Archive for April 2010


Why smoking should be regulated, but not by the government.

My previous post triggered a lot of comments accusing me of misunderstanding Coase’s Theorem.  It is certainly possible that I did, but I am going to argue that many of my commenters are misunderstanding that famously misunderstood Theorem.
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Libertarian Paternalism

I haven’t yet weighed in on the subject of libertarian paternalism, partly because I don’t have strong views on the issue.  Now Cato Unbound is doing a debate on the topic.  After reading essays pro and con, I’m still undecided, but leaning pro.  Here’s Glen Whitman speaking out against paternalism:

Choosing Among Preferences

What does “irrationality” look like? How can you prove someone is irrational, rather than simply having preferences you don’t share? After all, there is nothing per se irrational about strongly valuing the present relative to the future, or enjoying food more than you enjoy good health.

To demonstrate irrationality, behavioral economists frequently point to inconsistent behaviors that suggest inconsistent underlying preferences. For instance, people make long-term plans for saving or dieting but then, when the time comes, reverse those plans and succumb to the desire for short-term gratification. They also make different choices in different emotional states — such as saying they would never sleep with an obese person, then reversing that preference when sufficiently aroused. (Yes, an experiment by Dan Ariely has actually shown that.)

There is some dispute as to whether all such behavioral inconsistencies reveal irrationality. But let’s say they do. Even so, that fact does not license a third party to choose among competing preferences. If a person is more patient when thinking about trade-offs in the distant future, but less patient when thinking about trade-offs near the present, which level of patience is “correct”? If you would sleep with a given person when you’re in a “hot” state but not in a “cool” state, which sexual preference is “correct”? Neither theory nor evidence provides a basis for answering these questions. As some new paternalists admit, behavioral inconsistencies may indicate that “true” preferences simply don’t exist.

Nevertheless, new paternalists have not hesitated to pick and choose the “right” preferences. O’Donoghue and Rabin, for instance, define “optimal sin taxes” in terms of a person’s most patient rate of time preference. Similarly, the new paternalists favor the preferences we display in a cool state (calm and sober reflection) over those we have in a hot state (fear, anxiety, arousal, etc.), even though arguably the “hot” preferences might do a better job of revealing our true desires.

So how are the paternalists choosing, if not on the basis of hard science? It’s not hard to see: they are favoring their own preferences, which also happen to be the socially approved ones.
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Brad DeLong strays dangerously close to mentioning M*V

As most of you know, I have become obsessed with NGDP.  A number of other bloggers such as Bill Woolsey, David Beckworth and Josh Hendrickson have also emphasized the role of falling NGDP in the current recession.  But NGDP is a variable that you don’t see liberals discuss very often.  David had a famous post last year that showed just how sharply NGDP had fallen below trend since mid-2008.  Paul Krugman agreed that the graph was suggestive, but warned that talking about NGDP could lead people to consider some dangerous ideas, such as the quantity equation of exchange:

Here’s my problem. Underlying the focus on nominal demand or GDP is some notion that there’s a quantity equation:


where M is the money supply, V the velocity of money, P the price level, Y real GDP. And of course this always holds true, by definition. But the temptation is to take it as a causal relationship — to say that real GDP fell because nominal GDP fell, and that this in turn was caused by either a fall in M or a fall in V; and furthermore that any such decline is a failure of monetary policy, because the central bank should have either prevented the fall in M or increased M enough to offset the fall in V.

Thus I was surprised to see not one but two liberal bloggers (Brad DeLong and Matt Yglesias) give big play to the same sort of graph that Beckworth and Woolsey often display on their blogs.  Let’s hope Brad can avoid the temptation to start talking about M and V.

PS.  Just so I am not misunderstood, there is no “point” to this post.  I agree with the two posts, and don’t have any objections to anything they said.  I’m glad to see more people paying attention to NGDP.  If it becomes a more widely discussed variable then severe nominal shocks such as 2008-09 will be easier for people to identify.  Right now these shocks are obscured by the focus on (flawed) inflation estimates.  As I pointed out in my previous post, inflation is a variable that central banks hide behind when it suits their purposes.  Yglesias also has a recent post on the ECB, which is presiding over an even more dreadful collapse in NGDP.

4 Questions

Warning: The first question is tricky.  But I’ve noticed that economic blog readers are very smart, and I have confidence that you will get it right.

1.  Take a look at “Figure 1″ in this Mark Thoma post.  According to the BEA, did housing prices reach a peak near the end of 2006?  If not, about when did they peak?

2.  Use the answer to question 1 to figure out why I think BEA inflation figures are worthless.   Hint; housing is nearly 40% of the core CPI.  Fortunately, it is only 18% of the PCEPI.

3.  Is there any other nominal aggregate that might give a more accurate reading of the timing and scale of nominal shocks hitting the US economy?

4.  The ECB is proud of their recent success in keeping inflation low and stable.  Does this imply they believe Europe was not adversely affected by the worldwide collapse in AD that began in August 2008?

I will provide my answers tomorrow night in an update.  Those who aren’t longtime readers may be surprised by some of the answers.

Update 4/7/10:  

See, I knew you guys were smart. Declan nailed it with the very comment.

A few comments:

Declan is right that the monthly changes over the last year would be below the 12 month changes. This is the “average/marginal” distinction that you may recall from drawing demand curves and marginal revenue curves. When the 12 month average is falling at a steady rate, the marginal monthly change is lower, and falling more rapidly. When there is a “kink” in the rate of decline, as in about May 2009, then the monthly numbers must have fallen discontinuously to a much lower level. It looks to me like the monthly numbers went negative in the second half of 2009—so I’d guess housing prices peaked about that time.

2. So the BEA said housing prices were rising 2006-09, right through the biggest house price crash in American history. And now that house prices are actually rising, they show them falling. Not good for a product that is 40% of the core CPI. The basic problem is that flaws in BEA procedures make it look like prices respond with a long lag to monetary shocks. There actually is some lag due to some prices being sticky, but much less than the BEA data suggests.

3. NGDP.

4. Yes, for the following reasons:

a. The ECB is able to influence AD, not AS.

b. If they target inflation, presumably they believe that inflation is the appropriate indicator of whether AD is higher or lower than desired.

c. If they have hit their inflation target, then they presumably believe AD is at the appropriate level.

d. If they don’t believe AD is at the appropriate level, but they are fine with the current inflation rate, then they should not be targeting inflation.

In my view, answer “d” describes the actual situation in the Eurozone. For instance, the Eurozone has done fiscal stimulus, which makes no sense if inflation is on target.

Concerned, not concerned, or happy?

James Hamilton has a March 28 post discussing the recent rise in interest rates:

Interest rates spike up

How scary is it?

The Wall Street Journal reports:

A sudden drop-off in investor demand for U.S. Treasury notes is raising questions about whether interest rates will finally begin a march higher– a climb that would jack up the government’s borrowing costs and spell trouble for the fragile housing market.

This week, some investors turned up their noses at three big U.S. Treasury offerings. Demand was weak for a $44 billion 2-year note auction on Tuesday, a $42 billion sale of 5-year debt on Wednesday and a $32 billion 7-year note sale Thursday.

The poor demand, especially from foreign investors, sent the bonds’ prices sharply lower and yields higher.

Paul Krugman (also here) and Brad DeLong are not concerned, noting we’ve seen lots of yield changes of this size or higher in the past.

I regard medium term nominal rates as a pretty good indicator of NGDP growth expectations.  So, I’m neither “concerned” nor “not concerned;” I’m happy to see rates rise. 

Hamilton discounts the possibility that the higher rates signal higher inflation:

One possibility that I think we can rule out is that recent bond moves signal renewed worries about inflation. The recent surge in yields on Treasury Inflation Protected Securities is just as dramatic.

I’ve also been following the TIPS, and agree that real rates are rising.  I believe this signals higher real growth expectations.  Hamilton understands this argument, but is a bit skeptical of market forecasts:

When bond yields and stock prices rise together, I would usually read that as a signal of rising investor optimism about future real economic activity. The February numbers for home sales and other indicators that we’ve been receiving most recently don’t exactly support that thesis. Let’s hope that investors are correctly anticipating that better news lies ahead.

These quotations represent Hamilton’s views as of  March 28.  So what’s happened since then?  Here is Hamilton on April 4th

Looks good to me

Finally we’re starting to see some convincing indications of economic recovery.

There are no “indications” that are more convincing than the consensus market forecast.  Market’s aren’t even close to being infallible, but they’re the best indicators that we have.

PS.  I forgot to mention the good news on the Chinese yuan.  The Obama administration has backed off from a reckless policy of confrontation.  And look how the markets reacted:

China’s yuan barely reacted in offshore forward Asian markets on Monday, apparently reflecting investor sentiment that the U.S. decision will not shift of the value of the yuan a year hence.

One-year NDFs moved from 6.645 per dollar to 6.639, which still implied an appreciation of about 2.8 percent in a year’s time. But markets in Hong Kong and Shanghai, the main centers for yuan trading, were closed for holidays.

So the yuan actually rose slightly in the futures markets.  This suggests to me that the Chinese don’t like being pushed around, and the markets figured that any US pressure on China would be ineffective, or perhaps even counterproductive.  Three percent a year appreciation in the yuan seems appropriate if their goal is low inflation.