Steve Reads

Category: Economics

Greg Mankiw overloads two words until they collapse — October 12, 2010

Greg Mankiw overloads two words until they collapse

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There’s been a bit of a debate about Greg Mankiw’s recent [newspaper: New York Times] column, with Kevin Drum giving it a rather nice smackdown. Mankiw comes back today with some responses. I didn’t get past the first one:

> If no one is proposing eliminating taxes, why compare the Obama policy to a world without taxes?  Economists understand that, absent externalities, the undistorted situation reflects an optimal allocation of resources. […]

My first thought was that that’s a very narrow description of “optimal allocation of resources.” If you don’t pay taxes, the government doesn’t build roads, doesn’t fund a Defense Department to keep the borders safe, doesn’t keep your food safe via the FDA, doesn’t regulate airlines via the FAA, etc. How exactly will the corn (the “resource” in this example) arrive at your grocery store (that is, be “allocated”) without a system of roads to get it there? And how will those roads be built without taxes? This is the economists’ magical definition of “optimal allocation of resources”.

That’s when I realized: all the things I mentioned are hidden within Mankiw’s “absent externalities”. Those are two bizarrely overloaded words in this context.
As Justin Fox makes clear in his terrific [book: Myth of the Rational Market], there’s been a long divide in economics between the institutionalists and the rest. (I think the rest have a name, but I’ve forgotten it.) The institutionalists emphasize that when Mankiw talks about “optimal allocation of resources,” he’s brushing aside most of what makes the world interesting.

Take contracts, for instance, which are the most basic weapon within the economist’s arsenal. Economists assume that transactions can be “completely contracted,” meaning that every detail of the transaction can be spelled out and its violation quickly detected. But a contract, so described, is an abstraction hiding a lot underneath it. What happens if I violate a contract that you and I signed? You take it to a court, presumably. The court rules against me and orders me to pay up. What happens if I don’t? The full weight of the state comes down on me to make me pay you. So even talking about “complete contracting” — which is an essential element leading to Mankiw’s “optimal allocation of resources” — requires you to talk about some sort of enforcement mechanism. That enforcement mechanism could be a government, or it could be a mafia that’s willing to break my legs, but in any case there’s an *institutional structure* underneath the contract. Getting the institutions to ensure complete contracts costs money: either the government has to be willing to bring cops with guns to my house to make me pay up, or the mafia has to employ dudes with baseball bats, but someone somewhere needs to be standing ready to enforce that contract.

Now then. I hope we agree that we need to give up something — be it taxes or Vinny’s valuable free time — in order to allow contracts to be signed and enforced. I hope we agree that signing contracts is vital to the optimal allocation of resources. Therefore, I hope we agree that we need to give up something to attain the optimal allocation of resources. So how does it even begin to make sense for Mankiw to say that a tax-free world is relevant in any discussion at all? I contend that it’s only relevant if you ignore institutions — which is exactly what Mankiw is doing.

(Note also that the most basic contract of them all — the labor contract — cannot be completely contracted, as has been known since 1951.)

Jamie Galbraith and the NAIRU — September 10, 2010

Jamie Galbraith and the NAIRU

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I linked on Twitter to Jamie Galbraith’s old NAIRU paper, but explaining why it’s important to people who don’t care about economics, in 140 characters or fewer, turns out to be really hard. Here’s a quick note.

Basically, economists envision that there’s a tradeoff between the rate of unemployment and the rate of inflation. Suppose unemployment is very low. Now workers have more bargaining power. So they can demand higher wages. Enough of them do this, and prices rise. Eventually one can even end up with the dread “embedded inflation”: workers anticipate lots of inflation in forthcoming years, so they ask for wage contracts that guard against that inflation. Let’s say inflation was 10% per year. Now their contracts command, say, 11% raises per year. Now, inasmuch as prices depend on the costs of labor, prices will rise even more. And so the spiral goes.

There’s supposed to be a “natural rate” of inflation, an idea which apparently goes back to Milton Friedman’s 1968 presidential address to the American Economic Association and Phelps’s paper from the preceding year. This natural rate corresponds to a particular rate of unemployment called the NAIRU, for the “non-accelerating-inflation rate of unemployment”. As the name suggests, it’s supposed to be the rate of unemployment at which inflation stays where it is.

The only problem, says Galbraith, is that no one knows where the NAIRU is, and what economists say about it changes over time. Oh wait, there’s another problem: it’s not clear that labor costs have actually been responsible for inflation; it may just be that we got inflation when an “external shock” like a war or an oil embargo intervened. [1]

Most importantly, the focus on the tradeoff between inflation and unemployment takes our eyes off other, more-important things, like the unemployment-inequality tradeoff. Galbraith presents an alternative to Friedman’s “natural” rate of unemployment, which, again, is a rate above which inflation is supposed to start accelerating; Galbraith’s “natural” rate is the one above which inequality is supposed to start increasing, and he estimates it “quite stably” at 5.5 percent.

I need to emphasize just how important this is. The Federal Reserve emphasizes one goal — price stability — to the exclusion of others. Which would be fine — price stability is in the Congressional mandate — if the Fed weren’t using a phantom to achieve that goal. And the Fed is too cautious, too worried about the effects of labor costs, which likely keeps unemployment higher than it needs to be. Which, in turn, is a weapon to maintain increasing inequality.

[1] — It’s oddly unremarked-upon that the U.S. government took very active control over the U.S. economy during World War II. With the government printing so much money and dumping so much of it into the economy to get war production going, inflation would be inevitable. To avoid that end, the government had to enforce strict price controls. Jamie Galbraith’s father, the great John Kenneth Galbraith, was one of the folks in charge of these controls; he writes a bit about this in [book: Money: Whence It Came, Where It Went], and probably in other works.

At another time, I will write about how silly I find the usual American mythologizing of World War II. Yes, maybe it had something to do with “Americans coming together, as never before, to defeat a common enemy.” A more straightforward explanation is that World War II was the natural endpoint of two centuries of capitalist development, centralized control, and the deployment of industrial processes toward warmaking. “Total war,” the idea that an entire nation’s resources are devoted toward destroying one’s enemies, and that war should naturally be brought to bear against the civilians of other countries, helped. There may be room for patriotically beating hearts in here, but these other explanations seem more fruitful.

A question about Keynesian stimulus — August 16, 2010

A question about Keynesian stimulus

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Here’s my dime-store understanding of Keynes (which tells me, by the way, that I need to go reread the [book: General Theory]):

* Companies aren’t investing because they expect that in the near future, customers won’t be buying. They expect this for the completely justified reason that customers aren’t buying right now.
* So companies don’t put their money into new factories and new machines and so forth. Instead they put it in the bank.
* So they don’t hire new workers to man the new machines.
* Now there’s less money in the pockets of the workers. So they buy less.
* So rational companies look ahead and see more of the same: nobody’s buying, so they won’t be investing.
* And so on down the drain.

So the government steps in to halt the self-fulfilling prophecy. The government hires workers to pave the roads, build bridges, paint murals, etc. They give those workers, let’s say, $10,000 apiece. Since they’re largely on the poorer end of the economic ladder, they spend most of that money on food and other necessities. Let’s say they spend 80% of what the government pays them. So they spend $8,000 of that $10,000. Someone else has then earned $8,000; assuming the recipient is situated similarly to the spender, 80% of that $8,000 then becomes new spending. And so forth. The initial $10,000 becomes $50,000 through this process of multiplication. (In general, if people spend r% of what they earn, the initial investment gets multiplied by 100/(100-r).)

Now companies expect that things will be different. They expect that next quarter will look a lot like this one, and this one turned out not to be too bad. So they invest. They hire more workers. Those workers spend money. That money gets multiplied, as above. The pump has been primed, the economy is rolling again, and yay.

Here’s my question, though: shouldn’t we expect companies to know that the good times won’t last? Companies must be expected to know that business will only keep moving so long as the government is supplying the jobs, right? Likewise, those employees working at government-provided jobs know that their jobs — paving roads, building bridges, painting murals — are only temporary. To the extent that they have any control over it, they’re going to try to save that money for a rainy day; they know that a rainy day is just around the corner.

The only honest way I can see out of this is for the government to credibly commit to a certain amount of continuous job-creation until the economy has reached some pre-determined goal (GDP increasing by a 3% annualized rate per quarter or whatever). Once the economy is moving on its own, the government promises to stop making work; until then, it’ll do everything it can. This creates the right expectations.

On the basis of this argument, including the bit about the multiplier, I don’t see what the difference — from the perspective of getting the economy moving — would be between a) the government mailing $10,000 checks to a million newly unemployed people, and b) the government creating jobs for a million newly unemployed people. In both cases you’re putting money in the unemployed folks’ pockets, and you expect that they’ll spend roughly the same fraction in each case.

Obviously there are non-stimulus reasons to prefer employment to mailing a check: work is good for people’s self-esteem, crime goes down when people are occupied, and in any case we should be spending money to fix things that need fixing. But toward the goal of setting expectations about the future, the cash and the work seem identical.

So *is there* any stimulus explanation for not just giving people a check? And, to get to the earlier question: is the idea of a one-time stimulus — *any* one-time stimulus — just doomed from the start? If you don’t set the expectation that you’ll pay whatever is needed, for however long it’s needed, won’t minimally rational economic actors be too cautious about spending what they have?

Methods of measuring GDP — May 30, 2010

Methods of measuring GDP

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A colleague the other day mentioned his annoyance with the Hans Rosling TED talks on global poverty. His annoyance generally stems from treating developing nations’ GDP estimates as anything more than numerical hocus-pocus.

A few things I know basically nothing about:

* I really have no idea how hocus-pocusy these GDP estimates are.
* I also have no idea how hocus-pocusy the U.S.’s own GDP estimates are.
* Another thing I have no idea about is whether every year’s GDP estimates from a given country are mangled in the same way, so that (estimated GDP in year 2) minus (estimated GDP in year 1) is actually a reasonably accurate measure of year-over-year change in GDP.
* Per-capita GDP estimates might introduce another source of uncertainty, namely uncertainty in the population estimates. I likewise have no idea how accurate most nations’ population estimates are. And I have no idea whether per-capita-GDP estimates come from sampling individual people on their incomes, or estimating the country’s aggregate GDP and dividing by an estimate of the population.

I guess what I’d like, then, is a good introduction to the problems of measurement in countries with not-very-well-established economic-measurement systems — and for that matter, an introduction to how the U.S. statistical-measurement agencies do their work. Paging Chris Blattman…