Illegal Drugs

A student in ec 10 emails me:

Hi Professor Mankiw,

Friday's Wall Street Journal had an article regarding the shortcomings of U.S. drug policy ("Drugs Beget Thugs in the Americas"), and I was wondering what your thoughts were on the issue.

I recall that in the fall we discussed the different effects of supply and demand shifts on drug quantity and prices. Given the theoretical arguments (supply shift -> higher prices), and the high costs and empirical ineffectiveness of drug interdiction, it seems like the U.S. should reevaluate its policy.

Also, I wanted to thank you for doing a great job with Ec10 this semester. I've really enjoyed the course a lot (to the point where I'm now thinking about economics on my Saturday afternoons).

All the best,
[name withheld]

Here is an excerpt from the Wall Street Journal article:

Nobel economist Douglas North taught us the importance of institutions in development economics. Yet prohibition and the war on drugs are fueling a criminal underworld that handily crushes nascent democratic institutions in countries that we keep expecting to develop. Is it reasonable to blame Mexico for what enormously well-funded organized-crime operations are doing to its political, judicial and law enforcement bodies when we know that Al Capone's power during alcohol prohibition accomplished much the same in the U.S.? These are realities of the market, of supply and demand and prices under prohibition that no amount of wishing or moralizing can change.

My own views on this issue are not fully formed. Two things are clear to me:

1. The use of illegal drugs has a lot of bad effects. My colleague David Laibson, who lectured in ec 10 in the fall, is famous for modeling the self-control problems that lead people to suboptimal behavior such as drug use.

2. The war on drugs has a lot of bad effects. The paragraph I have excerpted above gives a good sense of them.

To go beyond these bland generalities, one has to know a lot of details to weigh the pros and cons of various policy options. I am ignorant enough of these details that I should avoid opining.

My colleague Jeff Miron has studied this issue extensively, however, and he is a proponent of drug legalization. I recommend that ec 10 students look out for Jeff's courses, including ec 1017 (A Libertarian Perspective on Economics and Social Policy) and ec 1471 (Economics of Crime).

John Kenneth Galbraith

John Kenneth Galbraith died yesterday. Here are the reports from the Washington Post and the New York Times. You can find a summary of Galbraith's economics here.

I have long been a fan of Galbraith as a person, even though I disagree with almost all of his conclusions as an economist. Galbraith marched to his own drummer and did not feel compelled to follow the dictates of his profession. A prolific writer, he tried to reach a broad audience, rather than aiming only for the narrow club of economists. And he did it spectacularly well. I recall reading when I was an undergraduate in the 1970s that Galbraith was the economist with the highest name recognition among the general public.

I assigned his most famous book, The Affluent Society, in a freshman seminar at Harvard about five years ago. The students enjoyed it. Even though the book was about half a century old, it did not feel dated, which is quite a feat. (In the new edition of my Principles text, I have a new passage on Galbraith and Hayek, which I previewed in this post.)

I once asked Galbraith the secret to his success as a popular writer. He told me that he revises extensively and puts his books through many drafts. Around the fifth draft, he manages to work in the touch of spontaneity that everyone likes.

When I became chairman of the CEA in 2003, Galbraith wrote me a kind note congratulating me on the job. He said he had some role in the creation of the Council, which was established as part of the Employment Act of 1946, and this was what he had in mind--Harvard professors taking leave from the Ivory Tower to advise the President. He added, wryly, that he had hoped it would be a President of a different party.

For students who want to learn more about this great man, I recommend his memoir A Life in Our Times.

Fundamental Attribution Error

In the psych class I've been auditing, Steven Pinker yesterday talked about a phenomenon called the fundamental attribution error. When evaluating others, people have a tendency to overestimate the importance of personal characteristics and underestimate the role of situation.

Example:
Why am I smiling? Because it is a sunny day.
Why is he smiling? Because he is a cheerful person.

I wonder if this common error can help explain some unfortunate impulses in economic policy.

Example:
Why did I raise my price? Because demand increased more than supply.
Why did the gasoline station raise its price? Because oil companies are greedy price gougers.

Similarly, in judging policymakers, perhaps we give too much credit to those who were simply lucky and too much blame to those who were unlucky. In this paper, I did not refer to the fundamental attribution error, but I was following its logic:

If you were to poll monetary historians, most of them would tell you that Alan Greenspan is a hero among central bankers and that Arthur Burns is a goat. Just as Greenspan gave us low and stable inflation, together with robust and stable growth, Burns gave us high and rising inflation, together with anemic and volatile growth. The standard assessment of these two men is easy to understand.

Yet, in looking back at these polar two experiences, I wonder whether we exaggerate the role of policy decisions and understate of role of luck. One reason is that the bad inflation performance of the 1970s and the good inflation performance of the 1990s were not limited to the United States. Most developed countries had about the same experience. If there was a policy failure in the 1970s and success in the 1990s, the blame and credit go to the world community of central bankers, not to the single person leading the Federal Reserve.

I suspect, however, that the difference cannot be fully explained by policy at all. These two eras saw very different exogenous supply shocks. The relative price of food and energy was extraordinarily volatile during the 1970s and extraordinarily tame during the 1990s. The standard deviation of this relative price differs in these two decades by a factor of almost three. (Table 1.3, Mankiw 2002) Moreover, the 1970s witnessed an unexpected slowdown in productivity growth and an increase in the natural rate of unemployment, whereas the 1990s witnessed an unexpected acceleration in productivity growth and a decline in the natural rate of unemployment. The favorable supply-side developments of the 1990s were not caused by monetary policy, but they did make the job of monetary policymakers a lot easier. Luck plays a large role in how history judges central bankers.

The same could be said of Presidents. I have long thought that Bill Clinton gets too much credit for the booming economy of the 1990s, and Jimmy Carter gets too much blame for the lousy economy of the 1970s. Now I have a term for it: the fundamental attribution error.

Update: Arnold got here first.

Krauthammer on Oil Prices

Columnist Charles Krauthammer writes about what's happening in the oil market, using economists' two favorite words--Say It With Me: Supply and Demand.

Feldstein on the Dollar II

In today's Wall Street Journal, my colleague Martin Feldstein continues his call for the dollar to weaken in foreign-exchange markets:

the primary reason for wanting the dollar to become more competitive in the near future is that we may need an improved trade balance over the next few years to sustain the economy's expansion. Although forecasters generally believe that the likely outlook for the economy in 2006 and 2007 is a continuation of solid economic growth, there is a serious risk that the combination of falling house values and an end to the low-interest incentive to refinance mortgages will cause consumer spending to decline relative to incomes. A sharp slowdown in consumer spending could cause an economic downturn.

What can take the place of the lower consumer spending to maintain overall aggregate demand? Business investment is unlikely to rise faster when sales to consumers are declining. Housing construction is already in decline. The key to maintaining aggregate demand, i.e., the key to our continued expansion if consumer spending slows, must be a shift in our trade balance -- increased exports, lower imports and more spending on goods and services produced in the U.S. For this, the dollar must decline to make U.S. goods and services more attractive.

Even if the dollar does decline during the coming months, the delays in the response of exports and imports to the more competitive dollar will mean that the increase in aggregate demand from this source may not happen for a year or more. That's why the U.S. needs to shift to a more competitive dollar as soon as possible.

How Not to Respond to High Gas Prices

Reuters reports:

Senate Republicans unveiled a proposal on Thursday to soften the blow of rapidly rising gasoline prices by giving taxpayers a $100 check and suspending a retail fuel tax....The proposal was similar to a Democratic measure first proposed by Senate Minority Leader Harry Reid of Nevada.

One might be tempted to applaud this sudden rush of bipartisanship. But let's first consider the economics of the proposal. I can see four drawbacks.

1. The economy is at or near full employment, and the Fed is raising interest rates to prevent the economy from overheating. Any stimulus to consumer spending would likely cause the Fed to increase interest rates to higher levels than it otherwise would have. The end result would be more consumption and less investment.

2. A lump-sum tax rebate has no supply-side incentive effects. Indeed, the history of such proposals is that the payments often phase-out as income rises. If so, this would be an increase in the effective marginal tax rate, which has adverse supply-side effects.

3. The federal budget is already on an unsustainable path. From the standpoint of the government budget constraint, this is a step in the wrong direction.

4. If gasoline taxes are suspended whenever prices go up, then consumers are partly insulated from price increases, making the effective demand curve for oil products less elastic. To the extent that prices are set by a supplier with market power (OPEC), a less elastic demand curve means higher prices.

Fortunately, the Senate proposal is a bit better than it might at first appear because

To pay for the lost revenues, [Senator] Thune said, the legislation "would suspend a number of tax credits and royalty waivers received by oil corporations."

I don't know enough of the details to say whether these "tax credit and royalty waivers" should be suspended. But it seems that these policies should be judged on their own merits. The evaluation of these provisions need not be coupled with a lump-sum tax rebate and lower gasoline taxes, which are hard to defend on economic grounds.

Related link: Economist Jim Hamilton discusses President Bush's proposals to deal with higher gasoline prices.

I'm with Arnold

Arnold Kling, that is, who writes:

The problem is that Social Security and Medicare payments are on course to rise to unprecedented levels as a percent of GDP....The solution, as I have argued for several years, is to raise the age of government dependency for workers now in their 30's and 40's. This is a painless solution, because (a) it does not affect anyone who currently receives or is counting on government entitlements and (b) it does not really affect people now in their 30's and 40's.

For people in their 30's and 40's today, the age of government dependency is only a promise. As of now, projected entitlement benefits to young workers are only promises that, under conservative assumptions, the government will be unable to meet.

Rich Dad, Poor Dad

Yesterday's Washington Post contained a story about the intergenerational transmission of inequality. It began as follows:

Rags-to-riches dream an illusion: study
By Alister Bull

WASHINGTON (Reuters) - America may still think of itself as the land of opportunity, but the chances of living a rags-to-riches life are a lot lower than elsewhere in the world, according to a new study published on Wednesday.

The likelihood that a child born into a poor family will make it into the top five percent is just one percent, according to "Understanding Mobility in America," a study by economist Tom Hertz from American University. By contrast, a child born rich had a 22 percent chance of being rich as an adult, he said.

"In other words, the chances of getting rich are about 20 times higher if you are born rich than if you are born in a low-income family," he told an audience at the Center for American Progress, a liberal think-tank sponsoring the work.

He also found the United States had one of the lowest levels of inter-generational mobility in the wealthy world, on a par with Britain but way behind most of Europe.

"Consider a rich and poor family in the United States and a similar pair of families in Denmark, and ask how much of the difference in the parents' incomes would be transmitted, on average, to their grandchildren," Hertz said.

"In the United States this would be 22 percent; in Denmark it would be two percent," he said

I am struck by how much "spin" there is here. The last number on the U.S. economy (22 percent) is consistent with other things I have seen, but one can just as easily put the point in a different light:

How much does income inequality persist from generation to generation? After two generations, 78 percent of the benefit of being born into a wealthy family has dissipated.

I think many people would find this to be a surprisingly small degree of persistence.

(I don't know much about Denmark, other than that it is a society with a lot less inequality than the United States. Here is a conjecture: Persistence of inequality is lower in nations where there is less inequality. I am guessing that it is easier to make it from the bottom to the top of the income distribution when it is a smaller jump.)

One might ask why being born into a high-income family means you will likely have higher income. Is it the good genes that you inherited from your successful parents or the nice neighborhood and expensive private schools that their high income could purchase for you? Is it nature or nurture?

The evidence suggests that nature trumps nurture. In a fascinating paper, Dartmouth economist Bruce Sacerdote asks "What happens when we randomly assign children to families?" He examines a data set in which adopted children were, literally, assigned randomly--a great natural experiment for studying these issues. He reports:

Having a college educated mother increases an adoptee's probability of graduating from college by 7 percentage points, but raises a biological child's probability of graduating from college by 26 percentage points. In contrast, transmission of drinking and smoking behavior from parents to children is as strong for adoptees as for non-adoptees. For height, obesity, and income, transmission coefficients are significantly higher for non-adoptees than for adoptees.

Sacerdote suggests that income is like height. Having a tall father means you are likely to be tall, but it is because he has given you the tall gene, not because he has created an environment that fosters height. The same appears to be true for income. Sacerdote's Table 3 shows that although there is a positive correlation between the incomes of parents and their biological children, the positive correlation disappears when we examine the incomes of parents and their randomly-assigned adopted children.

Alesina on Italy

My friend and colleague Alberto Alesina opines about his homeland's economy:

In Denmark, it takes two days to open a new business; in Italy, two months. Alberto Alesina, the Nathaniel Ropes Professor of Political Economy, mentioned this fact to emphasize the economic reforms that Italy's new prime minister, Romano Prodi, must bring about if he hopes to change Italy's current status as "the sick man of Europe."...

"Italy has very serious economic problems," Alesina said. "It needs an injection of free-market, liberal, economic reforms." Among the reforms he recommended were reducing the high income tax rate, cutting back on bloated public employment and the overly generous pension system, enhancing the service sector, and making it easier to fire workers.

A Comeback for Pigou?

In the past few days, I have run across a couple of articles (here and here), admittedly in relatively minor places, arguing for higher Pigovian taxes, such as a tax on gasoline or a tax on carbon. As all ec 10 students know, Pigovian taxes both produce government revenue and correct a market failure arising from an externality like pollution. I have long thought that Pigovian taxes are underused.

How about this for a political compromise?

The Democrats say they want more environmental protection. The Republicans say they want to make permanent the recent cuts in income, dividend, and estate taxes. Everyone says they want a smaller budget deficit. We can achieve all of these objectives by agreeing to higher Pigovian taxes, such as taxes on gasoline or carbon. The Republicans concede that government revenue will be higher than it is under the President's proposed budget, and the Democrats concede that the President's tax cuts on income, dividends, and estates will be permanent.

Please don't post a comment saying how politically naive this is. I know it is. But I bet I could convince a majority of the American Economic Association to sign on!

The Many Facets of Macro

In the previous post, a student in ec 10 expressed puzzlement about how to fit the pieces of macroeconomics together. One way to try to fit the pieces together is to look at the big, complicated macro picture all at once. What follows is an excerpt from my intermediate macro book that tries to do this.

Warning: This material is more mathematical than other things I post on this blog. Proceed at your own risk!

Appendix to Chapter 13:
A Big, Comprehensive Model

In the previous chapters, we have seen many models of how the economy works. When learning these models, it can be hard to see how they are related. Now that we have finished developing the model of aggregate demand and aggregate supply, this is a good time to look back at what we have learned. This appendix sketches a large model that incorporates much of the theory we have already seen, including the classical theory presented in Part Two and the business cycle theory presented in Part Four. The notation and equations should be familiar from previous chapters.

The model has seven equations:

Y = C(Y-T) +I(r) + G + NX(ε), Goods Market Equilibrium

M/P = L(i, Y), Money Market Equilibrium

NX(ε) = CF(r-r*), Foreign Exchange Market Equilibrium

i= r+πe, Relationship between Real and Nominal Interest Rates

ε=eP/P*, Relationship between Real and Nominal Exchange Rates

Y = Yn + α(P - Pe), Aggregate Supply

Yn = F(K, L), Natural Level of Output

These seven equations determine the equilibrium values of seven endogenous variables: output Y, the natural level of output Yn, the real interest rate r, the nominal interest rate i, the real exchange rate ε, the nominal exchange rate e, and the price level P.

There are many exogenous variables that influence these endogenous variables. They include the money supply M, government purchases G, taxes T, the capital stock K, the labor force L, the world price level P*, and the world real interest rate r*. In addition, there are two expectation variables: the expectation of future inflation πe and the expectation of the current price level formed in the past Pe. As written, the model takes these expectations as exogenous, although additional equations could be added to make them endogenous.

Although mathematical techniques are available to analyze this seven-equation model, they are beyond the scope of this book. But this large model is still useful, because we can use it to see how the smaller models we have examined are related to one another. In particular, many of the models we have been studying are special cases of this large model. Let's consider six special cases.

Special Case 1: The Classical Closed Economy Suppose that Pe = P, L(i, Y) = (1/V)Y, and CF(r-r*) = 0. In words, this means that expectations of the price level adjust so that expectations are correct, that money demand is proportional to income, and that there are no international capital flows. In this case, output is always at its natural level, the real interest rate adjusts to equilibrate the goods market, the price level moves parallel with the money supply, and the nominal interest rate adjusts one-for-one with expected inflation. This special case corresponds to the economy analyzed in Chapters 3 and 4.

Special Case 2: The Classical Small Open Economy Suppose that Pe = P, L(i, Y) = (1/V)Y, and CF(r-r*) is infinitely elastic. Now we are examining the special case when international capital flows respond greatly to any differences between the domestic and world interest rates. This means that r = r* and that the trade balance NX equals the difference between saving and investment at the world interest rate. This special case corresponds to the economy analyzed in Chapter 5.

Special Case 3: The Basic Model of Aggregate Demand and Aggregate Supply Suppose that α is infinite and L(i, Y) = (1/V)Y. In this case, the short-run aggregate supply curve is horizontal, and the aggregate demand curve is determined only by the quantity equation. This special case corresponds to the economy analyzed in Chapter 9.

Special Case 4: The IS-LM Model Suppose that α is infinite and CF(r-r*) = 0. In this case, the short-run aggregate supply curve is horizontal, and there are no international capital flows. For any given level of expected inflation πe, the level of income and interest rate must adjust to equilibrate the goods market and the money market. This special case corresponds to the economy analyzed in Chapters 10 and 11.

Special Case 5: The Mundell-Fleming Model with a Floating Exchange Rate Suppose that α is infinite and CF(r-r*) is infinitely elastic. In this case, the short-run aggregate supply curve is horizontal, and international capital flows are so great as to ensure that r=r*. The exchange rate floats freely to reach its equilibrium level. This special case corresponds to the first economy analyzed in Chapter 12.

Special Case 6: The Mundell-Fleming Model with a Fixed Exchange Rate Suppose that α is infinite, CF(r-r*) is infinitely elastic, and e is fixed. In this case, the short-run aggregate supply curve is horizontal, huge international capital flows ensure that r=r*, but the exchange rate is set by the central bank. The exchange rate is now an exogenous policy variable, but the money supply M is an endogenous variable that must adjust to ensure the exchange rate hits the fixed level. This special case corresponds to the second economy analyzed in Chapter 12.

You should now see the value in this big model. Even though the model is too large to be useful in developing an intuitive understanding of how the economy works, it shows that the different models we have been studying are closely related. Each model shows a different facet of the larger and more realistic model presented here. In each chapter, we made some simplifying assumptions to make the big model smaller and easier to understand. When thinking about the real world, it is important to keep the simplifying assumptions in mind and to draw on the insights learned in each of the chapters.

Micro versus Macro

An ec 10 student emails me:

I really enjoyed microeconomics, but have not enjoyed macroeconomics nearly as much. I feel like it's all thrown together haphazardly, with random connections being made without much justification being given for them.

One thing that particularly bothers me is the long term - short term distinction. In micro, the distinction made sense because when looking at firms one could focus on an individual firm and see over what time frame all costs were variable. In an economy as a whole, no such abstraction is even feasible for me.

Isn't the long term just a series of short term decisions? Don't central banks just decide each year what trade off they want to make on the phillips curve, and over the course of 20 years those 20 decisions will determine inflation and unemployment?

When I first studied economics as a freshman, I had a similar reaction. I liked micro a lot more than macro. Given this initial reaction, it may seem odd that I ended up a macroeconomist. Two things happened.

First, macro started to make more sense to me over time. The pieces started fitting together a bit better in my second course in macro (the intermediate course, which is ec 1010b and 1011b at Harvard). Because macro involves the whole economy at once, it is harder for introductory students to see immediately how the pieces fit together. But the more a person thinks about the issues, the clearer the overall picture becomes. I don't want to overstate things, however: Macro is less fully developed than micro. There is simply more we don't know, and so the field is intrinsically messier.

Second, even if the models of micro were more appealing to me, I became attracted to the questions of macro. When you read the newspaper, most of the big economic issues are macro issues, not micro issues. I know some microeconomists will take offense at this claim, but I think it is true. Consider: Economic growth, the business cycle, inflation, unemployment, fiscal policy, monetary policy, trade imbalances--these are things that laymen think economists should have insight into. And they are right: We should. I think this is what draws a lot of macroeconomists into the field.

On the other issue raised in the email: Isn't the long run simply the result of a series of short runs? Yes, that is true, but that is not always the most fruitful way to think about it.

Let me give you an analogy. Biological phenomena are simply the result of things happening at the level of subatomic particle physics, aggregated up. But that is not a particularly useful way to proceed if you are a biologist. Instead, biologists ignore particle physics (for the most part) and start with theories more directly useful for the things they want to study. Similarly, long-run economic models (such as growth theory) can ignore much of what is crucial for understanding short-run economic fluctuations (such as sticky prices and monetary nonneutrality).

Nonetheless, it would be nice if you could see one mega-model that incorporated both short-run and long-run forces. If you keep you studying macroeconomics, you will get there. (For a taste of more complete macro models, see my next post.)

An iTunes Puzzle

Economist Tyler Cowen poses a puzzle and explores some answers: Why are all songs the same price on iTunes?

On Just Deserts

Okay, Harvard students: As a group, you are smarter than average, more athletic than average, more musical than average, better looking than average, and taller than average. (I admit: I made some of that stuff up, but I bet it is all true.) You have a whole range of innate talents, which means, after you graduate, you will make more money than the average person. Do you deserve it?

Bryan Caplan (libertarian, econ prof, and blogger) says YES. He thinks people with more talent deserve the fruits of those talents.

By contrast, the standard approach to optimal taxation says NO. The same is true of Rawls’s approach to economic justice.

According to optimal tax theory, taxing income or consumption is a second-best solution. Those taxes distort incentives and cause deadweight losses. What we would really like to tax, the theory posits, is innate talent. We could then provide “social insurance” against the unfortunate outcome of being born with less talent in a way that does not distort incentives.

Behavioral geneticists tell us that a large fraction of the variation in life’s outcomes (50 percent or more) can be explained by the genes you have when you are born. Suppose that one day we could identify the high-IQ gene, the attractive symmetrical face gene, the tall gene, and so on. Optimal tax theory says that we should levy special taxes on the lucky people with those genes. After all, you don’t deserve the fruits of those genes.

Or do you? As an economist, rather than a moral philosopher, I have no idea about the answer.

U.S. Hegemony

Economic columnist Gerard Baker writes in today's Times of London that the United States will likely stay on top of the world economy:

In an era in which China embodies the hopes and fears of much of the developed world, the US, with a growth rate of half that of China’s, is adding roughly twice as much in absolute terms to global output as is the Middle Kingdom, with its GDP (depending on how you measure it) of between $2 trillion and $4 trillion....

The only real threat to American economic hegemony, I suspect, is the willingness of its people to continue to tolerate the pains associated with its success. Income and wealth inequalities have grown rapidly in the past ten years — even as the long-term growth rate has accelerated — and, given the continuing direction associated with globalisation, they may get even worse over the next 20 years.

That could tempt Americans to turn their backs on the very free markets that have been the foundations of their continuing prosperity.

Becker on Rising Inequality

Economist Gary Becker opines on the increase in economic inequality the United States has experienced over the past few decades:

Should not an increase in earnings inequality due primarily to higher rates of return on education and other skills be considered a favorable rather than unfavorable development? Higher rates of return on capital are a sign of greater productivity in the economy, and that inference is fully applicable to human capital as well as to physical capital. The initial impact of higher returns to human capital is wider inequality in earnings (just as the initial effect of higher returns on physical capital is widen income inequality), but that impact becomes more muted and may be reversed over time as young men and women invest more in their human capital.

I conclude that the forces raising earnings inequality in the United States is on the whole beneficial because they were reflected higher returns to investments in education and other human capital.

Not Sustainable

Blogger Angry Bear draws attention to a great chart put out by the White House. I suggest every member of Congress carry a copy in his or her pocket.

Update and clarification: The terms "mandatory" and "discretionary" can be confusing to those not schooled in the Washington budget process. "Mandatory spending" includes entitlement programs such as Social Security and Medicare, which are provided by law rather than through the annual appropriations process. "Discretionary spending," which includes defense, homeland security, farm subsidies, and education, are those types of spending that the president and Congress set through the annual appropriations process. Of course, all government spending can be changed through legislation, so no spending is really "mandatory."

Why Economists Love Wal-Mart

An article in yesterday's Pittsburgh Times-Review explains why economists have a more favorable view of Wal-Mart than, it seems, everyone else:

A larger complaint against Wal-Mart charges that the giant retailer comes in and wipes out main street, puts an end to all those mom-'n-pops that are selling everything from hammers to salmon.

The other side of the story is that salmon is no longer a high-end delicacy, beyond the reach of the average household. With fresh fillets selling for $4.50 a pound in Wal-Mart's display cases, the price for an 8-ounce dinner portion is 44 cents lower than the current price of a Cheeseburger Happy Meal at McDonald's.

The end result is better nutrition in America, especially among lower-income households, and less poverty and unemployment in Wal-Mart's primary supply regions in southern Chile.

Altogether, Wal-Mart's prices, according to a study by M.I.T. economist Jerry Hausman and USDA economist Ephraim Leibtag, are saving U.S. consumers more than $50 billion a year, money that's spent elsewhere, boosting volume at other businesses and creating new enterprises, including mom-'n-pops.

The net impact? The director of economic policy for the 2004 Kerry-Edwards campaign, New York University economist Jason Furman, contends that Wal-Mart is "a progressive success story." With Wal-Mart's prices ranging from 8 percent to 40 percent lower than people would pay elsewhere, states Furman, the increase in buying power that Wal-Mart delivers, disproportionately to lower-income families, more than offsets any impact that the company has allegedly produced in the earnings of retail workers.

By the way, Jason Furman was a former student of mine at Harvard. (We had some interesting dinner conversations while I was at the CEA and he was working to unseat my boss.) You can find Jason's study of Wal-Mart here.

Orrenius on Immigration

Pia Orrenius, a senior economist at the Federal Reserve Bank of Dallas, has an op-ed in today's Wall Street Journal. I was fortunate to have Pia on my staff at Council of Economic Advisers from 2004 to 2005, when she was the lead author of the chapter on immigration in the 2005 Economic Report of the President.

An excerpt from today's article:

The stereotype of the hard-working immigrant still rings true in our country. Male immigrants have labor force participation rates of 81%, exceeding U.S.-born men's participation rate of 72%. Illegal immigrant men have even higher participation rates -- around 94%....

Economists have noted time and again that the effect of immigration on natives' wages is small. In a study with Madeline Zavodny of Agnes Scott College, we found that during the mid- to late-1990s, immigration had a small negative impact on manual laborers' wages -- about 1% -- but did not adversely affect the wages of professionals or service workers....

Immigration's impact on wages has little relevance on the debate over how we deal with the 12 million illegals in this country -- because there has been virtually no interior enforcement of immigration laws, these immigrants have largely been incorporated into the labor force, and prices and wages have already responded to their presence. It is estimated that over half of the illegal immigrants are working "on the books," paying income and payroll taxes. Bringing the rest of them into compliance will actually raise the cost of employing them. This aspect of legalization should even the playing field and help, not hurt, native-born workers.

You can read an interview with Pia here.

Will the U.S. Trade Deficit End Badly?

In today's NY Times, Paul Krugman renews his prediction that we are heading for a crisis:

the answer to the question, "Why haven't we paid a price for our trade deficit?" is, just you wait.

On the other hand, in a new NBER working paper, Sebastian Edwards says that this outcome, while possible, is unlikely:

In this paper I use a large multi-country data set to analyze the determinants of abrupt and large “current account reversals.” The results from a variance-component probit model indicate that the probability of experiencing a major current account reversal is positively affected by larger current account deficits, lower prices of exports relative to imports, and expansive monetary policies. On the other hand, this probability is lower for more advanced countries, and for countries with flexible exchange rates. An analysis of the marginal effects of current account deficits and of the predicted probability of reversal indicates that both have increased significantly for the U.S. since 1999. However, the level of this probability is still on the low side. I estimate that the predicted probability of a current account reversal in the U.S. has increased from 1.7% in 1999, to 14.9% in 2006.

Update and clarification: The "current account" is a broad measure of the trade balance. Click here for details on the definition.

Okun's Big Tradeoff

An op-ed today by pollster Peter Brown reminds us that Arthur Okun was right: the "big tradeoff" is between equality and efficiency:

In case you haven't noticed, a number of countries --China, Russia, India, much of the rest of Asia and Eastern Europe -- that used to be more focused on the idea of making sure everyone is treated the same have changed their tune.

They haven't fallen in love with inequality, but have come to realize that in the real world, incentives spur productivity, which creates wealth that is shared unevenly. The alternative is equality in poverty, or at least in a lower standard of living.

Welcome to economics 101.

The Optimal Use of Economists' Time

I received this email over the weekend:

Hi Professor Mankiw,

I am from Ireland and have an economics degree. We had to study your economics books 'Principles of Economics' and the intermediate level 'Macroeconomics' throughout the course, and I found them not only very insightful, but also incredibly well written. I have been reading your blog a lot as well, and find it equally well written.

At the moment I think that there is a dearth of 'popular' economics books, the exception being Tim Harford's 'Undercover Economist'. Popular books are endlessly written on science (which has entire sections of bookshops devoted to it) politics, philosophy etc, but almost none on popular economics. This is, in my opinion, a serious problem as there is a considerable degree of economic illiteracy among non-economics graduates. I put the question 'why is ireland rich and africa poor?' to many of my friends recently, who study law, science and even business (but not economics), and their response was depressing. The main answer was that Africa was 'dominated by western multinational companies', with variations on it being that ireland stole goods from the third world or conducted 'unfair' trading practices, to the alarming 'ireland is rich because it has a minimum wage'.

In light of this I think that you should write a popular economics textbook. The first lesson in opportunity cost I had was from Ben Bernanke's own 'Principles of Economics' where he asked the question (p 50) 'should Greg Mankiw mow his own lawn?'. He pointed out that even though you could mow the lawn quicker than someone you might hire to do so, that it still did not pay to do it, as in that time you could be writing an economics textbook and making millions. I think you should apply that logic to writing a popular economics book - you could make millions. Also, as an economist, you can exploit a 'gap' in the market, and as Tim Harford has shown, there is demand for it.

Think about it, in the time it has taken to read this email (if you have, of course) you could be writing a popular economics book, each extra minute costs you money. What are you waiting for? You would not only make a lot of money, but you would do the world a favour. The positive externalities resulting from its publication, showing people how the world really works, or, as Harford puts it showing 'why poor countries are poor' would be enormous. Write write write!

Sincerely,
[name withheld]

PS If you do write it, try and organise it to be dropped on France, for free, and in large quantities. You would be doing Europe, and in particular my own country (whom France is repeatedly trying to bring into line with the nightmare 'European Social Model' through the EU, regarding us as a neoliberal trojan horse), a favour.

The email alludes to a pervasive phenomenon: A relatively small percentage of professional economists' time is devoted to educating the broad public. (I am not counting educating students in the classroom or through textbooks). Occassionally, there are some big hits, such as Freakonomics, but they are few and far between, and even Freakonomics emphasized off-beat facts rather than economic fundamentals.

Most top economists spend most of their time writing for each other rather than for non-specialists. Having spent much of my time writing for those obscure scholarly journals, I won't be too hard on the activity. However, I have often wondered whether our profession has misallocated resources, given the pervasiveness of economic ignorance.

I am always delighted when good young economists (such as Alan Krueger, Tyler Cowen, and Austan Goolsbee) venture outside the Ivory Tower to write for broader audiences. They are following in the footsteps of some great economists before them: Paul Samuelson and Milton Friedman, for example, wrote for Newsweek for many years. I remember reading those columns when I was a student. They certainly helped inspire me to enter the field.

I tried my hand as a columnist for Fortune magazine some years ago. You can find my old columns here. Maybe I will try a book for the general public at some point. Right now, this blog is scratching that itch.

Why don't we see more economists writing for broad audiences? The answer is that economists, like other people, respond to incentives. The email writer is wrong: Economists writing this kind of thing don't "make millions." Freakonomics may be the only exception in my lifetime. Moreover, writing for the general public is not rewarded very much by university deans and hiring committees, who are more interested in articles in scholarly journals than in op-eds in the Wall Street Journal or books on the New York Times bestsellers list.

Perhaps it would be good if the economics profession rewarded this kind of activity more highly. As Oliver Wendell Holmes once said, “It seems to me that at this time we need education in the obvious more than the investigation of the obscure.”

The Minimum Wage Debate

A student calls to my attention a recent release from Senator Hillary Clinton's office, which says "Senator Clinton is a strong advocate of increasing the minimum wage." It also says "she will introduce legislation when Congress returns to link Congressional pay increases to increases in the federal minimum wage."

It looks like the minimum wage is shaping up to be an issue in the 2008 Presidential election.

To read conventional analyses of the economics of minimum wages, click here and here. For Steven Landsburg's always provocative take on things, click here.

Finally, I cannot resist offering an excerpt from my favorite textbook:

The minimum wage has its greatest impact on the market for teenage labor. The equilibrium wages of teenagers are low because teenagers are among the least skilled and least experienced members of the labor force. In addition, teenagers are often willing to accept a lower wage in exchange for on‑the‑job training. (Some teenagers are willing to work as "interns" for no pay at all. Because internships pay nothing, however, the minimum wage does not apply to them. If it did, these jobs might not exist.) As a result, the minimum wage is more often binding for teenagers than for other members of the labor force.

Many economists have studied how minimum-wage laws affect the teenage labor market. These researchers compare the changes in the minimum wage over time with the changes in teenage employment. Although there is some debate about how much the minimum wage affects employment, the typical study finds that a 10 percent increase in the minimum wage depresses teenage employment between 1 and 3 percent. In interpreting this estimate, note that a 10 percent increase in the minimum wage does not raise the average wage of teenagers by 10 percent. A change in the law does not directly affect those teenagers who are already paid well above the minimum, and enforcement of minimum-wage laws is not perfect. Thus, the estimated drop in employment of 1 to 3 percent is significant.

In addition to altering the quantity of labor demanded, the minimum wage also alters the quantity supplied. Because the minimum wage raises the wage that teenagers can earn, it increases the number of teenagers who choose to look for jobs. Studies have found that a higher minimum wage influences which teenagers are employed. When the minimum wage rises, some teenagers who are still attending school choose to drop out and take jobs. These new dropouts displace other teenagers who had already dropped out of school and who now become unemployed.

The minimum wage is a frequent topic of political debate. Advocates of the minimum wage view the policy as one way to raise the income of the working poor. They correctly point out that workers who earn the minimum wage can afford only a meager standard of living. In 2005, for instance, when the minimum wage was $5.15 per hour, two adults working 40 hours a week for every week of the year at minimum-wage jobs had a total annual income of only $21,424, which was less than half of the median family income. Many advocates of the minimum wage admit that it has some adverse effects, including unemployment, but they believe that these effects are small and that, all things considered, a higher minimum wage makes the poor better off.

Opponents of the minimum wage contend that it is not the best way to combat poverty. They note that a high minimum wage causes unemployment, encourages teenagers to drop out of school, and prevents some unskilled workers from getting the on-the-job training they need. Moreover, opponents of the minimum wage point out that the minimum wage is a poorly targeted policy. Not all minimum-wage workers are heads of households trying to help their families escape poverty. In fact, fewer than a third of minimum-wage earners are in families with incomes below the poverty line. Many are teenagers from middle‑class homes working at part-time jobs for extra spending money.

Moving to a Better Life

I remember once reading an economist (I think it was Milton Friedman) point out that World War II, as horrific as it was for so many families, may have actually had one benefit for subsequent generations: It induced many people to move to the United States, where opportunities were greater.

According to today's New York Times (alternate link), a similar phenomenon may be occurring with many victims of Katrina. A brief excerpt:

The exodus took low-income families to areas richer in opportunity....

Given the physics of race and class, there was reason to worry about where they would land. Three-quarters of flood-zone residents were black, and nearly 6 in 10 were living on less than $30,000 a year. Nationally, such families tend to be crowded together in areas long on crime, short on jobs and plagued by inferior schools.

That is not the story of Katrina evacuees. In both Atlanta and Houston, their neighborhoods look much like the region as a whole. Measured against where they had lived in New Orleans, most find that a big step up.

To examine relocation patterns, The Times counted evacuees at elementary schools in metropolitan Atlanta and Houston: 13,000 students at 1,100 schools. Using the schools as proxies for neighborhoods, The Times then analyzed the surrounding Census Bureau tracts.

In both cities, the average evacuee lives in a place extraordinary only for its ordinariness. Neighborhoods where evacuees settled have virtually identical levels of education, employment and homeownership as the surrounding metropolis.

Those areas do have somewhat greater concentrations of minority residents and single mothers, and slightly lower incomes. But they are no more prone to outright poverty.

"It looks a lot better than I would have guessed," said Myron Orfield, a law professor at the University of Minnesota who studies regional inequality. "I would have guessed that Katrina families would have been relocated in tracts much more disadvantaged and more segregated than the region as a whole."

Jesse Rothstein, a Princeton economist, agreed. "These are better neighborhoods than I would have expected," Mr. Rothstein said.

The real contrast for evacuees is with the neighborhoods they have left behind. In the flooded neighborhoods of New Orleans, annual household income was $27,000. In the average evacuee's tract in Atlanta, it is $52,000.

In New Orleans, 42 percent of the neighborhood children were poor. In evacuee tracts in Atlanta, the rate is 12 percent.

In New Orleans, about half the child-rearing families in the flood zones had fathers in their homes. In evacuee tracts in Atlanta, nearly three-quarters do.

"I love New Orleans, don't get me wrong," Ms. Marcell [an evacuee] said. "But I thank God we are in Atlanta."

Get Rid of the Penny!

Today's New York Times reports:

it costs the mint well more than a cent to make a penny.

The solution, in my view, is to get rid of the penny.

Indeed, I would advocate this even if the penny were free to manufacture, as I argued earlier this year in the Wall Street Journal. The purpose of the monetary system is to facilitate exchange. The penny no longer serves that purpose. When people start leaving a monetary unit at the cash register for the next customer, the unit is too small to be useful. It is just wasting peoples' time--the economy's most valuable resource. The fact that the penny is costly to make only adds force to the argument.

Maybe we should get rid of the nickel, too. We can then round all prices to one decimal rather than two.

Cathy on Personal Saving

An ec 10 student suggests that to increase saving, we may need more than rants from economists like me. Maybe it is time to bring in the big guns--the nation's comic strip writers.

Rajan on IMF Reform

With the world economy growing smartly, international financial crises are in short supply, giving the International Monetary Fund less to do. Yesterday's Wall Street Journal contains an intriguing idea:

the IMF's chief economist, Raghuram Rajan, is pushing to have the Fund offer a kind of "insurance" to developing countries. So long as their policies meet IMF standards they would be assured easier access to IMF funds in emergencies.

The idea is to fix the roof when the sun shines, rather than when it is raining.

But would this policy be time consistent? For it to work, the IMF would need to be harder on those nations whose policies did not meet IMF standards.

Ellis Island

I just spent the past two days on a field trip to Ellis Island with my older son Nicholas and his fifth-grade class. Immigration has long been a fifth-grade theme at his school, and this field trip is one of the highlights of their year.

It was a great trip. I highly recommend it, even if you don't have a fifth grader to take along. (I especially recommend the self-guided audio tour.) With the immigration issue so heated these days, it would be good if more Americans visited Ellis Island and reminded themselves that the issues today are similar to the issues that concerned people when their grandparents and great-grandparents arrived here.

Intellectual Property Protection Abroad

Today's Washington Post reports:

Once again, President Bush had a difficult time wresting concessions from Chinese President Hu Jintao....At each of those meetings, the list of U.S. trade demands has been the same: China must stop unfairly depressing the value of its currency to gain trade advantages; it must halt rampant copyright piracy that is costing American companies billions of dollars in lost sales; and it must open its markets wider to U.S. exports.

Of the three issues listed here, the most troubling one is copyright piracy. As I have noted previously, the currency issue is not as big a problem for the U.S. economy as is often suggested, and ultimately it is in China's interest to open their markets. (David Ricardo really had it right.) But it will be hard to get China to get serious about piracy.

Piracy is a big deal for the U.S. economy. We have a comparative advantage in producing intellectual property (software, movies, economics textbooks), and it is a significant problem if other nations simply steal the fruits of those efforts. However, if a country is an importer of intellectual property, as China probably is, its self-interest is served by not cracking down on piracy. Why pay for something you can get for free?

Update: Economist Hal Varian writes to tell me that "in 1891, the U.S. was the world's biggest copyright pirate, for the same reason that is true of China today."

I am infuriatingly judicious

So says Justin Fox of Fortune.

The Next Financial Mess

The Washington Post draws attention to the looming problems at the Pension Benefit Guaranty Corporation (PBGC)--the government agency that back-stops private defined-benefit pension plans. Here is the essence of the issue:

Defined benefit pension plans should remind us of the character Wimpy in old Popeye cartoons, whose motto was, "I'll gladly pay you Tuesday for a hamburger today."

The defined benefit pension plan says, "I'll gladly pay you 40 years from Tuesday for a hamburger--namely your work--every day until then." What if, when the hamburgers are all eaten and the distant Tuesday finally arrives, the pension plan's assets don't cover the promised payments--and neither do the assets of the PBGC?

The answer may be that the taxpayer will be on the hook, at the same time other looming financial liabilities--Social Security and Medicare for baby-boomers--are coming due. The longer-term solution is to transition away from defined-benefit pension plans toward defined-contribution pension plans, as is in fact happening. But that does not solve the more immediate problem.

Notice the parallel between these problems with private defined-benefit pension plans and the problems with Social Security. Last year, in the New Republic, I wrote:

One problem with traditional Social Security is that liabilities are implicit and, therefore, easy to ignore. Politicians have found promising higher benefits too attractive, because the cost of those benefits has been too well-hidden. Indeed, the funding shortfalls now facing Social Security are like those many companies face with defined-benefit pension plans. Recognizing these problems, younger businesses are more likely to set up defined-contribution plans like Harvard's. A defined contribution system is more transparent--the worker knows what he is getting, and the employer knows what he is paying.

If every private company had a defined-contribution pension plan, we wouldn't be having PBGC problems. And if Social Security had been set up with a defined-contribution structure, we would not be facing funding shortfalls.

U.S.-China Economic Relations

China's president, Hu Jintao, is now visiting the United States, so many people are focused on economic relations between the two countries.

In an op-ed in today's Wall Street Journal, Stanford economist Ronald McKinnon addresses the topic. He says we should stop worrying about the exchange rate between the Chinese yuan and the U.S. dollar. (For previous posts on this topic, click here and here.) McKinnon then suggests that, instead, we should worry about saving rates in the two countries:

[P]ersistent trade surpluses in China and trade deficits in the U.S. reflect very high saving in China and unusually low saving the U.S....China needs to increase private consumption in order to reduce its saving glut....But the U.S. needs to drastically rein in the federal budget deficit in order to reduce the national saving deficiency.

The positive economics that links saving and the trade imbalances should be familiar to every student in ec 10. It follows from that important but often neglected accounting identity: NX = S-I.

The normative economics, however, is not obvious. I am sympathetic to the view that the United States should want to increase national saving, as I noted here. But the case for lower national saving in China is less clear, especially from an American perspective.

From a Chinese perspective, one can argue that China should save less and consume more in order to alleviate current poverty, even at the expense of future generations. But should Americans care if the Chinese save a lot? Sure, the likely outcome is that some of that Chinese saving will flow into the U.S. economy, financing investment here, which in turn means a U.S. trade deficit. But so what? If China saved less, interest rates would be higher around the world, including in the United States, and investment would be lower. How would that benefit us?

It may be easier to think about the issue in personal terms. If I am not saving enough for my retirement, that is a problem for me. If my neighbor is saving too much for his retirement, then he should think about taking a nicer vacation or buying a new car. But is it a problem for me if my neighbor saves too much? I don't think so.

So, if high saving in China is a problem, it is a Chinese problem, not an American problem.

Neuro-economics

In his fall lecture in ec 10, David Laibson introduced us to neuro-economics, the new area of study that merges economics and brain science. In today's NY Times, economist Tyler Cowen has an article on the topic on the third page of the Business Section. It is well worth reading.

Summer Reading

I have read quite a few reviews of the new book "The Undercover Economist: Exposing Why the Rich Are Rich, the Poor Are Poor--and Why You Can Never Buy a Decent Used Car!" by Tim Harford. Almost all of them have been positive. For recent examples, click here, here, and here. The last review says:

I take my hat off to Harford for producing 288 pages of lucid prose aimed at convincing a general reader that economics is more useful — and certainly more interesting — than he or she might have thought.

Advice to my students: If you find yourself missing ec 10 this summer, this book might be good beach reading. (See this post for two other suggestions.)

Price Gouging

Yesterday President Bush said his administration will "investigate possible price-gouging" in the gasoline market, leading my libertarian friend Jeff Miron to object.

Many economists cringe when they hear politicians talk about price-gouging. To economists, the price system is central to how market economies allocate resources. Sometimes prices need to rise to balance supply and demand, even if that outcome is politically unpopular. Talk of price gouging raises the specter of price controls, which in the 1970s led to widespread shortages and long lines at gas stations.

In the fall, I participated in a debate about price gouging with political philosopher Michael Sandel in his Justice class at Harvard, where I took the standard economist's position. For a good summary and defense of that view, see this article by journalist John Stossel.

A more charitable interpretation of the President's statement is that the government will be on the look-out for collusion among suppliers to restrict supply and raise prices. Such price fixing would be a violation of the antitrust laws. Even Miron admits that prosecuting price fixers is a reasonable governmental function.

Outsourcing as Urban Myth

Remember when worry about outsourcing was all the rage? Remember when John Kerry was ripping George Bush over his alleged insensitivity to American workers? Remember when that Bush economic adviser got into hot water with some members of Congress for saying that outsourcing was "the latest manifestation of the gains from trade that economists have talked about at least since Adam Smith?" Whatever happened to that guy?

In today's New York Times, David Leonhardt (one of my favorite business and economics reporters) writes that some of the scare stories were, well, just stories:

A FEW years ago, stories about a scary new kind of outsourcing began making the rounds. Apparently, hospitals were starting to send their radiology work to India, where doctors who make far less than American radiologists do were reading X-rays, M.R.I.'s and CT scans.

It quickly became a signature example of how globalization was moving up the food chain, threatening not just factory and call center workers but the so-called knowledge workers who were supposed to be immune....

But up in Boston, Frank Levy, an economist at the Massachusetts Institute of Technology, realized that he still had not heard or read much about actual Indian radiologists. Like the once elusive Snuffleupagus of Sesame Street, they were much discussed but rarely seen. So Mr. Levy began looking. He teamed up with two other M.I.T. researchers, Ari Goelman and Kyoung-Hee Yu, and they dug into the global radiology business.

In the end, they were able to find exactly one company in India that was reading images from American patients. It employs three radiologists. There may be other such radiologists scattered around India, but Mr. Levy says, "I think 20 is an overestimate."

A good reminder that, in the public discourse, anecdotes can sometimes overtake the facts.

Time Inconsistency

My previous post mentioned the time inconsistency literature that began with Kydland and Prescott's Nobel-prize winning work. We haven't addressed this topic in ec 10 yet; I plan to talk about it in lecture in a couple of weeks. In the meantime, here is a primer, lovingly ripped off from my intermediate macroeconomics text.

The Time Inconsistency of Discretionary Policy

If we assume that we can trust our policymakers, discretion at first glance appears superior to a fixed policy rule. Discretionary policy is, by its nature, flexible. As long as policymakers are intelligent and benevolent, there might appear to be little reason to deny them flexibility in responding to changing conditions.

Yet a case for rules over discretion arises from the problem of time inconsistency of policy. In some situations policymakers may want to announce in advance the policy they will follow to influence the expectations of private decisionmakers. But later, after the private decisionmakers have acted on the basis of their expectations, these policymakers may be tempted to renege on their announcement. Understanding that policymakers may be inconsistent over time, private decisionmakers are led to distrust policy announcements. In this situation, to make their announcements credible, policymakers may want to make a commitment to a fixed policy rule.

Time inconsistency is illustrated most simply in a political rather than an economic example‑‑specifically, public policy about negotiating with terrorists over the release of hostages. The announced policy of many nations is that they will not negotiate over hostages. Such an announcement is intended to deter terrorists: if there is nothing to be gained from kidnapping hostages, rational terrorists won't kidnap any. In other words, the purpose of the announcement is to influence the expectations of terrorists and thereby their behavior.

But, in fact, unless the policymakers are credibly committed to the policy, the announcement has little effect. Terrorists know that once hostages are taken, policymakers face an overwhelming temptation to make some concession to obtain the hostages' release. The only way to deter rational terrorists is to take away the discretion of policymakers and commit them to a rule of never negotiating. If policymakers were truly unable to make concessions, the incentive for terrorists to take hostages would be largely eliminated.

The same problem arises less dramatically in the conduct of monetary policy. Consider the dilemma of a Federal Reserve that cares about both inflation and unemployment. According to the Phillips curve, the tradeoff between inflation and unemployment depends on expected inflation. The Fed would prefer everyone to expect low inflation so that it will face a favorable tradeoff. To reduce expected inflation, the Fed might announce that low inflation is the paramount goal of monetary policy.

But an announcement of a policy of low inflation is by itself not credible. Once households and firms have formed their expectations of inflation and set wages and prices accordingly, the Fed has an incentive to renege on its announcement and implement expansionary monetary policy to reduce unemployment. People understand the Fed's incentive to renege and therefore do not believe the announcement in the first place. Just as a president facing a hostage crisis is sorely tempted to negotiate their release, a Federal Reserve with discretion is sorely tempted to inflate in order to reduce unemployment. And just as terrorists discount announced policies of never negotiating, households and firms discount announced policies of low inflation.

The surprising outcome of this analysis is that policymakers can sometimes better achieve their goals by having their discretion taken away from them. In the case of rational terrorists, fewer hostages will be taken and killed if policymakers are committed to following the seemingly harsh rule of refusing to negotiate for hostages' freedom. In the case of monetary policy, there will be lower inflation without higher unemployment if the Fed is committed to a policy of zero inflation. (This conclusion about monetary policy is modeled more explicitly in the appendix to this chapter.)

The time inconsistency of policy arises in many other contexts. Here are some examples:

• To encourage investment, the government announces that it will not tax income from capital. But after factories have been built, the government is tempted to renege on its promise to raise more tax revenue from them.
• To encourage research, the government announces that it will give a temporary monopoly to companies that discover new drugs. But after a drug has been discovered, the government is tempted to revoke the patent or to regulate the price to make the drug more affordable.
• To encourage good behavior, a parent announces that he or she will punish a child whenever the child breaks a rule. But after the child has misbehaved, the parent is tempted to forgive the transgression, because punishment is unpleasant for the parent as well as for the child.
• To encourage you to work hard, your professor announces that this course will end with an exam. But after you have studied and learned all the material, the professor is tempted to cancel the exam so that he or she won't have to grade it.

In each case, rational agents understand the incentive for the policymaker to renege, and this expectation affects their behavior. And in each case, the solution is to take away the policymaker's discretion with a credible commitment to a fixed policy rule.

---

PS to ec 10 students: There really, really is a test today. I will avoid temptation. I promise.

Taylor on the IMF

Stanford economist John Taylor has an article in today's Wall Street Journal about the International Monetary Fund. Although some are concerned that "the IMF is in eclipse, " Taylor argues that policymakers need not be worried about "the recent sharp decline in IMF loans outstanding." Why? Here is his bottom line:

The IMF has intervened in fewer crises in part because there are fewer crises to intervene in. And there have been fewer crises in part because of the expectation that the IMF will intervene less: Anticipating fewer large-scale loans from the IMF, countries have built up reserves and greatly improved monetary and fiscal policies.

John seems to be suggesting that the IMF is moving toward a policy rule under which it resists country bail-outs. A credible IMF commitment to this policy rule improves countries' decisions, which in turn means we have fewer crises in the first place. In short, he is viewing IMF policy through the lens of Kydland and Prescott's work on time inconsistency. (My next post gives a brief overview of this topic.)

Maybe this is right. Or maybe we have just been lucky. The real test of the Taylor hypothesis will come when a crisis does occur somewhere. Then we can see whether the IMF is in fact more resistant to bail-outs than it was during what John calls "the bad old days." (John is not completely clear what he means by this phrase, but it seems to refer to the Mexican and Asian IMF programs during the 1990s, orchestrated by Rubin, Summers, et al.)

Is Social Security Income Risky?

In ec 10 this spring, Marty Feldstein talked about proposals to incorporate personal accounts into Social Security. Critics of such proposals say they put too much risk onto retirees.

A new paper by John Shoven and Sita Slavov, however, points out that our current Social Security system is far from risk-free:

Pay-as-you-go Social Security is typically characterized as a universal defined benefit pension program. Implicit in this characterization is a sense that the participant’s investment in future benefits is somehow guaranteed, or safe from risk. This study develops the concept of “political risk” as the possibility that some future legislature will be forced to change the tax and benefit provisions of pay-as-you-go social security programs, when there are changes in the demographic and macroeconomic variables that support it. Thus there is a “political risk” to participants that might be compared to the “market risk” in a personal accounts retirement scheme....The debate over personal accounts, therefore, is not one of “safe” versus “risky” benefits, but one of portfolio choice.

I emphasized a similar theme in an article in the New Republic last year.

Interview with Ken Rogoff

My colleague Ken Rogoff gives an interview with the German publication Spiegel.

According to the inset, Rogoff "describes himself as a 'Schwarzenegger Republican.'" I am not quite sure what that means. Two quotations from the interview may give a clue:

This unbridled capitalism in the United States can't be sustained socially. It leads to tensions. If we experience another five years like the last five, we will start seeing greater social friction....

I can't understand why we should get rid of the inheritance tax. It hasn't harmed the economy, and it has evened out the distribution of income across generations.

For my view on the estate tax, follow this link.

Borjas on Immigration

In today's Wall Street Journal, economist George Borjas (professor at Harvard's Kennedy School) has an article that discusses research on how immigration affects wages. His bottom line:

My Harvard colleague Lawrence Katz and I recently examined the impact of the 1980-2000 immigrant influx (and particularly Mexican-origin immigration) for U.S. wages. The results are that, in the short run -- holding all other things equal -- immigration lowered the wage of native workers, particularly of those workers with the least education. The wage fell by 3% for the average worker and by 8% for high school dropouts.

The "all other things equal" assumption is not sensible from a long-run perspective. Over time, employers will certainly make capital investments to take advantage of the cheaper labor. This adjustment implies that, in the long run, the average worker is not affected by immigration, but the wage of high school dropouts still fell by 5%....This does not imply that immigration is a net loss for the economy. After all, the wage losses suffered by workers show up as higher profits to employers and, eventually, as lower prices to consumers. Immigration policy is just another redistribution program. In the short run, it transfers wealth from one group (workers) to another (employers). Whether or not such transfers are desirable is one of the central questions in the immigration debate.

---

Update: Economist-blogger Arnold Kling objects to the Borjas analysis:

I am angry any time an economist misleadingly describes trade as a "redistribution program." At that point, you forfeit your identity as an economist and instead become a demagogue.

Sweatshop Protests at Berkeley

An article in the San Francisco Chronicle reports that, last week, "Eighteen students demanding that University of California-logo apparel not be produced in 'sweatshops' were arrested at a sit-in at the UC Berkeley chancellor's office Tuesday afternoon."

Apparently, the students had not read this classic article by Nicholas Kristof and Sheryl Wudunn, which we read in ec 10 last semester. In case some of those students are reading this blog, here is an excerpt:

Asian workers would be aghast at the idea of American consumers boycotting certain toys or clothing in protest. The simplest way to help the poorest Asians would be to buy more from sweatshops, not less....

For all the misery they can engender, sweatshops at least offer a precarious escape from the poverty that is the developing world's greatest problem. Over the past 50 years, countries like India resisted foreign exploitation, while countries that started at a similar economic level -- like Taiwan and South Korea -- accepted sweatshops as the price of development. Today there can be no doubt about which approach worked better. Taiwan and South Korea are modern countries with low rates of infant mortality and high levels of education; in contrast, every year 3.1 million Indian children die before the age of 5, mostly from diseases of poverty like diarrhea.

The Economist as Art Lover

If you are a student interested in the arts, you probably don't turn to your economics professor to deepen your appreciation. For most of us econ profs, the arts are not our comparative advantage. Economist Tyler Cowen, however, is an exception.

Here is an excerpt from his new book, Good and Plenty: The Creative Successes of American Arts Funding:

Many of my conservative and libertarian friends find government funding for the arts unacceptable. They note that after the so-called "Gingrich revolution" of 1994, "we were not even able to get rid of the NEA." They speak of the NEA (National Endowment for the Arts) as the lowest of lows, the one government program that has no justification whatsoever. If such an obvious basket case could survive a conservative Republican Congress, how we can ever hope to rein in government spending?

Most of my arts friends take the contrary political position. They assume that any art lover will favor higher levels of direct government funding. To oversimplify a bit, their basic attitude is that the arts are good, and therefore government funding for the arts is good. They find it difficult to understand how an individual can appreciate the arts without favoring greater public-sector involvement. They lament how American artists are underfunded and undervalued by the state, relative to their western European counterparts....

I write with one foot in the art-lover camp and with another foot in the libertarian economist camp. I try to make each position intelligible, and perhaps even sympathetic (if not convincing), to the other side. I try to show how the other side might believe what it does, and how close the two views might be brought together. Furthermore, I use the fact of persistent disagreement as a kind of datum, as a clue for discovering what the issues are really about.

Follow this link to read more.

Hubbard on the Fiscal Future

Economist Glenn Hubbard (who preceded me as CEA chair and is now back at Columbia) has an op-ed in today's Wall Street Journal. He reminds us that unless we see significant entitlement reform, taxes are heading higher:

Imagine the nightmare of a tax burden 50% higher -- not so farfetched as it sounds....The Congressional Budget Office regularly quantifies these shadows of the Ghost of Tax Day Future. Their forecasts are not sanguine. A generation from now, absent any changes, increases in Social Security and Medicare spending alone are projected to consume 10 more percentage points of national GDP than they do today.

There is nothing very new here, but it is good to have Glenn saying it anyway. As George Orwell once said, "We have now sunk to a depth where the restatement of the obvious is the first duty of intelligent men."

AMT: Catalyst for Tax Reform?

There has been a rash of recent news stories about the alternative minimum tax, including one in Slate and one on the PBS Newshour. Over time, this tax is hitting more and more Americans, which is why the media are paying attention.

The AMT is an income tax system that runs parallel to the regular income tax, but with its own rules and tax rates. A taxpayer has to pay the maximum of the two computed tax liabilities. So if your regular income tax liability is too low, the AMT kicks in to make sure you don't get away with it.

If it sounds crazy to you for the government to have two parallel tax systems with the taxpayer paying the maximum of the two, you are not alone. I don't know any economist who thinks it makes sense to conduct policy in this way. (Challenge to budding economic theorists: Can you think of any set of assumptions under which two parallel tax systems like this is optimal? I know if you try hard, you can do it!)

There may be one small advantage to this situation: As more taxpayers hit up against the AMT, they may complain enough to force Congress to pay serious attention to fundamental tax reform. Last November, the President's Advisory Panel on Federal Tax Reform put forward a very sensible report describing two prototypes for reform. Either plan if enacted would be a large step forward toward a more rational tax policy.

The panel included two top-notch economists, Eddie Lazear from Stanford and Jim Poterba at MIT. Eddie is now chairman of the Council of Economic Advisers, the job I had for the two years I was away from Harvard working in Washington. Jim is a renowned specialist in public finance (who began his economics career about thirty years ago as a student in ec 10).

The Panel recommended repealing the AMT. By itself, repeal is very expensive. To make the reform revenue-neutral, the Panel also recommended broadening the base of the income tax by eliminating the deductibility of state and local taxes (as well as many other changes, such as cutting back on the mortgage interest deduction). There is a certain rough justice in this recommendation: The taxpayers in high-tax states would lose more from eliminating deductibility of state and local taxes, but they would gain more from repealing the AMT.

Will we see fundamental tax reform over the next few years? It is far from certain, but every news story about the AMT reminds me that there is reason for hope.

Question for ec 10 students: Should people living in high-tax states pay less in federal income taxes than other people with the same income living in low-tax states? Current law answers YES to this question, while the Panel answered NO. What do you think?

Equality versus Efficiency, Japanese-Style

In a wonderful little book written in 1975, economist Arthur Okun said the "big tradeoff" facing economic policymakers is between "equality and efficiency." An article in this Sunday's NY Times suggests that this is precisely the tradeoff with which Japan is now struggling. Here is how the article begins:

Revival in Japan Brings Widening of Economic Gap

Japan's economy, after more than a decade of fitful starts, is once again growing smartly. Instead of rejoicing, however, Japan is engaged in a nationwide bout of hand-wringing over increasing signs that the new economy is destroying one of the nation's most cherished accomplishments: egalitarianism.

Today, in a country whose view of itself was once captured in the slogan, "100 million, all-middle class society," catchphrases harshly sort people into "winners" and "losers," and describe Japan as a "society of widening disparities." Major daily newspapers are running series on the growing gap between rich and poor, with such titles as "Divided Japan" and "Light and Darkness."

The moment of reckoning has come as the man given credit for the economic revival, Prime Minister Junichiro Koizumi, prepares to retire in September after more than five years in office. Mr. Koizumi's Reaganesque policies of deregulation, privatization, spending cuts and tax breaks for the rich helped lift the national economy, but at a social cost that Japan's more 127 million residents are just beginning to grasp.

Thanks to a growing economy and rising corporate profits, companies hired several hundred thousand more young Japanese for the start of the fiscal year on April 1. The broad Topix stock index closed recently on a 14-year-high. Commercial land prices in the country's three biggest metropolitan areas rose for the first time in 15 years, and high-rise luxury apartment buildings have kept sprouting across Tokyo.

At the same time, the number of Japanese without any savings has doubled in the last five years, and the number receiving welfare payments or educational assistance have spiked by more than a third.

Economists Take On the Media

Economists have recently become interested in studying the media. For examples, click here, here, here, and here.

The most recent paper I have seen in this new literature is by Stefano DellaVigna and Ethan Kaplan. (DellaVigna got his PhD in economics at Harvard a few years ago.) Here is the abstract:

The Fox News Effect: Media Bias and Voting

Does media bias affect voting? We address this question by looking at the entry of Fox News in cable markets and its impact on voting. Between October 1996 and November 2000, the conservative Fox News Channel was introduced in the cable programming of 20 percent of US towns. Fox News availability in 2000 appears to be largely idiosyncratic. Using a data set of voting data for 9,256 towns, we investigate if Republicans gained vote share in towns where Fox News entered the cable market by the year 2000. We find a significant effect of the introduction of Fox News on the vote share in Presidential elections between 1996 and 2000. Republicans gain 0.4 to 0.7 percentage points in the towns which broadcast Fox News. The results are robust to town-level controls, district and county fixed effects, and alternative specifications. We also find a significant effect of Fox News on Senate vote share and on voter turnout. Our estimates imply that Fox News convinced 3 to 8 percent of its viewers to vote Republican. We interpret the results in light of a simple model of voter learning about media bias and about politician quality. The Fox News effect could be a temporary learning effect for rational voters, or a permanent effect for voters subject to non-rational persuasion.