predict the "collapse of civilization" in an article about new technologies is completely misguided.

Thursday, July 15, 2010

Companies pile up cash but remain hesitant to add jobs

Washington Post article "Companies pile up cash but remain hesitant to add jobs" (July 15th, 2010) claims that whenever companies have profits, they should hire more labor.
Yet all the good news from big business hasn't translated into much promise for jobless Americans, leading many to wonder: If corporations are sitting on so much money, why aren't they hiring more workers?
Presumably, businesses are operating optimally. That they are making profits and "sitting on cash" at this optimal point should not imply in any way that the correct thing to do next is to invest that cash into more labor. It is quite possible that expansion would not make the businesses more money, and even if it did, more labor doesn't always follow an expansion. Corporations may invest more in capital during an expansion, and hire less labor.

The graph below plots the percentage of capacity in use over time (click here to enlarge)

Certainly, companies are not just "sitting" on cash. The economy is quickly climbing to use available capacity productively. Hiring more labor in order to please the unemployed may simply not be the most productive use of a firm's resources, nor the optimal path to growth.

Wednesday, July 14, 2010

LeBron James: True to his generation

LA Times OpEd "LeBron James: True to his generation" (July 13th, 2010) suggests that young workers are more mobile than older workers. Apparently, this all has to do with generational-characteristics, not economics.
If younger workers have displayed anything as employees, it's that they prize mobility more than they do fidelity to their employers.

"Stability and company loyalty are high values for . . . those whose worldviews were shaped by experiencing the Great Depression in their formative years," Chip Espinoza, Mick Ukleja and Craig Rusch write in their new book, "Managing the Millennials." "But the work world has changed."
At all ages, workers seek to find a job at which they can earn the highest wage, and employers seek the best workers. Since it is not possible to know one's productivity perfectly before actually working at a particular job, workers will not necessarily find their best job immediately, and will continue to look for jobs until they find the one that they believe suits them best. Hopefully, by the time they are 50 all workers will have found their best job.

In addition, unlike their older counterparts, young workers sometimes are building their human capital while working. For example, they may be enrolled in a part time business school. When they are done, the will be able to find a better job. This move has nothing to do with "disloyalty," since firms rarely have higher-level positions ready and waiting for such workers.

The notion that young workers should stay put is completely out of equilibrium, and would likely only occur when productivity differences and wage differences between jobs were trivially small. In the current job market, this is not the case.

Monday, July 12, 2010

Handguns shouldn't be a household staple

Chicago Tribune article "Handguns shouldn't be a household staple" (July 9th, 2010) argues that handguns in homes make suicide easier for young people:

A gunshot is quick and irreversible. About 90 percent of suicide attempts with a firearm are fatal, compared with 2 percent of drug overdoses and 3 percent of attempts by cutting. Adolescents who experience a moment of despair and act impulsively with easy access to a gun almost always have a deadly result. Adolescents also are likely to survive most other methods of suicide, and nine out of 10 who attempt suicide and survive will not die by suicide at a later date.

Of course, people choose different weapons when they want to die with certainty. Those who take drugs or cut their wrists may not substitute into a handgun even if one is available because they seek attention or risk, not certain death. The proper comparison for the author to make would be whether suicide rates rise as soon as gun laws change in a state. A study by doctor David C. Stolinsky published in the Medical Sentinel notes that
The U.S. suicide rate has fluctuated between 10 and 17 for a century, with peaks in 1908 and 1932, and shows no relation to gun laws or gun availability.
Further research that exploits within-state variation is necessary to fully understand the impact of gun availability on suicide rates. Nonetheless, the Chicago Tribune's article attempts to make fact from what is quite possibly fiction, using irrelevant statistics to convince readers of a largely untested hypothesis.

Saturday, July 10, 2010

Farm Work should be an honored, palatable job for Americans

Los Angeles Times article "Farm Work should be an honored, palatable job for Americans" (July 10th, 2010) bemoans the decline in wages for farm workers but completely ignores the economics behind these fluctuations.

By 1981, the contract provided about double minimum wage, at which point we were probably the best-compensated grape pickers in the world. We had paid holidays, and for high-seniority workers, two weeks' paid vacation; disability and unemployment insurance; family medical insurance (with 60 hours of work or more in a month); even a modest pension plan. The Coachella Valley had a UFW medical clinic for the workers and their families, and a legal aid center to help with taxes, Social Security and other issues.
The legacy of David Freedman Co. under the UFW contract is one all Americans can be proud of. It is proof that American agriculture does not have to be based on the labor of an underclass denied the rights and benefits of other workers.
Sadly, only one UFW contract remains in the Coachella Valley, and wages and benefits are not as generous as they were 25 years ago.

In fact, wages in these competitive markets are not set by the sentiments of Americans, but rather by market forces. For example, if demand for produce increased, then firms would want to increase their production. However, most farmers were likely constrained in their ability to purchase more capital (farm equipment) and so were only able to increase their demand for farm labor. This caused an increase in farm worker wages.

Again, the reason that wages increased by as much as they did may simply have been that in the short run, capital is inelastic. In the long run, it is perfectly elastic. Thus, the long-run rise in wages would be heavily mediated by substitution into high capital-share production.

Don’t punish the children

Jerusalem Post article "Don't punish the children" (July 5th, 2010) argues that though immigrants take jobs from citizens, expelling them would be unfair to their children. Speaking on immigrants, the Post noted:
All along, economists argued, with some credibility, that foreign workers took jobs away from locals – certainly those jobs that Israelis, if paid fairly, would be prepared to take.
Unfortunately for those Israelis, those jobs wouldn't be there at a higher wage rate. Labor demand curves slope down, just like other demand curves. What does this mean? At a higher price, firms demand fewer workers. Anyone would be "prepared" to take any job for a high enough wage, that desire has absolutely nothing to do with the demand for labor.

For a New Generation, an Elusive American Dream

New York Times article "American Dream is Elusive for New Generation" (July 6th, 2010) neglects forces of supply when discussing the labor market facing recent college graduates. Referring to the choices of one recent college graduate, the article notes:

Over the last five months, only one job materialized. After several interviews, the Hanover Insurance Group in nearby Worcester offered to hire him as an associate claims adjuster, at $40,000 a year. But even before the formal offer, Mr. Nicholson had decided not to take the job.

Rather than waste early years in dead-end work, he reasoned, he would hold out for a corporate position that would draw on his college training and put him, as he sees it, on the bottom rungs of a career ladder.

Interestingly, a recession resulting in a decrease in the number of jobs available to skilled workers (a decrease in the demand for skilled labor) may not be the only thing keeping college graduates from "good" work. In fact, the supply of college graduates has continued to increase over time. The graph below plots BLS records of the number of college graduates in the labor force (both employed and unemployed) over time (click here to enlarge). Such competition for work drives down wages.

In addition, we should expect the number of college graduates to increase during a recession simply because fewer job opportunities make investment in future productivity more attractive. Potential labor force members will instead spend their time in school so that when they are able to find work, they will be paid even more for their labor. The article then cites work by a Yale economist meant to worry readers that a low payoff to education now will persist into the future:

In a recent study, she found that those who graduated from college during the severe early ’80s recession earned up to 30 percent less in their first three years than new graduates who landed their first jobs in a strong economy. Even 15 years later, their annual pay was 8 to 10 percent less.

Of course, those who choose to enter the labor force during a recession are those for whom additional human capital accumulation will likely not pay off. Specifically, if everyone who does not take their first job during a recession chooses to invest in a two year law or business school degree, taking their first job after the recession passes, why would we expect them to have the same annual pay fifteen years later? The author notes this in her paper:
I also find that cohorts who graduate in worse national economies are in lower level occupations and have slightly higher educational attainment.
In fact, the author argues that such high effects persist when we assume that students cannot shift their graduation and educational attainment decision in response to economic fluctuations. Far weaker effects than those reported in the article persist when people are allowed to endogenously choose their education--OLS results suggest a long run 1.5% wage loss. Though the New York Times article may be correct in noting a long-run wage differential, it completely mis-interprets a theoretical exercise (instrumenting for year of graduation using year of birth) to make a point.

Tuesday, July 6, 2010

Loss of Jobless Benefits Could Lower Unemployment Rate

CNBC article "Loss of Jobless Benefits Could Lower Unemployment Rate" (June 30th, 2010) argues that when unemployment benefits run out, some unemployed will become depressed and stop looking for work, causing the unemployment rate (a measure of those looking for jobs but unable to find them) to decrease. Presumably, this is bad for the economy and such a decrease in the unemployment rate would be a false sign of recovery. Then the article makes a point that would seem to wash over its whole argument, but the article does not elaborate.
"We believe that the expiration of jobless benefits will cause many workers to drop out of the labor force and will motivate others to accept jobs they had previously rejected."
If jobless benefits were causing people to stay out of the labor force by rejecting jobs in order to continue a search for work they likely will not find, the these benefits were creating frictions in the economy that kept it from adjusting to a shift in the labor force composition. Unemployment benefits are rationalized by the notion that people need time to find the most efficient job. If months of search prove fruitless, it may be time to adjust to a new labor market equilibrium. It is unclear exactly why people would drop out of the labor force if they are not paid to look for jobs. On the contrary, it would seem that in order to eat, they would start working immediately. The economist Casey Mulligan provides evidence to this effect at his blog Supply and Demand. He creates the following chart, showing that as soon as unemployment benefits run out (weeks around exhaustion = 0), there is a huge jump in the number of people returning to work (click here to enlarge image).

Monday, July 5, 2010

Help Needed for the Economy

New York Times editorial "Help Needed for the Economy" (July 2nd, 2010) tries to worry people about a "double dip recession" without any cause to do so.
If the economy were a coal mine, the job market would be an 800-pound canary, warning of a recovery that is running out of oxygen.
Before panicking, let's remember that there have been approximately three double-dip recessions since the 1850's. In addition, let's analyze the job market in the most recent example: a recession that began in January of 1980, recovered for a year between July of 1980 and July of 1981, and then re-surfaced until November of 1982. What did the job market look like in the lull? Below, we plot the percentage change from the previous month in the unemployment rate from July of 1980 to November of 1981 (click here to expand figure).

There seems to be no evidence that the job market in any way predicted the double dip. The editorial seems to be a guess by the likely unqualified author that more economic trouble is around the corner. In addition, the article claims that
Republicans and several Democrats have made the argument that cutting the deficit is more important than spurring the economy. The argument is wrong — jobs and the resulting tax revenue are crucial to repairing the budget. But the Democratic leadership in Congress and the White House has been incapable or unwilling to successfully rebut the deficit-mongers.
Certainly this is not necessarily true! After a certain point, additional taxes only discourage people from working and lower total government revenue. Jobs created by the government require tax revenue from those already working. Taxing the productive sector, which indisputably creates lost surplus in the economy, in order to create jobs that the private sector may have created anyway had the government not interfered is extraordinarily unlikely to create gains in the economy. University of Chicago economist Kevin Murphy provides a very illuminating analysis of the parameters determining the success of the stimulus here. He finds that extremely optimistic assumptions (not supported by data) are needed in order to justify a government stimulus.