Gas goes up, gas goes down... you can't explain that!

My favorite Bill O'Reilly moment came during an interview last year with David Silverman of American Atheists. O'Reilly was arguing that the regularity of phenomena in the universe supported the existence of God.

O'REILLY: I'll tell you why [religion's] not a scam, in my opinion: tide goes in, tide goes out. Never a miscommunication. You can't explain that.

SILVERMAN: Tide goes in, tide goes out?

O'REILLY: See, the water, the tide comes in and it goes out, Mr. Silverman. It always comes in, and always goes out. You can't explain that.

There's nothing better than a guy who calls people he disagrees with "pinheads" revealing his profound ignorance of 8th grade Earth Science.

This week, O'Reilly went on The View, and when the topic turned to gas prices, O'Reilly criticized the Obama Administration:

O'Reilly pushed back and said, "gas will be at 8 dollars a gallon." Host Joy Behar jumped in, criticizing O'Reilly's argument. "Americans know that gas prices don't have to do with Obama. It has to do with world affairs. Everybody knows that," she said. "I don't know that. I don't know that," O'Reilly charged.

Whether or not O'Reilly knows it, gas prices are set in a global market. How do we know this? The best evidence is the extent to which gas prices are correlated across different countries. If countries that have different energy policies see gas prices move the same way, then it's clear that they are exposed to the same global market. As the chart below shows, this is most certainly the case:

Source: U.S. Energy Information Agency

Given that these countries have differing energy policies, it seems that global economic trends overwhelm domestic concerns. Further, it's not clear what the Obama administration could even do here. The most frequent Republican criticism on this issue is that the U.S. needs to drill more, but the inconvenient truth is that U.S. oil production is at its highest level since 2003 and has grown considerably since 2008. Whether or not you think it's a good policy, the charge that the Obama administration opposes domestic drilling is patently false.

The U.S. accounts for roughly 9% of global oil production, so in order to impact the global price it would need to expand production far beyond any reasonable estimate of remaining reserves. Even then, the increased production would be offset by reduced output from OPEC member states (most of the world's oil is produced by countries with considerable market power).

So yes, Mr. O'Reilly, gas prices are set in a global market; we can explain that.

Is U.S. inequality special?

In this post, Greg Mankiw argues that the U.S. is not the only country to see an increase in inequality over the past 40 years. Referring to a plot of the top income shares in the U.K., Mankiw notes:

“The figure suggests that the explanation of growing inequality over the past several decades cannot be U.S.-specific but must have broader applicability... You find a similar U-shaped pattern in Australia, Canada, Ireland, and New Zealand but much less so in France, Germany, Japan, and Sweden.”

Mankiw uses the impressive “Top Incomes Database,” compiled by (among others) Thomas Piketty and Emmanuel Saez. It is a fantastic resource; it enables you to plot data on income shares and inequality for a wide-range of countries over more than one-hundred years. Perusing the data, one finds that, in fact, many countries have seen an increase in inequality. But Mankiw seems to be implying that, since this is a global phenomenon, that shifts in U.S. policy aren’t driving the increase in inequality.

Using the database, I generated the following graphs: (1) comparing the U.S. with other rich English-speaking countries; and (2) comparing the U.S. with rich, but non-English speaking countries. I chose the countries Mankiw cites as examples in his post. The data covers the period between 1950 and 2007:*

As Mankiw notes, the changes in the top share of incomes for other rich English-speaking countries largely track those of the U.S. It is worth noting the discontinuous jump in the U.S. series in the mid-1980s, coinciding with the reform of the tax system during the Reagan administration.

In contrast, the rich non-English-speaking countries do not see much of a change in their top income shares. For example, the share of the top 1% in France was 8.98% in 1950 and 8.94% in 2007. The corresponding numbers for the U.S. are 11.60% and 18.29%. It takes a lot of motivated reasoning to detect an upward trend in the non-English-speaking countries.

To explain the difference between the two groups, Mankiw offers the following idea:

“Might the rising share of the top 1 percent be related to the increasing use of English as a global language?”

I’m not exactly sure what this means or what the causal mechanism here would be. I would suggest a simpler explanation: English-speaking countries have tended to follow an economic model (often referred to as the “Anglo-Saxon Model”) that is more market-driven and relies on a smaller welfare state than the rest of Europe. Thus one should expect those countries to have higher levels of market-income inequality. Further, like the U.S., these countries have reformed their tax systems and de-regulated much of their economy, leading to even greater inequality. So while it’s true that increased inequality is not solely a U.S. phenomenon, it does not follow that policy changes aren’t an important part of the explanation. In fact, countries that have followed similar policies to the U.S. have seen increases in inequality, while those that haven’t, well, haven’t.

*I chose the years based on data-availability. I encourage people to play around with the database if they are curious about other countries, years or variables.

It is also worth mentioning that the data presented here is pre-tax gross income. Given that other countries have more progressive tax/transfer systems than the U.S., this is likely an underestimate of the difference in inequality between the U.S. and the rest of the rich world.

That used to be you

This evening, I attended a talk through the Hudson Union Society given by Thomas Friedman and Michael Mandelbaum about their recent book That used to be us: How America fell behind in the world it invented and how we can come back.

Those of you who read Friedman’s New York Times column, may be familiar with some if the main points of the book. Namely that there is a global trend towards overpopulation, increased communication and dwindling resources. And that while many predict China may be on the rise to power and the US has mismanaged its economy and slowed on innovation, America should look back at its successes in the past and return to the policy that made it strong while keeping up with communication and green technology.

The book ends with Freidman and Mandelbaum’s ideal 2012 presidential platform. They are advocating that an independent candidate take up issues of investment in infrastructure and education, spending cuts to Medicare and Social Security and tax increases – perferably related to fuel usage.

Of course in a situation like this, topdown change often has the greatest impact. However, I would like to take one of the major questions of the evening and apply it to the individual, in particular the 9.1% of Americans that are unemployed. The question to ask is “What were you doing in the past that worked?” When you think about the good things you’ve done it can focus your energy towards repeating those habits and outcomes. There is something very powerful about putting a positive spin on your assessment of the past. Understanding what you have done well can help you make decisions on where you can add the most benefit. Yes, top down change is going to be necessary to change the direction the US is headed, but bottom-up change and a need for individual innovation and reinvigoration is also going to be crucial to our recovery. This isn’t about glossing over what may have gone wrong – but if you’ve had success in the past chances are you can pinpoint what went right and harness that into more future success.

I think we need a Fox News to English dictionary

Dick Cheney famously said that, "deficits don't matter". Well Fox News has taught us that definitions don't matter. First, they merged the words "socialism" and "fascism" together and carelessly defined them as any government intervention in the economy, no matter what. Now, it seems that "secularism" and "paganism" have been conflated:



Of course, if religious belief is important to economic growth than that relationship should hold within Europe, as well as between Europe and the US. Is there any evidence for this? Not that I've seen. Northern Europe is more secular than Southern Europe, and is also more prosperous. Nor does this hold outside of Europe. East Asia, despite being relatively secular, has seen enormous economic growth over the past 40 years. In the Middle East, Iran was quite rich until theocratic rule took over in 1979; but then again, the Fox News crew might call Iran a "fascist state", or complain that only Christianity is good for economic growth.

I could go on, but this conversation doesn't warrant serious engagement. These commentators have abused words to the point where debate simply cannot happen. Secularism is not paganism and environmentalism is not "worshiping the Earth". Just saying these things doesn't make them true.

A New Way to Measure Poverty

The official federal poverty measure, designed in the 1960s, is the most commonly used indicator of economic hardship in America. Unfortunately, it provides no guidance on pressing questions like the role of regional price variations on poverty or the impact of Food Stamps.

Researchers have been aware of these deficiencies for some time. Now the Census Bureau will begin reporting supplemental poverty measures based on recommendations from the National Academy of Sciences. These new measures will take into account the impact of taxation, in-kind public assistance and medical out-of-pocket costs, and will use more realistic poverty thresholds.

While this is a new step at the federal level, the City of New York has been working on alternative poverty measures since 2008. The efforts of New York City's Center for Economic Opportunity are described here in today's New York Times. A copy of CEO's new report is available on CEO's website for download. It describes the development of the measure as well as poverty trends in NYC between 2005 and 2008.

Department of Really Unintended Consequences

One important factor that set the stage for last year's financial crisis was the "global savings glut". Massive savings accumulated around the world, particularly in East Asia, which needed to be invested somewhere--that "somewhere" ended up being the US housing market*. Paul Krugman explains:

"The speech, titled 'The Global Saving Glut and the U.S. Current Account Deficit,' offered a novel explanation for the rapid rise of the U.S. trade deficit in the early 21st century. The causes, argued Mr. Bernanke, lay not in America but in Asia.

In the mid-1990s, he pointed out, the emerging economies of Asia had been major importers of capital, borrowing abroad to finance their development. But after the Asian financial crisis of 1997-98 (which seemed like a big deal at the time but looks trivial compared with what’s happening now), these countries began protecting themselves by amassing huge war chests of foreign assets, in effect exporting capital to the rest of the world."

The Chinese, in particular, provided a lot of capital. This begs the question, "why do the Chinese save so much?" Shang-Jin Wei, writing in VoxEU, has an answer:

"In my recent research paper with Xiaobo Zhang (Wei and Zhang 2009), we hypothesised that a social phenomenon is the primary driver of the high savings rate. For the last few decades China has experienced a significant rise in the imbalance between the number of male and female children born to its citizens.

There are approximately 122 boys born for every 100 girls today, a ratio that means about one in five Chinese men will be cut out of the marriage market when this generation of children grows up. A variety of factors conspire to produce the imbalance. For example, Chinese parents often prefer sons. Ultra-sound makes it easy for parents to detect the gender of a foetus and abort the child that’s not the 'right' sex for them, especially as China’s stringent family-planning policy allows most couples to have only one or two children.

Our study compared savings data across regions and in households with sons versus those with daughters. We found that not only did households with sons save more than households with daughters on average, but that households with sons tend to raise their savings rate if they also happen to live in a region with a more skewed gender ratio. Even those not competing in the marriage market must compete to buy housing and make other significant purchases, pushing up the savings rate for all households."

His thesis makes intuitive sense: if the relative supply of women decreases, they can demand more on the marriage market. Why settle for a man of modest wealth if a wealthier man is just around the corner? So families with male sons have to amass more wealth if they want to marry those sons off.

Unintended consequences are a reality for policymakers. I wonder if the Chinese officials who first devised the "one-child policy" ever thought it would have an impact on the country's savings rate, let alone global financial markets?

__________________________________________________________________
* This is not intended to "blame" East Asians for the financial crisis. They did not force anyone to make bad loans or underestimate the risks in the housing market. East Asian savings merely provided the capital necessary for the investment boom.

Keynes vs Hayek: the rap showdown

Russ Roberts' long awaited (by me at least) new music video is here. Roberts, an economist by trade, wrote the lyrics for a rap battle between John Maynard Keynes and F. A. Hayek on the nature of the business cycle:



Keynes and Hayek were certainly ideological opponents during their lives. Hayek was a central figure in the Austrian school of economics, whose focus on voluntary contracts between individuals and the organizing power of the price system saw little role for the government in the economy (or anywhere else). Keynes, on the other hand, argued that markets (capital markets in particular) can fail on their own; when they do, government has a crucial role to play in stabilizing the economy.

Roberts, himself an adherent of the Austrian school, is better positioned to argue Hayek's side (he blogs at "Cafe Hayek"). While Keynes' basic ideas are laid out in the video, much of the nuance is missing (as is probably to be expected in a 6 minute rap-debate on the subject). In particular, I felt Keynes' views on savings were somewhat misrepresented.

In the video, the Keynes character explains his "paradox of thrift" idea: people save money, which is good for them, but it reduces the amount that they spend, which in turns lowers other people's incomes, causing them to save more; this reduces the income of others, perpetuating the cycle. Thus an individually beneficial action (saving) has negative consequences if everyone does it.

Some take the paradox of thrift to mean that "Keynes opposed savings", but this interpretation is simply untrue. James Hamilton explains the distinction:

"...aren't I delighted that consumers are now, finally, saving more? Well, no. It is one thing to identify a higher national saving rate as the long-term goal, and quite another thing to try to get there overnight in the form of a sudden drop in consumption spending. Here I am very much taking the side of Brad DeLong ([1],[2]) and Arnold Kling and against Eugene Fama ([1], [2]) and John Cochrane. The relevant question is whether, in response to an abrupt decrease in consumption spending such as we're now experiencing, some of the other variables (most importantly, Y) might adjust in response as well. It is certainly true that in a very simple economic setting-- for example, an economy that consists of a single farm producing only one good-- the decision to save more of your income (leave some of your wheat unconsumed) is necessarily identical to the decision to invest more (save the wheat for later). And one can write down more complicated models in which economic actors and markets adjust in a way to see through the veil of production and exchange and make sure it is I + X that adjusts in response to a higher saving rate, and not Y."

Much of Keynes' theory had to do with the translation of savings into investment. The classical economic perspective was that savings, by definition, equals investment. Thus, if people save more, then they invest more, leaving GDP unchanged. But Keynes argued that when people were fearful about the future, they would hoard money (e.g. stuff money in the mattress), diverting savings from investment. This means that sudden shifts in savings (for example, in response to a financial crisis that hurts household portfolios) can result in an economic contraction. In Keynes' mind, this was where government should enter with stimulus, to counter the drop in spending and soften the blow to the economy.

Is the paradox of thrift real? Not everyone would agree, but Paul Krugman provides some compelling evidence for it.

The point here is that one of the main differences between Keynes and Hayek (indeed between Keynes and most of the economists who came before him) had to do with the nature of the savings/investment relationship. Keynes was not advocating profligate spending for the sake of spending. Rather, he postulated that markets could fail and that government could play a role in mitigating the business cycle.

That being said, I thought the video was great; it was entertaining and provides a wonderful introduction to a major debate in the history of economic thought.

Social Norms and Strategic Defaults

Richard Thaler has some interesting analysis of why more underwater homeowners don't simply default on their mortgages. As I've written before, social norms play a large role. This was particularly interesting:

The morality argument is especially weak in a state like California or Arizona, where mortgages are so-called nonrecourse loans. That means the mortgage is secured by the home itself; in a default, the lender has no claim on a borrower’s other possessions. Nonrecourse mortgages may be viewed as financial transactions in which the borrower has the explicit option of giving the lender the keys to the house and walking away. Under these circumstances, deciding whether to default might be no more controversial than deciding whether to claim insurance after your house burns down.

In fact, borrowers in nonrecourse states pay extra for the right to default without recourse. In a report prepared for the Department of Housing and Urban Development, Susan Woodward, an economist, estimated that home buyers in such states paid an extra $800 in closing costs for each $100,000 they borrowed. These fees are not made explicit to the borrower, but if they were, more people might be willing to default, figuring that they had paid for the right to do so.

Of course, if people were more likely to default, then the implicit costs would be higher than the $800 estimated by Susan Woodward. Still, many homeowners are continuing to make mortgage payments at a loss, and it would be interesting to see how they behaved if they felt they already paid fees to cover the risk of default.

Should we hold homeowners to a higher moral standard than businesses?

In the wake of the collapse of the housing bubble, nearly 11 million American families are "underwater", meaning that they owe more money on their mortgage than their house is currently worth. Some of these families simply can't afford to make the mortgage payments. Others can make the payments, but have decided to walk away from what is clearly a losing financial proposition. By pursuing "strategic default", these families allow banks or other lenders to foreclose on their homes and eat the loss. This allows them to seek other housing options and re-build their financial lives. While this is often a good individual financial move, not everyone agrees that it is the (morally) correct thing to do. Roger Lowenstein's interesting piece in the New York Times Magazine highlights this point:

"John Courson, president and C.E.O. of the Mortgage Bankers Association, recently told The Wall Street Journal that homeowners who default on their mortgages should think about the 'message' they will send to 'their family and their kids and their friends.' Courson was implying that homeowners — record numbers of whom continue to default — have a responsibility to make good."

Mortgage bankers aren't the only ones who feel this way. The US government similarly discourages strategic default:

"The moral suasion has continued under President Obama, who has urged that homeowners follow the 'responsible' course. Indeed, HUD-approved housing counselors are supposed to counsel people against foreclosure."

None of this should surprise anyone. Lenders want to avoid defaults because they want to get paid back. And the government is desperate to stem the tide of financial losses and prop-up the housing sector. Further, defaults create a sort of externality: if I default, I can depress the value of the houses in my neighborhood, weakening the financial position of my neighbors.

However, in many cases default is the best financial option for individual homeowners. As Lowenstein points out, businesses use strategic default in the same sort of situations. Recently, Morgan Stanley walked away from buildings it owned in San Francisco, without incurring moral outrage. In their case, it was simply business.

While it's understandable that policymakers are unhappy with strategic default, it makes no sense to hold individuals to a higher moral standard than corporations. Any coercion from government to try and get people to keep paying their mortgage is essentially a transfer of wealth from homeowners to lenders. That is not, in and of itself, a worthy policy goal.

Rather, if the government is truly concerned with the strategic default, it could try a suggestion put forth by economist Dean Baker. Baker has advocated for "The Right to Rent Plan", which would grant homeowners facing foreclosure the right to rent their home for a period of 5-10 years from the lender at the fair market rental rate. Such a policy would give borrowers and lenders an extended period to work out mortgage modifications, which would prevent the externalities imposed on communities by foreclosures. It provides a better deal for the lender (who gets revenue from the rental fees) and the borrowers (who avoid the credit impact of foreclosure). Further, this would not require government revenue, nor would it unduly reward reckless borrowers or lenders.

We all have an interest in preventing future foreclosures, but guilt is probably not the most effective policy tool to achieve this goal.

How I learned to stop worrying and love the deficit

Large deficits can elicit emotional reactions (see Tea Party Movement). But Robert Frank gives some good reasons not to be too worried about our current fiscal situation:

"...when total spending falls well below the level required for full employment, the economy won’t recover quickly on its own. Consumers won’t lead the way, because even those who still have jobs are fearful they might lose them. And most businesses won’t invest, since they already have more capacity than they need. Only government, Mr. Keynes concluded, has both the motive and opportunity to increase spending significantly during deep downturns.

Of course, if the government borrows to do so, the debt must eventually be repaid (or the interest on it must be paid forever). That fact has provoked strident protests about government “bankrupting our grandchildren.” It’s an absurd complaint. Failure to stimulate the economy would mean a longer downturn. That, in turn, would mean longer stretches of reduced tax receipts, increased unemployment insurance payouts, and depressed private investment. The net result? Higher total public borrowing and a permanent decline in productivity compared with what we would have had under effective economic stimulus. Once the economy is back on its feet, deficit logic changes. At full employment, extra borrowing often compromises future prosperity, just as critics say. On President George W. Bush’s watch, for example, the national debt rose from $5 trillion to $10 trillion. Some of that borrowing paid for an expansion of prescription coverage and a financial bailout a year ago, but most went for a war in Iraq and tax cuts that largely just allowed for additional consumption. Our grandchildren will be forever poorer as a result.

But the reverse would be true if government borrowing were used for productive investments. After decades of neglect of the nation’s infrastructure, attractive public investment opportunities abound. It’s been estimated, for example, that eliminating bottlenecks on the Northeast rail corridor would generate $12 billion in benefits at a cost of only $6 billion. These are present value estimates. When government undertakes such investments, our grandchildren become richer, not poorer...

In the meantime, however, such commentary continues to render intelligent political decisions about deficits less likely. For example, 58 percent of respondents in a recent NBC News-Wall Street Journal poll said the president and Congress should worry less about bolstering the economy than keeping the deficit down, while only 35 percent said economic recovery was a higher priority. If we really want to bankrupt our grandchildren, that poll charts a promising course."

Much of Frank's argument is basic Keyensian economics: in a recession, government spending is needed to offset the decline in private spending. But whatever your feelings about Keynes' theories, Frank's basic point is quite intuitive. The vast majority of the deficit has been caused by a collapse in tax receipts, which were caused by the recession. That means that anything that will cause output to grow faster will reduce the long-term deficit by increasing tax receipts. That means that spending today won't necessarily "bankrupt our grandchildren".

The politics of deficit reduction are all too predictable: when a party is out of power, they seem to find that old religion. But that doesn't mean we can't have a rational discussion about budgets.

Debating the Keynesian Multiplier

The old joke about economists is that if you laid them all together from head to toe they still wouldn't reach a conclusion. While there are many areas where economists broadly agree, the virtues of economic stimulus is not one.

The latest salvo in this rather un-gentlemanly (and gentlewomanly) debate comes via Harvard's Robert Barro, writing in the Wall Street Journal:

"The bottom line is this: The available empirical evidence does not support the idea that spending multipliers typically exceed one, and thus spending stimulus programs will likely raise GDP by less than the increase in government spending. Defense-spending multipliers exceeding one likely apply only at very high unemployment rates, and nondefense multipliers are probably smaller. However, there is empirical support for the proposition that tax rate reductions will increase real GDP."

Barro is summarizing his research into the size and impact of multipliers, in which he analyzed US GDP and changes in government spending data over time. Increases in government spending, according to Barro, haven't led to proportionally larger increases in GDP, as Keynesian analysis might suggest.

Mark Thoma chastens Barro for essentially re-cycling an op-ed (compare his new piece to this article from January) and, in response, re-posts some of the criticisms made at the time by people like Paul Krugman, Brad DeLong and Christina Romer.

For as important an issue as fiscal stimulus is, there is surprisingly scant research into its effectiveness. The best work is by David and Christina Romer, but they look at tax cuts as opposed to government spending.

Fortunately, Ethan Ilzetzki, Enrique G. Mendoza and Carlos A.Vegh have just published some new research, which looks at the impact government spending on GDP for a panel of 45 countries (20 developed, 25 developing). Their conclusions include:

1. In developing countries, the response of output to increases in government spending is smaller on impact and considerably less persistent than in high income countries.
2. The degree of exchange rate flexibility is a critical determinant of the size of fiscal multipliers. Economies operating under predetermined exchange rate regimes have long-run multipliers of around 1.5, but economies with flexible exchange rate regimes have essentially zero multipliers.
3. The degree of openness to trade (measured as exports plus imports as a proportion of GDP) is another critical determinant. Relatively closed economies have long-run multipliers of around 1.6, but relatively open economies have very small or zero multipliers.
4. In highly-indebted countries, the output response to increases in government spending is short-lived and much less persistent than in countries with a low debt to GDP ratio.
5. The multipliers for the US in the post-1980 period are rather small (in the range 0.3-0.4) both in the short and long-run. On the other hand, multipliers for government investment are large (around 2).

While far from the last word on the issue, the Ilzetzki, Mendoza and Vegh (IMV) work provides us with a much more subtle analysis of the nature of the Keynesian multiplier. It suggests that developed countries can use fiscal stimulus to boost employment in recessions, particularly if the spending takes the form of government investment. Interestingly, IMV's conclusions support Keynes' original claims. I'm currently reading Keynes' "The General Theory" and stumbled upon these passages:

Fiscal stimulus in rich vs. poor countries:

"Thus whilst the multiplier is larger in a poor community, the effect on employment will be much greater in a wealthy community, assuming that in the latter current investment represents a larger proportion of current output." (p126)

Trade openess and fiscal stimulus:

"In an open system with foreign trade relations, some part of the multiplier of the increased investment will accrue to the benefit of employment in foreign countries... so that if we consider only the effect on domestic employment as distinct from world employment, we must diminish the full figure of the multiplier." (p120)

It seems that Keynes, writing in 1935, predicted findings (1) and (3) in IMV.

Finally, as one might expect, Paul Krugman weights in, yet again:

"On a happier note, this piece by Ilzetzki et al is interesting, and offers a wide range of multipliers depending on a country's situation. The question for the United States is which estimate is most relevant.

I'd say it's the fixed exchange rate estimate. Yes, I know, we have a floating rate. But they explain the relatively high fixed-rate number by pointing to Mundell-Fleming, which says that fiscal policy is effective under fixed rates because it doesn't drive up interest rates (capital flows in). We're in a similar position for a different reason: fiscal expansion doesn't drive up rates because we're at the zero bound.

Oh, we're also relatively closed.

The thing is that both the fixed rate and closed multipliers are around 1.5 — which so happens to be just about the number assumed by Christina Romer in her analysis for the Obama administration. Just saying."

Ha Joon Chang on Culture and Economic Development

Ha-Joon Chang, Cambridge University Professor of Economics makes an eloquent argument for why differences in culture don't explain differences in income:

"...in the early days of capitalism when most economically successful countries happened to be Protestant Christian, many people argued that Protestantism was uniquely suited to economic development. When Catholic France, Italy, Austria, and Southern Germany developed rapidly, particularly after the Second World War, Christianity, rather than Protestantism, became the magic culture. Until Japan became rich, many people thought East Asia had not develop because of Confucianism. But when Japan succeeded, this thesis was revised to say that Japan was developing so fast because its unique form of Confucianism emphasised cooperation over individual edification, which the Chinese and Korean versions allegedly valued more highly. And then Hong Kong, Singapore, Taiwan, and Korea also started doing well, so this judgment about the different varieties of Confucianism was forgotten. Indeed Confucianism as a whole suddenly became the best culture for development because it emphasised hard work, saving, education, and submission to authority. Today, when we now see Muslim Malaysia and Indonesia, Buddhist Thailand, and even Hindu India doing economically well, we can soon expect to encounter new theories that will trumpet how uniquely all these cultures are suited for economic development (and how their authors have known about it all along)."

Culture has a certain appeal on both the left and the right as a determinant of a country's politics and economics. But cultural arguments are often subject to a winner's bias: since rich countries will typically have high levels of education and entrepreneurial spirit, we can look for teachings within a given culture that promote those values. But we're looking the wrong way. As Chang argues:

Culture is the result, as well as the cause, of economic development. It would be far more accurate to say that countries become “hardworking” and “disciplined” (and acquire other “good” cultural traits) because of economic development, rather than the other way around.

This is from a chapter in Chang's book "Bad Samaritans", a critical look at global trade. It's definitely worth a look.

The trouble with tariffs

The stated logic behind tariffs is that they protect domestic jobs against international competition. That's the justification behind the recent tariffs on Chinese tire imports imposed by the Obama administration. Many people think this is a laudable goal; but is it worth the cost? As Brad DeLong explains, probably not:

"Let's see... 250 million cars in America... need 4 tires per car... need new tires every 2.5 years. 400 million tires a year... $1.4 billion dollars a year... 10,000 worker jobs saved... $140,000 dollars per worker-job per year.

Looks like we could (a) let the Chinese sell us tires, (b) tax each tire by $2.50, (c) pay each tire worker who loses his or her job $100K a year, and we come out ahead: American households have more money to spend on other things, China has more jobs to help what is still a very poor country grow, and tire workers have higher incomes and more leisure as well.

But, you say, it would be stupid to impose a $2 a tire tax and use the money to pay each laid-off tire worker $100K a year.

That's the point: when the policy you are adopting is worse for everybody than a policy you agree is stupid, the policy you are adopting is best characterized as really stupid."

We should not ignore or diminish all concerns about free trade. But the trouble with tariffs is that they usually cost more than they're worth in terms of protecting domestic jobs*.

Some have suggested that this tariff is designed to boost support for healthcare reform among labor groups. In that case, the cost/benefit calculation changes depending on the desirability of the proposed legislation. However, the point is that tariffs are rarely justified by their overall economic impact.

*Not everyone would agree that protecting domestic jobs is a worthwhile public policy goal. Assuming that it is, however, we need to consider whether it's a cost-effective policy.

Why care about inequality?

This is a follow-up post to a previous discussion about economic inequality.

Emmanuel Saez, the UC Berkeley economist, recently produced a fascinating chart on income distribution in the US, depicting the share of national income held by the top 10% of Americans over time:


As you can see, the top 10% of families accounted for roughly 50% of national income in 2007, a level not seen since the time of Jay Gatsby. Though this is only one of numerous measures of income inequality, it clearly shows that the distribution of income in America is more skewed now than at any point since before the Great Depression.

Why should we care about this? There are good economic reasons for discounting measures of inequality. First, economics is not, in general, a zero-sum game. We can all do better even if some gain more than others. And conversely, while some poor societies are highly equal, equal poverty is no great virtue.

Second, there are good reasons why some people make more than others. People who make great innovations (eg the founders of Google) or who have specialized skills (eg neurosurgeons) have every right to be compensated for what they do, since they provide value for society. Bill Gates is enormously wealthy, but he didn't get that way by stealing from others; he became wealthy by providing valuable products to society, making everyone better off (Vista notwithstanding). The carrot of great individual wealth has done much to improve human welfare.

However, there are equally good economic reasons to care about inequality. First, sometimes inequality does result from zero-sum interactions. As Harvard labor economist Larry Katz notes,

"Much of the growth of high-end incomes stemmed from market forces, like technological innovation... But a significant amount also stemmed from the wealthy’s newfound ability to win favorable government contracts, low tax rates and weak financial regulation".

If government is captured by narrow interests, then we are likely to see the growth of policies that privilege one group and do nothing to help (or sometimes even hurt) other groups. A less regressive tax code, for example, helps the wealthy but can hurt the poor.

We should also care about changes in inequality because it can indicate how well the economy is functioning for different groups in society. For this reason it is important to understand what is driving inequality. For example, Katz and co-author Claudia Goldin have argued that inequality has increased because of a decline in the relative supply of highly skilled workers. This suggests that increasing college enrollment (and completion rates) for lower-income groups would stem the growth in inequality and increase incomes for poorer Americans.

On the other hand, Arnold Kling and others have argued that inequality has been driven by changes in technology and the growth of "winner take all" markets, as well as changes in family structure. People today are more likely to marry someone of a similar economic and educational background than they were 50 years ago. This re-enforces inequality among now and in the future, as successful, highly educated parents are likely to have successful, highly educated children. If these are the causes, Kling argues, then there is little government policy to can do to stop them, since we are obviously not going to put restrictions on technological progress or prevent wealthy people from marrying each other.

Inequality is not something that the government can directly set, like interest rates or the budget deficit. It is the product, of complex economic, political and social forces. It is important to recognize that inequality has many causes and that by understanding those causes, we can understand fundamental structures in the economy. We should care about inequality because we should care about an economy that satisfies the needs of everyone in society. By understanding what causes inequality, we can better understand how to get there.

Prices also ration goods and services

Princeton bioethicist Peter Singer has an interesting piece in the NT Times Magazine about rationing health care. On the general point of "rationing", Singer says:

"There’s no doubt that it’s tough — politically, emotionally and ethically — to make a decision that means that someone will die sooner than they would have if the decision had gone the other way. But if the stories of Bruce Hardy and Jack Rosser lead us to think badly of the British system of rationing health care, we should remind ourselves that the U.S. system also results in people going without life-saving treatment — it just does so less visibly. Pharmaceutical manufacturers often charge much more for drugs in the United States than they charge for the same drugs in Britain, where they know that a higher price would put the drug outside the cost-effectiveness limits set by NICE. American patients, even if they are covered by Medicare or Medicaid, often cannot afford the copayments for drugs. That’s rationing too, by ability to pay."

While it seems painfully obvious, the point needs repeating: prices are used to ration goods. So the American healthcare system, which is largely based on individual ability to pay, rations healthcare in this way. Yes, most medical costs are payed by insurers, but insurance is expensive for individuals to buy and employer provided benefits are more generous for higher-payed workers.

No American should oppose any public health plan on the basis that it will ration care. Rather, we should judge policies based on how efficiently and ethically that care is rationed.

A little competition never hurt anyone

Robert Cringely had a strange editorial in the NY Times last week -- strange because its central thesis seemed to disregard 400 years of economic thought. Referring to the recent competition between Microsoft and Google, Cringely writes:

"This is all heady stuff and good for lots of press, but in the end none of this is likely to make a real difference for either company or, indeed, for consumers. It’s just noise — a form of mutually assured destruction intended to keep each company in check."

According to Cringely, competition between Microsoft and Google is more about posturing --Microsoft showing that it can compete in the search engine market and Google showing it can compete in the operating system market--than about innovation.

This begs the question, 'what's the difference?' Modern economics is largely founded on the idea that competition improves social welfare. So we should expect that Microsoft's new search engine Bing will push Google to make its search engine better and Google's Chrome OS should push Microsoft to make Windows better.

Of course, that's just theory. What does the empirical evidence say? According to the Atlantic Monthly, we're already seeing the fruits of competition:

"...Microsoft is hoping to launch a cheap, online version of its Office suite that doesn't include all the features of the paid-for version, to keep companies buying that product. But the company still claims that its software will provide "fuller service" than Google Apps, the free suite of online applications with about 15 million users. In short, Microsoft is trying to thread the needle here by creating a free online Office version with enough features to displace Google Docs, but not enough features to encourage companies to give up their lucrative Office purchases. That strikes me as a pretty significant challenge."

I seriously doubt that Microsoft the monopolist would launch an online version of its Office software; Microsoft the competitor, on the other hand, feels the need to answer Google's challenge. What will Google do to counter Microsoft? We consumers can only wait excitedly for the next innovation out of Mountain View, CA.

The point is simple: competition is good, monopoly is bad. If Microsoft had no competition, then they'd still be selling copies of Windows Vista, rather than working feverishly on Windows 7 -- and that's good for all of us.

Thoughts on the Waxman-Markey Bill

The Waxman-Markey bill is the US's first major attempt to control the emissions linked to global warming. As you might expect, it has elicited a fury of views from economists.

Greg Mankiw points out the bill's major shortcoming: that most of the emissions permits are given away for free. These permits were projected to bring in $1 trillion in revenue over the next ten years, money that could be used to pay down the debt or help fund healthcare reform; instead, the bulk of this value will simply be given away to business interests.

In spite of the shortcomings, however, Dean Baker and Paul Krugman support the bill because the cost of doing nothing is higher than the cost of a bad bill:

"Temperature increases on the scale predicted by the M.I.T. researchers and others would create huge disruptions in our lives and our economy. As a recent authoritative U.S. government report points out, by the end of this century New Hampshire may well have the climate of North Carolina today, Illinois may have the climate of East Texas, and across the country extreme, deadly heat waves — the kind that traditionally occur only once in a generation — may become annual or biannual events.In other words, we’re facing a clear and present danger to our way of life, perhaps even to civilization itself. How can anyone justify failing to act?"

Provocatively, Krugman calls failure to act against the "existential threat" of Global Warming treasonous.

Don Boudreaux takes issue with Krugman's accusation:

"It's more accurate to say that Mr. Krugman is committing treason against reasoned debate. One of the most compelling arguments against climate-change regulation is not that global warming isn't occurring but, rather, that the dangers of further regulation far outweigh its likely benefits. Government regulation inevitably is a political animal; it's never guided purely, or even largely, by disinterested science.

Is it treasonous to worry about the influence of interest-groups on regulation? Is it treasonous to fear that centralizing more power in Washington will result in unforeseen negative consequences? Is it treasonous to believe that the threat to our well-being posed by further constraints upon markets is worse than is the threat posed by higher temperatures?"

The interchange between Krugman and Boudreaux highlights the major ideological conflict surrounding attempts to curb Global Warming. Putting science aside for a moment, we are talking about the correct response to a market externality (carbon emissions). For Krugman, externalities can be dealt with through policy intervention, such as a tax (or a cap-and-trade bill, which has the same desired intent). Boudreaux, on the other hand, is a firm adherent of Public Choice Theory, and worries about interest groups capturing the policy process and stifling individual liberty. Theirs is a conversation that would be substantively the same if we were talking about subsidizing research, overfishing or any other commonly cited externality. Krugman is more worried about the externality and Boudreaux is more worried about the intervention.

Like anything else, we economists can easily boil the issues of our time down to the basics of "government vs. the market."

Where can we find the money?

Here's a terrific Letter to the Editor from today's New York Times, courtesy of an economist from the US Air Force Academy:

To the Editor:

Re "Lettuce From the Garden, With Worms" (column, June 21):

Nicholas D. Kristof makes a compelling case for the link between how our food is produced and our health. He doesn't mention that agricultural subsidies (on sugar and corn, for instance) are one reason Twinkies are cheaper than broccoli. Here's a suggestion for how to pay for health care reform: Eliminate all agricultural subsidies.

Kate Silz-Carson
Colorado Springs, June 22, 2009

I couldn't have said it better myself.

Poverty and income inequality over time

Justin Wolfers posted this graph at Freakonomics, showing income growth by quintile since the 1970s:

His analysis was that economic growth has done little for the poor, accruing mostly (almost entirely) to the upper incomes.

Russ Roberts, however, takes issue with this analysis. In two separate posts (here and here), he criticizes Wolfers' interpretation:

"This alas, is a meaningless chart. It tells you nothing about who got the gains of the last 35 years. Why? Because they're not the same people in the quintiles. Starting in 1973, and it's not a coincidence, the divorce rate in the United States began to rise. The number of families increased dramatically simply because of divorce. There was also an increase in the number of families headed by single women with children. The quintile breaks-points changed, not because the economy was growing or shrinking but simply because of changes in the types of families."

In a sense, Roberts is not wrong. Looking at static graphs of quintiles does not account for differences in composition. If people move up the income ladder, then we will mistake static income growth among the groups for static income growth among individuals. The key here is the degree of social mobility. Basically, what are the odds that a person who is poor today will be poor next year, or in ten years?

Emmanuel Saez, the most recent winner of the John Bates Clark Medal, looks at this question in depth. Using Social Security data, Seaz tracked individuals over time to assess income growth and social mobility in the US over time. He concludes:

"We found that changes in short-term mobility have not substantially affected the evolution of inequality, so that annual snapshots of the distribution provide a good approximation of the evolution of the longer term measures of inequality. In particular, we find that increases in annual earnings inequality are driven almost entirely by increases in permanent earnings inequality with much more modest changes in the variability of transitory earnings. However, our key finding is that while the overall measures of mobility are fairly stable, they hide heterogeneity by gender groups. Inequality and mobility among male workers has worsened along almost any dimension since the 1950s: our series display sharp increases in annual earnings inequality, slight reductions in short-term mobility, large increases in long-term inequality with slight reduction or stability of long-term mobility.

Against those developments stand the very large earning gains achieved by women since the 1950s, due to increases in labor force attachment as well as increases in earnings conditional on working. Those gains have been so great that they have substantially reduced long-term inequality in recent decades among all workers, and actually almost exactly compensate for the increase in inequality for males."

Certainly, some longitudinal studies have found larger amounts of social mobility, but the bulk of the literature has not found the degree of mobility that Roberts implies.

So while the graph posted by Wolfers is static, there is evidence that it is a good approximation of reality. Income growth has accrued largely to wealthier individuals and families over the past 30 years, and it has not been sufficiently counterbalanced by social mobility.

Curiously, Roberts says that liberals lack a causal mechanism for changes in inequality and stagnant incomes among the poor. However, Wolfers was explicitly citing one of the most powerful arguments for this phenomenon, namely "skill-biased technological change". As Harvard's Larry Katz and Claudia Goldin explain, technological change has raised the productivity of skilled workers relative to less skilled workers, causing changes in relative incomes. In manufacturing, for example, advanced machinery has decreased demand for assembly line workers, but increased demand for engineers and mechnical operators. At the same time, the supply of educated workers has not kept up, resulting in large income gains in the upper half of the income distribution and much lower gains at the bottom.

Roberts is correct, however, in asserting that there is a difference between income inequality and absolute well-being. A rising tide can lift all boats, even while it lifts some faster than others. But it's important not to minimize slow income growth among lower income Americans; they may be better off than they were 30 years ago, but they are still struggling.

In a follow-up post, I'll delve more into the measurement, economics and politics of inequality.

Time to fix the answer key

A lot of unusual things have happened in our economy over the past year, and sometimes it feels like the old rules don't apply anymore. The people who write the questions for the Foreign Service Exam, however, haven't seemed to notice (via NPR's Planet Money):

I recently bought the foreign service exam study guide since I am taking the test this Friday. The test consists of, among other things, basic economics questions. I was so amused by one of the sample questions that I just had to share:
All of the following are examples of United States products that would typically fail to be produced to optimal output without government intervention EXCEPT:
A. national defense products.
B. light provided by lighthouses.
C. new automobiles.
D. new highways.

And in the answer section:

C. This is the correct answer. Automobiles are not a public good. Optimal production of automobiles is related to the demand for them by individual consumers.