EZ crisis: Ireland’s recovery, European Safe Bonds and a reform agenda for the Eurozone

In this VoxEU.org audio Philip Lane talks to Viv Davies about Ireland’s export-led recovery; they also discuss the interplay between banking and sovereign risk in Europe. Lane presents his and other economists’ proposals for European Safe Bonds and a reform agenda for the Eurozone.

The why of deregulation

Over the last 20 years or so deregulation has become the norm for many industries and markets in many countries. This movement has often been portrayed as a case of "free market" economics winning out over state (or social) control. In a 1999 comment economist W. Bentley MacLeod looks at these changes in a different light. He writes,

Viewing the evolution of transaction costs as an innovative process suggests that the recent deregulation movement [...] is not an example of free market economics winning over state intervention, but it is an example of the remediableness criteria in practice, as changes in transaction cost technologies make it possible to commodify products such as telephone or electricity services. It may even be the case that some future innovation in transaction costs makes it possible commodify probity, in which case it would be efficient to privatize the State Department. (MacLeod 1999: 347).

In other words as the level of transaction costs change the efficient organisational form that transaction take place in also changes.

The idea of "remediableness" referred to by MacLeod is due to Oliver Williamson and refers to the notion that an extant mode of organisation for which no superior feasible alternative can be described and implemented with expected gains is presumed to be efficient. That is, an "efficient" organisational form is one which is better than the possible alternatives, rather than being better than some theoretical standard.

The existence of transaction costs means there exists a profit opportunity for anyone who can discover ways to reduce these costs, and a reduction in transaction costs could lead to what is now a government provided service being moved into the marketplace. As transaction costs are reduced, new "feasible and implementable" alternatives to government supply are developed, with resulting gains, and thus government supply may no longer be efficient by the remediableness criteria. Thus deregulation, outsourcing and/or privatisation may just be the result of transaction cost reducing activities of entrepreneurs.

• Macleod, W. Bentley (1999). 'Comment on "Public and Private Bureaucracies: A Transaction Cost Economics Perspective;" by Oliver Williamson', Journal of Law, Economics and Organization, 15(1) April: 342-7.

Interesting blog bits

1. Tim Bresnahan on Jobs: A Vision of American Entrepreneurship
2. Joshua Gans on The Representative Agent in the Technological World
3. Steven Horwitz on RIP: Steve Jobs, Prince of Peace
4. Liberty Scott on Steve Jobs - he lived!
5. Peter Klein on Dissing Apple, Loving Steve
6. Not PC on Steve Jobs, 1955-2011
7. David Henderson on Steve Jobs: Insanely Great
8. Mark J Perry on Steve Jobs: American Manufacturing Icon at One of the Most Successful Manufacturing Firms in History
9. Art Carden on The Process That Made Steve Jobs Great
10. Homepaddock on In memory of Steve Jobs

Incentives matter: teachers pay file

Gadi Barlevy and Derek Neal have a column at VoxEU.org in which they put forward, yet another, scheme for teacher pay: A different approach to assessment-based accountability. Barlevy and Neal write,

For more than two decades, school systems in the US and around the world have introduced new accountability and incentive systems for public school educators that rely of the test scores of students as performance signals for educators. There is now a large empirical body of evidence on the effects of these assessment-based accountability and performance pay systems.

Existing systems often suffer from two design flaws: They rely on performance targets or standards that are vulnerable to manipulation, and they use exams that can be easily compared to past formats in ways that encourage coaching or teaching to the test. (References removed.)

The Barlevy and Neal pay method is Pay for Percentile:

In Barlevy and Neal (forthcoming), we describe an assessment-based incentive system for educators built around educator performance metrics that are invariant to the scaling of student assessments. These metrics are also relative-performance metrics because they do not express educator performance relative to a statistical target but relative to the performance of other educators that form an appropriate comparison set.

We call this scheme Pay for Percentile. It is built around a performance metric called the Percentile Performance Index (PPI). The following algorithm describes how one might calculate PPI scores for teams of teachers that work together to teach one class, eg fifth-grade maths, in the same school.

• Step One: Consider all students in a large school district or state who are taking the same class, eg fifth-grade maths. Place each student in a comparison set with students who are similar in terms of their expected achievement given their past academic performance, their demographic characteristics, and the characteristics of other students in their school or classroom.
• Step Two: At the end of the year, when the fifth-grade maths assessment results are reported, rank all students in each comparison set based on their end–of-year scores, and assign each student a percentile equal to the fraction of students in her comparison set who performed the same or worse.
• Step Three: Overall the students in a given school who are taking a particular subject, eg fifth-grade maths, form the average of their percentile scores. This average is the PPI score for the team of fifth-grade maths teachers at this school. It reflects how often students in a given course in a given school perform as well or better than comparable students elsewhere.

We show that it may be possible to elicit effective teaching by paying teams of educators performance bonuses that are proportional to PPI metrics. Further, our basic result holds in the presence of instructional spillovers, peer effects, and heterogeneity in rates of student learning within classrooms.

A large literature in economics explores how properly seeded contests can be used to create incentive systems. Pay for Percentile generalises these results to a setting where workers (educators) produce many different outputs (achievement growth for many students) simultaneously by allocating time among several different tasks (lecturing, tutoring, lesson planning, etc). Because all contests are properly seeded, teachers respond by allocating efficient effort to all tasks that foster achievement for the set of students in a given class.

Pay for Percentile uses seeded competition to create performance metrics. PPI scores implicitly summarise the outcomes of many different simultaneous contests among students, and every contest that one fifth-grade maths team wins is a contest that another team lost. By construction, PPI scores do not tell policymakers how often students in a given school or classroom reached some pre-determined achievement target. Rather, PPI scores tell policymakers how often students in a given class or school outperformed students in other schools that began the year as their academic peers.

Because every contest between matched students in different schools must have one winner and one loser by construction, this approach also eliminates the Lake Wobegon effects that plague many accountability and performance pay systems. Neal (2011) argues that often, in target-based systems that permit the possibility that all educators can be judged satisfactory, almost all educators are deemed satisfactory whether they deserve to be or not.

As we note above, since Pay for Percentile involves assessments that avoid repeated items and predictable formats, these assessments will not provide much information about secular trends in student achievement. However, if policymakers use a separate no-stakes assessment system to measure student achievement, they eliminate incentives for educators to engage in the "teaching to the test" behaviours that often inflate reported achievement trends derived from high-stakes testing systems.

This approach may seem bizarre to many in the education testing and policy community. To many, it seems intuitive that, if educators should be held accountable for what their students learn, education officials should create measures of student achievement and educator performance using a single assessment system. However, the job of placing student assessment results on modern psychometric scales does not need to be and should not be part of the process of building accountability and incentive systems for educators. Whenever policymakers insist that these tasks be intertwined, they are only guaranteeing that education officials will perform both tasks poorly.

Reference:

• Barlevy, Gadi and Derek Neal (2011), “Pay for Percentile”, American Economic Review, forthcoming.

The political economy of protectionism

Donald J. Boudreaux has an article in the October 2011 issue of the journal, Economic Affairs in which he attempts to answer the question, Do Subsidies Justify Retaliatory Protectionism? The abstract reads,

A theoretical case can be made to justify trade protectionism on the ground that foreign governments are subsidising export industries. This case is based on overall international welfare grounds. However, the country receiving the subsidised products benefits from the subsidies. Furthermore, imposing retaliatory protectionist measures risks encouraging rent-seeking behaviour. In practice, it is impossible to define exactly what behaviour does and does not amount to the grant of subsidies by the government of an exporting country.

If another country wants to make itself poorer by sending their wealth to us via export subsidies, Why should we complain? The real trick is to get them to do it forever!

Price distortions slow economic growth in sub-Saharan Africa (updated)

Real income in sub-Saharan Africa has grown by less than 1% per year over the past half century. Yet within this dismal statistic, there is wide variation. A new column at VoxEU.org explores the policy reforms that may have caused growth to flourish or stagnate.

In their column Kym Anderson and Markus Bruckner note that,

Economic growth in sub-Saharan Africa has been slow for decades

• Sub-Saharan African real income per capita grew at less than 1% over the past half century 
• Some countries have enjoyed faster growth in recent years, but the reasons for that acceleration, and the extent of its sustainability, are still uncertain

(References removed)

Anderson and Bruckner then point out that the in the majority of sub-Saharan African countries, there was a strong policy bias against agriculture over the past half century. By which they mean a negative relative rate of assistance. The relative rate of assistance is the ratio of the nominal rates of assistance to agricultural and the non-agricultural tradables, where the nominal rate of assistance is defined as the percentage by which government policies directly raise the gross return to producers of a product above what it would be without the government’s intervention (or lowered it, if NRA<0). They also note that there is substantial RRA [RRA is the relative rate of assistance, which is defined as RRA = [(100+NRAagt)/(100+NRAnonagt)] - 1 where NRAagt and NRAnonagt are the percentage NRAs for the tradables parts of the agricultural and non-agricultural sectors, respectively, and NRA is the percentage by which gross returns to producers of a product have been raised directly by government policies above what they would be without the government’s intervention (or lowered it, if NRA<0)] variation across time and countries. For example, in Ethiopia, Madagascar, and Tanzania there was a continuous reduction in policy biases against agriculture, while in countries such as Zambia and Zimbabwe the strong bias against agriculture has persisted.

When discussing their study, Anderson and Bruckner (2011), Anderson and Bruckner say,

Our key finding is that policy-induced price distortions had a quantitatively large negative effect on economic growth. In other words, reductions in those distortions in recent decades have contributed significantly to economic growth in sub-Saharan Africa. More specifically, a one standard-deviation decrease in distortions to relative agricultural prices raised real GDP per capita growth in the region by about half a percentage point per annum on average

Why does this matter?

Our finding of a statistically significant and quantitatively large negative effect of distortions to relative agricultural prices on sub-Saharan African economic growth is important for several reasons.

• First, it implies that reducing distortions to incentives faced by even the world’s poorest farmers can be growth-enhancing. Thus this result does not support the view that there are significant growth benefits associated with supporting manufacturing and other sectors at the expense of agriculture.
• Second, our finding suggests that the returns from investments in agricultural development will be greater in countries with less-distorted relative prices. Since funding for agricultural development in sub-Saharan Africa is expanding rapidly at present, particularly via development assistance programmes, our findings provide additional empirical support to those arguing that aid flows would be more effective in those African countries that have reduced, or are willing to reduce, their anti-agricultural policy bias.
• Third, our empirical analysis shows that there is a significant within-country effect of policy distortions on economic growth. This is an important result. It implies that the relationship between price distortions and economic growth is unlikely to be a consequence of the strong ethnic divisions that characterise many sub-Saharan African countries. The reason is that ethnic divisions, as measured by countries' ethnic fractionalisation or polarisation, are mostly time-invariant variables. Hence, these variables cannot be a cause of within-country variations in price distortions. From an economic policy viewpoint, this is important because it suggests that in African countries there are significant factors that influence economic growth other than ethnic divisions.

Yes people, market prices really do matter.

Reference:

• Anderson, K and M Brueckner (2011), “Price Distortions and Economic Growth in sub-Saharan Africa”, CEPR Discussion Paper No. 8530.

Update: Tim Worstall also notes The Importance of Market Prices

Quote of the day

From Peter Boettke at the Coordination Problem blog:

I applied once for a fellowship to Stanford to a program on 'Ethics and Society' and I got back a rejection which read "As a student of Buchanan and Tullock, you undoubtedly have philosophical interests, but they have nothing to do with either ethics or society." Seriously!

Solow on Mises

In this book review Robert Solow writes,

Hayek’s mentor, the even more far-right economist Ludwig von Mises, undertook to argue that efficient centralized economic planning was an impossibility in an advanced economy. The main reason was that no central planning bureau could conceivably have all the knowledge needed to allocate resources to alternative uses effectively. That knowledge—technological possibilities, local conditions, consumer preferences, likely futures for all these—is necessarily scattered around the economy. A system of (competitive) markets is a uniquely suitable way for this knowledge to be expressed and converted into decentralized decisions about production and consumption. No central organization could conceivably access and analyze this information and calculate the appropriate allocations.

First what can we make of this "far-right" comment. I mean von Mises is after all the author of the book "Liberalism: In the Classical Tradition" and a great defender of classical liberalism, so I don't get where the "far-right' bit comes from.

But more importantly Solow's description of Mises's argument on why central planning can not work is, I would argue, at best somewhat inaccurate, if not misleading. I would take Mises's point to be that the rational economic use of resources is only possible if market pricing is applied not only to final goods but also to all intermediate products and factors of production. Without markets, and prices, for the factors of production, rational allocation of said factors is impossible. Markets for the factors of production are, of course, impossible, by definition, under socialism.

An Austrian view of the firm

Per L. Bylund has an interesting article in the Quarterly Journal of Austrian Economics, Vol. 14, No. 2, pp.188–215, Summer 2011, on The Division of Labor and the Firm: An Austrian Attempt at Explaining the Firm in the Market. The abstract reads:

This paper reviews Austrian approaches to the firm and drafts a theory that emphasizes the firm as a market phenomenon. Here the firm is a vehicle for imaginative entrepreneurs to create artificially high factor density, thereby increasing its internal “extent of the market” to support specialization of factors beyond the general level of division of labor in the market. The firm therefore becomes a product of, and prospective catalyst for progressing the market’s overall division of labor, and the firm emerges as an entrepreneur-generated means toward increased efficiency and more roundabout production. It consequently may play a crucial role in the evolution of market structure and, by extension, the development of civilization.

Bylund opens his paper by noting

The theory of the firm has been a neglected area of study in mainstream economics. Despite Ronald Coase bringing the issue up for discussion in 1937, it was not on the research agenda until the 1970s. Even now, as both Coase and Oliver Williamson, the founder of and prominent scholar in the transaction cost-focusing analysis of firm organization, have received the Nobel Prize in economics, the area remains in the periphery of economic analysis.

This does raise the somewhat strange question of, If the theory of the firm is an area of study significant enough to warrant a couple of Nobel Prizes, why is it at the periphery of economics? Part of Bylund's answer is that,

Part of the reason the firm is not considered worthy of analysis in the economic mainstream is undoubtedly, to a degree, because it should not exist.

As Coase pointed out in a world of zero transactions costs firm have no rationale. He noted that firms would exist only in a world in which there were costs to using the price mechanism, that is, a world of positive transaction costs. The mainstream theory of the firm has grown out of this Coaseian insight. But

[...] even as mainstream economists began to realize Coase’s contribution, some thirty years after “The Nature of the Firm” (1937) was published, Austrians still had no such theory. About two decades after the rediscovery of Coase (1937) by Williamson (1967; 1973; 1979) and others (see e.g. Alchian and Kessel, 1962; Alchian, 1965; 1968; Alchian and Demsetz, 1972; Demsetz, 1967; Klein, Crawford and Alchian, 1978; McManus, 1975; Monsen Jr and Downs, 1965; Silver and Auster, 1969), O’Driscoll and Rizzo stated that “there is no […] Austrian theory of the firm” (1985, p. 123) and another decade later Foss (1994) made the same observation and could still, a few additional years later, safely theorize about “the Austrian lack of interest in the firm” (Foss, 1997, p. 176). More than seventy years after Coase’s seminal article, Foss and Klein identified that “a small Austrian literature on the firm has emerged” but that “[u]ntil recently the theory of the firm was an almost completely neglected area in Austrian economics” (2009, p. 2).

So while the mainstream has at least started to develop a theory of the firm, even if not with too much enthusiasm, the Austrians have lagged behind. Again the question is, Why?

As to why the firm was ignored in Austrian economics Witt (1999: 108) writes,

“[t]he neglect of the firm as the organizational form of an entrepreneurial venture has a tradition in Austrian economics. It may be traced back to a characteristic of the scientific community in the German language countries. There, economic theory (Volkswirtschaftslehre) and business economics (Betriebswirtschaftslehre) were institutionally segregated as early as at the turn of the century to a degree still unknown today in the Anglo Saxon world. As Lachmann once conjectured, Austrian writers therefore considered the organizational form of entrepreneurial activities to be a topic best left to their business economics fellows.”

As Bylund's paper shows this tradition is changing, which is all to the good.

Forgive student loans? (updated)

No says Freakonomics contributor and economist Justin Wolfers, who calls the suggestion the Worst Idea Ever. Wolfers writes,

Let’s look at this through five separate lenses:

1. Distribution: If we are going to give money away, why on earth would we give it to college grads? This is the one group who we know typically have high incomes, and who have enjoyed income growth over the past four decades. The group who has been hurt over the past few decades is high school dropouts.
2. Macroeconomics: This is the worst macro policy I’ve ever heard of. If you want stimulus, you get more bang-for-your-buck if you give extra dollars to folks who are most likely to spend each dollar. Imagine what would happen if you forgave $50,000 in debt. How much of that would get spent in the next month or year? Probably just a couple of grand (if that). Much of it would go into the bank. But give $1,000 to each of 50 poor people, and nearly all of it will get spent, yielding a larger stimulus. Moreover, it’s not likely that college grads are the ones who are liquidity-constrained. Most of ‘em could spend more if they wanted to; after all, they are the folks who could get a credit card or a car loan fairly easily. It’s the hand-to-mouth consumers—those who can’t get easy access to credit—who are most likely to raise their spending if they get the extra dollars.
3. Education Policy: Perhaps folks think that forgiving educational loans will lead more people to get an education. No, it won’t. This is a proposal to forgive the debt of folks who already have an education. Want to increase access to education? Make loans more widely available, or subsidize those who are yet to choose whether to go to school. But this proposal is just a lump-sum transfer that won’t increase education attainment. So why transfer to these folks?
4. Political Economy: This is a bunch of kids who don’t want to pay their loans back. And worse: Do this once, and what will happen in the next recession? More lobbying for free money, rather than doing something socially constructive. Moreover, if these guys succeed, others will try, too. And we’ll just get more spending in the least socially productive part of our economy—the lobbying industry.
5. Politics: Notice the political rhetoric? Give free money to us, rather than “corporations, millionaires and billionaires.” Opportunity cost is one of the key principles of economics. And that principle says to compare your choice with the next best alternative. Instead, they’re comparing it with the worst alternative. So my question for the proponents: Why give money to college grads rather than the 15% of the population in poverty?

And Wolfers's punchline?

Conclusion: Worst. Idea. Ever.

And I bet that the proponents can’t find a single economist to support this idiotic idea.

I just hope that those in New Zealand who favour forgiving loans read Wolfer's posting and learn from it.

Update: Eric Crampton also asks if we should Forgive student loans?

Buy American

And what could be more American than Apple’s iPad 2 tablet? Or is it?

The following comes from Grossman-Hart (1986) Goes Global: Incomplete Contracts, Property Rights, and the International Organization of Production by Pol Antràs.

Apple’s iPad 2 tablet is a case in point. Its slim and sleek exterior hides a complex manufacturing process combining components provided by multiplier suppliers located in various countries. Apple does not disclose information on its input providers, but teardown reports (such as those published by isuppli.com and ifixit.com) have shed light on the global nature of the iPad 2 production process. The tablet itself is assembled in China (and by the end of 2011 also in Brazil) by Taiwan-based Foxconn. The displays are believed to be manufactured by LG Display and, more recently, by Samsung, both of which are based in South Korea. The distinctive touch panel is produced by Wintek, a Taiwan-based company that also owns plants in China, India and Vietnam, while the case is provided by another Taiwanese company, Catcher Technologies, with operations in Taiwan and China. A third important component, the battery pack, also originates in Taiwan and is sold by Simplo Technologies and Dynapack International. Apart from these easily identifiable parts, the iPad 2 incorporates a variety of chips and other small technical components provided by various firms with R&D centers in developed economies and manufacturing plants (under various organizational structures) worldwide. A non-exhaustive list includes (again) Korea’s Samsung, which is believed to manufacture the main processor (designed by Apple) and possibly the flash memory, Japan’s Elpida contributing the SDRAM, Germany’s Infineon and U.S. Qualcomm both supplying 3G modules, and Italo-French STMicroelectronics, Japan’s AKM Superconductors and U.S. TAOS each contributing key sensors.

I guess "American" just isn't what it once was. Which means it's difficult, if not impossible, to workout what to buy if one want to "Buy American". In this globalised world the same problems occur for those who wish to "Buy New Zealand".

EconTalk this week

Bruce Meyer of the University of Chicago talks with EconTalk host Russ Roberts about the middle class, poverty, and inequality. Many economists and pundits argue that the middle class has made little or no economic progress over the last 30 years, that poverty rates are stagnant or rising, and that inequality has increased dramatically. Meyer, drawing on his research over the last ten years, argues that these conclusions are either false or misleading. He argues that standard measures of economic progress and inequality are based on faulty inflation data or a misplaced focus on pre-tax income instead of post-tax income or consumption.

Is there a 'hidden cost of control' in naturally-occurring markets?

There is a new, interesting working paper from the NBER on incentives and their effects. The paper, Is there a 'Hidden Cost of Control' in Naturally-Occurring Markets? Evidence from a Natural Field Experiment (NBER Working Paper No. 17472, September 2011), is by Craig E. Landry, Andreas Lange, John A. List, Michael K. Price and Nicholas G. Rupp.

The authors note that,

Behavioral economics has matured to the point where theorists are leveraging psychological insights to improve their models and government officials are using behavioral results to fine tune policy. One particular result that has attracted increasing attention is the interaction of psychological and economic incentives [...]. For example, in a novel set of experiments, Gneezy and Rustichini [...] show that extrinsic incentives influence effort in an unexpected manner—small monetary incentives can crowd out intrinsic motivation, resulting in a perverse relationship between incentives and effort.

Complementing such insights is the line of work in the spirit of [papers by Fehr and Rockenbach, and Fehr and List], who find that the use of control and explicit incentives entail “hidden” costs: such control causes the principal’s actions to backfire, leading to lower profits. As this literature points out, such effects are first order and should be a concern for economists interested in studying labor markets. Yet, whether, and to what extent, such hidden costs manifest themselves outside the confines of the laboratory remains an important open empirical question [...]. Difficulties arise, however, in finding natural instances where agents are randomly allocated to appropriate treatment groups to permit a clean test of the relevant hypotheses. Because of these challenges, the literature has to date been unable to provide tests of the major hypotheses of ‘control’ in the field.

The point of the current paper is to make a first step in this direction.

We present an empirical approach that is composed of a set of field treatments that parallel the important economic features of the environments in Fehr and Rockenbach [...], Fehr and List [...], and the literature that has followed. To do so, we examine solicitor (worker) effort in a door-to-door capital campaign for the Center for Natural Hazards Research at East Carolina University. Importantly, we use natural incentives to exogenously change the action space of solicitors randomly assigned to one of three treatment groups. In the baseline treatment, workers are provided a pre-announced, fixed hourly wage of $10. In a second treatment, workers are provided an unconditional gift – a copy of Freakonomics – in addition to the pre-announced hourly wage. In our final treatment, the most opportunistic actions are ruled out by making the gift conditional – solicitors must raise at least $10 per hour to obtain the copy of Freakonomics. If trust is a characteristic rewarded by workers, then the control evoked in the final treatment might crowd out effort compared to the second treatment – particularly amongst those who would have raised more than $10 if the gift were provided unconditionally.

The authors argue that there are several important insights which emerge from their field experiment.

First, unconditional gifts have the ability to enhance worker productivity. Solicitors in our unconditional gift treatment were approximately 56 percent more likely to elicit a contribution than counterparts in the baseline. Similarly, solicitors in this treatment raised approximately 10.1 to 63.4 percent more per hour than those in our baseline treatment. These results are consonant with the existing literature [...] and suggest that reciprocal motives are an important determinant of worker behavior.

Second, conditionality proves a profit enhancing strategy. Participation rates and dollars raised per hour in our conditional gift treatment are higher than those observed in both the baseline and unconditional gift treatments. For example, solicitors in our conditional gift treatment elicit contributions from nearly 26 percent of all households approached – a rate of giving that is approximately 68 percent (8 percent) greater than that observed in our baseline (unconditional gift) treatment. Similarly, solicitors in our conditional gift treatment raise approximately 83 percent more per hour than counterparts receiving an unconditional gift and more than double that observed in our baseline group.

Finally, solicitors in the conditional gift treatment are approximately two and half to three times more likely to raise at least $10 per hour – the required threshold for receiving the gift – than are counterparts in our unconditional gift and baseline treatments respectively. As this threshold corresponds with the level of productivity necessary to cover labor costs, conditionality therefore has a positive effect on net revenues. Taken jointly, these data are at odds with models suggesting that agents respond adversely to control. Accordingly, our data suggest that hidden cost relationships identified in prior laboratory studies [...] do not arise in our field setting.

So, yes incentives do matter, just as economists normally argue.

Trade and the number of jobs

C. Fred Bergsten writes in the New York Times about the U.S. trade imbalance and the number of jobs in the U.S.:

BY virtually ignoring trade, President Obama and Congressional Republicans are missing a major opportunity to create jobs. The United States runs an annual trade deficit of about $600 billion, or 4 percent of our entire economy. Eliminating that imbalance would create three million to four million jobs, according to Commerce Department estimates, at no cost to the budget.

E. Frank Stephenson over at the Division of Labour blog responds,

Not so fast. There are (at least) two reasons why moving toward trade balance might not increase employment in the US. First, many imports are inputs to things that are produced here; making those imports more expensive might harm production of (and jobs making) the goods that use the imports as inputs. Second, the flip side of a trade deficit is net capital inflow which may create jobs by financing factories such as BMW in SC, Pirelli here in GA, etc. Hence, eliminating a trade deficit also means eliminating a net capital inflow and potentially harming job creation.

The basic point is that trade protection doesn't create jobs, all it will do is move jobs around in the economy. If measures are put in place to reduce the trade deficit, areas of the economy which benefit from these measures will grow and those which suffer will diminish. The net effect on jobs will approximate zero.

Currency wars: lessons from the U.S. experience: 1973-95

At VoxEU.org Michael Bordo and Owen F Humpage have a new column on Currency wars: Lessons from the US experience: 1973-95. Bordo and and Humpage write,

The disparate and ongoing impacts of the Great Recession have resulted in sharp exchange-rate changes as the large developed economies focus policy on their domestic situations. Threats of ‘currency wars’ linger, and some countries – notably Japan and Switzerland – have shown an interest in foreign-exchange intervention. The situation raises a perennial question: Does foreign-exchange intervention afford monetary authorities a means of systematically influencing exchange rates independent of their domestic policy objectives? The US experience during the floating-exchange-rate era suggests not.

Foreign-exchange intervention can be of two types. Nonsterilised intervention is an open-market operation conducted through foreign exchange and, as such, affects the level of bank reserves. It is tantamount to introducing an exchange-rate target into a central bank’s reaction function, but it also sets up the possibility for conflict between domestic and exchange-rate objectives. When, for example, short-term interest rates are at or near the zero bound, purchasing foreign exchange may provide a means of undertaking quantitative easing (McCallum 2003). In such cases, the exchange-rate objective – depreciation or avoiding appreciation – and the domestic monetary goal – easing policy – are compatible. But if a country’s currency is appreciating because of monetary policies abroad, as in Brazil, nonsterilised intervention to prevent a currency appreciation will create inflation at home. Because of this potential for conflict, and because there are usually better assets for conducting open-market operations, countries generally eschew nonsterilised intervention (Neely 2001 and 2007, Lecourt and Raymond 2003).

Sterilised intervention does not affect bank reserves. Since sterilised intervention has no effect on the money stock – a key determinant of exchange rates – observers often wonder how it might actually affect exchange rates. Economists have suggested two principal transmission mechanisms: the portfolio-balance and the expectations channels.

Sterilised intervention affects the currency composition of privately held government securities. The act of sterilising an intervention increases outstanding government securities denominated in the currency that central banks are selling relative to government securities denominated in the currency that central banks are buying. If risk-averse asset holders view these securities as imperfect substitutes, they will only hold the relatively more abundant asset if the expected rate of return on that asset compensates them for the perceived risk of doing so. Their initial reluctance to hold the relatively more abundant security forces a spot depreciation of the corresponding currency. The spot depreciation relative to the exchange rate’s longer-term expected value then raises the anticipated rate of return on the now more abundant securities and compensates asset holders for the perceived increase in risk.

The portfolio-balance mechanism conceivably could provide central banks with a channel for affecting exchange rates independent of their domestic policy objectives. Unfortunately, however, most empirical studies find the relevant elasticities to be either statistically insignificant or quantitatively negligible (Edison 1993). Dominguez and Frankel (1993) is a notable exception. Central banks do not put much stock in the portfolio-balance channel (Neely 2007).

Alternatively, sterilised intervention might affect market expectations. Exchange markets are highly efficient processors of information, but not perfectly so. Information is costly and, at any time, asymmetrically distributed. Large foreign-exchange traders appear to have an informational advantage derived from a broader customer base and market network (Cheung and Chinn 2001). In markets characterised by information asymmetries, non-fundamental forces may affect short-term exchange-rate dynamics, and any trader that others suspect of having superior information, including monetary authorities, could affect the price if market participants observed his or her trades. The actions of any trader with a consistent informational advantage should have value as a forecast of near-term exchange-rate movements.

With this transmission mechanism in mind, we tested to see if US intervention between 1973 and 1997 had forecast value with respect to two simple criteria – both consistent with stated objectives of US intervention – and a general criterion that combined the two (Bordo et al 2011). [...] Over that time, the US intervened on 971 days against German marks and on 243 days against Japanese yen. Approximately 60% of all US interventions were successful under one or the other criterion – an amount that was not different from what we would have randomly anticipated given the volatile nature of day-to-day exchange-rate changes. The overall results mask two distinctive outcomes:

• First, US purchases and sales on foreign exchange show no systematic correspondence with dollar depreciations or appreciation, respectively.

Sometimes US intervention had just the opposite effect, suggesting that speculators could have profited by betting against the operation.

• Second, and more favourably, US intervention often accompanied a same-day moderation of dollar exchange-rate movements in a manner broadly consistent with leaning against the wind.

While generally greater than random, the number of successes under the second criterion accounted for less than one fourth of all US interventions. When we tested over various sub-periods, these results were not materially changed.

The conclusion of all of this?

The results suggest that sterilised intervention does not afford monetary authorities a means of systematically affecting their exchange rates independent of their domestic policy objectives. Intervention is more of a hit-or-miss proposition than a sure bet. Countries that engage in currency wars run a real risk of shooting themselves in the foot.

I'm sure there are lessons here for some in New Zealand who favour exchange rate intervention.

References

• Bordo, MD, O Humpage and AJ Schwartz (2011) “ The Federal Reserve as an Informed Foreign Exchange Trader: 1973-1995” NBER Working Paper 17425. September.
• Cheung, Y, and MD Chinn (2001) “Currency Traders and Exchange Rate Dynamics: A Survey of the US Market.” Journal of International Money and Finance 20 (4): 439-471.
• Dominguez, KM, and JA Frankel (1993a) “Does Foreign-Exchange Intervention Matter? The Portfolio Effect.” American Economic Review 83 (5): 1356-1369.
• Edison, H (1993) "The Effectiveness of Central Bank Intervention: A Survey of the Literature after 1982." Princeton University, Special Papers in International Economics 18.
• LeCourt, C, and H Raymond (2006) “Central Bank Interventions in Industrialized Countries: A Characterization Based on Survey Results.” International Journal of Finance and Economics 11(2): 123-138.
• McCallum, BT (2003) “Japanese Monetary Policy, 1991-2001.” Federal Reserve Bank of Richmond Economic Quarterly 89 (1): 1-31.
• Neely, CJ (2001) “The Practice of Central Bank Intervention: Looking Under the Hood.” Central Banking 11 (2): 24-37.
• Neely, CJ (2007) “Central Bank Authorities Beliefs about Foreign Exchange Intervention.” Journal of International Money and Finance 27 (1): 1-25.

Religion as happiness insurance?

A new column at VoxEU.org looks at data on religion and life satisfaction from across the globe and argues that it might just be insurance for the unhappy. The column by Bruno S Frey and Jana Gallus notes that the happiness research leaves no doubt that religious people are happier than their contemporaries. And the causality runs from religion to happiness, but this raises a puzzle: if religion creates happiness, why are people living in those countries with the highest life satisfaction increasingly turning their back on religion? Frey and Gallus write,

The data unmistakably reveals a clear trend. A country’s economic situation critically influences its citizen's religiousness. People living under harsh conditions with low per-capita income and life satisfaction are much more likely to be religious. Religiousness will then increase their life satisfaction. In fact, religion can be seen as a sort of "insurance". Their belief at least partly helps people cope with difficult life situations. Also, religion offers supportive and integrative institutions, which accompany their members in difficult times. Herein, the social contacts that churches help establish and foster are crucial. Happiness research shows that interaction with others is of utmost importance for subjective wellbeing. As Diener et al. (2011) demonstrate, these results hold for all major religions – for Buddhists, Christians, Hindus, and Muslims alike.

The punchline?

The combination of facts allows the following conclusions to be drawn:

• Churches tend to lose members during stable and economically prosperous times.
• They stand to gain members notably when economic, political, and other societal conditions are harsh.

The comparative advantage of churches therefore consists in providing support and stability in times of insecurity – a function that neither the economy nor the state fulfil. This applies especially to the psychological strain under which many people nowadays suffer. In his book "Happiness: Lessons from a New Science", Richard Layard, an English happiness researcher who is also member of the Upper House, forcefully argues that one of the central problems of modern life consists in the fact that many individuals are no longer able to orient themselves in the economy and in society at large. In this respect, churches can fulfil an important function.

The column also contains the following note:

Editors' note: A similar article was published on Oekonomenstimme. Sept. 20, 2011

Hmmmm ............

• References:Diener, Ed, Louis Tay, and David G Myers (2011), “The Religion Paradox: If Religion Makes People Happy, Why Are So Many Dropping Out?”, Journal of Personality and Social Pysychology, 101(2):354-365.
• Layard, Richard (2005), Happiness: Lessons from a New Science, Penguin Books.

Making the case for contract theory

And who better to do so than Oliver Hart?

In the U.S., the National Science Foundation's Directorate for the Social, Behavioral and Economic Sciences put out an invitation to describe "grand challenge questions” that transcend near-term funding cycles, questions which therefore might benefit from investment in infrastructure. Among the 252 very short papers, by experts in various disciplines, which were written in response are 55 from economists. One of those papers is by Oliver Hart who is Making the Case for Contract Theory.

Hart notes that

The basic philosophy behind contract theory is the idea that parties can design their relationship to be efficient and that a contract is the means to do this. In this respect there is significant overlap with the mechanism design literature. However, there are also important differences. In mechanism design theory it is usually assumed that there is an impartial planner who oversees the system, and may indeed design it. In contract theory the mechanism is designed by the parties themselves and the only (possibly) impartial player is a judge who adjudicates disputes. Each literature has learned from the other, but they have developed independently.

The idea and techniques of contract theory have found their way into a surprisingly large number of areas in economics.

The techniques of contract theory have permeated many areas of economics, including labo[u]r economics, industrial organization, macroeconomics, corporate finance, international trade, public finance, and development economics. Contract theory also draws on and contributes to ideas in law and economics.

In this essay Hart sets out to discuss some of the major themes of contract theory and also issues that are still not well understood.

A classic topic of contract theory is the design of incentive schemes. Principal‐agent theory studies how a principal, e.g. an employer, can motivate an agent, e.g., an employee, to act in her interest. A formal contract can tie the agent’s compensation to the outcome of the agent’s actions. The early literature emphasized the employee’s desire to shirk as the main incentive problem, and the employee’s risk aversion as the main reason why making compensation very sensitive to outcome—high‐powered incentives—might not be a perfect solution. The more recent literature has emphasized different issues. Suppose that the principals are the shareholders of a public company and the CEO is the agent. The problem may not be that the CEO does not want to work hard: rather it may be that the CEO is an empire‐builder, takes excessive risks, pays himself too much (or in the wrong sort of way), or is overconfident about his ability to run things. Or suppose that the principals are parents and the agent is the teacher of their children. The problem may be that it is hard to measure the true outcome of teaching. Performance on tests can be assessed but this may be a very imperfect measure of what children should be learning. Paying a teacher according to test performance may encourage the teacher to focus on the wrong things: rote learning rather than more creative material. Also educating a child is a team process, and, if a teacher is rewarded narrowly according to the test scores of children directly under her control, she may be discouraged from collaborating with other teachers.

The compensation of CEOs, teachers, and others, is highly topical. There is no shortage of proposals for improving matters. Contract theory is enormously useful in clarifying the trade‐offs and helping us to avoid the adoption of policies that may actually be counter‐productive.

Advances in technology make it possible to measure performance more finely and in the future it will become feasible to pay people in increasingly subtle, and possibly high‐powered, ways. But is such a trend desirable? Or might it interfere with the reason that the employees are under the umbrella of a single firm in the first place? The question of what constitutes a firm, what’s different about transactions inside and between firms, and what determines the boundaries of firms, is one that contract theorists have studied intensively. The early transaction cost literature on this topic, by Coase, Williamson, and others, was insightful but largely informal. In recent years, contract theorists have developed formal models to elucidate these issues.

The starting point of this recent literature—known as the property rights approach—is the idea that if parties can anticipate all future eventualities and include these in a contract then the boundaries of the firm are irrelevant: it is only if contracts are incomplete that boundaries matter. In practice contracts are incomplete and a key question is who has residual rights of control, that is, the right to make decisions not covered by the contract. The property rights approach takes the view that the owner of an asset has residual control rights. In the simplest property rights model parties can renegotiate an incomplete contract once an unforeseen contingency has occurred and, under symmetric information, they will reach an ex post efficient outcome. However, the division of surplus will depend on the assets they own. This division of surplus will in turn influence the incentives of parties to invest. An implication of the theory is that assets will be owned by those whose investments are important. To the extent that one can identify a firm with the assets it owns this yields a theory of firm boundaries.

As an example of how this more formal approach can be useful, consider the question of how improvements in information technology will affect firm boundaries. It is often argued that, because more information makes it easier to write good contracts, advances in information technology will favo[u]r independent contracting :independent contracting: carrying out transactions outside the firm. Indeed this is an implication of transaction cost economics. The property rights approach provides a more nuanced perspective. A reduction in contracting costs also makes it easier to carry out transactions inside a firm and so firms may become bigger rather than smaller. Support for this possibility has been found in empirical work on the trucking industry by Baker and Hubbard (2004).

The property rights approach has been applied extensively in the recent international trade literature on the structure of multinational companies. Antras (2003) uses the approach to explain why U.S. companies are less likely to own foreign suppliers if the goods they import are labor intensive (in which case the human capital investment of the foreign firm is likely to be important) than if they are capital intensive (in which case the physical capital investment of the U.S. firm is likely to be important). Many other papers have extended this work.

One limitation of the property rights approach is that the standard model does not explain why transactions inside firms have a different character from those between firms: the theory supposes that parties will use monetary sidepayments to bargain to an ex post efficient outcome whether the parties are in the same firm or in different firms. This does not square with an observation of Coase that inside firms the price mechanism is superseded. Recent work has argued that it is possible to explain Coase’s observation if one is willing to step outside the standard framework and introduce some psychological considerations, including the idea that contracts are reference points for entitlements.

Psychological and behavioral elements can broaden the scope of contract theory in many interesting ways. Recent theoretical and experimental work has argued that explicit contracts can interfere with feelings of fairness and trust and as a consequence extrinsic motivation can crowd out intrinsic motivation. Given this, informal and incomplete contracts may outperform formal and complete contracts even when the latter are feasible. This provides new insights into why high‐powered incentives may be costly, and why parties may deliberately write incomplete contracts. Contracts may also be written by one party to take advantage of the cognitive limitations of another party. All this work is informed by experiments. It seems likely that in the future collaborations between contract theorists and experimentalists—both in the lab and in the field—will yield important new insights, and help contract theorists to refine the assumptions they make.

Another significant application of contract theory has been to understand firms’ financing decisions. Consider an entrepreneur who has an idea for a firm or project but does not have the funds to finance it. The entrepreneur might borrow from an investor. But should the borrowing be short‐term or longterm? How much collateral does the entrepreneur need to provide? Might it be better for the entrepreneur to issue equity rather than debt? Or might some sort of hybrid security be preferable to both?

Many of these questions are, of course, studied in the standard corporate finance literature. The difference is that this literature tends to take the form of the securities a firm issues as given: equity or debt. In contrast, the financial contracting literature considers all possible contracts or securities and tries to explain why debt or equity may be optimal among these. This has yielded new insights.

Hart goes on to ask some interesting questions about the recent financial crisis.

Economists are still grappling with the causes of the recent financial crisis. Although there is not yet consensus, most explanations are based on the idea that key institutions had excessive debt, that much of this debt was short‐term, and that the failure of one institution triggered the failure of others. There is also a widely held view that banks and other financial institutions are different: they are more sensitive than regular industrial companies, and hence their failure is more serious. But why? Economists do not have fully convincing answers to these questions. Did institutions write suboptimal contracts with their investors (or for that matter with their customers, e.g., home‐owners), or were these contracts individually optimal but collectively suboptimal? What does a bank do that makes it different from other firms? How should large financial institutions be regulated to prevent the next financial crisis? The tools of modern contract theory seem indispensable if we are to make progress on these vital questions. But inevitably answering these questions will require new thinking. Understanding the financial crisis requires putting contract theory into a general equilibrium perspective. Although Kiyotaki and Moore (1997), among others, have made a notable start in this direction, much remains to be done. The next twenty years promise to be both challenging and exciting.

Unfortunately the most depressing observation make by Hart is also one of the most true,

Economics has changed a great deal in the last thirty years and there is every reason to think that the changes in the next twenty to thirty years will be at least as great. In the 1970’s and 80’s theory was dominant. In the first part of the twenty first century this is no longer the case: there has been a huge shift towards empirical work.

Yes the majority of economists today seem to think that running a million regressions and picking the one that confirms your prejudices is how you do economics. :-(

Fortunately Hart remains them that,

Although theory may not be as prominent as it once was, it remains essential for understanding the (increasingly) complex world we live in. One cannot analyze the bewildering amount of data now available without the organizing framework that theory provides. I would also suggest that one cannot understand the extraordinary events that we have recently witnessed, such as the financial crisis, or make sensible policy recommendations in response to these events, without the organizing framework of theory.

Well said that man!

References

• Antras, Pol (2003), “Firms, Contracts, and Trade Structure”, Quarterly Journal of Economics, November, 1375‐1418.
• Baker, George and Thomas N. Hubbard (2004), “Contractibility and Asset Ownership: On‐BoardComputers and Governance in US Trucking”, Quarterly Journal of Economics, November, 1443‐1479.
• Kiyotaki, Nobuhiro and John Moore (1997), “Credit Cycles”, Journal of Political Economy, April, 211‐248

Proudly dismal

The master of the letter to the editor, Don Boudreaux, is at it again, this time in the New York Times Sunday Book Review section:

To the Editor:

Reviewing “American Dreamers,” Michael Kazin’s paean to the country’s radical left, Beverly Gage echoes Kazin by including the abolition of slavery among the great achievements of leftists — an example of their “utopian spirit” (Sept. 18). Such radicals did call for abolition, but radicals of a very different sort — thinkers who offered a new understanding of how societies hang together and prosper without the centralized commands that Kazin’s leftists so extol — also lent their influential voices to the cause of abolition. These radicals were classical economists.

It was economists’ prominence in the abolition movement that led Thomas Carlyle, in an 1849 essay, to defend slavery and ridicule economists as “rueful” thinkers, each of whom “finds the secret of this universe in ‘supply and demand,’ and reduces the duty of human governors to that of letting men alone.” Economists’ advocacy of freedom, even for slaves, so incensed Carlyle that he gave it, in the same essay, a nickname that — considering its provenance — economists should forever wear proudly: the “dismal science.”

Incentives matter: bureaucrats file

From Greg Mankiw's blog:

Managers in the Social Security Administration, struggling to handle a skyrocketing number of disability cases, had an unusual request for their workers this week: slow down.

Social Security judges and employees in Florida, Alabama, Colorado, Georgia, Tennessee, Ohio and Arizona were among those instructed to set aside disability cases this week, with the slowdown allowing managers to boost their performance numbers for the coming fiscal year, which starts Monday.

Top officials, in a bid to meet goals to win promotions or thousands of dollars in bonuses, directed many employees to refrain from issuing decisions on cases until next week, according to judges and union officials. This likely would delay benefits paid to thousands of Americans with pending applications, many of whom are financially needy and have waited for a government decision for more than a year.

The directive stemmed from a wrinkle in the federal calendar, in which this week fell between the federal government's 2011 and 2012 fiscal years. This happens every five or six years, as officials are allowed to count just 52 weeks in their calendar. Counting this week would make the current fiscal year 53 weeks long. That meant any applications for disability benefits completed between Monday and Friday wouldn't count toward the annual numerical targets set for Social Security judges or field offices.

Bad reasons for asset sales

Over at Offsetting Behaviour Seamus Hogan notes that next Tuesday he will be speaking at a forum run by U of C Political Science students to inform students for the upcoming general election. He says he lay out some principles that he thinks all economists should agree on (and that more than 90% would agree on), independent of their underlying values. He will present four general principles that would be relevant to pretty much any election campaign and two others specific to the issues of this year’s election. One of these principles is

CGT versus Asset Sales: As best I can tell, the parties are not promising radically different paths for the deficit. We therefore need two separate debates: one concerning whether our fiscal position would be better addressed by selling equity rather than debt, and one concerning the mix of taxes. The issues regarding both are technical and complicated; confusing the two does not promote informed debate.

The point I want  to make here is that the idea that asset sales should be used to pay-off debt is wrong-headed. Having a debate about whether to use asset sales to pay for the deficit is the wrong debate to be having about asset sales. The reasons for privatisation have nothing to do with dealing with the deficit, the reasons for asset sales should hold even if you get nothing from the privatisation programme. Talking about maximising the return from asset sales to cover the deficit misses the whole point of privatisation. Asset sales are about improving the efficient and productivity of the economy. If we just worry about how much we will get for the sale of assets then we should sell all of the state assets with the firms being monopolists. But that's unlikely to do much for welfare but would cover a lot of the deficit.

The point to note is that the advantage of privatisation is that it will depoliticise the firm. The aim is to have the greatest possible "distance" between the government and the firm. Government interference in the running of a firm is impossible to eliminate completely but a good privatisation plan will result in a situation where any government interference is as obvious and politically costly as possible.

For successful privatisation it is more important to get the regulatory environment right so that competition can breakout in the industry than it is to maximise the price for which the asset is sold. Basically I'm arguing we should have lexicographic preferences, with price low on the list. Worrying about whether or not the ‘family silver’ was sold too cheaply misses the point, the price received can only be see as too high or low relative to the market structure the firm finds itself it. Just arguing that a higher price could be obtained with a different market structure is only useful if the new market structure improves welfare.

In short, having to cover a deficit is nether a necessary not sufficient reason for the sale of state assets.