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.

Interview with Daron Acemoglu

The September 2011 issue of The Region has an interview with the MIT economist Daron Acemoglu on tech innovation, inequality and dynamics of political economy.

Region: A related question, about intellectual property rights and innovation, jumps back to your discussion of Apple and patent infringement. In a recent paper, you suggested that optimal policy regarding IPR protection is “state-dependent.” The idea is that patent or IPR protection should be strongest for competitors that have their greatest advantage over their competitors or their rivals. That seems kind of counterintuitive to me, but your explanation is intriguing—it relies on dynamic incentives and the sort of “trickle down” effect you were just touching on. Can you explain your thinking on this?

Acemoglu: Yes, it is sort of a counterintuitive result—and not what we were expecting when we started working on this. In fact, our intuition was the opposite, so it’s one of the places where you sort of are surprised.

We started with a model that is very traditional, in some sense, for this set of questions. It has two companies within each sector that compete, and they’re trying to improve over each other. We thought that it would be a great idea to cut the leads of companies that are farther ahead of others. If Microsoft, or Apple, is very far ahead of its rivals, that will discourage the rivals. They’ll think,

“Well, we’re never going to catch up with Apple; we might as well give up.” And Apple itself reduces research because part of the reason it was doing R&D was to rise above its rivals and be able to charge higher prices than its rivals. Well, if the rivals aren’t doing R&D, then they’re not much of a threat to Apple, so then they don’t do as much.

So we thought, “Ah, well, then it would be a great thing to say, ‘If Apple is so far ahead of its rivals, let’s get rid of its IPR protection, so it brings them closer, and then once they are closer, they’ll all start running faster.’” So that was our intuition.

And it turns out, that intuition is not correct. And the reason it’s not correct is because if you do that—if you get rid of the IPR protection—the cost is not so much that you discourage Apple today, but you discourage companies that were trying really hard to build a lead over their rivals in order to become like Apple.

So instead, it remains true that full IPR is not generally optimal, because full IPR:

(a) Slows down how successfully some ideas that have been invented are used by others, which you want to encourage. You know, once Apple comes up with a great device, you don’t want it to be the only company that does so, leaving me in my corner trying to work with a bad technology. You want me to use that good technology as well.
(b) This effect that I mentioned is still there, that if you can bring us closer, we both run faster and we’re both more innovative.

But it turns out in such models—and in a robust way—the optimal policy is to relax IPR protection when you and I are a few steps apart, but dangle the carrot that if you increase the gap between you and your rival to a sufficiently high level, then you’ll be given better patent protection.

Then in some sense, you’ll have your cake and eat it too. You can benefit from this effect that by letting me use your technology, you’re encouraging both of us to run faster, but at the same time not creating this very strong discouragement effect that people are going to put off doing R&D because they’re not going to be rewarded for that effort. On the contrary, they’ll be rewarded even more, because they’re going to escape not only their competitor, but they’re going to also escape the regime where their IPR is not very well protected. So that’s sort of the twisted logic of it all

Climate change: incentives to mitigate and incentives to adapt

From VoxEU.org comes this audio interview in which Matthew Kahn of the University of California, Los Angeles, talks to Romesh Vaitilingam about global warming – and the incentives for individuals, cities and nations to reduce their greenhouse gas emissions or to adapt their lives to a warmer planet. He explains how free market capitalism might drive effective climate change mitigation or adaptation.

Herbert Hoover: father of the new deal

The Cato Institute has released a new Briefing Paper, by Steven Horwitz, titled "Herbert Hoover: Father of the New Deal". The Executive Summary reads:

Politicians and pundits portray Herbert Hoover as a defender of laissez faire governance whose dogmatic commitment to small government led him to stand by and do nothing while the economy collapsed in the wake of the stock market crash in 1929. In fact, Hoover had long been a critic of laissez faire. As president, he doubled federal spending in real terms in four years. He also used government to prop up wages, restricted immigration, signed the Smoot-Hawley tariff, raised taxes, and created the Reconstruction Finance Corporation—all interventionist measures and not laissez faire. Unlike many Democrats today, President Franklin D. Roosevelt's advisers knew that Hoover had started the New Deal. One of them wrote, "When we all burst into Washington ... we found every essential idea [of the New Deal] enacted in the 100-day Congress in the Hoover administration itself."

Hoover's big-spending, interventionist policies prolonged the Great Depression, and similar policies today could do similar damage. Dismantling the mythical presentation of Hoover as a "do-nothing" president is crucial if we wish to have a proper understanding of what did and did not work in the Great Depression so that we do not repeat Hoover's mistakes today.

Worth a read.

Kevin Dowd: the decapitalisation of the west

The Decapitalization of the West. A lecture delivered on the 12th of September 2011 at St Stephen's Club Westminster by Professor Kevin Dowd for the Adam Smith Institute.

A harsh dose of reality from the indispensible Kevin Dowd. The lecture above was given on Monday night. Dowd weaves together the strands of economic breakdown created by central banks, bailouts and high taxes into a tapestry of ruin. It's gripping and horrible, and essential viewing to anybody who thinks the worst is behind us. Dowd's message: you ain't seen nothing yet.

A failsafe way to end the Eurozone crisis (?)

That the Eurozone is in crisis comes as news to no one. But what to do about it? At VoxEU.org Charles Wyplosz has come up with a 3 step plan which he claims will end the crisis.

Three steps to a solution

The first step deals with the existing stock of public debts.

• The ECB should set a floor on public debt values by offering a guarantee.

The guarantee should be partial to allow defaults for countries unlikely to serve their debts. A guarantee could cover each country’s debt up to, say, 60% of GDP.

• Markets would promptly re-price debts. Greece’s debt would likely trade at 60% of its GDP, about 50 cents to the euro;
• Others would trade higher all the way to Germany’s, which would stay at par.

The market price would offer a clear guide for governments to negotiate a restructuring. The ECB – and German taxpayers – would suffer no loss. The crisis would be over, moving to the resolution phase.

The second step is designed to shift from fiscal austerity to growth-enhancing action.

• To allow governments to borrow again, the ECB should guarantee all future public debts – excluding the rollover of non-guaranteed debts.

Without complementary policies, this would obviously create endless moral hazard (ie temptation for Eurozone governments to issue cheap debt irresponsibly on the back of the guarantee).

To eliminate the moral hazard created by both guarantees, two conditions are needed.

• First, each country would have to adopt domestic institutional arrangements (fiscal rules, independent fiscal councils, etc.) that lock in lasting fiscal discipline as a matter of national law. (Just as US states avoid the problem with state constitutions that require balanced budgets.)

To be credible to the domestic body politic, each nation’s arrangements must fit local political institutions – but the proposed change would be subject to approval by the European Commission and the ECB.

• The second condition for the ECB’s guarantee would be that each country strictly enforces its own arrangement.

Access to the ECB guarantee on new issues will start only once an arrangement has been validated. It would be suspended if and when particular nations failed to respect their approved arrangement. Such suspensions would immediately raise the cost of further borrowing by the delinquent country, but it would not affect the guarantee already given to debt issued previously– that guarantee would be meaningless if the ECB could renege.

Step three addresses banks' vulnerabilities arising from the fact that sovereign defaults are likely to result in bank failures.

• Given that some countries will default, the EFSF will have to recapitalise failed banks.

Here the ECB would act as lender of last resort with the EFSF guaranteeing its interventions. Well-crafted recapitalisations do no need to be costly. For example, the Swiss National Bank is now making profits on its creative recapitalisation of UBS during the global crisis.

Importantly, these schemes would be voluntary. No country would be forced to accept the ECB guarantees but any country could ask for it at any time.

Could the ECB suffer losses? A crucial element of this solution is that the ECB would spend almost no money if the guarantees are well-specified enough to be credible.

The only question is, Would it really work?

EconTalk this week

Alex Rosenberg of Duke University talks with EconTalk host Russ Roberts about the scientific nature of economics. Rosenberg, a philosopher of science talks about whether economics is a science. He surveys the changes in economics over the last 25 years--the rise of experimental economics and behavioral economics--and argues that economics has become more scientific and that economists have become more aware of flaws in economic theory. But he also argues that economics is unable to make precise predictions about the effects of various changes in policy and behavior. The conversation closes with a discussion of the role the philosophy of science can play in the evolution of economics.

The impact of economics blogs

An issues so important that the World Bank has been researching it!

From the Bank comes a new Policy Research Working Paper on The Impact of Economics Blogs (pdf) by David McKenzie and Berk Özler. The abstract reads,

There is a proliferation of economics blogs, with increasing numbers of economists attracting large numbers of readers, yet little is known about the impact of this new medium. Using a variety of experimental and non-experimental techniques, this study quantifies some of their effects. First, links from blogs cause a striking increase in the number of abstract views and downloads of economics papers. Second, blogging raises the profile of the blogger (and his or her institution) and boosts their reputation above economists with similar publication records. Finally, a blog can transform attitudes about some of the topics it covers.

Can't say I have noticed any of these effects myself!

Economic freedom of the world: 2011

The index published in Economic Freedom of the World measures the degree to which the policies and institutions of countries are supportive of economic freedom. The cornerstones of economic freedom are personal choice, voluntary exchange, freedom to compete, and security of privately owned property. Forty-two data points are used to construct a summary index and to measure the degree of economic freedom in five broad areas:

1. Size of Government: Expenditures, Taxes, and Enterprises;
2. Legal Structure and Security of Property Rights;
3. Access to Sound Money;
4. Freedom to Trade Internationally;
5. Regulation of Credit, Labour, and Business.

The top ten countries in this year’s index are

1. Hong Kong 9.01 out of 10;
2. Singapore (8.68);
3. New Zealand (8.20);
4. Switzerland (8.03);
5. Australia (7.98);
6. Canada (7.81);
7. Chile (7.77);
8. United Kingdom (7.71);
9. Mauritius (7.67);
10. and the United States (7.60).

The bottom ten countries in this year’s index are

1. Zimbabwe (4.08);
2. Myanmar (4.16);
3. Venezuela (4.28);
4. Angola (4.76);
5. Democratic Republic of Congo (4.84);
6. Central African Republic (4.88);
7. Guinea-Bissau (5.03);
8. Republic of Congo (5.04);
9. Burundi (5.12);
10. and Chad (5.32).

I don't think there are any real surprises in either list. That Hong Kong is at the top and Zimbabwe is at the bottom is not great surprise, but perhaps the most interesting point is that the U.S. is down to 10th. Over the last 10 yeasrs, the United States, has suffered one of the largest declines in economic freedom. Much of this decline is a result of higher government spending and borrowing and lower scores for the legal structure and property rights components.

EconTalk this week

Garett Jones of George Mason University talks with EconTalk host Russ Roberts about the workers who were hired with money from the 2009 American Recovery and Re-investment Act--the stimulus package. Jones (with co-author Daniel Rothschild) recently completed two studies based on surveys and interviews with firms who received stimulus funds and workers who work at those firms. They found that 42% of workers hired had been unemployed. The remainder came from other jobs or from outside the labor force such as retirement or school. Is 42% a big number or a small number? Jones argues it is small and defends his conclusion. The conversation also includes a discussion of the labor market generally and why the stimulus spending may not have been effective.

Innovation and foreign ownership

or why foreign ownership isn't bad. Studies have shown that foreign-owned firms are typically more productive. A new column from VoxEU.org presents evidence from Spain that suggests this is mainly due to foreign firms buying the most productive domestic companies.

In their column Maria Guadalupe, Olga Kuzmina and Catherine Thomas ask whether foreign owned firms superior productivity is due to Improvement or selection? That is, they ask Does the observed productivity advantage of the subsidiaries of foreign owned firms reflect improvements due to the multinational companies (MNCs) or acquisition by MNCs of the most productive domestic performers? They write,

Data from Spanish manufacturing firms reveal that up to two-thirds of the performance premium associated with multinational control is due to the fact that multinational firms acquire domestic firms that were initially more productive. The remaining one-third is due to changes made within the subsidiary after acquisition. Specifically, we show that acquired firms undertake more process innovation – simultaneously investing in new machinery and adopting new organisational practices.

We ask why multinationals acquire the best firms, and why these firms subsequently undertake more innovation once they are under multinational control. We find that the optimal amount of innovation is larger when an acquired firm is more productive to start with, because the benefits associated with technology upgrading are proportional to initial firm productivity.

We then show how these benefits are further amplified when the acquired firm accesses export markets through its multinational parent. Empirically, we find evidence for this mechanism. The extent of technology upgrading is significant in firms that use the foreign parent to increase their exports. Taken together, these results suggest that the multinational advantage that results from acquisition is not necessarily due to a transfer of technology from a sophisticated parent firm with lower costs of innovating to a newly acquired subsidiary. It can come about because acquired firms that are part of multinationals gain access to integrated global product markets, even when all firms have the same costs of innovating.

But what is the mechanism explaining both acquisition patterns and technology upgrading.

The mechanism explaining both acquisition patterns and innovation after acquisition relies on the simple assumption that a firm chooses to invest to upgrade its technology as long as the marginal benefits to the firm – in terms of future production profits – exceed the marginal cost of technology investment. The key insight of our paper is that the ownership structure can lower the costs of investment in technology, for example, because a foreign parent firm has proprietary production processes, but can also affect the benefits of technology investment. If the parent firm has large-scale sales and marketing operations, perhaps in other countries, then this may increase the incremental profit from technology upgrading since it increases the average per-unit production profit for a larger volume of sales. In either case, a firm will make more profits from a given improvement in technology under foreign ownership, and will also choose to upgrade technology to a higher level. The additional value created by any technology upgrade is positively related to the initial productivity of the firm. This means that the value-added of foreign ownership relative to domestic control is increasing in initial productivity and, hence, multinationals will opt to acquire the best-performing domestic firms in an economy.

The implications of this?

What are the implications of the findings for the evolution of the distribution of productivity within industries? Our key result is that foreign firms are more likely to acquire the most productive firms within industries, and acquired firms start to innovate more on acquisition.

Taken together this implies that acquisition activity can lead to an increase in the dispersion of the productivity distribution.

Under this mechanism, foreign entry does not lead to productivity convergence, but, on the contrary, could lead to further divergence. Of course, there could be other reasons (such as spillover effects or other externalities) why multinational entry may improve less productive firms’ productivity, and their entry could drive out of business the least productive firms, thus increasing the minimum level of productivity in the industry. However, the direct effect of the foreign acquisition process is an increase in productivity heterogeneity.
A novel result in the paper is to show that an important underlying reason for this divergence in productivity in the Spanish data is not just that the newly acquired firms may have access to superior technologies, but that technology upgrading is also significantly related to firms’ differential access to new export markets.

One important policy implication of the findings, then, is that other channels that reduce the fixed cost of export-market access and open up markets for domestic-controlled firms could lead to some of the productivity improvements documented in foreign-acquired Spanish manufacturing firms.

Rationality, games and conflict

From VoxEU.org comes this audio in which the Nobel laureate Robert Aumann of the Hebrew University of Jerusalem talks to Romesh Vaitilingam about his work on ‘rule rationality’, the development of game theory and its potential for understanding conflict – from the Pax Romana to the modern day Middle East.

EconTalk this week

Robert Frank of Cornell University and author of The Darwin Economy talks with EconTalk host Russ Roberts about competition, government and the relevance of Darwin for economics. In a lively and spirited discussion, Frank argues that because people care about their relative standing with their neighbors, standard conclusions about the virtues of competition are misleading. He argues that competition is often wasteful and he suggests directions for tax policy and other forms of government intervention to take these effects into accounts

Incentives matter: the firm file

Antti Kauhanen, “The Perils of Altering Incentive Plans: A Case Study”, Managerial and Decision Economics, 32(6) September 2011: 371-384.

This paper studies a retail chain that introduced a sales incentive plan that rewarded for exceeding a sales target and subsequently cut the incentive intensity in addition to increasing the target. Utilizing monthly panel data for 54 months for all 53 units of the chain the paper shows that the introduction of the sales incentive plan increased sales and profitability, whereas the changes in the plan lead to a marked drop in sales and profitability. Thus, modifying the incentive plan proved costly for the firm. The results are consistent with the gift-exchange model of labor contracts.

(HT: Organisations and Markets)