Time for some Mundellian medicine?

Several commenters have sent me this excellent AEI piece by John Makin.  This quotation caught my eye.

Additionally, Japan’s new government’s proposal to double the consumption tax as a way to promote growth has been appropriately chastised by the opposition Your Party leader Yoshimi Watanabe, who retorted: “Boosting the economy with a tax hike? That is an obscene stretch.” Japan is threatening to repeat its disastrous experience of 1997, when a consumption tax hike threw the economy back into a sharp slowdown followed by intensified deflation.

He’s right of course.  But it’s also true that Japan has big long-term fiscal problems.  Some pundits have discussed the idea of easier fiscal policy in the short run combined with tighter policy in the long run.  Nice idea, but that’s just not how modern democracies work.  Instead, how about returning to the ideas of Robert Mundell?

Back in the 1970s the US suffered from stagflation–a combination of high inflation and sluggish real growth.  Demand-side economists weren’t able to offer any appealing policy choices.  Mundell (who is the father of supply-side economics) argued that we needed tight money combined with supply-side tax cuts.  The basic idea is that in macroeconomics you can’t kill two birds with one stone.  You need two stones of different size and shape to kill two birds.  Monetary policy differs from fiscal policy is two ways:

1.  Monetary policy has a more powerful impact on nominal aggregates like inflation and NGDP.

2.  Some types of fiscal policy can boost the supply side of the economy.

So Mundell recommended tight money to stop inflation and cuts in MTRs to boost real growth.  The tax cuts were spread out, but when they took full effect in January 1983 the economy took off, recovering rapidly from a severe recession with all sorts of “malinvestment” problems (such as the permanent loss of millions of rust-belt jobs.)

Today the two problems are fiscal imbalances and weak AD, i.e. weak NGDP growth.  If we try to end fiscal imbalances through austerity, then the AD problem gets worse.  But if we follow the Mundellian approach we would try to strike a Grand Bargain, easier money combined with smaller budget deficits.  Here’s how it might work:

1.  Fiscal policy leaders agree to cut the budget deficit by X amount.

2.  In return, the Fed commits to return the US to a core price level trajectory rising 2% per annum from September 2008.

Right now the US is 1.4% below the 2% core inflation trajectory, so we need 2% growth plus another 1.4% catch-up.  That is far more than markets currently expect over the next few years.  In fact, the likely inflation rate over the next year is only about 1%, or perhaps a bit higher.  If the Fed made this commitment, it would mean that the combined effect of fiscal austerity and monetary ease would be much more expansionary that current policy is expected to be.  How can that be?  Very simple; monetary policy has a much more powerful effect on NGDP growth than fiscal policy.

There are huge potential gains for the fiscal authorities.  Under current trends, the fiscal problems in the US will paralyze the Obama administration for the next 6 1/2 years.  They will be constantly fighting battles with an increasingly Republican Congress.  In contrast, this Grand Bargain would reduce the budget deficit in two ways; directly through cuts and tax increases, and indirectly as the Fed’s more expansionary policy would boost NGDP growth and lower the cyclical part of the deficit.

There are also huge potential gains to the Fed.  Reading between the lines it is clear that lots of people at the Fed are worried about AD.  There is a sense that AD growth is falling short of their expectations and their goals.  But big institutions have trouble changing course and admitting errors.  A Grand Bargain would give the conservatives an out.  They could agree to ease policy and yet still console themselves that the increased fiscal austerity made future hyperinflation less likely (as they wouldn’t be pressured to monetize massive public debts.)  And they could still claim to be adhering to their implicit 2% inflation target.

In a subsequent post I will provide evidence that the Fed understands that it does need to move, and I will suggest how they can do so.  In the meantime, check out this depressing article in the Telegraph:

Perhaps naively, I still think central banks have the tools to head off disaster. The question is whether they will do so fast enough, or even whether they wish to resist the chorus of 1930s liquidation taking charge of the debate. Last week the Bank for International Settlements called for combined fiscal and monetary tightening, lending its great authority to the forces of debt-deflation and mass unemployment. If even the BIS has lost the plot, God help us.

When the BIS was created in 1930 it was the progressive’s great hope.  They suggested that it might be able to coordinate central bank practices to reduce gold hoarding and make monetary policy easier.  Alas, it did not succeed.  But it is still shocking to see that once progressive institution calling for both fiscal and monetary tightening.  In some ways we have even regressed from the 1930s.

Update:  The commenter Karen found this very good example, which I had forgotten:

The Grand Bargain sounds like a similar “deal” President Clinton made with then Fed Chairman Greenspan. It has been a while since I read the book “The Maestro” but if I remember correctly, Bob Woodward recounts a conversation early on in the Clinton years (coming out of early 90’s recession) where Greenspan convinced Clinton of the need to keep deficits low and if he did so Greenspan agreed to keep interest rates low. (I know this isn’t necessarily loose monetary policy but in retrospect it seems to be what was implied.) The Grand Bargain seemed to have worked until one side stopped keeping the bargain

PS.  If you suffer from depression, make sure to take your medication before reading the entire Telegraph article.

PPS.  By the way, in the long run we also desperately need some revenue neutral supply-side reforms to our tax code.  Unfortunately, we are currently moving in the opposite direction.

HT:  Benjamin Cole and John Salvatier


Tags:

 
 
 

28 Responses to “Time for some Mundellian medicine?”

  1. Gravatar of Mikko Mikko
    8. July 2010 at 09:06

    So can the German austerity be considered a first mover decision to force the hand of the central bank and give it the reason it needs to intervene with more monetary stimulus? Could it somehow be made to be such a thing?

  2. Gravatar of Morgan Warstler Morgan Warstler
    8. July 2010 at 09:06

    “In contrast, this Grand Bargain would reduce the budget deficit in two ways; directly through cuts and tax increases, and indirectly as the Fed’s more expansionary policy would boost NGDP growth and lower the cyclical part of the deficit.”

    We do not need tax increases. We are winning, there is no reason to bargain here. See NJ. We need to make Bush’s tax cuts permanent.

    Revenue neutral tax changes, great! Major productivity gains in government? great!

    No new taxes.

  3. Gravatar of Benjamin Cole Benjamin Cole
    8. July 2010 at 09:55

    An excellent post.

    I don’t get it. This should be the time that monetarists stern-facedly put on their uniforms, and intone, “This is our hour.”

    Instead, they are saying, “This is our cower.”

    Hey-zuze Alou, will you look at the CPI? It is going down. Unit labor costs are going down. Property values are down, and stock are selling for 1998 prices.

    There is little mood for more federal spending, and anyway public debt to GDP levels are getting too high.

    We need monetary stimulus, qualitative, quantitative, and every other way possible. There is no threat of inflation, though deflation looks possible. And our financial system simply will collapse in a deflationary environment.

    I don’t get it. Right-wingers should applaud monetary activism–it is an alternative to more taxes and federal outlays. Instead, they are stuck in the old grooves, about tight money. Yeah, yeah tight money, gold and all of that. Fine, you can make money tight, but can we wait until the economy is blowing the doors off again?

    And even at that–I wqould rather live through a long inflationary boom than a long deflationary recession. We are setting up for the latter. Somehow that is supposed to be good for us. Teach us a lesson. What lesson I don’t know, and neither does anybody else.

    What am I afraid is that the “lesson” taught will be that capitalism is far too fragile, and that state-run systems, Like China are better.

  4. Gravatar of Dilip Dilip
    8. July 2010 at 09:57

    “What would really be effective would be a credible commitment to a higher inflation target, which would reduce real interest rates. But that’s not on the menu, at least not yet.”

    http://krugman.blogs.nytimes.com/2010/07/08/how-much-can-the-fed-help-wonkish/

  5. Gravatar of Indy Indy
    8. July 2010 at 09:59

    “Some pundits have discussed the idea of easier fiscal policy in the short run combined with tighter policy in the long run. Nice idea, but that’s just not how modern democracies work.”

    This is key – and because we can’t build enough trust between partisans to make credible pre-commitments, we probably can’t achieve a grand bargain compromise even to save ourselves.

    I heard this conversation the other day that seems relevant. Of course, I live in a College Town, so opinions tend to be pro education funding:

    P1: “I know that the state and local budgets are tapped out, but reducing spending and firing teachers during a recession is stupid policy.”

    P2: “Yeah, but we’re out of money, and you’re not supposed to raise taxes during a recession either. What choice do we have?”

    P1: “Well, if we can’t go into debt to maintain spending and employment because of the state constitution, then the Feds should do it on our behalf and grant us the funds we need.”

    P2: “Yeah, but we’ll have to pay those debts back from future tax revenues, and it looks like there still won’t be enough money left over to afford the current number of teachers. So would it be OK if we kept them on at full pay during the recession, but fired them later or lowered their salaries and benefits, during the recovery?”

    P1: “NO! Of course not. No firing or lowering of pay!”

    P2: “So, no cuts, and only a promise to raise taxes, not now, but in a few years just as things start to get better?”

    P1: “Yes.”

    P2: “I wouldn’t vote for that.”

    The moral of that conversation, to me, was to confirm my suspicion that people make a lot of claims about “Austerity is stupid during a recession, Economic Science proves it!” not because they actually understand any economics, but only because they are parroting a line from certain pundits in the popular media that seems to justify their position and presently helps achieve their current policy preferences.

    They fail to share the corollary view that “Austerity to fix severe fiscal imbalances is a smart thing to do during an expansion”, mostly because they have no intention or desire to ever make any fiscal cuts whatsoever. And without the trust that someone might be willing to compromise in the future on cuts, no will will make the “shared pain” bargain of higher taxes tomorrow either.

    So, the inverse-Mundell-maneuver is probably the best choice we have.

  6. Gravatar of Karen Karen
    8. July 2010 at 10:33

    The Grand Bargain sounds like a similar “deal” President Clinton made with then Fed Chairman Greenspan. It has been a while since I read the book “The Maestro” but if I remember correctly, Bob Woodward recounts a conversation early on in the Clinton years (coming out of early 90’s recession) where Greenspan convinced Clinton of the need to keep deficits low and if he did so Greenspan agreed to keep interest rates low. (I know this isn’t necessarily loose monetary policy but in retrospect it seems to be what was implied.) The Grand Bargain seemed to have worked until one side stopped keeping the bargain ……..

  7. Gravatar of David Pearson David Pearson
    8. July 2010 at 10:45

    Its hard to see how a mild increase in inflation expectations would change behaviors. The five year TIPs spread is about 1.5%, and you argue for a 2% target. You want velocity to increase in response to a near-term incremental 2% inflation penalty for hoarding cash. Is this enough to overcome the deflationary inertia produced by excessive leverage and illiquidity? Take the example of households–is a 3% negative real rate sufficient to reduce precautionary balances?

    The Fed can obviously manufacture inflation. The question is, are reactions to inflation expectations linear or non-linear? If they are linear, then a little higher expectation leads to a little more AD. If non-linear, then the Fed has to push harder and harder to raise AD. This push must appear to be permanent–returning, after a year, to a target .5% above current market expectations is, in market actor terms, a “yawner”. There is a trade off between a higher long term inflation target and overcoming deflationary inertia. The Fed seems reluctant to make that trade-off, but eventually I believe they will.

  8. Gravatar of Richard H. Serlin Richard H. Serlin
    8. July 2010 at 11:48

    How can you argue that marginal tax rate cuts stimulate the economy supply side (long run, and more than just what you could get from increased government spending on high return investments or monetary stimulation), especially for the wealthy, in light of the income and substitution effects, the backward bending labor supply curve, which emperically is shown to bend back at around the upper middle class level, and the overwhelming emperical evidence that hours worked – in the long run – responds little (and often negatively) to an increase in real after tax income? I mean form 1900 to 1970 real after tax wages per hour skyrocketed and the number of hours per week people worked plumeted.

    And the more you cut taxes the less money you have for high return long run growth inducing social investment of the kind the pure free market will grossly underprovide due to well established in economics pure free market problems like externalities, inability/impracticality to patent, etc. Cutting individual taxes leads to more consumption and less investment, and that’s what we’ve seen. We’ve eaten our seed corn and stopped cultivating new fields and technologies to pay for mansions and McMansions, yachts and $300,000 cars and $10,000 suits.

    I suggest these two articles from Cornell economist Robert Frank:

    http://www.robert-h-frank.com/PDFs/WP.1.24.99.pdf

    http://www.robert-h-frank.com/PDFs/WP.1.24.99.pdf

  9. Gravatar of jsalvati jsalvati
    8. July 2010 at 11:50

    @ David
    That’s a decent point, but remember that Sumner suggested a 2%/year increase from the 2008 level. Since we are about 1.4% below that, he is actually advocating ~2.3% 5 year inflation.

  10. Gravatar of Richard H. Serlin Richard H. Serlin
    8. July 2010 at 11:51

    Second article:

    http://www.nytimes.com/2007/04/12/business/12scene.html

  11. Gravatar of JimP JimP
    8. July 2010 at 11:51

    http://moneywatch.bnet.com/economic-news/blog/maximum-utility/dont-expect-miracles-from-monetary-policy/699/

    But Toma forgot to talk about the Krugman recommendation on inflationary expectations.

    Or even better, the deal now on offer from Scott.

  12. Gravatar of JimP JimP
    8. July 2010 at 11:54

    Toma = Thoma

  13. Gravatar of scott sumner scott sumner
    8. July 2010 at 12:30

    Mikko, I don’t know, the Germans also favor tight money.

    Morgan, I also oppose tax increases, but I wasn’t elected President in 2008.

    Benjamin, You gave me an idea for a post.

    Dilip, Thanks for the link.

    Indy, Good points. BTW, Civic-minded cultures are able to negotiate mutually beneficial compromises. I guess we aren’t as civic-minded as the Danes.

    Karen. Very good analogy. I should add an update.

    David; You said;

    “Its hard to see how a mild increase in inflation expectations would change behaviors. The five year TIPs spread is about 1.5%, and you argue for a 2% target.”

    No that’s not what I advocated. Read it again. I advocated 3.4% inflation next year. To get one year TIPS spreads that high you’d need a booming economy. I would take a lot of stimulus.

    You said;

    “The Fed can obviously manufacture inflation.”

    The SRAS is pretty flat right now. If they can obviously produce inflation then they can obviously produce NGDP growth and RGDP growth. QED.

    Richard, There are many errors in your post, but the biggest is referring to backward bending labor supply curves. That has no bearing on the efficacy of tax cuts, as tax cuts represented income-compensated changes. There is a massive literature on the disincentive effects of high MTRs, and the effects are very real. If anyone you read mentions backward bending labor supply curve, you instantly know that they don’t understand the theory.

    Time series data is almost useless, as the income effect dominates, you need cross-sectional data. Compare hours worked on high and low tax developed economies.

    And McMansions are definitely investment, not consumption. McMansions last far longer than factories.

    I’ll do a series of posts on supply-side econ later this month (if I can find time!)

    jsalvati. Exactly.

    Thanks JimP.

  14. Gravatar of pireader pireader
    8. July 2010 at 12:45

    Professor Sumner — “the idea of easier fiscal policy in the short run combined with tighter policy in the long run. Nice idea, but that’s just not how modern democracies work.”

    I can think of several exceptions off the top of my head, such as every major war that the US fought during the 20th century. Do you have any scientific evidence for this rather large claim, or is it just ideological boilerplate?

  15. Gravatar of Doc Merlin Doc Merlin
    8. July 2010 at 12:46

    @mikko:

    “So can the German austerity be considered a first mover decision to force the hand of the central bank and give it the reason it needs to intervene with more monetary stimulus? Could it somehow be made to be such a thing?”

    If the central bank uses IS-LM models to gauge what rates should be, then it will functionally that way. Also, if a bank uses IS-LM models to pick rates and the real multiplier is smaller than what they have in their models then they will over-tighten when the fiscal authority is too loose.

  16. Gravatar of Richard H. Serlin Richard H. Serlin
    8. July 2010 at 14:02

    I will listen to what you have to say about supply side economics, but long run growth is about investment, especially investment that leads to advance in science, technology, medicine.

    A McMansion may last a long time but it doesn’t add much (relative to a much smaller home that could provide the same shelter and comforts) to the advancement of science, technology, and medicine like infrastructure and productive facilities can do indirectly, education can do more directly, and investment in basic science can do most directly. It’s not just the hours worked at all. It’s how much of those hours worked goes towards advance in science, technology, and medicine indirectly or directly. As the world gets more and more advanced it gets more and more ideas based for growth, and the great growth economist Paul Romer has a fantastic quote regarding this:

    As just one example, recall that the increasing returns to scale that is implied by nonrivalry leads to the failure of Adam Smith’s famous invisible hand result. The institutions of complete property rights and perfect competition that work so well in a world consisting solely of rival goods no longer deliver the optimal allocation of resources in a world containing ideas.

    – Forthcoming American Economic Journal paper, page 8, at:

    http://www.stanford.edu/~promer/Kaldor.pdf

    With regard to income and substitution effects, etc.:

    You write, “Time series data is almost useless, as the income effect dominates”, but that’s what actually happens; to a large extent the income effect will, in reality, dominate, or people just get used to a certain after tax wage per hour, and the short term effects of a sudden cut in taxes start to fade.

    Clearly it’s not the real after tax wage per hour that’s making much difference (unless it gets subsistence low). The time series data makes that clear. It’s relative real income per hour and psychological factors that make any difference that may exist. And it’s not that dramatic comparing societies across space and time. The U.S. had top marginal rates over 90% from World War II through 1964, and 70% from 1964 through 1980. Most of those years, especially the 90% years, had outstanding economic growth, and there wasn’t an epidemic of mass laziness. People typically worked at least 40 hours.

    But, yes there are psychological (or behavioral) factors. People will certainly behave differently if they make $100/hour, but it comes from $125/hour in wages taxed at 20%, then if it comes from $1,000/hour in wages taxed at 90%. It’s the same $100/hour take home, and in a typical model with a typical utility function that’s all that matters, but not with real human beings. So it’s a reason to be concerned about extreme rates, and it makes hidden taxes like the VAT more attractive (the lack of progressiveness of a VAT can be offset by using the money raised progressively, like with free universal pre-school, nutritious free school breakfasts and lunches, and undergraduate college).

    Notwithstanding, many hours worked in production of luxury suits and granite countertops does a lot less for long run growth than fewer hours worked, but still a lot more spent on high return investment. $10 trillion in GDP with $3 trillion on high return investment will create far higher long run growth than $14 trillion in GDP with $12.5 trillion spent on consumption. And $7 trillion of spending on consumption relatively evenly spread, and with relatively little spent on zero-sum-game (or largely zero-sum-game) positional/context/prestige externality goods (see the first Frank article in my first comment), will create more total utils than $12.5 trillion extremely unevenly spread and largely spent on high positional/context/prestige externality goods.

  17. Gravatar of Richard H. Serlin Richard H. Serlin
    8. July 2010 at 14:14

    And that’s not even mentioning that the people in the $10 trillion GDP world will have a lot more free time to spend with their families and just to rest and relax and get out in the fresh air. That can certainly add a lot to utility. And if you say why don’t they just do it then in the $14 trillion world, why don’t they optimize like that, then please read the Frank article. Positional/context/prestige externalities are huge. They fall behind neighbors and peers who don’t do it and that leads to exposure to some powerful negative positional/context/prestige externalities).

  18. Gravatar of Policy Focus, Arnold Kling | EconLog | Library of Economics and Liberty Policy Focus, Arnold Kling | EconLog | Library of Economics and Liberty
    8. July 2010 at 14:17

    […] Scott Sumner is worried about little things like unemployment and fiscal sustainability. Fortunately, our political leaders are not distracted by such trivialities. The Treasury, the Federal Deposit Insurance Corporation, the Federal Housing Finance Agency, the 12 Federal Reserve regional banks, the Board of Governors of the Fed, the National Credit Union Administration, the Comptroller of the Currency, the Securities and Exchange Commission, the new Consumer Financial Protection Bureau…all would get their own Office of Minority and Women Inclusion. This is in the financial reform bill. Evidently, the financial crisis was caused by flawed human resources policies at Federal regulatory agencies. I am glad that our leaders are focused on the big picture, so that they are not distracted by little things like housing policy. […]

  19. Gravatar of Richard H. Serlin Richard H. Serlin
    8. July 2010 at 15:53

    And finally, here is the conclusion of an expert in this area, well versed in this literature, MIT economist Jonathan Gruber, “Changes in tax rates appear to have relatively modest effects on total gross income; the total amount of income actually generated through work or savings does not respond in a sizable way to taxation”, (“Public Finance and Public Policy”, 2nd edition, 2007, page 734)

  20. Gravatar of scott sumner scott sumner
    9. July 2010 at 16:11

    pireador, No evidence–just ideological boilerplate. Seriously, I don’t see the relevance of wars–of course spending will fall after a war. But what about when Congress does something expansionary, and then pays for it by promising to fix Medicare doctors payments, or end the AMT, to make the numbers work out. When the time comes they never carry through with the cuts in Medicare, or in reinstating the full AMT. That’s what I am thinking of.

    I actually don’t have any ideological objection to what you propose, as long as it is revenue neutral. I just don’t think it will get us out of the recession–only monetary policy can do that. If it’s revenue neutral in the long run, go ahead–but it won’t get us out of the recession, because the Keynesian model is wrong, and Krugman’s fix is technically correct but implausible.

    Doc Merlin, I agree.

    Richard, You said;

    “A McMansion may last a long time but it doesn’t add much (relative to a much smaller home that could provide the same shelter and comforts) to the advancement of science, technology, and medicine like infrastructure and productive facilities can do indirectly, education can do more directly, and investment in basic science can do most directly.”

    OK, but the McMansion is investment, and the other things you talk about are technological change, which is treated separately in most production functions. I might add that the return on federal investment in medical research has recently been dropping rapidly. The more we spend the less we have to show for it.

    Supply-side tax reforms encourage more small entrepreneurial firms that boost technology. It is one of the reasons (not the only) that Silicon valley is in the US. The Nordics do well in high tech, but people often forget that they have low taxes on capital.

    You said;

    “As just one example, recall that the increasing returns to scale that is implied by nonrivalry leads to the failure of Adam Smith’s famous invisible hand result.”

    These kind of statements make me want to pull my hair out. You can’t prove anything on a blackboard. It is an empirical issue. It has always been known that the perfect competition model is an approximation of reality, not literally true. But it is a useful approximation.

    You said;

    “You write, “Time series data is almost useless, as the income effect dominates”, but that’s what actually happens; to a large extent the income effect will, in reality, dominate, or people just get used to a certain after tax wage per hour, and the short term effects of a sudden cut in taxes start to fade.”

    You aren’t understanding my point. Tax money doesn’t get destroyed, it is transferred. There is no first order AGGREGATE income effect from tax changes. There is only a substitution effect. My point was that income has been rising over time for unrelated reasons, and that has caused less hours worked. For tax changes you must use an income compensated labor supply curve.

    You said;

    “The U.S. had top marginal rates over 90% from World War II through 1964, and 70% from 1964 through 1980. Most of those years, especially the 90% years, had outstanding economic growth, and there wasn’t an epidemic of mass laziness. People typically worked at least 40 hours.”

    First of all most people didn’t face those tax rates. But your data actually proves my point. In the 1960s the french had similar tax rates to the US, and worked about as hard. Now french tax rates are much higher, and they work far fewer hours. I constantly read articles about how up-middle class and wealth couples work harder than in the 1960s. You expect them to work less, given that we are richer. One reason they work harder is that the wive’s income (for aflfuent households) is taxed at a lower rate than in the 1950s. In contrast, the tax rate on low income women rose after the 1950s, and their hours went down. Until welfare reform, which lowered their tax rate, and increased their hours.

    BTW, the “outstanding growth” was 1964-73, after the cut from 90% to 70%. There were three recessions under Eisenhower. After 1973 things were very bad, but that’s partly because inflation pushed people into higher brackets (plus environmental cleanup, which was needed but costly, and oil shocks)

    I do favor higher taxes on luxury consumption, so we agree there. I’d like to replace the income tax with a progressive consumption tax. And I’d like to see a carbon tax.

    I am very aware of Frank’s work on positional goods, and I assume you have read the many persuasive critiques of that research.

    Gruber’s statement is so vague I can’t comment on it. I agree most tax changes do have a big impact on hours worked. The supply-side effects show up in all sorts of areas—the efficiency of production being perhaps more important than hours worked. And then there is saving and investment.

  21. Gravatar of Richard H. Serlin Richard H. Serlin
    9. July 2010 at 18:34

    I’d very much like to read these critiques of Frank’s work. Can you please cite some?

  22. Gravatar of scott sumner scott sumner
    10. July 2010 at 06:17

    Richard, The attached paper by Wilkinson isn’t specifically devoted to Frank, but raises some interesting points about inequality. If you look at footnote 25 to the paper, you will see references to two other papers (by Nye and Wilkinson) that I believe directly address Frank’s positional goods ideas (although I haven’t read them.)

    http://www.cato.org/pubs/pas/pa640.pdf

    My problem is that I see lots of short critiques on Frank is various places, but don’t keep up with the literature enough to know all of the longer papers on these issues.

    My view is that envy is part of human nature. It may be that economists overestimate the utility derived from success, but Frank may underestimate the utility of living in a society where you are free to dream of success, and struggle to get there.

    We know so little about human psychology that we are better off shaping polices on revealed preference that abstract psychological theory. And more Asians want to move to the US than Europe, which makes me think that Frank’s argument is weaker than he believes. (By the way, I actually prefer the less competitive European model, as I don’t like to work.)

  23. Gravatar of Richard H. Serlin Richard H. Serlin
    11. July 2010 at 09:51

    Not much time to reply to this now, but I will more in depth in the future. Quickly though:

    Neither Frank nor I are advocating getting rid of prestige or position. We are simply saying we should make it cheaper to obtain a given level.

    If taxes made it so that a $50,000 Corvette was just as rare and hard to purchase as a $130,000 Porsche, then people would still dream of owning a Corvette, and strive to be successful enough to own one, just as much as they used to for the Porsche; it’s just that now the Corvette would come with $80,000 in spending on alternative energy, medical research, beautiful, open, unwalled community parks and ice rinks and recreation, etc.

    Prestige and postion can be a great thing, to dream of, motivate, and reward success. Appropriate taxes would just make it societally cheaper to achieve the same level prestige and position. The Porsche with higher taxes, so it’s harder to afford, becomes just as exclusive as the Ferrari used to be; it makes you feel just as successful and prestigious as the Ferrari (and differences in intrinsic utility are tiny, perhaps even negative), only now it’s really cheaper for society, because now you get that tax money going towards alternative energy, medical research, beautiful community parks and ice rinks and recreation, etc.

  24. Gravatar of ssumner ssumner
    12. July 2010 at 09:42

    Richard, I thought Frank wanted us to work less? But once you throw out the rules of classical economics, how can you assume working less is a good thing? People like Phelps seem to think that work, especially creative work, gives meaning to our lives. The constant striving to build a better Ferrari is what drives skilled Italian workers. But then they need someone to buy those cars.

    Why are the French and Germans less happy than Americans? They have better urban amenities and much more leisure. Frank’s argument hinges on the accuracy of experimental economics (i.e. surveys) but those same surveys show Americans are happier than French and German people.

  25. Gravatar of Richard H. Serlin Richard H. Serlin
    20. July 2010 at 17:57

    I’ve had previous correspondence with Bob Frank, so I emailed him to see if he might enter this discussion, perhaps in a guest post on my blog. And I also encouraged him to start a blog of his own. He replied that he’s currently busy working on a new book that he’s excited about, so no blogging at this time.

    Honestly, what I’ve found out from this discussion is that it looks like you don’t have anything persuasive for not considering, and addressing – at least to some substantial extent, in at least some ways – positional/context/prestige externalities, which are enormous. And I’ve found the same in other attempts at criticism.

    And of course this doesn’t mean going to some horribly problematic extreme like a command economy, but rather things like smart taxation to pull money away from high positional/context/prestige, zero-sum-game consumption, and instead into high social return investments that are predominantly inconspicuous consumption, like education (free universal pre-school and bachelors degree, we’ve been stuck on only free K-12 for a hundred years while the educational requirements for high productivity have sky rocketed in that time), basic scientific and medical research, alternative energy, infrastructure, etc.

    With regard to whether it increases total societal utility for people to work less, it depends on the people, what the trade is, and how it’s structured. I do think most typical families would be happier having cars with less horsepower, less “silky transmissions”, four wheel drive when they rarely if ever have a need for it, giant wheels, leather, and doo-dads, and with the money saved working less, spending time with family more, sleeping more, exercising more, etc., but for this to really work well requires everyone else doing it, or else it’s not be or seem worth it for the average family because then their cars may seem cheap and “low quality” to them (even though they’d still be thought of as very high quality compared to cars of a generation or two ago), they may seem less successful, they may feel some embarrassment, plus, due to economies of scale, they may not even have a good option to buy such a car of the appropriate type and size. And the same goes for home size, granite countertops, wood floors, etc.

    Of course, you would still have creative work and striving if we had a (largely hidden) VAT, carbon taxes, and a more progressive income tax. People would still be able to get very rich. If an entrepreneur was only looking at the prospect of success meaning $20 million instead of $200 million, or $200 million instead of $2 billion, or $20 billion, that would still be an awesome dream, especially if $20 million was thought of as as rich and successful as $200 million is today because it was just as rare. And the entrepreneur would enjoy the adventure more, and be more likely to go on it, if he knew his family wouldn’t be homeless and without health insurance if he failed (I’m actually a successful entrepreneur and self-made millionaire so I know firsthand of what I speak).

    And the Ferrari makers of a generation ago, who made Ferraris that had to meet real price targets a fraction of those of today, still had just as much passion to do the best they could, and just as much pride in the cars they made, because it’s relative, relative to the other cars being sold at the time and how much they cost.

    As far as happiness surveys, these have to be looked at and thought about very carefully. There are certainly cultural issues. Some cultures are just a lot more cynical than others. Some people will say their car is not that good if it’s a new Lexis, while others will say they have a great car if it’s a 30 year old beat up Firebird. Likewise, person A may get way more net pleasure out of his life than person B, but person A is a complainer, so he says he’s so-so happy, while person B says he’s very happy. There are issues of, are you just looking at medians and so truncating out the homeless (who can be very hard to reach in a survey), the unemployed, etc. There’s a lot that you have to examine carefully. The case, like much of economics, depends on the evidence and logic from human psychology (I hope to present this as a long series of blog posts at some future time, too busy now).

    Plus, Europe is hardly monolithic; it depends on the European country. And in any case, even though Europe in general does some things well (universal health care about as good, or better than, in the US at about half the price, or less, per person), other things are big problems, worse than in the US (strong and stifling unions, a lot lower economies of scale and scope due to language and culture barriers).

  26. Gravatar of ssumner ssumner
    21. July 2010 at 08:13

    Richard, I appreciate the effort, but Frank should really be debating someone who knows the literature better than me. I have read some summaries of research, but don’t really know enough to debate him. Money is my area of expertise, and the only thing I am qualified to debate with a talented economists.

    I have a general problem with arguments for regulation based on market failure. It’s not that markets never fail, there are failures all around us, it that they ignore the risk of government failure.

    I’d rather focus government attention on clear problems, like pollution and global warming and poverty, and not try to figure out which type of car purchase is out of bounds because it invites envy in others. Regulation is very costly, and subject to abuse, so I’d need to see far more evidence for me to want the government to wade into that area. And I am saying this as someone who would personally benefit from many of those policies. I prefer a world where the standard work week is half as long, and we all make half as much. I prefer leisure to more goods. But I just don’t see enough evidence to have the government focus in this area right now.

    Sorry I can’t do justice to your thougtful post, it’s just that I am so swamped with new comment sthat I have limited time to respond. But here are a few brief comments:

    I agree that a carbon tax and a progressive consumption tax are the way to go. So we aren’t far apart on that.

    I agree that the Europeans do some things well, and there are things we could learn from them.

    I agree that happiness surveys are flawed, but I also see that as a problem for behavioral economists. They are basing their policy recommendations on survey results and lab experiments that may not apply in real world situations. I saw one example where a well established theoertical proposition of behavioral econ (from lab experiments) was tried in the real world. The behavior started out that way, but quickly became more rational. Sorry, I don’t recall the study, but the general point is that this theory is still in its infancy, and the policy implications are not always clear.

    Immigration is the mother of all natural experiments. And more immigrants want to come here than Europe.

  27. Gravatar of Richard H. Serlin Richard H. Serlin
    25. July 2010 at 21:16

    Scott,

    In your comment above, 9. July 2010 at 16:11, when you wrote:

    Gruber’s statement is so vague I can’t comment on it. I agree most tax changes do have a big impact on hours worked. The supply-side effects show up in all sorts of areas””the efficiency of production being perhaps more important than hours worked. And then there is saving and investment.

    Did you mean, “do not have a big impact”?

  28. Gravatar of ssumner ssumner
    26. July 2010 at 10:47

    Richard, Yes, I meant do not. Sorry about that typo.

Leave a Reply