Archive for March 2011


A dilemma for conservatives

Milton Friedman helped revive capitalism when he showed that the Great Depression didn’t show capitalism was unstable, but rather that monetary policy had been unstable.  Some critics argue he actually was a closet interventionist, as he thought capitalism required active stabilization policy.  Perhaps, but one could also argue that he was saying “as long as the government runs our monetary regime, they need to do it well.”  Sort of like a libertarian arguing that if governments build our bridges, they should build them so that they don’t collapse.

In any case, conservatives later started to drift away from the Friedman/Schwartz view of the Great Depression, and became increasingly disdainful of “demand shock” explanations of the business cycle.  This created a huge problem in 2008, as conservatives had great difficulty defending the free market, which seemed to have once again failed us.

To be sure, they did find some important policy failures; from the GSEs to deposit insurance to the regulation of the ratings agencies to the moral hazard created by “Too-Big-to-Fail.”  Nevertheless, given all the bad loans that were made without government pressure, by private banks, to middle class borrowers, it was pretty hard to completely absolve the private sector.

I believe that abandoning the Friedman/Schwartz view of the business cycle was a big mistake.  It’s not that this view would have magically absolved the private sector from any role in the sub-prime fiasco, I’m somewhere in the middle on this issue, believing both regulators and private actors made huge mistakes.  Rather the F/S view would have absolved the financial crash from being the primary cause of the Great Recession.  It would be much easier to live with the occasional financial fiasco if it didn’t lead to a Great Recession.  Remember 1987?

If RGDP hadn’t fallen sharply in 2009 then the banking crisis would have been resolved much more easily, with far less public money.  For that to have happened we would have needed to prevent NGDP growth from turning negative.  And that would have required that conservatives accept the F/S view of the Great Depression, instead of drifting toward “real” theories of business cycles.

Why focus on conservatives, weren’t liberals also clueless about monetary stimulus?  If people like Fisher, Plosser, and Hoenig had warned that aggressive monetary stimulus was needed to prevent a severe slump; does anyone really believe the doves at the Fed would have stood in the way?

In 1930-33 the policies advocated by Friedman and Schwartz would have been viewed as being highly progressive.  Later Friedman moved away from steady monetary growth toward policies that would offset velocity shocks—even more progressive.  It’s a pity that so few liberal and conservative economists picked up the torch when Friedman died in 2006.  What is “the torch?”

1.  Demand shocks drive the business cycle.

2.  Monetary policy is the best tool for demand stabilization.

3.  Monetary policy is very powerful at the zero bound.

How many economists believed all three in October 2008?

Why does money matter?

Everyone but a few crazy post-Keynesians acknowledge it matters for NGDP. Everyone except a few crazy PKs and real business cycle types agrees it matters for RGDP in the short run.  The question is why?  Here are some theories:

1.  Tight money raises interest rates–which leads to less output.

2.  Tight money reduces the amount of the medium of exchange, which leads to less exchange and less output.

3.  Tight money raises the ratio of hourly wages to per capita NGDP, which reduces employment and output.

Nick Rowe thinks the second mechanism is especially important, whereas I focus on the third.  Most people like the first, but I’m not even going to bother with that one.   Here’s Nick:

The unemployed hairdresser wants her nails done. The unemployed manicurist wants a massage. The unemployed masseuse wants a haircut. If a 3-way barter deal were easy to arrange, they would do it, and would not be unemployed. There is a mutually advantageous exchange that is not happening. Keynesian unemployment assumes a short-run equilibrium with haircuts, massages, and manicures lying on the sidewalk going to waste. Why don’t they pick them up? It’s not that the unemployed don’t know where to buy what they want to buy.

If barter were easy, this couldn’t happen. All three would agree to the mutually-improving 3-way barter deal. Even sticky prices couldn’t stop this happening. If all three women have set their prices 10% too high, their relative prices are still exactly right for the barter deal. Each sells her overpriced services in exchange for the other’s overpriced services….

The unemployed hairdresser is more than willing to give up her labour in exchange for a manicure, at the set prices, but is not willing to give up her money in exchange for a manicure. Same for the other two unemployed women. That’s why they are unemployed. They won’t spend their money.

Alex Tabarrok has a very intriguing post that tries to find evidence for the “medium of exchange” theory of money’s importance.  He finds that barter increased sharply during the Great Depression:

Rowe’s explanation put me in mind of a test. Barter is a solution to Keynesian unemployment but not to “RBC unemployment” which, since it is based on real factors, would also occur in a barter economy. So does barter increase during recessions?

There was a huge increase in barter and exchange associations during the Great Depression with hundreds of spontaneously formed groups across the country such as California’s Unemployed Exchange Association (U.X.A.). These barter groups covered perhaps as many as a million workers at their peak.

That evidence seems to support Nick’s view.  Is there any way it could be consistent with my sticky-wage model?  Perhaps in the Great Depression many workers became so poor that they could not afford certain items unless they were first able to earn some “money” (actually wealth) by selling something they could produce.  Barter was a way of affording something that you otherwise could not afford.  (And maybe saving a bit on taxes.)

My theory is more ad hoc than Nick’s, but does have one implication.  In a modern recession you’d expect to see much less barter, as workers are not nearly as poor.  Most people in American have enough “money” (i.e. media of exchange) to buy something if they want it.  What usually holds them back in recessions is not the inability to find some media of exchange, but a lack of income or wealth.  Because we usually have enough media of exchange to make purchases, if wealth is much higher than the 1930s you’d expect barter to be much rarer.  And that is what Alex finds:

What about today? Unfortunately, the IRS doesn’t keep statistics on barter (although barterers are supposed to report the value of barter exchanges).  Google Trends shows an increase in searches for barter in 2008-2009 but the increase is small. Some reports say that barter is up but these are isolated, I don’t see the systematic increase we saw during the Great Depression. I find this somewhat surprising as the internet and barter algorithms have made barter easier.

So I think the evidence cuts both ways; and we are still left with two plausible hypotheses for why money matters.  (I’m calling the first one listed above implausible.)  It’s likely that both sticky wages/prices and a monetary economy are necessary conditions for money non-neutrality; with barter you can’t have the sort of wage-stickiness that would cause unemployment.  So it’s hard to tell which is the most important.

Perhaps I should say a few words about why I think sticky wages matter, and why other economists don’t agree.  The sticky-wage theory is usually assumed to imply that real wages should be countercyclical, at least during demand shocks.  I think they are somewhat countercyclical during demand shocks (Sumner and Silver, JPE, 1989), but the evidence is unclear because we lack good data for either hourly nominal wages or the price level.

The biggest drop in the monetary base in the past 100 years was in 1920-21.  That was also the biggest drop in the WPI in the past 100 years.  And that was also the biggest increase in hourly manufacturing wages divided by the WPI in the past 100 years.  Coincidence?  Maybe, but when the data is awful I look for shocks so enormous that even with awful data the underlying relationships should be visible.  For me that’s 1920-21, and also 1929-1939.  And both periods suggest that sticky wages are a problem.

The modern data is much less clear.  In my view the right way to define real wages is nominal wages over per capita NGDP.  Since nominal wages are sluggish, and NGDP is highly cyclical, that definition would make “real” (actually relative) wages look countercyclical.  Unfortunately, other economists would argue that this pattern doesn’t prove much, as it would be expected under almost any business cycle theory.  So we are back to square one.  I think sticky wages are the key to money non-neutrality, but can’t prove it to those who use more conventional models.

In the comments someone recently argued that I don’t rely on formal models.  Yes I do, but like Milton Friedman I like ad hoc partial equilibrium models, not the DSGE models that are so popular today.  One model for output and employment, another for monetary policy and NGDP, another for interest rates, another for exchange rates, etc.  Yes, you can try to put them all together in a general equilibrium model, but I don’t think macroeconomists know enough for those large abstract models to be useful.  The world is too complicated.  Better to stick with what we do know.

BTW, don’t confuse the issue of real wage stickiness and the natural rate of unemployment, with nominal wage stickiness and cyclical unemployment.  For instance this post Tyler Cowen discusses evidence that has a bearing on the real wage/structural unemployment issue, but no bearing on nominal stickiness and cyclical unemployment.  (That’s not to say real and nominal stickiness cannot interact to make the problem worse, they almost certainly do.)

Karl Smith, Matt Yglesias, and Greg Mankiw

Greg Mankiw linked to a post showing data for income inequality and tax progressivity.  Matt Yglesias argued that Mankiw is unreliable because the data he used is incomplete (income taxes only.  But actually it’s not just income taxes.)  Then Karl Smith presented the exact same data in the form of a graph rather than a table, and Yglesias praised Smith’s graph, while continuing to argue that Mankiw engaged in “malfeasance.”  I’m confused.  Here’s how Matt Yglesias interpreted the Smith chart:

 The rich pay a huge share of the total taxes in the United States because they have a huge share of the money.

But that’s not really what Karl Smith’s graph shows.  It’s not saying that if you make twice as much money you pay twice the taxes.  It shows something far more interesting, something that I was unaware of.  The graph shows that countries with more income inequality tend to adopt tax regimes with more progressivity.  I knew that was true between the US and Europe, but didn’t know it was also true within Europe.  That’s completely consistent with Mankiw’s (implied) claim that the US tax system is the most progressive.

PS.  The reason it shows progressivity related to inequality is that the line on Smith’s graph has a relatively flat slope.

Update:  On second thought  I may have erred in saying it was simply a function of the relatively flat slope; the intercept also matters.  Math isn’t my forte.

HT:  Commenter “example”

The marshmallow test

There are two kinds of people, those who eat one marshmallow, and those who eat two.  More specifically, The Economist reported:

FORTY years ago Walter Mischel, an American psychologist, conducted a famous experiment. He left a series of four-year-olds alone in a room with a marshmallow on the table. He told them that they could eat the marshmallow at once, or wait until he came back and get two marshmallows. Recreations of the experiment on YouTube show what happens next. Some eat the marshmallow immediately. Others try all kinds of strategies to leave the tempting treat alone.

Nothing surprising there. The astonishing part was the way that the four-year-olds’ ability to defer gratification was reflected over time in their lives. Those who waited longest scored higher in academic tests at school, were much less likely to drop out of university and earned substantially higher incomes than those who gobbled up the sweet straight away. Those who could not wait at all were far more likely, in later life, to have problems with drugs or alcohol.

I am a libertarian, but I am also a utilitarian, so I don’t really object to reasonable “nudge” policies like making the 401k plan the default option for new hires, or having banks warn people who rely too much on expensive overdrafts.

What bothers me is when I see attempts to redistribute wealth from the two marshmallow eaters to the one marshmallow eaters.  For instance, by the time I retire in 6 years I will have probably averaged about $80,000/year over my working life, which makes me comfortably upper middle class.  Because I am a two marshmallow personality, I’ve probably saved about half of that income.  So I’m doing fine.  Most Americans with similar incomes are one marshmallow types, and save something closer to 10% of their incomes.

What do we do if Social Security needs to be trimmed in order to balance the budget?  I hear lots of talk about cutting back on benefits for those who “don’t need it.”  That would be people like me.  Here’s why I don’t trust the Dems—I see them as the party of one marshmallow eaters.  They represent people who have less self-control.  I fear they will cut my benefits, but not cut the benefits of people who didn’t save for retirement.  I fear they will use “wealth” as the criterion to determine who is needy and who isn’t; not lifetime wage earnings.

In my view there is nothing egalitarian about redistributing income from two marshmallow eaters to one marshmallow eaters.  They’ve already had their fun when young, loading up their three car garages with all sorts of fun toys.  I’ve never even had a garage.

I’m not saying that the rich shouldn’t be the ones who accept cutbacks in Social Security to save the system, that is a defensible argument (although interestingly many progressives oppose the idea, hoping that Social Security doesn’t become seen as “welfare.”)  But if you are going to do means-testing, it should be on lifetime wage income, not wealth.  If they do that then I need not fear for my SS benefits, as most Americans who have averaged about $80,000 a year over their lifetime have not saved much, and would march on Washington if their SS benefits were cut back.

Update:  Commenter Edwin A pointed out that I shouldn’t have picked on the Dems.  I do think they are usually the one marshmallow party, but in this case many Dems oppose means-testing Social Security, and some conservatives support the idea.

If you are going to argue that people who make mistakes should be ostracized . . .

. . . it’s best not to make a serious mistake in your attack.  Here’s Matt Yglesias:

The answer is that the column labeled “Share of taxes of richest decile” is in fact the share of income taxes paid by the richest decile. The federal income tax in the United States does, in fact, have a progressive rate structure. Federal payroll taxes, state and local sales taxes, most excise taxes, and property taxes all have a regressive rate structure. So, yes, if you look exclusively at the most progressive element of the American tax code, it’s highly progressive. If you compound that exercise by mislabeling your chart, then you can mislead people. You might think it’s a little strange that Greg Mankiw, an economics professor, would mislead people by uncritically endorsing such a misleading chart but Mankiw believes that progressive taxation is immoral and should be opposed even if it enhances human welfare. Perhaps this same moral theory leads him to believe that misleading people about the subject is an act of justice. If so, then I’m not sure it’s really in the interests of Harvard (or the many universities that assign his textbook) to entrust him with the instruction of teenage economics students.

Now I’m not going to argue that the chart Mankiw links to is exactly correct, but it looks like it’s in the right ballpark.  And I could tell that Yglesias’ assertion about income taxes was wrong without even looking up the numbers.  The top 10% in America pay way over 45% of income taxes, at least as tax incidence is normally estimated.  (BTW, the assumption that the incidence of income taxes falls on the people who write out checks to the IRS seems crazy to me, but my fellow economists of the left and right don’t agree.)

It is common knowledge among progressive public finance experts like Peter Lindert that the European tax regimes are able to collect more revenue than ours (as a share of GDP, not in total) by having a more regressive tax system.  Mankiw’s link may not be exactly right, but the stylized facts are in the right ballpark.  Given that Yglesias is a fan of the European welfare state, I’m surprised he hasn’t read Lindert’s research.

Actually, what most surprised me was the very low share of income earned by the top 10% in Switzerland.  That can’t possibly be right, can it?

Yglesias’ strongest argument might be that tax plus transfers in Europe might be more progressive than taxes alone.

BTW, I agree with Yglesias that a progressive (consumption) tax system is desirable, and don’t really buy into Mankiw’s “just deserts” approach.  So this post has nothing to do with my ideology.  (Of course if I had been born as Greg Mankiw I might feel differently about the just deserts approach.)

To summarize, it’s still safe to use Mankiw’s text, but Cowen/Tabarrok is also excellent.   (Can’t afford to piss off any influential bloggers.)

Update:  Scott Winship sent me a post with some quite interesting graphs on income inequality.  (BTW, I don’t think income inequality is the best way to measure economic inequality–I prefer consumption inequality.  But income is what most people use.)