Headline I never thought I would see ...

Jeff Sachs is Right! by William Easterly.

Actually the full headline is "Jeff Sachs is Right! (at least about one thing)", but that's one more thing than I thought Bill Easterly would say Sachs is right about. The headline links to an article by Easterly called Leaders Go Left, But Economists Get Back To Basics on Forbes.com. Easterly writes:

The conventional view at Davos is that a previous consensus in favor of free enterprise has taken a huge beating from the Great Crash of 2008-2009. What is much less known is that many economists are not willing to play along.

Damn right we're not! Easterly continues:

Instead, the crisis seems to have scared many economists of all kinds--including some previously heterodox--to reassert the orthodox recommendations of Econ 101.

I knew something very different was going on among economists when the world's leading trade skeptic, Dani Rodrik of Harvard, the intellectual protector of protectionists, said on his blog on Dec. 31 that protectionism would be catastrophic right now.

A very diverse group of leading economists of all ideological stripes met at a preparatory conference for Davos in Dubai in November 2008. They said in a formal statement that one of their chief tasks is "advocating against the deregulation backlash." An update right before Davos by this same group stressed the importance of "openness to trade" and "competitive markets."

Then there's another school of thought that asks WWJD? What would Jeff do? Jeffrey Sachs has spent more than two decades calling for the U.S. government to spend huge sums on anything that moves, from Bolivia to Poland to Russia to global health to Africa to global warming. But on Wednesday, Jan. 28, as Davos opened, Sachs suddenly announced that he is now a U.S. deficit hawk.

"Without a sound medium-term fiscal framework, the stimulus package can easily do more harm than good, since the prospect of trillion-dollar-plus deficits as far as the eye can see will weigh heavily on the confidence of consumers and businesses, and thereby undermine even the short-term benefits of the stimulus package."

He sounds like one of those IMF fiscal austerity priests issuing a stern reprimand to some benighted land--like those that prior to Wednesday he derided at every opportunity. But on today's deficit dangers at home, I had to agree with Jeff Sachs for the first time in over a decade.

After that statement, I think I need a wee lie down.

Economics: three insidious teachings

Philip Salter at the Adam Smith Institute blog refers us to this essay by the economist Anthony de Jasay. In his essay Anthony de Jasay sets out what he considers to be the three insidious mistakes that are taught to secondary school children in Europe. Only three? These mistakes are the distribution-independence, the worker-defence and the property "rights" theses. Salter notes

In regards to the distribution independence thesis, “high school textbooks teach that capitalism, leaving as it does the distribution of income to the free play (or, as some will say, the caprice) of the market, generates inequality. It goes without saying that inequality is bad both because it is "socially" unjust and because it reduces the aggregate "utility" derived from aggregate income.” This of course rests on the supposition that income is independent of its distribution, which is of course patently absurd.

The worker-defence thesis relies on the idea that employers would abuse workers if "workers' rights" were not defined, extended and bolstered by legislation. Of course, in truth the dominant effect of this legislation is to “create excess supply in the labour market by making employers shun the increased risk of hiring.” As a result the bargaining power of workers is weakened.

The property “rights” thesis is the idea that property is a social construction, granted by society (read government). In reality property is “generated by contracts and matched by the corresponding contractual obligations. Lending and borrowing, mortgages, leases, partnerships, insurance policies, options and other derivatives represent property "rights." They are derivatives of property, and are offset by the corresponding obligations of counter-parties as assets are offset by liabilities.” Thus, property is not the governments to give “rights” to.

de Jasay was inspired to write this essay because of the growing concerns expressed in German and French business circles about the type of economics taught in secondary schools. I have yet to hear of such concerns from business people here in New Zealand. Have I missed them? Do business people even know economics is taught in schools here? Or do they think that what is taught is right, or just irrelevant so they don't care?

Winner and losers

Matt Nolan over at TVHE points us to these two short articles in the The Dominion Post. They make the point that are winners and losers from interest rate cuts. Interest rates are just prices, and like all prices, high ones are good for sellers and bad for buyers. Low prices, on the other hand, are good for buyers and bad for sellers.

Just ask a dairy farmer.

More on Dutton and the art instinct

This time Denis Dutton is interviewed on the Colbert Report, here. Dutton starts at about 14:40, but Eric Crampton tells me it's also worth watching the McCartney bit before that. He reckons he laughed his ass off. Dennis says that Colbert is art.

An $800 billion mistake

In the Washington Post Martin Feldstein writes about An $800 Billion Mistake. He writes:

As a conservative economist, I might be expected to oppose a stimulus plan. In fact, on this page in October, I declared my support for a stimulus. But the fiscal package now before Congress needs to be thoroughly revised. In its current form, it does too little to raise national spending and employment. It would be better for the Senate to delay legislation for a month, or even two, if that's what it takes to produce a much better bill. We cannot afford an $800 billion mistake.

And this from a guy who supports a stimulus package!

Feldstein goes on:

Start with the tax side. The plan is to give a tax cut of $500 a year for two years to each employed person. That's not a good way to increase consumer spending. Experience shows that the money from such temporary, lump-sum tax cuts is largely saved or used to pay down debt. Only about 15 percent of last year's tax rebates led to additional spending.

and

The proposed business tax cuts are also likely to do little to increase business investment and employment. The extended loss "carrybacks" are primarily lump-sum payments to selected companies. The bonus depreciation plan would do little to raise capital spending in the current environment of weak demand because the tax benefits in the early years would be recaptured later.

He continues:

On the spending side, the stimulus package is full of well-intended items that, unfortunately, are not likely to do much for employment.

and

The largest proposed outlays amount to just writing unrestricted checks to state governments. Nearly $100 billion would result from increasing the "Medicaid matching rate," a technique for reducing states' Medicaid costs to free up state money for spending on anything governors and state legislators want. An additional $80 billion would be given out for "state fiscal relief." Will these vast sums actually lead to additional spending, or will they merely finance state transfer payments or relieve state governments of the need for temporary tax hikes or bond issues?

On infrastructure Feldstein writes:

A large fraction of the stimulus proposal is devoted to infrastructure projects that will spend out very slowly, not with the speed needed to help the economy in 2009 and 2010. The Congressional Budget Office estimates that less than one-fifth of the $50 billion of proposed spending on energy and water would occur by the end of 2010.

He ends his piece by noting:

All new spending and tax changes should have explicit time limits that prevent ever-increasing additions to the national debt. Similarly, spending programs should not create political dynamics that will make them hard to end.

This last point is very important. If any stimulus plan is put in place it must have an used by date. And that date must be enforced.

More of the same

USA Today reports

Treasury Secretary Timothy Geithner picked a former Goldman Sachs lobbyist as a top aide Tuesday, the same day he announced rules aimed at reducing the role of lobbyists in agency decisions.

Mark Patterson will serve as Geithner's chief of staff at Treasury, which oversees the government's $700 billion financial bailout program. Goldman Sachs received $10 billion of that money.

Just business as usual in politics.

(HT: Cafe Hayek)

Economists against the "stimulus"

Major newspapers across the United States have been carrying a full page advertisement, paid for by the Cato Institute, with a strong statement signed by many economists, including a number of Nobel laureates, against President Obama's stimulus package. It quotes Obama's statement:

There is no disagreement that we need action by our government, a recovery plan that will help to jumpstart the economy.

Actually there is quite a bit of disagreement. As Greg Mankiw wrote recently

As I have documented on this blog in recent weeks, skeptics about a spending stimulus include quite a few well-known economists, such as (in alphabetical order) Alberto Alesina, Robert Barro, Gary Becker, John Cochrane, Eugene Fama, Robert Lucas, Greg Mankiw, Kevin Murphy, Thomas Sargent, Harald Uhlig, and Luigi Zingales--and I am sure there many others as well.

There are many others, and a number of them signed the above statement.

Goff's goof. (updated)

Having made comments on Goff's idea that people should be able to easily break out of their fixed rate mortgage contracts over at TVHE and Monkey with Typewriter I thought I may as well comment here as well.

I take from what I have read that Phil Goff has suggested that people should be able to easily break out of their fixed rate mortgage contracts to enable them to jump to a lower interest rate. This is not a good idea.

As Matt Nolan points out one problem with contracts is what economists call the "hold-up problem". The hold-up problem is where one party to a contractual relationship exploits the other party's vulnerability due to relationship-specific assets. You try to write a contract complete enough for this problem not to occur. (Insofar as the contract is still incomplete hold-up can still occur. But there are other ways around it, such as determining ownership of assets.) But if you can't deal with it then under-investment can occur since the fear of hold-up can stop parties making the efficient levels of investment.

But if Goff's suggestion was actually implemented, this would not be your normal hold-up. In this case, one party to the contract isn't holding up the other, as such. Here the government would be holding-up one party, in this particular case the banks. The banks have made a specific investment, the loan, and are being forced to renegotiate it, not by the other party, as would be the case under the standard hold-up problem, but by a third party, the government.

I’m sure if banks had thought for a moment that the government would act in this way, they would not have made as many loans as they did, that is, under-investment would have occurred. Some borrowers would have missed out on loans. And if the government does act in the manner Goff suggests, how will banks act in the future? What will they do to protect themselves from this kind of thing happening again? Whatever they do, it won't be good for their customers. Either fewer loans would be made or the conditions of the loans and the interest rates charged would be worse than if the government doesn't intervene. Or may be both.

I wonder if rates where going up, and the banks were in hardship would Goff call for banks to be able to easily break out of their fixed rate contracts to jump to a higher interest rate? I think not. There aren't many votes for Labour among bankers. I think Goff is just playing politics.

Update: Matt Nolan at TVHE points out that in addition to the above there is another problem with Goff's idea: "households are willing to take more risk with their mortgage - as they realise the government will intervene to help them out."

EconTalk this week

EconTalk host Russ Roberts talks about the role of empirical evidence and bias in economics and why economists disagree. Roberts talks about how his interviews with various economists at EconTalk have forced him to reassess the role of empirical evidence in various debates in economics and economic policy. Roberts is joined by Robin Hanson of George Mason University for counterpoint and therapeutic advice for those uneasy about the scientific or non-scientific nature of economics.

Interesting blog bits

1. Mark Koyama on The BBC Account of the Great Depression.

   I wonder if this "documentary" will be seen in NZ

2. Homepaddock on a Silly question.
3. Will Wilkinson asks What's Fair?
4. A news report on Swedish couple denied right to name their son Q
5. Bryan Caplan on Why People Don't Want More Kids, and What It Means
6. adamsmith1922 on UK rules out cutting off Internet users
7. Matt Nolan on Labour suggests breaking mortgage contracts.
8. Not PC suggests Save the earth: Exploit a greenie

How economists analyse the stimulus

Arnold Kling writes on How economists analyze the stimulus in the Atlantic magazine. Kling writes

Two economists on opposite sides of the stimulus debate recently expressed their opinions in terms of algebra. The opponent, Kevin Murphy of the University of Chicago, laid out the basic framework at a panel where he was the second speaker. The proponent, Brad DeLong of Berkeley, reacted by reprinting Murphy's framework and using it to articulate his disagreement with Murphy.

A summary of the differences between Murphy and DeLong is given in the table below:

$100 of Government Spending	Murphy's Estimates	DeLong's Estimates
Keynes Effect	$50	$150
Housework Effect	-$25	-$30
Galbraith Effect	-$25	$0
Feldstein Effect	-$80	-$33
The Bottom Line	-$80	$87

The Keynes Effect is the use of unemployed resources to produce useful output. The Housework Effect reflects the fact that we count the output people produce in the market but not the value of leisure or unpaid work that they can produce when not on a paying job. The Galbraith Effect is the additional value of government output over private output. The Feldstein Effect is the fact that government output eventually must be paid for with taxes, and most taxes cause supply-side distortions to the economy. Taxes tend to penalize work, thrift, and investment, which are the sources of prosperity. The Kling Atlantic piece explains in more detail.

Kling comments on the framework used above:

First, it assumes that the four parameters are constants. That is, they assume that what is true of $100 of government spending is proportionately true for $800 billion of government spending or for $100 trillion of government spending. However, the more the government spends, the less likely it is that the additional dollars will soak up unemployed resources and the more likely it is that instead additional dollars will draw resources away from private output. Furthermore, there probably are diminishing returns to the Galbraith effect--as you get beyond the "low-hanging fruit," the usefulness of additional government projects will decline.

Second, I think that the spending plan will pass because politicians, particularly Democrats, assume a huge Galbraith effect. They value government output much more highly than private output. Larry Summers famously said that in order to be effective, fiscal stimulus must be "timely, targeted, and temporary." The Democrats' plan is none of those things. Instead, it is an enormous Galbraithian transfer from the private sector to the public sector. While I can understand their enthusiasm for this transfer, I cannot share in their glee.

Personally I'm more in the Murphy camp than the DeLong camp.

The big mac is back

Well the index anyway. The US dollar's recent revival has made fewer currencies look dear against the Big Mac index.



(HT: The Economist)

Great new blog

William Easterly professor of economics at New York University and author of The White Man’s Burden: Why the West’s Efforts to Aid the Rest Have Done So Much Ill and So Little Good, and The Elusive Quest for Growth: Economists' Adventures and Misadventures in the Tropics has started a blog called Aid Watch. Put it on your blog list, it will be well worth reading.

Interview with the central banker of Zimbabwe

Is this strange ... or what:

I've been condemned by traditional economists who said that printing money is responsible for inflation. Out of the necessity to exist, to ensure my people survive, I had to find myself printing money. I found myself doing extraordinary things that aren't in the textbooks. Then the IMF asked the U.S. to please print money. I began to see the whole world now in a mode of practicing what they have been saying I should not. I decided that God had been on my side and had come to vindicate me.

I really don't know if God is on the side of hyperinflation. The whole interview is here.

(HT: Marginal Revolution.)

Yes, institutions do fail, but ...

Let me respond to Matt Nolan's response to my response to his response to me. At least I think that's what I'm doing!!! :-) You can see Matt's response over at TVHE, and it is worth reading and thinking about.

He is right, all institutions do fail to some degree. As I said previously

Clearly markets don't work perfectly, if they did firms would not exist, for example.

But the important issue here is, do markets fail often enough and badly enough to justify government intervention, given that governments also fail. In general I would say no. In the above case, positive transaction costs mean that markets are not always the most efficient way to produce goods, and firms have arisen to deal with this. Could government action have done any better?

Matt says

[...] in reality market failures are also endemic.

But how true is this? If you are a Stiglitz type, then it is totally true, at all times. But by what criteria? As Philip Booth has put it

If I were to give you an engineering lecture and I were to start by saying, correctly I believe, that the maximum theoretical speed of a perfect car was the speed of light and that a car that travelled at any speed lower than that was a 'failed car' or suffered from 'car failure', you would probably think that it was a pretty useless lecture. And you would be right.

But this is what the market failure guys are doing. They say, as markets don't meet the perfect competition standard there is market failure. But perfect competition is a lot like travelling at the speed of light, it just isn't going to happen.

Most people, even those who are not engineers, understand the best way for evaluating cars is that you take two cars and look at different characteristics and evaluate which is best for a particular purpose. But when economists teach about market failure they, instead, suggest policies which governments could, in theory, use to make an imperfect market perfect regardless of whether it is possible, in practice, to improve economic welfare by adopting such policies.

Matt points out a number of reasons why, in theory, markets can fail.

1. Sellers of a product have market power,
2. Buyers and sellers without a voice in the market are adversely/positively influenced by the market,
3. Entry and exit from the market are difficult,
4. Information is asymmetric,
5. Institutional conflict pushes firms/buyers away from rational behaviour.

And he is right, markets will not meet the perfect competition standard for these reasons. But so what? Governments can not meet this standard either. Governments can not deal with these issues in such a way as to get the markets to perfect competition. So the real comparison is between imperfect markets and whatever imperfect outcome governments can create.

As I have argued, for the case of asymmetric information, market solutions to this problem deal with the issue as best as it can be handled. When you look at the empirical literature, some of which I discussed, you see that markets do adjust to the point where asymmetric information doesn't collapse the market.

The reasons that Matt points out above can be seen as necessary reasons for government intervention, but are they sufficient? What will the outcomes of government intervention be? What of the unintended consequences? The kinds of questions we should ask ourselves when thinking about markets failure are: 'given what we know about the imperfections of government, might non-intervention be better than intervening?', 'if we intervene, how do we minimise the possibility of bureaucratic capture?', 'how do we ensure that rights to produce whatever are held by the people who value them most?'. In short, can government intervention in reality, not just in theory, improve on the market solution to a "market failure".

Regulation really can go too far......

From the Adam Smith Institute blog

Interesting blog bits

A bit of weekend reading:

1. Michael Giberson on More on airline fuel cost hedging: Air New Zealand takes hit.
2. Greg Mankiw asks Is Joe Biden disingenuous or misinformed?
3. Mankiw also has A Question for Class Discussion.
4. Will Wilkinson on Glaeser's Libertarian Progressivism
5. Arnold Kling asks Is Europe Insolvent?
6. Andrew J Oswald comments on World-leading economics research in Europe
7. Tyler Cowen on Dumping on Robert Barro.
8. Philip Salter on Hayek: understanding the financial crisis

Market failure (updated)

In this second part of my response to Matt Nolan's comments let me look at the idea of market failure. Much of what is below is based on two books, which are worth looking at for more information: Market Failure or Success: the New Debate, edited by Tyler Cowen and Eric Cramption, Edward Elgar, 2002 and Famous Fables of Economics: Myths of Market Failures, edited by Daniel F. Spulber, Blackwell, 2002. For an outright libertarian view on market failure see Markets Don't Fail! by Brian P. Simpson, Lexington Books, 2005.

There have been many reasons put forward for market failure. Aspects of these theories can be traced back to the beginnings of economics, but the modern formulations were laid down by Paul Samuelson, James Meade, Francis Bator and others in the 1950s. From then until the 1970s the general consensus would have been that governments should provide at least a few basic public goods, such as national defence, but that markets do the best job of providing most goods and services.

Clearly market don't work perfectly, if they did firms would not exist, for example. But that's not the point, markets don't have to be perfect, they just have to be better than the alternative. So market failure supporters can't just show that markets fail when compared to some hypercritical perfect competition model, they have to show they fail when compared to some real, actually workable alternative. And they have to show there solution is better than any market solution.

Since the 1970s a new set of reasons for market failure based around the idea of asymmetric information has arisen. Arguments like Akerlof's famous example of the "lemons problem" suggest that market failure is widespread. Few if any markets don't suffer from at least some asymmetry in information. According to market failure supporters this will result in mutually beneficial trade not taking place and in the most extreme situations markets collapsing altogether.

But does asymmetric information really cause market failure or does it in fact cause markets to exist? The great Austrian economist Friedrich Hayek would surely argue the latter, markets are the answer to the problem of asymmetric information.

For Hayek markets eliminate the asymmetry by revealing relevant aspects of information in market prices, but not so for the Akerlofs of this world. As Cowen and Crampton (2002: 5) put it "[t]he Canadian plumber's knowledge of substitutes for copper piping influences the French electrician's choice of home wiring through its effect on the market price of copper. For the market failure theorists, however, asymmetry cannot be overcome by exchange precisely because the unequal distribution of information interferes with mutually beneficial exchange." The fundamental point of markets for Hayek is that they utilise dispersed, asymmetric, knowledge in such a manner as to align production plans with consumption plans.

This alignment takes place in three ways: "First, ex ante, prices transmit knowledge about the relative scarcities of goods to various market participants so they may adjust their behavior accordingly. If the price of a good goes up, this informs economic actors that the good has become relatively more scarce and that they should economize on its use. For this reason, participants in the market have an incentive to include the knowledge contained in prices in their actions over time. Second, the price system serves the ex post function of revealing the ultimate profitability or unprofitability of economic actions. Prescient entrepreneurship (in the broad sense of the term) is rewarded with profits; errors are penalized by losses. Market prices, therefore, not only motivate future decisions by conveying information about changing market conditions, but also help market participants evaluate the appropriateness of past market decisions and correct erroneous ones. Seen in this light, the market process is a matter of dynamic adjustment. What is it adjustment to? It is, in effect, adjustment to the gaps between a static equilibrium of universal satisfaction and the many departures from this model that are present in the real world. Each of these gaps between the counterfactual and the factual represent a profit opportunity. Price information is also motivation for profitable real-world adjustment, over time, to the profit opportunities of a particular place." (Boettke 1997: 25-6)

New markets can develop to deal with asymmetric information, if you don't know the condition of a second hand car you take it to the AA and get a report on what's right or wrong with it. If you don't know what maybe wrong with a house you want to buy you can get that checked as well. These services have developed to deal with the asymmetric information in the used car and housing markets. The basic point is that markets constantly innovate, informational asymmetries create demand for product assurance from which profits can be made by alert entrepreneurs.

Klein ("The Demand for and Supply of Assurance" in Cowen and Crampton 2002) is one paper which looks at the institutions that have arisen in the market system to mitigate problems of information, quality and certification. The lesson to be drawn here is that while "[m]arket failure theory predicts massive deadweight losses accruing from the trades that fail to take place because of informational asymmetries. In reality, alert entrepreneurs see deadweight losses as potential profits to be earned by removing the impediment to trade." (Cowen and Cramption 2002: 12-3)

On the empirical front, in a recent paper ("Lemons hypothesis reconsidered: An empirical analysis", Economics Letters 99:3 (June): 541-544) in Economic Letters, Arif Sultan sets out to test this idea. He argues that used cars, if inferior to new cars, would require higher maintenance expenditures. His paper tests the hypothesis that there is no difference in the average maintenance expenditures required for cars acquired used and those acquired new.

The results he gets show that there is no evidence that cars acquired used required more maintenance expenditures than those of a similar age acquired new. The conclusion to the paper reads, in part,

The purpose of this paper was to examine the difference in the quality between cars acquired used and those acquired new. I measured the quality of the car by using maintenance expenditures incurred on a car [... ] I found that cars acquired new required the same maintenance expenditures as those acquired used, all else being equal, implying that cars acquired used are of same quality as cars acquired new of a similar age. If cars acquired used were of lower quality, they would have required more maintenance expenditure.

In another test of adverse selection, Eric Bond studies the used car market. His paper is "A Direct Test of the “Lemons” Model: The Market for Used Pickup Trucks." The American Economic Review 72:4 (September): 801-4. Bond concludes that trucks purchased in the used market required no more maintenance than other trucks of similar age and mileage. If the used trucks market suffered from a lemons problem, truck owners would keep high quality older trucks while selling lemons on the used truck market. Yet data collected by the US Department of Transportation reveal no significant differences in maintenance costs between trucks kept by their original owners and trucks sold on the used car market. In the market used as exemplar by Akerlof, Bond finds no empirical support for the lemons hypothesis.

Cawley and Philipson ("An Empirical Examination of Information Barriers to Trade in Insurance." The American Economic Review 89:4 (September) 827-46) test the implications of the asymmetric information model in the term life insurance market and find no evidence of market failure. The asymmetric information theory would predict increasing unit prices for insurance purchases, quantity-constrained low-risk individuals, and prohibitions on the purchasing of multiple small contracts to prevent arbitrage. But Cawley and Philipson find robust evidence for decreasing unit prices, for low-risk individuals holding larger policies than high-risk customers, and for frequent multiple contracting.

Another test for asymmetric information comes from the Chiappori and Salanie ("Testing for Asymmetric Information in Insurance Markets." Journal of Political Economy 108:1 (February): 56-78) study of the French market for automobile insurance. The results are similar to those of Cawley and Philipson. Where asymmetric information models predict that, among observationally identical individuals, those with more coverage should have more accidents, Chiappori and Salanie find no correlation between unobserved riskiness and accident frequency. And there are other similar studies which also cast doubt on the empirical validity of the asymmetric information story for market failure.

I have discussed just one reason for market failure and there are many others. But if you look at the books noted above you will see that these other stories don't hold up any better than the asymmetric information story - Coase shows that lighthouses were privately supplied, Steven N. S. Cheung shows that the moral hazard problems involved sharecropping have market solutions, Liebowitz and Margolis undermined the technology lock-in arguments, Steven N. S. Cheung shows that beekeepers and orchard owners contracted routinely and so on. My basic point is that the standard market failure stories don't hold up well either theoretical or empirically and there are good reasons for thinking that even if there is market failure, market solutions are the best, or at least, the least imperfect solution.

Update: A couple of extra references from Eric Crampton: Propitious selection in insurance by David Hemenway. Abstract:

The theory of propitious selection suggests that there are risk-avoiding personalities who both take physical precautions and buy financial security (insurance). Conversely, there are risk seekers who tend to do neither. Survey evidence is presented that is consistent with the theory. Individuals who obtain motor vehicle liability coverage are less likely than others to drink-and-drive, and are more likely to engage in health-beneficial (risk-avoiding) behaviors. Propitious selection may be a general phenomenon promoting favorable selection in many real world insurance markets. (Emphasis added.)

Does Propitious Selection Explain why Riskier People Buy less Insurance by Philippe De Donder and Jean Hindriks. Abstract:

Empirical testing of asymmetric information in the insurance market has uncovered a negative correlation between risk levels and insurance purchases, rather than the positive correlation predicted by the standard insurance theory. Hemenway (1990) proposes an explanation for this negative correlation, called “propitious selection”. He argues that potential insurance buyers have different tastes for risk and that “individuals who are highly risk avoiding are more likely both to try to reduce the hazard and to purchase insurance” (p. 1064). Chiappori and Salanié (2000) also suggest that this line of argument, which they call “cherry picking”, may explain the observed negative correlation.

In this paper, we show that the propitious selection argument does not imply negative correlation between risk levels and insurance purchases, because it fails to take into account the supply side of the insurance market. To illustrate this claim, we provide a model where, although we assume that individuals differ in risk aversion and that the more risk averse individuals exert more precaution and buy more insurance, we end up with a positive correlation between risk and insurance purchases at equilibrium. The reason is that, in any separating equilibrium, the more risk averse individuals face insurance overprovision which, combined with moral hazard, increases their risk relative to the less risk averse individuals. To obtain the negative correlation between risk and insurance purchases, one further needs the extra condition of decreasing marginal willingness to pay for the less risk averse individuals. Finally, we find that propitious selection has profound policy implications for social insurance.

Governemnt failure

In a previous posting I said

"Now there may be something wrong with the price system, but there is a lot more wrong with the government system."

In the comments to that posting Matt Nolan, of The Visible Hand in Economics fame, takes issue with me

"That's really your key value judgment isn't it. I'm not sure I agree. I am not a fan of "multipliers" - but in the face of a large, sustained, market failure I find it hard to conclude that there is no role for government."

Let me try and explain a part of my comment above. In particular the "more wrong with the government system" bit. It's important to realise that even if you accept the "market failure" idea you also have to deal with "government failure".

Why might government fail? In short, it's because people run governments and people aren't perfect. We tend to assume that in the economic area people act in their own best interests and that they have imperfect knowledge. The important point to note is that in the political sphere people have the same characteristics. This is not to say that altruism is impossible in either arena, but it seems prudent to adopt, as a working assumption, that voters, politicians and bureaucrats will be driven, at least to some degree, by self-interest.

A number of implications follow from this assumption.

• Bureaucrats cannot 'correct' market failure, even if they wished to do so, because they lack the information to know what the outcome of the market process would have been had the so-called 'failure' not existed.
• As argued above, bureaucrats will act in their own best interests. They will take actions that lead to promotion and advancement for themselves. In an effort to avoid problems, like public scandals, they may well become risk-averse, and thus they may regulate to reduce risks to a greater extent than consumers desire. They may also wish to increase there own power and prestige and the size of their regulatory bureau.
• Rational voters have, in general, no interest in being perfectly informed about political issues because the probability of an individuals vote impacting on the result of an election is so small. This means that there will be information asymmetries between regulatory bodies and those to whom they are (should be) ultimately accountable: us, the voters. Thus electors are at a relative disadvantage when assessing the merits of proposed regulations.
• While voters in general have little incentive to be actively involved in policy formation, in cases where the benefits of government actions are concentrated among particular voter groups, or institutions or companies, such groups have an increased incentive to lobby for expanded regulatory protection. Where the cost of such regulation is dispersed among voters, the losers from such regulation, will have no incentive to oppose the increased controls because the expected cost of lobbying to the individual voter will be large relative to the expected benefit.
• Politicians will, all other things being equal, respond to the preferences of the 'median voter' rather than act to create regulatory institutions that might address genuine problems of market failure.

For all of these reasons government failure will result. We will get a level of regulation greater than that which would lead to welfare maximisation. Political institutions will also be biased towards forms of intervention that benefit the interest groups on which benefits are concentrated. And my view would be that government failure is at least as much, if not more of, a problem as market failure.

Faculty panel: evalutating the Obama stimulus package

A panel discussion, at The University of Chicago, featuring Professors John Huizinga, Robert Lucas and Kevin Murphy. They evaluate and discuss the pros and cons of the Obama Stimulus Package. Watch video; View Huizinga pdf; View Murphy pdf;View Lucas pdf (panel presentation); View Lucas pdf (extended talk).

David Henderson comments on this video here and Arnold Kling comments here. Kling's summary is

Huizinga makes three points. First, we are hearing a lot of Keynesian macro being tossed around now, and it's not clear why. Second, so far this is not such a calamitous recession. The number of jobs lost is high, but relative to the size of the economy it's not out of line. (I would say that the media hype is greater for this recession. It's like the way that media magnify the horrors of war.) Some people forecast a long, deep recession, but it's a bit weird to base policy on a forecast of a long stagnation, when such forecasts are highly uncertain. The third point is that a fiscal deficit has costs as well as benefits. It will cut into national saving, which is not really a good thing long term.

Kevin Murphy points out that for fiscal stimulus to be cost-effective, the government has to make better use of resources. This is plausible when government uses unemployed resources, but it is implausible when government takes resources out of productive uses in the private sector. But if there is a 7 percent unemployment rate, then 93 percent of resources *are* being used, so the chances seem pretty high that a lot of the government spending is going to draw on resources that already are employed.

Henderson's comments are

Arnold covered Huizinga's highlights and so I have nothing to add other than that Huizinga laid it out beautifully and his overheads are worth showing to people. They show percentage job losses in various recessions to put this one in perspective. Huizinga, incidentally, was Yao Ming's agent.

The star presentation, though, was from baseball-cap-wearing Kevin Murphy. The clarity was superb. He laid out an equation that everyone could agree to so as to see if increases in government spending could have a good effect. The disagreements, he noted, would be on the various magnitudes and on one sign. Here's what Christie Romer must believe, here's what I believe, here's why Marty Feldstein is in trouble given his past work on deadweight loss from taxes, etc. Kevin made the point I made in my recent Forbes.com article about the destructiveness from cutting taxes without cutting marginal tax rates. Print out the equation and you can follow the numbers as you go along. Bottom line: if you share Kevin's view about the magnitudes, you will conclude that this Obama fiscal policy will be horrible. And you have to have a pretty extreme view of the magnitudes of the parameters to conclude that it will be on net good.

The final presentation was a sobering one from Bob Lucas, who made the Friedman-type points about the quantity equation and why the Fed must be the lender of last resort but we should avoid all the fiscal policy stuff.

The best contribution from the audience was from John Cochrane, who was a junior economist at the Council of Economic Advisers when I was a senior economist there. Cochrane pointed out that he had gone through the last 50 years of textbooks (on his web site, he says 40) and couldn't find any of them claiming that increases in government spending were a good way out of recessions. He pointed out that given that the problem is a lack of investment, having the government spend money that it borrows must crowd out some investment.

Tyler Cowen's comment is short but bang on

They are all excellent but I thought Kevin Murphy was the most to the point.

Watching the video is a hour well spent. Having a printout of the pdf files helps.

Government spending is no free lunch

Over at the Wall Street Journal Robert J. Barro makes the obvious point that Government Spending Is No Free Lunch. Barro writes about the so-called "multiplier" effect of government spending:

To think about what this means, first assume that the multiplier was 1.0. In this case, an increase by one unit in government purchases and, thereby, in the aggregate demand for goods would lead to an increase by one unit in real gross domestic product (GDP). Thus, the added public goods are essentially free to society. If the government buys another airplane or bridge, the economy's total output expands by enough to create the airplane or bridge without requiring a cut in anyone's consumption or investment.

The explanation for this magic is that idle resources -- unemployed labor and capital -- are put to work to produce the added goods and services.

If the multiplier is greater than 1.0, as is apparently assumed by Team Obama, the process is even more wonderful. In this case, real GDP rises by more than the increase in government purchases. Thus, in addition to the free airplane or bridge, we also have more goods and services left over to raise private consumption or investment. In this scenario, the added government spending is a good idea even if the bridge goes to nowhere, or if public employees are just filling useless holes. Of course, if this mechanism is genuine, one might ask why the government should stop with only $1 trillion of added purchases.

What's the flaw? The theory (a simple Keynesian macroeconomic model) implicitly assumes that the government is better than the private market at marshaling idle resources to produce useful stuff. Unemployed labor and capital can be utilized at essentially zero social cost, but the private market is somehow unable to figure any of this out. In other words, there is something wrong with the price system.

Now there may be something wrong with the price system, but there is a lot more wrong with the government system.

But back to the multiplier. Team Obama is reportedly using a multiplier of around 1.5. Barro's response:

A much more plausible starting point is a multiplier of zero. In this case, the GDP is given, and a rise in government purchases requires an equal fall in the total of other parts of GDP -- consumption, investment and net exports. In other words, the social cost of one unit of additional government purchases is one.

He notes that even looking at the massive expansion of U.S. defence expenditures during World War II you only get a multiplier of 0.8. What this means is that the war lowered components of GDP aside from military purchases. Declines occurred, in the main, in areas such as private investment, nonmilitary parts of government purchases, and net exports -- personal consumer expenditure changed little. Wartime production siphoned off resources from other economic uses so there was a dampener, rather than a multiplier. But as Barro points out:

There are reasons to believe that the war-based multiplier of 0.8 substantially overstates the multiplier that applies to peacetime government purchases. For one thing, people would expect the added wartime outlays to be partly temporary (so that consumer demand would not fall a lot). Second, the use of the military draft in wartime has a direct, coercive effect on total employment. Finally, the U.S. economy was already growing rapidly after 1933 (aside from the 1938 recession), and it is probably unfair to ascribe all of the rapid GDP growth from 1941 to 1945 to the added military outlays. In any event, when I attempted to estimate directly the multiplier associated with peacetime government purchases, I got a number insignificantly different from zero.

A multiplier of zero doesn't make government stimulus packages look at all good. Over at the Organizations and Markets blog, they make the point:

Of course, if GDP is adjusted for quality, the multipler is most likely negative, as resource allocation is directed by government officials, not consumer demands.

And that makes stimulus packages look even worse!

It should also be noted that Barro's estimate of the wartime multiplier could be an overestimate, if Robert Higgs is right, see here, and here.

Demography and the current financial crisis

Nick Silver over at the IEA blog has a posting on Demography and the financial crisis. He notes that Martin Wolf, the Financial Times' chief economics commentator has put forward an explanation for the cause of the current financial crisis. Briefly, Wolf argues that 'the savers' of the world, China, Germany and Japan et al produce more than they consume. This excess production gets exported to 'the spenders' who are lend by the USA along with other countries such as the UK and Spain. The resultant excess savings are exported by the savers to the spenders to fund the consumption, which has resulted in asset bubbles and huge debts amongst the spenders. Wolf goes on to suggest that 'the savers' need to reduce their "chronically high" savings rates so that they no longer run large current account surpluses.

Silver wants to offer an alternative view. He writes:

It is true that the UK and USA, for example, have younger populations than Germany and Japan. However, they still have ageing populations. Yet gross national savings rates in both countries are approximately 13% of GDP (compared with 27% and 25% in Japan and Germany respectively (IMF data)). The demographics therefore suggest that it is the USA and UK that have the serious problem - chronically low savings rates.

What might happen if the spenders’ savings were in line with their demographic situation? They would have a lower propensity to borrow and spend, so would have a lower demand for the savers’ capital. The savers would still export capital to the spenders, due to the age differential between the populations, but in far smaller quantities. Saving countries would therefore export more capital to younger countries, in regions such as South Asia, the Middle East and South America. Local investments would also be relatively more attractive, as would increased consumption.

Faced with the ‘credit crunch’, the mantra of most economists and politicians has been to encourage consumers and companies to borrow and spend. And if they stop spending, governments are acting as spenders of last resort.

This is akin to giving a heroin addict more heroin to stop the pain of withdrawal - it might stop the immediate pain but as a treatment it’s totally self defeating. The real problem is that certain economies, notably the UK and USA, are structured in such a way that they are heavily reliant on ever increasing borrowing backed by over-inflated asset values - when this stops, growth and employment collapse. It is this that has to change.

Silver's blog is based on work done under the IEA Empowerment Through Savings Programme.

Let's stimulate private risk taking (updated)

Alberto Alesina and Luigi Zingales have a piece in the Wall Street Journal on Let's Stimulate Private Risk Taking: Tax cuts are the way to nudge capital toward productive uses. With regard to the current crisis in the US they write:

But this particular recession is unique not in its dimensions, but in its sources. First, it is the result of a financial crisis that severely affected stock-market valuations. The bad equilibrium did not originate in the labor market, but in the credit market, where investors are reluctant to lend to risky firms. This reluctance is making it difficult for these firms to refinance their debt, forcing them to default on their credit, further validating investors' fear. Thus, the problem is how to increase investors' willingness to take risk. It's unclear how the proposed stimulus package would help inspire investors to do so.

The second reason this recession is unusual is that it was caused in large part by a significant current-account imbalance due to the low savings rate of Americans (families and government). Even assuming that more public spending would increase private consumption -- a big if -- such a measure would cause even more imbalance.

They then ask the question: So how do we stimulate the economy without increasing the already large current-account deficit? Their answer:

Create the incentive for people to take more risk and move their savings from government bonds to risky assets. There is no better way to encourage this than a temporary elimination of the capital-gains tax for all the investments begun during 2009 and held for at least two years.

If we fear this is not enough, we can temporarily increase the size of the capital loss that is deductible against ordinary income. This will reduce the downside of new investments and increase the upside.

More savings need to be invested, and firms need an incentive to invest in order to help aggregate demand in the short term and promote long-term growth. The best way to do this is to make all capital expenditures and research and development investments done in 2009 fully tax deductible in the current fiscal year.

A large temporary tax incentive may be just enough to jolt investors from their current paralysis to take action. Such a switch will also be fueled by the temporary capital-gains tax cut mentioned above, which will motivate people to move their savings from money-market funds to stocks, increasing valuations, investments and confidence.

Arnold Kling makes the point that eliminating the capital gains taxes for investments made in 2009 would cause much more trading than actual new investment. Allowing firms in 2009 to expense investment rather than have to use depreciation may not help much if companies continue to lose money. In such a case the value of tax deductions is not going to matter.

Update: See here for Donald J. Boudreaux's response to part of the Alesina and Zingales piece.

Quote of the day

From an interview in Esquire magazine, Charles Koch, the CEO of America's largest private company, Koch Industries:

The role of business is to produce goods and services that make people's lives better. And if you have to get a subsidy -- if you have to force other people to support your profit -- you're not doing that. You're not making them better off; you're making them worse off.

Interesting blog bits

1. Eric Crampton on Climate stocks at iPredict.
2. Luigi Zingales says, Yes we can, Mr Geithner.
3. Sylvester Eijffinger on Europe does not face deflation danger.

   There are growing concerns about deflation. This column argues that inflation remains the far more relevant danger and cautions against lowering Eurozone interest rates too quickly.

4. Peter Klein gives More Evidence Against the QWERTY Effect.
5. Mark J. Perry on the Wheels Falling Off Global Warming Bandwagon
6. Greg Mankiw on The Long Lags of Fiscal Policy
7. Michael Giberson on Carbon tax vs. cap-and-trade, again.
8. Will Wilkinson on the Obama inauguration speech.

Can Obama lead the US out of the recession?

Investor's Chronicle asked Russell Roberts, professor of economics at George Mason University, for 350 words on whether Obama can lead the US out of recession. His answer takes 351 words to say no.

"I love the image of President Obama leading the country out of recession. America is lost. Adrift. Off the path. But the Great Leader with his torch (or lantern or GPS system, depending on one's taste for nostalgia versus gritty realism) will lead us home, into the light, into the future, towards prosperity.

It makes for a good future hagiography. For human beings in the real world - it's a fantasy. Barack Obama has no idea of how to get the economy out of the mess we're in. That doesn't mean we're not going to get out. Or that he might help. It's just that the phrase "lead us out of the recession" implies a plan and design that isn't plausible in the current economic environment.

Until a few months ago, a lot of economists, including not a few Nobel Laureates, thought that we'd whipped this whole business cycle thing. Over the last quarter century, the American economy has had only two very mild recessions. Now all of a sudden, people are worrying the economy is going to go Japanese and enter a decade of stagnation.

So it's a time for humility rather than hubris in my profession. Obama's economic team, for all its brain power and good intentions, is in uncharted territory. There's no recipe or manual or roadmap for getting the economy back on track. No one is quite sure how to correct imbalances in financial markets and the housing market. And no one knows how to create confidence, the biggest element lacking in the current economic climate.

No man or woman runs the economy. No man or woman or team of people can possibly plan the evolution of the economy in the coming months. America will come out of the recession but the time and pace are unknown. Obama can help. But he can just as easily slow down any recovery. Some part of the current mess we're in is the result of erratic government policy that has added to the uncertainty facing consumer, investors, and entrepreneurs."

(HT: Cafe Hayek)

Shocked but not surprised

Tyler Cowen over at Marginal Revolution writes in a posting Blogging *The Origin of Species*,

That is a worthwhile endeavor and you will find the blog here. Nonetheless I was shocked (but not surprised) to read the following:

Evolutionary biologist John Whitfield is reading Origin for the first time and writing about it, chapter by chapter.

I would ask Tyler, if he is shocked but not surprised to learn that a biologist hasn't read Darwin, then how shocked, but not surprised, would he be to discover that few economists have read Adam Smith? Has Tyler? I will guess yes. Should he blog on "An Inquiry into the Nature and Causes of the Wealth of Nations" chapter by chapter?

I must confess I have only even read part of it myself. One day I will get round to reading the rest.

Lawrence H. White on India

Economist Lawrence H. White has just returned from three weeks in India, mostly in Bombay and Delhi. He makes a few observations about governments and markets based on his experience in India, over at the Division of Labour blog.

The sweeping Marine Drive in Bombay (aka Mumbai) hugs the shoreline of the Arabian Sea. Near the Drive's southern end is the 5-star Oberoi Hilton hotel. A block or two to the hotel's north begins a long row of Art Deco apartment buildings facing the Sea to the west. The area could be the Miami Beach of India -- if not for the sad and startling fact that about half of the apartment buildings are shabby and stained. They look like they haven’t been painted in 10 years. Why would such a high-rent district be left in such disrepair? Ah, but it isn't a high-rent district: it happens that Bombay has had severe rent controls for decades. What a shame, what a waste.

Streets and other public places in Bombay are often dirty or in disrepair. On the other hand, in the seaside Juhu neighborhood north of downtown one can walk or jog in a beautifully landscaped and maintained park. What gives? It turns out that the park is private, owned by the surrounding apartment co-ops. Admission is Rs. 5 (about US$0.11). Maintenance is provided by the HSBC bank, which has a few discrete signs posted about the park.

Corporate welfare: Calvin and Hobbes version

Thanks to Eric Crampton for pointing out this Calvin and Hobbes cartoon to me. Covers the auto industry in the US and, it seems, the recycling industry in New Zealand.
Click to get a larger version of the cartoon.

Economists have abandoned principle

Back in December last year Oliver Hart and Luigi Zingales had an article in the Wall Street Journal in which they make this statement. They write,

This year [2008] will be remembered not just for one of the worst financial crises in American history, but also as the moment when economists abandoned their principles. There used to be a consensus that selective intervention in the economy was bad. In the last 12 months this belief has been shattered.

Practically every day the government launches a massively expensive new initiative to solve the problems that the last day's initiative did not. It is hard to discern any principles behind these actions. The lack of a coherent strategy has increased uncertainty and undermined the public’s perception of the government’s competence and trustworthiness.

Peter Klein at Organizations and Markets (a blog well worth reading) says

Now, Hart and Zingales imply, but don't demonstrate, that these selective interventions are supported by the majority of economists. I think most economists oppose them, but I don’t have systematic evidence either. Still, their point is well taken. To the extent that the lay public associates the moves by Bernanke, Paulson, etc. as representing some kind of professional consensus, the reputation of economics as a scientific discipline will be forever destroyed.

Indeed. I think many economists are far from happy with the Bernanke/Paulson type response to the financial crisis but most non-economists don't realise this fact. Some of us still hold to our principles and thus are still of the view that selective intervention in the economy is bad.

As for the Hart-Zingales counter-idea that governments "should intervene only when there is a clearly identified market failure", I don't mind this since I think that such a condition is basically impossible to meet.

Drugs and the death penalty

Bryan Caplan at EconLog blogs on the fact that the death penalty is mandatory for drug trafficking in Singapore. At the end of his post Caplan asks

Question: Suppose you were Milton Friedman trying to convince Lee Kuan Yew to legalize drugs. What would you tell him?

A nice question, but what about some good answers.

Hyperinflation and then some

According to this BBC report, Zimbabwe is introducing a Z$100 trillion note, which is currently worth about US$30 or £20.

Just for the record, according to Steve H. Hanke at the Cato Institute Zimbabwe's inflation rate is 89,700,000,000,000,000,000,000% This is as at 14/11/08. There is an interesting note on the web page for Zimbabwe's inflation rate,

Since mid-November 2008, the weekly update of the HHIZ has been put on hold. The market-based price data from Zimbabwe have deteriorated and, at present, cannot be used to update the HHIZ. HHIZ updates will be resumed as soon as the quality of the data reaches a satisfactory level.

So we can't even estimate the inflation rate in Zimbabwe. We just know its got to be a lot more than what ever that number above is!

Denis Dutton on The Art Instinct

Denis Dutton is the founder and editor of the hugely popular web site Arts & Letters Daily. He also founded and edits the journal Philosophy and Literature, and is a professor of the philosophy of art at the University of Canterbury, New Zealand.

Dennis has a new book out, The Art Instinct - Beauty, Pleasure, and Human Evolution. Below is Dennis talking about his book at Authors@Google.

The Art Instinct combines two fascinating and contentious disciplines—art and evolutionary science—in a provocative new work that will change forever the way we think about the arts, from painting to literature to movies to pottery. Human tastes in the arts, Dutton argues, are evolutionary traits, shaped by Darwinian selection. They are not, as the past century of art criticism and academic theory would have it, just socially constructed.

Our love of beauty is inborn, and many aesthetic tastes are shared across remote cultures. Using forceful logic and hard evidence, Dutton shows that we must premise art criticism on an understanding of evolution, not on abstract theory. He restores the place of beauty, pleasure, and skill as artistic values.