[Update: Yikes, I wrote this yesterday but see that Tyler has already posted a reply to Avent.  Readers short of time will want to skip this post and read his instead.]

Tyler Cowen notes that American universities lead the world.  He finds this surprising (or at least “sobering”) given all the inefficiencies he sees all around him.  Ryan Avent points out that this dominance occurs despite heavy government involvement in American higher education:

Mr Cowen is clearly upset by the inefficiencies of the higher-education sector. And clearly there are inefficiencies; it would be surprising if there weren’t in a sector so dominated by the government. But contrary to what Mr Brooks’ writing might lead you to believe, American higher education is very much exposed to international competition. As Mr Cowen indicates, an American advanced degree is one of the country’s best exports (and your author opted to purchase from a foreign producer, the London School of Economics, when he went shopping for an advanced degree).

This, I think, is a significant challenge for both parties and indeed for economics. A sector dominated by the state””state-run in some cases, merely subsidised and regulated in others””is, I think most Americans would agree, both a major contributor to American prosperity and one of America’s most competitive industries on foreign markets, despite its glaring inefficiencies. What ought we to conclude based on this example?

Certainly, one could reasonably argue that the sector would be even better if state control were relaxed, monopolies broken up, subsidies curtailed, and market controls (like those on immigration) eliminated.

Let me start off by admitting that although I’ve taught at colleges in Australia and the UK, I’m no expert on foreign universities.  But I’ve heard lots of anecdotal reports that foreign university systems are even more completely dominated by the state.  In many systems tuition is quite low and there seems to be little competition for students.  I’ve heard all sorts of horror stories about faculty apathy due to lack of incentives.  This article from the University of Chicago alumni magazine says the entire Italian system is corrupt from top to bottom, with jobs doled out on the basis of connections and nepotism, not ability.

The qualified job candidates fregati by the baroni often leave the country and begin successful careers abroad. In the last 20-30 years, tens of thousands of Italian researchers have fled the country. The baroni‘s clans continue to operate undisturbed and have absolute control of the Italian academic system. As a result of such nepotism, the Department of Economics at the University of Bari had, at one point, eight professors who shared the same last name: Massari. They were all related. Apparently this set a new record for Italy; the previous record was six family members in the same department or institution.

The US has lots of elite private universities, which force even the very best public universities (such as the California system) to keep on their toes if they want to maintain their rankings.  Private ownership can certainly contribute to efficiency, but in my view competition is even more important than ownership.

If comparative advantage is what matters in international trade, then the US dominance in higher ed may tell us more about foreign universities than about our own system.

PS.  This post should not be viewed as a blanket condemnation of foreign universities.  Pound for pound the other Anglophone countries do very well in competing for foreign students.  And there are excellent universities in countries like France and Japan.  I was simply trying to show that an observation that looked perplexing was actually quite consistent with the theory of comparative advantage.

I am an optimist about China.  Some commenters mistakenly assume I am a China booster.  Actually, I don’t at all like the authoritarian nature of their political system or the gross inefficiencies of their economic system.  There’s nothing for us to emulate.

I’m an optimist because each time I visit China (and I plan to return this summer) I see dramatic changes.  Yes, it’s repressive and wasteful, but far less so than a few decades earlier.  And as this important story in the new issue of The Economist shows, the reforms roll onward relentlessly:

INFORMAL lending is rampant in China. Although some private banks like Minsheng do lend to small enterprises, the official banks that dominate Chinese banking prefer to lend to well-connected state firms. Many Chinese entrepreneurs have been forced to turn to shadow banks. . . .

At the end of March officials announced that Wenzhou, a dynamic city in Zhejiang, would be named a “special financial zone” in which two pilot schemes will be introduced. First, informal moneylenders will be encouraged to register as private lending institutions free to operate with the blessing of the state. Second, private citizens in Wenzhou will be allowed to invest up to $3m each directly in non-bank entities abroad, without the need for a formal government intermediary.

These moves are welcome. Legitimising black-market finance could accelerate economic growth by deepening the pool of capital available to the country’s cash-starved entrepreneurs. Michael Werner of Sanford C. Bernstein, an investment bank, also points out that such a reform would help by giving legal remedy in case of default. At the moment, there is none. During last year’s crunch in Wenzhou, for example, some bankrupt bosses simply boarded up their factories and fled town.

The move to allow direct overseas investment is also a promising step towards opening up China’s capital account. At the moment mainland residents can legally move only a pittance abroad in any given year. If the pilot scheme is expanded, the opening could help ease upward pressure on property prices by offering punters another way to seek high returns. Frederic Neumann of HSBC thinks allowing money to flow abroad could ease the “financial repression” of low interest rates for savers.

Tantalisingly, Wen Jiabao, the prime minister, this week declared that the “monopoly” grip of state-run banks must be broken, and hinted that the reforms in Zhejiang would be expanded nationally if successful. Officials also almost tripled the amount of foreign investment allowed in China’s capital markets, to $80 billion.

Chinese market reforms began in rural Anhui during 1979.  But the urban reforms began in the 1980s in Wenzhou, which is China’s most entrepreneurial city.  The Chinese government tends to try new policies on a small scale before rolling them out nationwide.  Often the reforms simply legalize what is already occurring.  That was true of the move away from communes in the late 1970s and early 1980s, and it’s true of the current banking reforms.  But legalization is very important, as it puts business people in a much less precarious position, especially in a country where prosecution for economic crimes can be politically motivated.

Over the past three years I’ve become very depressed seeing economists trying to substitute demand-side fiscal stimulus for monetary stabilization policy.  The central bank must do something, so why not set policy at a level expected to produce on-target demand growth?  Even supporters of fiscal stimulus must be frustrated by how illogical it is to ask Congress to make up for the lack if stabilization finesse at the Fed.  Surely there’s a better way.  Now Alberto Alesina and Francesco Giavazzi point the way forward:

Economists have engaged in some lively debates about how to measure and evaluate the effects of large fiscal adjustments episodes in OECD countries (Europe in particular). But a careful and fair reading of the evidence makes clear a few relatively uncontroversial points, despite the differences in approaches. The accumulated evidence from over 40 years of fiscal adjustments across the OECD speaks loud and clear:

• First, adjustments achieved through spending cuts are less recessionary than those achieved through tax increases.
• Second, spending-based consolidations accompanied by the right polices tend to be less recessionary or even have a positive impact on growth.

These accompanying policies include easy money policy, liberalisation of goods and labour markets, and other structural reforms.

That’s right, use monetary policy to boost NGDP and supply-side fiscal reforms to produce a better P/Y split.  A&G continue:

Tax-based stabilisations not only eventually fail, in the sense that they are unable to stop the growth of the debt-to-GDP ratio. When these fiscal packages are announced entrepreneurs’ confidence falls sharply, and this is reflected in a fall in output. On the other hand, spending-based stabilisations (especially if accompanied by appropriate contemporaneous polices) do not negatively affect economic confidence contemporaneously. Moreover they are often accompanied by an increase in output within a year.

It stands to reasons that European countries where tax revenues are close to 50% of GDP do not have the room to increase revenues even more.

A paper by Harald Uhlig and Mathias Trabandt (2012) nicely shows how close many European countries are to the top of realistically measured Laffer curves. Thus any additional tax hikes would lead to relative low increases in tax revenues and could be very recessionary, through the usual supply- and demand-side channels.

Given all of the above we should stop focusing fiscal policy discussions on the size of austerity programmes. A relatively small tax-based adjustment could be more recessionary than a larger one based upon spending cuts. Likewise, a small spending-based adjustment could be more effective at stabilising debt-to-GDP ratios than a larger tax-based adjustment.

.   .   .

One should go even further in disentangling the effects of composition.

• Which spending cuts are more likely to be effective?
• Which kind of tax reforms could achieve the same amount of tax revenue with fewer distortions?
• From where should market liberalisations start, and how fast should they proceed?

Some answers may be the same for all countries, others may differ.

• For instance, in general moving taxation towards the VAT and away from income taxes is preferable.
• In some countries there is no way out without a substantial raise in retirement age and cuts in government employment.

Incidentally this provides a clear link with labour-market reforms. Public-sector employment can only be reduced after firing constraints are moved and appropriate safety nets are put in place. Similarly the emphasis on the need and productivity of physical infrastructures is often misleading, at least in many countries.

.   .   .

We are in for a big disappointment on the centrepiece of Eurozone austerity – the fiscal compact. The fiscal compact bears the seeds of its failure:

• The new fiscal compact that Europe has decided to impose upon itself through a treaty change makes no mention of the composition of fiscal packages.
• European economies will remain stagnant – if not further fall into recession – if adjustments will be made mostly on the tax side and debt ratios will not come down.

And in the end, as was the case with the Growth and Stability Pact, the rules will be abandoned.

Great stuff.

HT:  Greg Mankiw

No, she didn’t quite say that, nor does she quite believe that.  But . . . well you’ll see.   Janet Yellen recently gave a very interesting speech on monetary policy:

Importantly, resource utilization rates have been so low since late 2008 that a variety of simple rules have been calling for a federal funds rate substantially below zero, which of course is not possible. Consequently, the actual setting of the target funds rate has been persistently tighter than such rules would have recommended. The FOMC’s unconventional policy actions–including our large-scale asset purchase programs–have surely helped fill this “policy gap” but, in my judgment, have not entirely compensated for the zero-bound constraint on conventional policy. In effect, there has been a significant shortfall in the overall amount of monetary policy stimulus since early 2009 relative to the prescriptions of the simple rules that I’ve described.

David Beckworth pointed to one obvious implication:

What Yellen and Bernanke both need to embrace is a NGDP level target.  This approach would allow the Fed to make up the cumulative shortfall created by the Fed’s passive tightening while at the same time keeping long-term inflation expectations anchored.

Interestingly, in the very next paragraph (after the one quoted by David), Janet Yellen hints that there are people at the Fed who see the logic of level targeting:

Analysis by some of my Federal Reserve colleagues suggests that monetary policy can produce better economic outcomes if it commits to making up for at least some portion of the cumulative shortfall created by the zero lower bound–namely, by maintaining a highly accommodative monetary policy for longer than a simple rule would otherwise prescribe.  This consideration is one important reason that the optimal control simulation generates a more accommodative path than the Taylor (1999) rule.

That’s exactly my view.  At this late date it would be appropriate to make up for only a portion of the policy shortfall since 2008. Yellen continues:

Risk-management considerations strengthen the case for maintaining a highly accommodative policy stance longer than might otherwise be considered appropriate. In particular, the FOMC has considerable latitude to withdraw policy accommodation if the economic recovery were to proceed much faster than expected or if inflation were to come in higher. In contrast, if the recovery faltered or inflation drifted down, the Committee could provide additional stimulus using its unconventional tools, but doing so involves costs and risks. Given the unprecedented nature of the current economic situation and the limits placed on conventional policy by the zero lower bound on interest rates, these issues of risk management take on special importance.

These three paragraphs form a devastating critique of Keynesian monetary policy.  Keynesians have lots of arguments for using interest rates as a policy tool (or instrument, or target, depending on your perspective) but none of them hold much water.  Yellen is basically admitting that the Fed is allowing hundreds of thousands of workers to remain unemployed because the Fed’s preferred policy tool is stuck at zero.  And they don’t like unconventional tools (which contrary to her assertion are not “risky.”)

The Fed really needs to move away from using any policy rules with a zero bound.  Some non-zero bound tools include Bennett McCallum’s policy rule for adjusting the money supply to offset changes in velocity, exchange rate targeting, CPI futures targeting, Divisia monetary index targeting, and NGDP futures targeting.  I’m sure there are many other options.  But interest rate targeting (which underlies all of New Keynesian economics) has been an unmitigated disaster for American workers.  And given that rates are likely to frequently hit the zero bound in future recessions (as trend productivity growth and population growth both slow) NK policy will fail us again and again in future recessions, i.e. when we most need it to be effective.  Our current monetary regime is roughly like a car with a steering wheel that works fine—except when driving on twisting mountain roads with no guard rail.

The inflation rate over the past 3 1/2 years has been the lowest since the mid-1950s, when Dwight D. Eisenhower was president.  But lots of people say they don’t believe that.  I certainly agree that inflation numbers are somewhat arbitrary, but the slightly more objective NGDP growth over the past 3 1/2 years is the slowest since Herbert Hoover was President.  And now Michael Darda has sent me a graph showing Federal spending falling for the first time since the year I was born, even in nominal terms.

I’m guessing Paul Krugman won’t be pleased.

PS.  The contrast between Clinton and the 2 Bushes is striking.